Question

While preparing the Cash Flow Statement, purchase of goodwill is treated as

• A. Operating activity
• B. Financing activity
• C. Investing activity
• D. Extraordinary item

Answer 1

The Correct Option is C

Cash Flow Classification: Purchase of Goodwill

The purchase of goodwill is classified as an investing activity in the Statement of Cash Flows. This is because goodwill represents an intangible asset acquired by a company when it purchases another business. 

Explanation

Investing activities include the purchase and sale of long-term assets and other investments not included in cash equivalents. Goodwill, being an intangible asset with a long-term benefit, falls under this category.

Why it's an Investing Activity

• Long-Term Benefit: Goodwill is expected to provide a benefit to the company for many years to come.
• Acquisition of an Asset: The purchase represents the acquisition of an asset, even though it's intangible.
• Not an Operating Activity: It is not related to the company's day-to-day operations.
• Not a Financing Activity: It is not related to how the company is funded.

Correct Cash Flow Statement Classification

Therefore, the correct answer is Option 3: Investing Activity.

Answer 2

Goodwill Purchase: An Investing Activity 

The purchase of goodwill is classified as an investing activity in the statement of cash flows because it represents an investment in an intangible asset that is expected to provide future economic benefits to the company.

Here's a more detailed explanation:

• Investing Activities: These activities involve the purchase and sale of long-term assets and other investments not included in current assets. They reflect expenditures made to acquire resources intended to generate future income and cash flows.
• Goodwill: Goodwill arises when a company acquires another business for a price higher than the fair value of its identifiable net assets. This excess payment is attributed to factors such as the acquired company's brand reputation, customer relationships, proprietary technology, or other intangible attributes. It's an asset because it represents the *expected* future economic benefits from those factors.

Since the purchase of goodwill involves an outlay of cash in the present with the expectation of future returns (increased profits, market share, etc.), it aligns with the definition of an investing activity. The company is essentially investing in the future success and profitability of the acquired entity (or the brand it is associating with).

Therefore, the cash outflow associated with the purchase of goodwill is reported in the investing activities section of the statement of cash flows, typically as a reduction in cash.