BA213: Chapter 14—Statement of Cash Flows

Study Objectives:

  1. Indicate the usefulness of the statement of cash flows.
  2. Distinguish among operating, investing, and financing activities.
  3. Prepare a statement of cash flows using the indirect method.
  4. Analyze the statement of cash flows.
  5. Prepare a statement of cash flows using the direct method

I. The Statement of Cash Flows. The three basic financial statements (comparative balance sheets, income statement, and retained earnings statement) do not show detailed summary of the net change in cash as a result of operating, investing, and financing activities during the period.

  1. INDICATE THE PURPOSE OF THE STATEMENT OF CASH FLOWS.
  1. The primary purpose of the statement of cash flows (SCF) is to provide information about an entity’s cash receipts and cash payments during a period.
  2. A secondary objective is to provide information about its:

a)Operating (profit-making activities of the enterprise),

b)Investing (purchase and sale of long-term assets), and

c)financingactivities of an entity during a period (obtaining resources needed to pay for long-term assets and repay borrowed money from creditors and owners).

  1. It provides answers to the following simple, but important, questions about an enterprise:

a)Where did the cash come from during the period?

b)What was the cash used for during the period?

c)What was the change in the cash balance during the period?

B. MEANING AND USEFULNESS OF “CASH FLOWS”

  1. The SCF is usually prepared using cash and cash equivalents as its basis. Cash equivalents are short-term, highly liquid investments that are both:

a)readily convertible to known amounts of cash, and

b)so near to their maturity that their market value is relatively insensitive to changes in interest rates.

  1. USEFULNESS: The information in the SCF should help investors, creditors and others assess the following aspects of the firm’s financial position:

a)The entity’s ability to generate future cash flows.

b)The entity’s ability to pay dividends and meet obligations.

c)The reasons for the difference between net income and net cash provided (used) by operating activities. NET INCOME is not the same as CASH PROVIDED BY OPERATING ACTIVITIES. The differences between net income and net cash provided by operating activities are illustrated by the results of the companies shown from annual reports for the same fiscal year.

d)The cash investing and financing transactions during the period to better understand why assets and liabilitieschangedduring the period.

C. CLASSIFICATION OF CASH FLOWS. TYPICAL RECEIPTS AND PAYMENTS CLASSIFIED BY ACTIVITY and Classification of Cash Receipts and Payments:

  1. Distinguish among operating, investing, andfinancing activities. Transactions and other events characteristic of each kind of activity are as follows:

a)Operating activities include the cash effects of transactions that create revenues and expenses. They thus enter into the determination of net income.

b)Investing activities include

1)acquiring and disposing of investments and productive long-lived assets, and

2)lending money and collecting the loans.

c)Financing activities include

1)obtaining cash from issuing debt and repaying the amounts borrowed, and

2)obtaining cash from stockholders and providing them with a return on their investment.

  1. The category of operating activities is the most important because it shows the cash provided by company operations and generally considered to be the best measure of a company’s ability to generate sufficient cash to continue as a going concern.
  2. Note the following general guidelines:

a)Operating activities involve income determination (income statement) items. Operating activities generally relate to changes in current assets and current liabilities.

b)Investing activities involve cash flows resulting from changes in investments and long-term asset items.

c)Financing activities involve cash flows resulting from changes in long-term liabilityand stockholders’ equity items.

d)Test your understanding of classification of activities by indicating the classification in the statement of cash flows for each of the following and check the bottom of the lecture notes for the answers:

1)Proceeds from the sale of investment falls under______.

2)Disbursement for the purchase of treasury stock ______.

3)Loan to another corporation ______.

4)Proceeds from an insurance policy for a building destroyed by fire______.

5)Proceeds from winning a lawsuit______.

6)Receipt of interest from an investment in bonds______.

7)Payment of dividends______.

8)Sale of merchandise for cash______.

9)Cash collected on an accounts receivable______.

10)Paid an accounts payable______.

11)Converting bonds into common stock______.

12)Purchased equipment issuing a long-term note______.

D. SIGNIFICANT NONCASH ACTIVITIES—Not all of a company’s significant activities involve cash.

  1. Examples of significant noncash activities are:

a)Direct issuance of common stock to purchase assets.

b)Conversion of bonds into common stock.

c)Direct issuance of debt to purchase assets.

d)Exchange of plant assets.

  1. Significant financing and investing activities that do not affect cash are NOT reported in the body of the SCF. Such activities are reported in either:

a)a separate schedule at the bottom of the SCF or

b)in a separate note or supplementary schedule to the financial statements.

  1. The reporting of these noncash activities in a separate schedule or the notes satisfies the disclosure principle and materiality concept (see chapter 6 in textbook).

E. FORMAT OF THE STATEMENT OF CASH FLOWS

  1. The general format of the SCF is the 3 activities previously discussed – operating, investing, and financing – plus the significant noncash investing and financing activities. To help remember, use the acronym, OIF, “O, IF I could just remember the three sections of the SCF.” FORMAT OF THE STATEMENT OF CASH FLOWS to see the following sections:

a)Cash flows from operating activities

b)Cash flows from investing activities

c)Cash flows from financing activities

d)Net increase (decrease in cash)

e)Noncash investing and financing activities

  1. SAMPLE STATEMENT OF CASH FLOWS that:

a)The individual inflows and outflows from investing, and financing activities are always reported separately so that the investing and financing activities of the enterprise will not be obscured.

b)The operating section also shows the inflows and outflows separately. But the operating depends on the method used (Direct or Indirect) to prepare the statement as discussed later.

c)Statement of Cash Flows illustrations shows the cash inflows first of each activity and then the cash outflows of each activity with examples of inflows and outflows for each.

  1. Note examples of the Statement of Cash Flows that the reported operating, investing, and financing activities result either net cash provided or used by each activity as follows:

a)Provided by indicates that cash receipts are greater than cash payments.

b)Used by indicated that cash payments are greater than cash receipts.

F. PREPARING THE STATEMENT OF CASH FLOWS

  1. The SCF is prepared differently from the 3 other basic financial statements.

a)FIRST: It is NOT prepared from the adjusted trial balance.

b)SECOND: The SCF deals with cash receipts and payments, so the accrual concept is NOT used in the preparation of the SCF.

  1. The information to prepare this statement usually comes from 3 sources:

Comparative balance sheet—two years balances sheets are used to determine the amount of changes in assets, liabilities, and stockholders’ equities.

Current income statement—helps determine the amount of cash provided or used by operating activities as mentioned previously operating activities are those that enter into the determination of net income.

Additional information—such astransaction datathat are needed to determine how cash was provided and used during the period.

  1. INFORMATION SOURCES FOR ACTIVITIES:

a)For OPERATING ACTIVITIES—analyze income statement items and changes in noncash current asset and current liability items.

b)For INVESTING ACTIVITIES—analyze increases and decreases in noncurrent asset items.

c)For FINANCING ACTIVITIES—analyze increases and decreases in noncurrent liability and stockholders’ equity items.

  1. Preparing the statement of cash flows from these data sources involves three major steps:

Step 1: Determine net cash provided/used by operating activities by converting net income from an accrual basis to a cash basis. This step involves:

a)Analyzing not only the current year’s income statement but also

b)Comparative balance sheets and selected additional data.

Step 2: Analyze changes in noncurrent asset and liability accounts and record as investing and financing activities, or as significant noncash transactions. This step involves analyzing comparative balance sheet data and selected additional information for their effects on cash.

Step 3: Compare the net change in cash on the statement of cash flows with the change in the cash account reported on the balance sheet to make sure the amounts agree. The difference between the beginning and ending cash balance can be easily computed from comparative balance sheets.

H. INDIRECT AND DIRECT METHODS—CONVERTING NET INCOME TO NET CASH PROVIDED (USED) BY OPERATING ACTIVITIES. In order to determine net cash provided/used by operating activities, NET INCOME must be converted from accrual basis to cash basis. This conversion may be accomplished by 1) the indirect method or 2) the direct method.

  1. Both Methods arrive at the same total amount for “Net cash provided by operating activities.” They differ in disclosing the items that comprise the total amount.
  2. The indirect method (A method of reporting net cash flows from operations that involves converting accrual-basis net income to cash basis) is used extensively in practice. The indirect is favored by companies for 2 reasons: 1) it is easier to prepare and 2) it focuses on the differences between net income and net cash flow from operating activities. It is called the indirect method as it does not directly show where cash came from (Cash receipts) or where cash went to (Cash payments:

a)(1) Begins with net income and adjusts for income statement items that did not affect cash.

b)(2) Reconciles net income to net cash provided (used) by operating activities.

  1. The direct method (A method of reporting net cash flows from operations that shows the major classes of cash receipts and payments for a period of time). It is called the direct method as it does directly show where cash came from (Cash receipts) or where cash went to (Cash payments).

a)The FASB has expressed a preference for the direct method, but allows the use of either method. This is the method that I used when preparing the SCF for my clients as they could understand this method better as indicated the direct source of cash receipts and cash payments.

b)When the direct method is used, the net cash flow from operating activities as computed using the indirect method MUST ALSO BE REPORTED IN A SEPARATE SCHEDULE so it requires more work and probably why the indirect method is favored by majority of companies.

c)The DIRECT METHOD:

1)Adjusts each item on the income statement from the accrual basis to the cash basis.

2)Major classes of operating receipts and cash payments are reported.

  1. PREPARING A STATEMENT OF CASH FLOWS: INDIRECT METHOD. The comparative balance sheets, the income statement, and additional information are used to illustrate and explain the indirect method of preparing the SCF:
  1. Step 1: Operating Activities—DETERMINE NET CASH PROVIDED/USED BY OPERATING ACTIVITIES BY CONVERTING NET INCOME FROM AN ACCRUAL BASIS TO A CASH BASIS:
  1. WHY net income MUST be converted to net cash provided by operating activities:

Under GAAP, most companies use the accrual basis of accounting which requires:

a)Revenues to be recorded when earned which may include credit sales that have not yet been collected in cash and

b)Expenses to be recorded when incurred which may include expenditures that have not been paid in cash.

c)Thus under accrual basis of accounting, net income is not the same as net cash provided by operating activities and therefore under the indirect method, net income must be adjusted to convert certain items to the cash basis.

Three type of adjustments to convert net income to net cash provided by operating activities:

1)Add back noncash expenses and losses that result from investing and financing activities, such as depreciation expense, amortization, or depletion. The indirect method (or reconciliation method) starts with net income and converts it to net cash provided by operating activities. In other words, the indirect method adjusts net income for items that affect reported net income but do not affect cash. Noncash charges in the income statement are added back to net income. OPERATING ACTIVITIES—INDIRECT ADJUSTMENTS FOR NONCASH ITEMS.

a)Note that Noncash charges are ADDED TO NET INCOME as these reduce net income but DO NOT REDUCE CASH. Example are:

Depreciation expense

Amortization expense of intangible assets and amortization of bond discounts.

Depletion expense

Loss on sale of plant assets

b)The adjustment for depreciation and the adjustment for loss on sale of equipment which are ADDED TO NET INCOME to arrive at cash from operating activities.

2)Deduct gains that result from investing and financing activities—ADJUSTMENT FOR NONCASH ITEMS:

a)Note that the gain on sale of equipment is DEDUCTED FROM NET INCOME as these noncash credits increase net income but DO NOT INCREASE CASH. The actual amount of cash received from the sale is reported as a source of cash in the investing activities section of the statement of cash flows.

b)Examples of noncash credits which are DEDUCTED from net income are:

Gain on sale of plant assets

Gains on retirement of debt

Amortization of bond premium

3)Analyze changes to noncash current asset and current liability accounts. Reconcile net income to net cash provided (used) by operating income by identifying adjustments to net income with current asset and current liability accounts other than cash—INDIRECT METHOD ADJUSTMENT FOR CURRENT ASSETS AND LIABILITIES. Some Rules of Thumb:

  • If current assetsdecrease, they are added to net income (because more cash is coming in than going out like with accounts receivable or cash is not being used to purchase more such as inventories, supplies, prepaid insurance, etc.).
  • If current assetsincrease, they are deducted from net income (because not collecting as much cash from accounts receivable as they are increasing or more cash is being used to purchase more inventories than selling them or supplies, prepaid insurance, etc. than using them).
  • If current liabilitiesincrease, they are added to net income (as not using cash to pay off the liabilities as they are increasing).
  • If current liabilitiesdecrease, they are deducted from net income (as using cash to pay off the liabilities as they are decreasing).

4)CASH FLOWS FROM OPERATING ACTIVITIES—INDIRECT METHOD PROBLEM DATA showing an example of the preparation of the operating activities section of the SCF:

  • The section begins with the net income.
  • Next the adjustments to reconcile net income to net cash provided by operating activities:
  • Noncash charges are added to net income—depreciation expense.
  • Noncash credits are deducted from net income—like gain on sale of land.
  • Decreases in current assets are added to net income—such as decrease in accounts receivable.
  • Increases in current assets are deducted from net income—like an increase in prepaid rent or an increase in inventory.
  • Increases in current liabilities are added to net income—like an increase in accounts payable or an increase in interest payable.
  • Decreases in current liabilities are deducted from net income—like a decrease in taxes payable.
  1. The presentation of net cash provided by operating activities—indirect method:

a)A decrease in accounts receivable are added to net income. When accounts receivable decrease during the year, revenues on an accrual basis are lower than are revenues on a cash basis.In other words, operations of the period caused revenues to increase, but not all of these revenues resulted in an increase in cash. Increases in revenues had to result in an increase in accounts receivable. To convert net income into net cash provided by operating activities, a decrease in accounts receivable must be added tonet income.

b)Note that an increase in merchandise inventory or prepaid expenses are deducted from net income because if these items are increasing, that the cost of merchandise inventory, supplies, prepaid insurance, etc., purchased exceeds the cost of goods sold, supplies expense, insurance expense, etc., shown on the income statement. Another way to look at this is that more cash is being expended for merchandise inventory, supplies, insurance as these items are increasing than being sold or used as these items are INCREASING. Therefore, the INCREASE must be DEDUCTED FROM net income.

c)An increase in accounts payable is added to net income. When current liabilities increase during the year, expenses on an accrual basis shown on the income statement are higher than they are on a cash basis.. To adjust net income to net cash provided by operating activities, an increase must be added to net income.

d)A decrease in income taxes payable is subtracted from net income. When current liabilities decrease during the year, expenses on an accrual basis shown on the income statement are lower than they are on a cash basis. That means that more cash is expended for expenses than shown on the income statements. Therefore, a decrease in income taxes payable is deducted from net income.

  1. Summary of conversion to net cash provided by operating activities—indirect method. Three type of adjustments required to convert net income to net cash provided by operating activities:

a)(1) Noncash charges such as depreciation, amortization, and depletion are added to net income.

b)(2) Losses are added to net income and gains are deducted from net income.

c)(3) Changes in noncash current asset and current liability are summarized as follows: