The accrual method of accounting is a fundamental feature of corporate financial reporting. Under this method, revenues are recognized when earned and expenses when incurred, even if cash is received or paid at some other time. But determining precisely when revenues are earned and expenses incurred requires judgment, and where there is judgment there is also the possibility of manipulation. One way for financial statement readers to deal with the possibility of manipulation is to analyze performance with the effects of accruals stripped from the accounts. That’s what the statement of cash flows is for.
The statement of cash flows provides a view of the firm’s performance independent of accruals. It summarizes cash inflows and cash outflows and, in so doing, reconciles beginning and ending cash. But the statement does more than just summarize cash flows. It reveals the nature of the activities that gave rise to those cash flows. To understand how this works, let’s examine how the statement is organized. Once again, we’ll use SAP Group as an example (see Exhibit 1.3).
The cash flow statement is prepared on the assumption that all cash flows result from just three types of activities—operating, investing, and financing.
Cash flows from operating activities are reported in either of two equivalent ways: the direct method or the indirect method.
Under the direct method, ...