Chapter 4: Chapter Highlights

1. The statement of cash flows, the third major statement discussed in this text, reports the impact of a firm's operating, investing, and financing activities on cash flows during an accounting period. The statement explains the reasons for the change in cash between balance sheet dates and classifies the reasons for the change as an operating, investing or financing activity.

2. The operating section of the statement of cash flows shows the adjustments required to convert net income, measured on an accrual basis, to the amount of net cash flows generated from operations during the period. The revenues and expenses reported on the income statement will differ from the cash receipts and disbursements because (a) the recognition of revenues will not necessarily coincide with the receipts of cash from customers, and (b) the recognition of expenses will not necessarily coincide with the disbursements of cash to suppliers, employees, and other creditors.

3. In presenting cash flows from operations, a firm may use either the indirect method or the direct method. Most firms report cash flow from operations using the indirect method. The indirect method begins with net income for a period and then shows adjustments to net income to convert revenues to cash received from customers and to convert expenses to cash disbursed to various suppliers of goods and services. Under the direct method, cash flows from operations results from subtracting cash disbursements for expenses from cash receipts from customers. Cash flow from operations is identical under the two methods.

4. Investing activities include cash received from sales of investments and property, plant, and equipment and cash paid for acquisitions of investments and property, plant, and equipment.

5. Cash received from issuing debt or capital stock and cash paid for dividends and reacquisitions of debt or capital stock appear as financing activities in the statement of cash flows.

6. Free cash flow is the excess of cash flow from operations over cash flow for investing. Firms can use free cash flow to repay borrowing, pay a dividend, repurchase common stock, and add to cash on the balance sheet.

7. Ambiguities exist for classifying some cash transactions into either operating, investing or financing activities. For example, GAAP requires firms to classify cash flows from interest and dividend revenues as operating activities, but the cash flows related to the purchase and sale of investments in securities appear as an investing activity. Another example is interest expense, which GAAP classifies as an operating activity, but the issue or redemption of debt appears as a financing activity. A dividend paid to shareholders is a financing activity.

8. Some financing and investing transactions do not directly affect cash but GAAP requires firms to disclose either in a separate note or in a supplementary schedule. An example of such a transaction is the acquisition of a parcel of land by issuing a mortgage.

9. The effects of various transactions on cash might be seen by reexamining the accounting equation. The accounting equation states that

Assets / = / Liabilities / + / Shareholders' Equity
Cash / + / Noncash Assets / = / Liabilities / + / Shareholders' Equity

If the start-of-the-period and the end-of-the-period balance sheets maintain the accounting equation, the following equation must also be valid:

Change in Cash / + / Change in Noncash Assets / = / Change in Liabilities / + / Change in
Shareholders'
Equity

Rearranging terms, we obtain the cash change equation:

Change in Cash / = / Change in Liabilities / + / Change in Shareholders'
Equity / ─ / Change in
Noncash
Assets

The cash change equation states that changes in cash (left-hand side) equal the changes in liabilities plus the changes in shareholders' equity less the changes in noncash assets (right-hand side).

10. Stated another way, the accountant can identify the causes of the change in cash by studying the changes in noncash accounts and classifying those changes as operating, investing, and financing activities.

11. We use a T-account work sheet to prepare the statement of cash flows. The use of a T-account work sheet involves the following steps:

a.  Step 1: Obtain balance sheets for the beginning and end of the period covered by the statement of cash flows.

b.  Step 2: Prepare a T-account work sheet. The top of the work sheet shows a master T-account titled Cash. Label sections of the Cash T-account with Operations, Investing, and Financing. Enter the beginning and ending amounts of cash in the master T-account for cash. Prepare T-accounts for each noncash asset, liability, and shareholders’ equity account and enter the beginning and ending balances in each account.

c.  Step 3: Explain the change in the master cash account between the beginning and end of the period by accounting for the change in each noncash account during the period. Accomplish this step by reconstructing the entries originally recorded in the accounts during the period and entering them in the same accounts on the T-account work sheet as the accounts originally used during the period. Classify the amounts entered in the master T-account for Cash as related to Operations, Investing, or Financing.

d.  Step 4: Use the information in the master T-account for Cash to prepare a formal statement of cash flows.

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12. To compute the amount of cash flow from operations using the direct method, follow these steps:

a.  Step 1: Enter the accounts and amounts of revenues, expenses, and net income from the income statement for the period.

b.  Step 2: For each item in the Operations section of the master Cash account in the T-account work sheet, enter the amount to the right of the revenue or expense in Step 1 to which it most closely relates. Debits in the master T-account for Cash appear as positive amounts and credits appear as negative amount in this step.

c.  Step 3: Sum the amounts horizontally from Step 1 and Step 2 for each revenue and expense item. This step yields the cash received and disbursed for operations. The net cash flow indicated by summing these amounts equals cash flow from operations. Compare the amount of cash flow from operations computed using the indirect method from the T-account work sheet with the amount computed using the direct method derived from these three steps.

12. Statement No. 7 of the International Accounting Standards Board recommends the preparation of a statement of cash flows that reports cash flows from operating, investing and financing activities. Standard-setting bodies in most countries have adopted this standard.

13. The statement of cash flows provides information that helps the reader to:

a. assess the impact of operations on liquidity, and

b. assess the relations between cash flows from operating, investing, and financing activities.

14. Users find interpreting a statement of cash flows requires an understanding of the economic characteristics of a firm's industry and the stage in its development. Examining the statement of cash flows over several years enhances understanding.

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