Cash inflows and outflows are a crucial part of any company. These flows may relate to financial or business transactions. When these transactions occur, companies can record the cash flows in their accounts. These cash transactions then become a part of the cash flow statement. In accounting, cash flows are not necessary to record a transaction. This feature relates to the accrual concept in accounting.
The cash flow statement summarizes a company’s cash inflows and outflows during a period. In other words, it includes a summary of cash generated and spent by a company. This statement combines those cash flows under three different heads. These include operating, investing and financing activities. This way, companies can segregate various cash transactions based on the areas to which they relate.
The accrual concept in accounting may interfere with some transactions in the cash flow statement. For example, it can impact the sale and acquisition of businesses. The primary reason for this interference is the distinction between the treatment for those items. The balance sheet and income statement follow the accrual concept, while the cash flow statement does not. One such area where conflicts may exist between the two includes the sale of fixed assets.
Before discussing its effect on the cash flow statement, it is crucial to understand the accrual treatment of a sale of a fixed asset.
An asset is any resource owned or controlled by a company that leads to future inflows of economic benefits. These resources may include short- and long-term items. For example, assets for a production company may consist of machinery, factory, inventory, receivables, cash, etc. These items are crucial in running a business and operating to generate revenues.
Fixed assets are resources that companies use for the long term. These are tangible assets that help companies generate revenues and run the business. In most cases, these assets include property, plant, equipment, etc. These assets also come with substantial costs and require companies to use depreciation to convert them into expenses. Overall, fixed assets are crucial for most companies, specifically capital-intensive ones.
Related article How Do Accounts Payable Present in the Statement of Cash Flow?Usually, companies acquire fixed assets that contribute to their operations. They keep these assets until the resource reaches the end of its useful life. At this point, the underlying fixed asset may have a salvage value, which companies can get from selling it. In some cases, companies may also dispose of their assets before it reaches the end of their useful life. Either way, selling fixed assets are common for companies.
When a company sells fixed assets, it may make profits or losses. It depends on the underlying fixed asset’s carrying value and the sales proceeds received for the transaction. The difference between them constitutes profit or loss. If the sale proceeds exceed the asset’s carrying value, it generates income for the company. On the other hand, if the sales proceeds are lower, it is a loss.
The profits and losses on the sale of fixed assets become a part of the income statement. Usually, these constitute other income/losses for companies that primarily operate in other sectors. If the underlying fixed asset makes a profit, it will increase net income or reduce net losses. On the other hand, a fixed asset sold for a loss decreases net income or increases net losses.
Most companies use the indirect method for preparing the cash flow statement. Under this method, companies report their cash flows into three categories. As mentioned above, these include cash flows from operating, investing and financing activities. Furthermore, it starts with a company’s net profits or losses for the period. This method adjusts that figure to conclude the net cash inflows and outflows for that period.
Related article Accounts Payable in Cash Flow Statement - How Is It Effect The Statement?When the cash flow statement begins with net profits, it includes profits or losses for fixed asset disposals. Some may think that adjustment is enough to account for the cash flows from the sale. However, that is not the case. Companies must remove any profits or losses associated with the disposal. These profits or losses come from the accrual method and are irrelevant to the cash flow statement.
The first effect that a sale of fixed assets has on the cash flow statement is an adjustment to net profits. This adjustment adds any losses to the figure or subtracts profits from it. As mentioned above, these profits or losses relate to the fixed asset. By doing so, companies can remove the effect of the accounting treatment for the sale of fixed assets. Consequently, companies can include the sales proceeds in the cash flow statement.
The above treatment falls under the cash flows from the operating activities section in the cash flow statement. Once companies remove the impact of profits or losses from selling fixed assets, they can move toward investing activities. This section includes any cash spent or generated from investments. Since fixed assets are a part of those, the sale proceeds will fall under this section.
Therefore, the second effect of the sale of fixed assets on the cash flow statement is to report the proceeds. Companies include these proceeds as an inflow in cash flows from investing activities. When a company acquires a fixed asset, it will be an outflow under the same section. The proceeds from the sale of a fixed asset include the full amount received in cash from the buyer. If non-cash compensation is involved, it will not fall under the cash flow statement.
Related article How to Prepare a Statement of Cash Flows Using the Indirect MethodWhen a company disposes of a fixed asset, it includes two impacts on the cash flow statement. As stated above, the first includes withdrawing its accounting treatment. Consequently, companies can remove the profits or losses recorded in the income statement. This adjustment occurs under the cash flow from operating activities. An example of this adjustment is below.
Profits and losses on the sale of fixed assets are non-cash items. Therefore, companies must adjust for the net profits or losses brought from the income statement. Once they do so, companies can move toward the other treatment for selling fixed assets in the cash flow statement.
After adjusting the profits and losses, companies must report the proceeds under the investing activities. As mentioned above, however, these proceeds can only include compensation paid in cash. If a company receives non-cash compensation, it will not be a part of the cash flow statement. Companies can report proceeds on the sale of fixed assets in the cash flow statement as follows.
The above adjustment concludes the treatment of the sale of fixed assets in the cash flow statement. Apart from these, this statement does not require further changes to report disposals.
The sale of fixed assets may occur when companies dispose of those assets to another party. This transaction may include a cash compensation which companies must report in the cash flow statement. However, they must adjust the net profits from the income statement first. Once they do so, they can include the proceeds from the sale of fixed assets under investing activities.