Confusion about cash flows

[thomaslyu]

Hi,

I found the below description about cash flows on investopedia:
“But the cash flow does not necessarily show all the company’s expenses. That’s because not all expenses the company accrues are paid right away. Although the company may incur liabilities, any payments toward these liabilities are not recorded as a cash outflow until the transaction occurs.”

I don’t understand this part "any payments toward these liabilities are not recorded as a cash outflow until the transaction occurs”.

Could anyone please help me to understand this? Thanks.

 

[DrStrangeLove]

From what you wrote, it sounds like the Investopedia article was trying to describe how cashflows and earnings can be different.

Suppose you run a merchandising company, you buy your inventory on trade credit, and your inventory uses a perpetual inventory system. You place an order, so you incur a liability. (We'll ignore the "goods have arrived, invoice hasn't arrived yet" problem, and just assume the invoice comes with the goods.) Suppose the invoice arrives on December 27th.

Your journal entry for the liability creates a payable (Inventory DR/Accounts Payable CR). But creating this liability did not make any cash change hands--you bought on credit. Eventually you pay for the inventory (Accounts Payable DR/Cash CR). Suppose you send the check January 5th.

Do you recognize the expense for the invoice in December or in January?

If you work on a cash basis, you account for the payment when the cash changes hands, so January 5th. But if you work on an accrual basis, you recognize the expense when the invoice arrives, so December 27th. If your year-end financial statements are as of December 31st, you'd recognize the expense if you use accrual accounting, but not if you use cash accounting.

 

[thomaslyu]

From what you wrote, it sounds like the Investopedia article was trying to describe how cashflows and earnings can be different.

Suppose you run a merchandising company, you buy your inventory on trade credit, and your inventory uses a perpetual inventory system. You place an order, so you incur a liability. (We'll ignore the "goods have arrived, invoice hasn't arrived yet" problem, and just assume the invoice comes with the goods.) Suppose the invoice arrives on December 27th.

Your journal entry for the liability creates a payable (Inventory DR/Accounts Payable CR). But creating this liability did not make any cash change hands--you bought on credit. Eventually you pay for the inventory (Accounts Payable DR/Cash CR). Suppose you send the check January 5th.

Do you recognize the expense for the invoice in December or in January?

If you work on a cash basis, you account for the payment when the cash changes hands, so January 5th. But if you work on an accrual basis, you recognize the expense when the invoice arrives, so December 27th. If your year-end financial statements are as of December 31st, you'd recognize the expense if you use accrual accounting, but not if you use cash accounting.

Thank you very much for your detailed explanation. I just want to understand what “the transaction” refers to in the sentence “any payments toward these liabilities are not recorded as a cash outflow until the transaction occurs”.

Thank you again for your answer.

 

[vpryce]

Hi,

I found the below description about cash flows on investopedia:
“But the cash flow does not necessarily show all the company’s expenses. That’s because not all expenses the company accrues are paid right away. Although the company may incur liabilities, any payments toward these liabilities are not recorded as a cash outflow until the transaction occurs.”

I don’t understand this part "any payments toward these liabilities are not recorded as a cash outflow until the transaction occurs”.

Could anyone please help me to understand this? Thanks.

Hi, When you are looking at Cashflow, we looked at in three (3) parts
1. Cashflow from Operations

2. Cashflow from Investing Activities and,
3. Cashflow from Financing.