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Cash flow accounting is the focus of the cash basis accounting method and the statement of cash flows. The statement of cash flows is part of the accrual accounting method, which does not accurately track cash movements through this method. Under the statement of cash flows, companies can prepare this information under the direct or indirect method. While both are acceptable, the direct method lists all receipts and payments coming from a company’s operations. The indirect method adjusts net income for items that are non-cash related under standard accounting rules.
The cash basis method recognizes business transactions only when cash changes hands. This system is more common in use when a company is small and does not report information to outside stakeholders. For example, a small business owner needs 200 yards of material to produce garments. He will record the purchase only when he pays for the material under this cash flow accounting system. If his supplier gives him 10 days to pay the bill, the business owner will record the purchase in his accounting ledger when he writes the supplier a check. The entry will record an increase inventory and reduce cash.
The same process works when selling the garments made from the material. When a customer pays the small business owner money for the shirt, the owner will record a debit to cash and credit to sales revenue, with both sides of the journal entry increasing these accounts. While simple and typically easy to use, this cash flow accounting process is often not allowed for larger organizations or publicly held companies. The reason for this is that the cash basis method creates an uneven historical record of financial transactions. Stakeholders are unable to accurately review the company’s financial stability and cannot make well-informed decisions.
For companies not using the standard cash flow accounting system, companies must prepare a statement of cash flows. This statement reconciles the recorded financial transactions to the actual cash movements in the company’s operations. Companies prefer the direct method, as information for this method is readily available. In the operating section of the statement, companies must total all receipts and deduct all cash expenses. Under the indirect method — which is preferred by most national accounting standards — the company will start with net income and add back all items that represent non-cash activities. When using this statement, companies using the accrual accounting method can show their transactions in a manner similar to the cash flow accounting method.
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