Introduction
The statement of cash flows is one of the most challenging financials to understand. Fortunately, you can learn this area with enough practice. I wanted to introduce one of the more common items of the statement of cash flows, which is fixed assets. You’ll see this on almost every business’ financials as you generally need assets to make your product, advertise, sell, and maintain your records. First, let’s refresh our brains on recording fixed assets on the income statement and balance sheet. Then, we will discuss the standard movements in the cash flows as a company’s assets go from initial purchase to final disposal. Let’s get started.
How does an asset reflect in the income statement?
When a property, plant, and equipment is purchased and placed into service, the item depreciates over time to reflect the cost to use the asset. The asset will fully depreciate, in a perfect world, when the company cannot physically (or virtually) use it anymore. However, it is more practical to establish a time period for that asset based on a company-wide classification system. The company records depreciation as an expense (debit) for each period. Then, they record a second entry in the balance sheet as accumulated depreciation (credit).
How does an asset reflect in the balance sheet?
A company records an initial asset purchase as a reduction in cash (or an increase in liabilities if not paid outright) and an increase in the said asset. Regardless of how the PP&E was acquired, there will be an initial credit (i.e., credit to liabilities to increase the amount owed or a credit to recognize the reduction of cash). On the debit side of the transaction, the company records the asset on their balance sheet (i.e., a debit to Property, Plant, and Equipment). By doing this, your books will balance. For future periods, that newly acquired asset will then depreciate to recognize the cost incurred (This was discussed in the section “How does an asset reflect in the income statement”).
How does an asset reflect in the statement of Cash Flows?
Now that we’ve had a refresher on recognizing newly purchased assets on the income statement and the balance sheet, we can see how the entries recorded within these two financial statements intertwine with the statement of cash flows. As a reminder, the statement of cash flows is simply a reconciliation of movements within the balance sheet and income statement accounts for items that do not have a cash impact (within operating activities) and those with a cash impact within the investing and financing activities. A typical comparative period is the beginning of the fiscal year to the current period-end. If we know what the entries are within the balance sheet and the income statement, we can then figure out which entries actually have a cash impact and which ones do not have a cash impact to prepare the statement of cash flows. Let’s first start with recognizing the asset in the first place from a cash flows perspective.
The initial recording of property plant and equipment
As we saw in the balance sheet refresher section, recording property, plant, and equipment first requires recognizing a new asset for the purchase price incurred. If there was no cash expenditure, then recording the statement of cash flows is easy for this new asset. There is no recognition because the company did not pay anything. Once the company pays cash for the investment, the purchase is an expenditure in the investing activities. The accounts payable also decreases if there are payment terms for the purchase. Let’s assume that the company paid cash. Then, they recognize the cash outflow in the investing activities for the amount purchased. Therefore, the initial debit recognition in the balance sheet is also the initial cash outflow within the investing section of the statement of cash flows.
The recording of depreciation in subsequent periods within the cash flow statement
After recognizing the expenditure as an investing activity, it is interesting to note that you acknowledge depreciation as a non-cash expense within the operating activities. Therefore, the initial cash outflow in investing will be slowly reverting to a cash-neutral balance, assuming everything else is equal. Let’s illustrate an example. If initially, you spent $100 on a new storage facility for your business, you would recognize that asset in the statement of cash flows as a cash expenditure in the investing activities. All else being equal, you now have a net cash outflow of $100. Currently, the expenditure has worked against you from a cash flow perspective. However, the operating cash flow from the asset then starts working in your favor by amortizing the initial expenditure. Over time, the equipment begins appreciating within the cash flow and gives you an “increase” in cash each period until the depreciation fully reaches the $100 you initially spent. I intentionally put the increase in quotation marks because, as we saw earlier, there was an initial cash outflow of $100. Therefore, you do not recognize a tangible increase in cash (e.g., more money in your bank account); you are recovering the initial $100 cash outflow from the initial purchase. This movement ties with the income statement perspective because you initially don’t recognize the total expense within one period for making the purchase. Still, you increase the overall cost of operations in the income statement to record depreciation over time, compared to recognizing the expense at once. This movement suggests that the cash flow and income statement have a precisely opposite relationship regarding how and when the asset benefits and disadvantages you.
What happens after fully depreciating an asset?
With the income statement, once fully depreciated, there is no more expense to recognize. As a result, there is no further recognition within the cash flow as well. As you can see, this implies that there is a relationship between the income statement in the statement of cash flows. As a matter of fact, during a financial statement review, it is standard practice for an auditor to gain comfort over the depreciation expense by tying it to the trial balance. If there is no depreciation expense, then there is no change in the statement of cash flows. Since there are no future entries towards the balance sheet or the income statement once the asset is fully appreciated, there is nothing else to do in the cash flow statement.
What happens to the asset after disposing of it for cash?
When disposing of an asset, the investing and operating activities are involved. If the company sells an investment higher (lower) than its net book value, they recognize a gain (loss) within the income statement. Since it is not incremental cash recognition, the company will only record the money received (in investing) while the gain (loss) decreases (increases) operating activities. This movement in the cash flow makes sense because, in the income statement, you recognize the gain that causes a boost within your total net income or loss. Since this is not an actual movement in cash, the gain (loss) needs to be excluded from the cash flows. Furthermore, you also have to reverse the accumulated depreciation balance for the net book value. Since depreciation initially gave you a benefit in the cash flow statement, it will decrease cash when clearing the accumulated depreciation. However, you are now also recognizing an increase in money from the disposal of your asset.
In summary, the asset removal in the balance sheet ties with the movement in the cash flow as follows. The balance sheet increases with the clearing of the accumulated depreciation and thus shows an outflow one-to-one in the operating section of the cash flows. The clearing of the asset is more involved. Clearing the asset sold lowers the balance sheet (the opposite expectation of the accumulated depreciation). Therefore, we expect the cash inflow to be positive in the investing activity. But wait! There is probably a difference between the dollar value of the disposal and the dollar amount received. The difference lies in the gain (loss) that in the operating activities. As you can see, disposals are more involved but can be understood when piecing the movements logically.
Students, Accountants, and Business Owners (SAB) 