Cash and Cash Equivalents; Transactions Affecting and Not Affecting Cash

Before a cash flow statement can be prepared, it must be clear what counts as 'cash' for the purpose of the statement, and which transactions actually change that cash.

Cash and cash equivalents. Under AS-3, the statement deals not with cash alone but with cash and cash equivalents:

• Cash comprises cash in hand and demand deposits with banks.
• Cash equivalents are short-term, highly liquid investments that are readily convertible into a known amount of cash and are subject to an insignificant risk of change in value — for example, treasury bills, or short-term marketable securities and deposits with a very short maturity (generally three months or less). Long-term investments and shares held for trading are not cash equivalents.

Transactions that affect cash. A transaction affects cash (and therefore appears in the cash flow statement) whenever it results in an actual inflow or outflow of cash or cash equivalents. Examples:

• Cash sales and collection from debtors (inflow).
• Cash purchases and payment to creditors (outflow).
• Purchase of machinery for cash (outflow); sale of a fixed asset for cash (inflow).
• Issue of shares or debentures for cash (inflow); repayment of a loan (outflow).
• Payment of cash expenses, tax and dividend (outflow).

Transactions that do NOT affect cash. Some transactions change the profit or the balance sheet but involve no movement of cash at all, and are therefore excluded (or adjusted out) when preparing the statement. Examples:

• Depreciation on fixed assets — a non-cash charge against profit; it is added back to net profit.
• Writing off goodwill, preliminary expenses or discount on issue of shares — non-cash charges, added back.
• A bonus issue of shares — reserves are merely converted into share capital; no cash moves.
• Purchase of a fixed asset by issuing shares or debentures — an asset is acquired without any cash outflow.
• Revaluation of assets and provision made (but not paid) — book entries with no cash effect.
• Conversion of debentures into shares — one liability is replaced by another, with no cash movement. …