CHAPTER 13
REPORTING AND INTERPRETING CASH FLOWS
CHAPTER OUTLINE
IBUSINESS BACKGROUND
IICLASSIFICATIONS OF THE CASH FLOWS (L.O. 1)
A.Cash Flows from Operating Activities
B.Cash Flows from Investing Activities
C.Cash Flows from Financing Activities
IIIREPORTING AND INTERPRETING CASH FLOWS FROM OPERATING ACTIVITIES (L.O. 2 & 3)
A.Noncurrent Accruals
B.Changes in Current Assets and Current Liabilities
C.A Comparison of the Direct and Indirect Methods
IVREPORTING AND INTERPRETING CASH FLOWS FROM INVESTING ACTIVITIES (L.O. 4 & 5)
VREPORTING AND INTERPRETING CASH FLOWS FROM FINANCING ACTIVITIES (L.O. 6)
VIPRESENTATION OF THE CASH FLOW STATEMENT
A.Noncash Investing and Financing Activities
B.Supplemental Cash Flow Information
VIIEPILOGUE
VIIICHAPTER SUPPLEMENTS
A.Adjustment for Gains and Losses
B.Spreadsheet Approach - - Cash flow statement: Indirect Method
CHAPTER LEARNING OBJECTIVES
1.Classify cash flow statement items as part of net cash flows from operating, investing, and financing activities.
2.Report and interpret differences between net income and cash flows from operating activities.
3.Analyze and interpret the quality of income ratio.
4.Report and interpret cash flows from investing activities.
5.Analyze and interpret the capital acquisitions ratio.
6.Report and interpret cash flows from financing activities.
7.Explain the impact of noncash investing and financing activities.
CHAPTER SUMMARY
The text materials contain many useful exhibits for this chapter. In addition, other chapter features useful in the teaching of this text are contained in this manual.
The cash flow statement is one of the required financial statements. Its primary purpose is to provide cash flow information in a manner that maximizes its usefulness to investors, creditors, and others in projecting future cash flows related to the enterprise.
The cash flow statement has three main sections: cash flows from operating activities which are related to earning income from normal operations; cash flow from investing activities which are related to the acquisition and sale of productive assets; and cash flows from financing activities which are related to the sources of financing the enterprise. The net cash inflow or outflow for the year is the same amount as the increase or decrease in cash and cash equivalents for the year. Cash equivalents are highly liquid investments with original maturities of less than three months.
Two different methods for reporting cash flows from operating activities are permitted. They are called the direct and indirect methods. Investing and financing activities are reported in exactly the same manner under both methods. The direct method reports the gross cash flows for the main classifications of revenues and expenses. In contrast, the indirect method reports operating activities by showing a reconciliation of net income with net cash flows from operating activities. The amount of net cash flow from operations reported is the same under both methods.
CHAPTER LECTURE NOTES
IBUSINESS BACKGROUND
1.Net income on the income statement (IS) indicates that revenues exceeded costs and expenses for the accounting period.
2.Net income does not pay bills. Cash pays bills. The cash flow statement (CFS) is an indication of a company's ability to pay bills. It presents the sources of a company's cash inflows and the uses of cash outflows. The statement highlights the internal generation of cash. It also details investments and external financing. The CFS is an important statement to use to predict the going concern ability (continuity) of a business. Both managers and analysts are interested in the CFS for a business. It helps to assess the "health" of a company in regard to expanding operations, replacing operational assets, taking advantage of market opportunities, and paying dividends.
3. The CFS is designed to give managers and analysts information about operating, investing, and financing activities.
IICLASSIFICATIONS OF THE CASH FLOWS -L.O.1
1.The CFS demonstrates how the beginning of the year cash balance became the end of the year cash balance. Cash balance, in this instance, includes cash and cash equivalents.
2.Cash equivalents are short-term, highly liquid investments. They possess two characteristics:
a.Readily convertible to known amounts of cash by the holder.
b.So near their maturity that the risk of change in value (because of interest rates) is insignificant. The "so near" characteristic considers maturities of less than three months from the investor’s acquisition date.
Examples of cash equivalents include Treasury bills, money market funds, and commercial paper.
3.There are three classifications of cash inflows and outflows presented on the CFS: operating activities, investing activities, and financing activities.
A.Cash Flows from Operating Activities
1.The operating activities (operations) section of the CFS reports cash inflows and outflows directly associated with income and expenses from normal operations reported on the IS. This classification includes:
InflowsOutflows
Receipts from customersPurchases of goods/services
Receipts of interestPayments of interest
Receipts of dividendsPayments to employees
Payments of income taxes
Payments of operating expenses
2.There are two alternative approaches for preparing the operating activities section of the CFS.
a.The direct method reports the components of cash flows from operating activities as gross receipts and gross payments. This method is recommended by the AcSB, but it is not widely used in practice because managers say it is more costly (cost/benefit constraint) to use than the indirect method. Cash receipts and cash expenditures are used to compute cash inflows and cash outflows from operations. The difference is called net cash inflow (outflow) from operating activities.
.b.The indirect method adjusts net income (net loss) to derive net cash flows from operating activities. It is widely used in practice. Adjustments are made to net income (including noncash items) to compute the net cash inflow (outflow) from operating activities.
3.The operating activities section of the CFS describes cash flows related to the profit making activities of a business. The IS presents net income on an accrual basis without regard to when the related cash flows occur. The CFS, on the other hand, provides information on a cash basis. Depreciation and amortization expense is a common difference in NI on the IS and net cash flows from operating activities on the CFS. Depreciation and amortization expense is deducted from revenues on the IS to arrive at NI. However, depreciation and amortization expense does not require a cash outlay so it is added back under the indirect method.
4.A company can report NI even when the cash account has decreased over the year. It can report a net loss even when the cash account has increased over the year.
- Cash Flows from Investing Activities
1.Cash flows from investing activities report cash inflows and outflows associated with the acquisition and disposal of operational and investment assets.
InflowsOutflows
Sales of plant, property, & equipmentPurchases of plant, property, & equipment
Sales of investmentsPurchases of investments
Sales of intangiblesPurchases of intangibles
Collections of loans (N/R), except interestLoans to other parties (N/R)
2.For cash flows from investing activities, analysis for changes in long-term asset accounts is performed (plant, property, and equipment, for example).
3.The difference between cash inflows and cash outflows from this category is the net cash inflow (outflow) from investing activities.
C.Cash Flows from Financing Activities
1.Cash flows from financing activities report cash inflows and outflows associated with owners and creditors. This category relates to the external financing sources of a business.
InflowsOutflows
Owners:Sales of stockOwners:Repurchases of stock
Payments of dividends
Creditors:Borrowing moneyCreditors:Payments of debt principal
2.For cash flows from financing activities, analysis for changes in liabilities and owners' equity accounts is performed (N/P, R/E, and capital stock, for example).
3.The difference between cash inflows and cash outflows from this category is the net cash inflow (outflow) from financing activities.
IIIREPORTING AND INTERPRETING CASH FLOWS FROM OPERATING ACTIVITIES - L.O. 2
1.Many analysts believe that the operating activities section of the CFS is the most important part of the statement. It focuses attention on a company’s ability to internally generate cash through operations. A company with increasing NI on the IS but decreasing cash flows from operations on the CFS should serve as a warning signal of a going concern issue. Most companies rely on at least some external financing. If the operating activities cash flows are of concern, creditors and investors may not lend money or invest money in that company.
2.There are two basic considerations for adjusting net income to net cash flows from operations:
a.Noncash expenses and revenues do not affect cash flows.
b.Changes in current assets (except for short-term investments and cash itself) and changes in current liabilities (except for the principal of debt to financial institutions and current portions of principal on long-term debt) reflect timing differences between net income and cash flows.
3.For cash flows from operating activities, analysis is performed for earnings related accounts. This will include all IS accounts and those BS accounts that are related to the IS items. These relationships are summarized as follows:
IS AccountRelated BS AccountCFS Impact
Sales A/RCustomer collections
CGSInventory and A/PPayments to suppliers
Operating expensesPrepaid expenses andPayments for operating
accrued liabilities expenses
Depreciation expenseAccumulated DepreciationNo Cash Effect
Amortization expenseAccumulated AmortizationNo Cash Effect
(or Intangible asset)
A.Noncurrent Accruals
Some expenses presented on the accrual basis IS (matching principle) do not require cash outlays during the accounting period. Following are examples of noncash expenses:
Depreciation expense (the cash outlay occurred with the acquisition of the tangible asset being depreciated).
Amortization expense (the cash outlay occurred with the acquisition of the intangible asset being amortized).
Bad debt expense (there is no cash outlay for bad debts and cash was not collected from the customer).
B.Changes in Current Assets and Current Liabilities
Computing the adjustments to net income to derive cash flows from operating activities requires several considerations of current balance sheet accounts.
1.Decreases in current assets are added to NI while increases in current assets are subtracted from NI.
a.Change in Accounts Receivable
The accrual sales presented on the IS often includes sales that have not yet generated cash from customers. These noncash amounts cause changes in the A/R account. If less cash is collected from customers than the revenue account reflects, A/R will increase. This increase must be subtracted from NI to derive cash flows. Conversely, if more cash is collected from customers than the revenue account reflects, A/R will decrease. This decrease must be added to NI to derive cash flows. If A/R (rent receivable, interest receivable, etc.) did not change, the revenues on the IS were equivalent to cash inflows and no adjustment is needed.
b.Change in Inventory
The cost of goods sold (CGS) amount presented on the IS considers the beginning and ending inventories in its computation. CGS is an accrual amount. In order to consider the cash purchases of inventory, adjustments must be made. If inventory increased from the beginning to the end of the period, the increase must be subtracted from NI to derive cash flows. Conversely, if inventory decreased, the decrease must be added to NI to derive cash flows.
c.Change in Prepaid Expenses
The accrual of expenses presented on the IS does not necessarily coincide with the cash payment for expense items. In order to consider the cash payments for expenses, adjustments must be made. If prepaid expenses increased from the beginning to the end of the period, the increase must be subtracted from NI to derive cash flows. Conversely, if prepaids decreased, the decrease must be added to NI to derive cash flows.
d. Changes in Other Current Assets and Other Assets
Some other current assets require inclusion, such as interest receivable or long-term accounts receivable as they result from short term or current operating activities.
2.Increases in current liabilities are added to NI while decreases in current liabilities are subtracted from NI.
a.Change in Accounts Payable
If accounts payable (A/P) increased from the beginning to the end of the accounting period, cash paid to suppliers was less than the purchases account. The amount of this increase must be added to NI to derive cash flows. Conversely, if the A/P account decreased, cash paid to suppliers was more than the purchases account. The amount of this decrease must be subtracted from NI to derive cash flows.
b.Change in Accrued Expenses
The accrual of expenses presented on the IS does not necessarily coincide with the cash payments for expense items. In order to consider the cash payments for expenses, adjustments must be made. If accrued expenses payable increased from the beginning to the end of the period, the increase must be added to NI to derive cash flows. Conversely, if accrued payables decreased, the decrease must be subtracted from NI to derive cash flows.
3.In summary, current assets are the opposite of current liabilities. Therefore, their treatment is opposite for making adjustments to NI on the IS to arrive at cash flows from operating activities on the CFS.
1.Decreases in current assets are added to NI.
2.Decreases in current liabilities are subtracted from NI.
3.Increases in current assets are subtracted from NI.
4.Increases in current liabilities are added to NI.
5.Noncash expenses and losses are added to NI.
6.Noncash revenues and gains are subtracted from NI.
There are some additional issues to consider in terms of deferred taxes and consolidated entities. These are usually covered in an advanced accounting course.
An income and an expense example applying the rules for the INDIRECT Method for cash flows
follows:
(Reconciliation approach to cash flows from operating activities). Start with net income (an accrual amount) and make adjustments to end up with the cash flow amount.
Adjustments Needed to NIIncome:
Sales / Income on IS / Already "in" NI
Accounts Receivable / Current assets:
Increase / Less paid in / -
Decrease / More paid in / +
Unearned Fees (Deposits) / Current liabilities:
Increase / More paid in / +
Decrease / Less paid in / -
Expenses/Costs:
Rent Expense / Expense on I/S / Already "out" of NI
Prepaid Rent / Current assets:
Increase / More paid out / -
Decrease / Less paid out / +
Rent Payable / Current liabilities:
Increase / Less paid out / +
Decrease / More paid out / -
Other adjustments needed for the Indirect Method:
Depreciation expense (noncash) / +Amortization expense (noncash) / +
*Loss on sale (take out the negative) / +
*Gain on sale (take out the positive) / -
*The entire sales proceeds will be presented in the investing activities
section of the CFS
C.Additional Issues in Interpreting Cash Flows from Operations
1.Gain or Loss on sale of property, plant and equipment need to be reversed to allow their inclusion in the investment portion of the CFS
2. Future Income taxes are a result of different calculations for income tax using GAAP and the tax laws. Any change must also be included to reflect the difference between the tax liability recognized and the actual remittance to the government.
3. Equity in income or losses of unconsolidated affiliates affects the income reported when using the equity method to account for investments but there are no cash affects and hence these incomes or losses must be reversed to reflect the true cash flow.
The impact of currency fluctuations also are reported as profits or losses and may require reversals if reported as such on the income statement.
D.A Comparison of the Direct and Indirect Methods
1.The only differences in presentations on the CFS are in the operating activities section of the CFS.
a.The indirect method of presenting cash flows follows a reconciliation approach. Adjustments are added to and subtracted from NI to derive "cash income".
b.The direct method presents gross cash inflows and gross cash outflows related to operating activities. Unlike the indirect method, this method gives the statement user a sense of the magnitude of dollars flowing in and out of the day-to-day operations of the business.
2.The amount of "net" cash flow from operating activities is the same under either method. It is just the presentation of the details that differs.
IV.REPORTING AND INTERPRETING CASH FLOWS FROM INVESTING ACTIVITIES - L.O. 4
1.The investing activities section of the CFS includes purchases (cash outflows) and sales (cash inflows) of operational and investment assets.
2.Cash outflows relate to capital expenditures such as the purchase of plant, property, and equipment. Purchases of intangibles and investments (assets not used in the operations of the business) are also included in this category.
3.Cash inflows relate to the sales of these assets. Any gain or loss on the sale is removed from the operating activities section so that the entire sales proceeds can be presented in the Investing activities section.
4.Cash outflows for lending money with notes receivables (N/R) and cash inflows for collecting principal payments or for sales of N/R are presented in this section. Any interest receipts related to N/R are presented in the operating activities section of the CFS.
V.REPORTING AND INTERPRETING CASH FLOWS FROM FINANCING ACTIVITIES - L.O. 6
1.The financing activities section of the CFS is associated with generating funds from creditors and owners.
2.Cash outlays include repayments of debt principal to creditors (any interest paid is presented under operating activities). Outlays of cash associated with owners include dividend payments, purchases of treasury shares, and purchases of shares for retirement.
3.Cash inflows include the proceeds of borrowing and the sale of stock (including the resale of treasury shares).
VIPRESENTATION OF THE CASH FLOW STATEMENT - L.O. 7
1.Once the amounts of cash flows have been determined, the proper category for reporting must be determined. After the amount and category are determined, the preparation of the CFS is basically a formatting issue.