Financial accounting in an economic context 8e chapter 014

Cash Flows from Operating Activities CF from operating activities is based on the income statement, and converts income activity to a cash basis.. from operating activity: – direct me

Chapter 14

Statement of Cash Flows

Figure 14-1

Definition of Cash

 Cash consists of coin, currency, and available funds on

deposit at the bank Negotiable instruments such as

money orders, certified checks, cashier’s checks, personal checks, and bank drafts are also considered cash.

Also certain cash equivalents, which include commercial

paper and other debt investments with maturities of less

than three months are included in the statement of cash

flows.

Standard Statement of Cash Flows

Statement of Cash Flows

 Required for financial statements by SFAS 95 (1987).

 Primary purpose is to provide relevant

information about cash receipts and cash

disbursements of the company during the

period.

 Serves to complement the other financial

statements.

 Focus is on cash flows, not income.

 Reconciles the balance sheet and the income statement.

Content of Statement of Cash Flows

 Explains change in cash and cash equivalents.

 Cash equivalents are defined as short-term,

highly liquid investments near to maturity.

 Examples of cash equivalents are Treasury bills and money market funds.

 Format of SCF includes the following three

sections:

- cash flow from operating activities.

- cash flow from investing activities.

- cash flow from financing activities.

 Like US GAAP, IFRS requires the presentation

of a SCF, and the format is largely the same.

Cash Flows from Operating Activities

 CF from operating activities is based on the

income statement, and converts income activity to

a cash basis.

from operating activity:

– direct method : this technique shows

cash received from customers and cash paid to various entities for operating

activities.

– indirect method : this technique starts

with net income and makes adjustments

to net income to convert it to a cash

basis.

Cash Flows from Operating Activities

must be presented in a supplementary schedule.

vast majority of companies present only the

indirect method.

method.

Cash Flows from Investing Activities

Cash Flows from Investing Activities

 CF from investing activities explain the changes in

– cash paid for purchase of equipment, land,

buildings, marketable securities (available-for-sale and equity), intangible assets, and most other long term assets

– cash received from sale of equipment, land,

buildings, marketable securities (available-for-sale and equity), intangible assets, and most other long term assets

– cash paid for issue of non-trade notes receivable (both short-term and long-term)

– cash received for repayment on non-trade notes

Cash Flows from Investing Activities

 General rule for investing activity:

– cash flows for purchase and sale of long-term assets.

 Exceptions to the rule:

– Short term notes receivable (non-trade) are included in the investing section.

– Long term notes receivable (trade) are not included in the investing section Because they relate to trade, they are treated just like accounts receivable in the operating section.

– The change in equity method investments is classified

in the operating section of SCF, because the change

deals with income (Purchase and sale of equity

investments are classified in investing.)

 Note: Trade receivables are created when inventory is sold

on account Non-trade receivables are created when a

company loans cash to employees or others (no sale is

involved).

Cash Flows from Financing Activities

 CF from financing activities explain the changes in

– cash received from issue of bonds, mortgages

and other long-term debt,

– cash received from issue of common stock and preferred stock,

– cash paid for the retirement of long-term debt,

– cash paid for the repurchase of treasury stock,

– cash paid for dividends,

– cash received for issue of non-trade notes

payable (both short-term and long-term), and

– cash paid for retirement or repayment on

non-trade notes payable (both short-term and

long-term)

Cash Flows from Financing Activities

 Note that cash paid for dividends is

classified as a financing activity, but cash

paid for interest is classified as an operating activity

 Note that cash received for dividends and

cash received for interest are both classified

as operating activities

Cash Flows from Financing Activities

 General rule for financing activity:

liabilities and equity

– Short term notes payable (non-trade) are

included in the financing section (Short term bank notes are very common examples.)

– Long term notes payable (trade) are not included

in the financing section Because they relate to

trade, they are treated just like accounts payable

in the operating section (LT trade N/P are rare.)

created when a company or borrows cash from a

bank or others (no inventory purchase is involved)

Cash Flows from Operations (Indirect Method)

To understand the adjustments to get from net income to

CF from operations, we will classify the adjustments into

3 categories:

(1) Items that affect income but not CFO

(noncash items)

(2) Double counted gains and losses

(3) Changes in related (accrual basis) assets and

liabilities from:

(a) Revenues recognized before cash is received.

(b) Expenses recognized after cash is paid.

(c) Revenues recognized after cash is received.

(d) Expenses recognized before cash is paid.

Remember: net income includes many activities that are noncash, or only partly cash

Indirect Method - Noncash Items

Noncash activities include

-Depreciation expense For example:

-Bad debt expense on the estimation of uncollectibles:

Since these expenses originally reduced net income, the

amount of these expenses would need to be added back to

Figure 14-3

Indirect Method - Noncash Items

premiums and discounts on bonds payable These

There are two components to interest expense each period: (1) the cash paid for interest expense, and (2) the amortization of premiums or discounts (the

noncash portion)

To find the direction of the adjustment, isolate the

noncash component (for amortization) of the interest expense entry:

Indirect Method - Double Counted Items

losses on investing and financing activity

cash, and the original cost was $9,000:

Gain on Sale of Land 1,000

In this case, the $10,000 cash received would be shown in Investing However, if the gain is not

adjusted out of net income, we would be “double counting” that effect.

Indirect Method - Double Counted Items

investing assets (equipment, land, buildings, AFS and equity investments, intangibles) The

– add the amount of loss to net income.

– subtract the amount of the gain from net

income

early extinguishment of debt (like the gains/losses from the retirement of bonds).

– add the amount of loss to net income.

– subtract the amount of the gain from net

income

Indirect Method - Change in Related Assets and Liabilities

assets and liabilities that relate to the remaining

income statement items, after the items in (1) and (2) have been removed.

effectively “squeeze” the income statement item

from the accrual basis of accounting to the cash

basis of accounting

Indirect Method Change in Related Assets and Liabilities

recognized for the year is $100,000 At the

beginning of the year, A/R were $2,000; at the end

of the year, A/R were $3,000.

customers?

account, and how it is increased and decreased.

Indirect Method Change in Related Assets and Liabilities

-Accounts Receivable

Cash Collection

relationship can be expressed in a formula involving A/R and

Indirect Method Change in Related Assets and Liabilities

A/RB + Sales - A/RE = Cash Collections

2,000 + 100,000 - 3,000 = Cash Collections

99,000 = Cash Collections Note that, to convert from accrual basis sales

revenues to cash basis sales revenues, an

increase in A/R should be subtracted from net

income to convert net income to a cash basis.

added to net income to convert net income to a

cash basis.

Indirect Method Change in Related Assets and Liabilities

-This pair of rules can be expanded to a general set of

rules to convert NI from accrual to cash basis:

Subtract increases in related assets.

Add decreases in related assets.

Add increases in related liabilities.

Subtract decreases in related liabilities.

The types of assets that relate to the income statement are

primarily current assets, but not always To decide, you must

look at each asset and its related income statement

component Also, remember that we are looking at the

1) Since we have already eliminated depreciation expense and amortization expense, etc., we would not include the

changes in these related assets (Accum Depr., Patents, etc.).

Indirect Method Change in Related Assets and LiabilitiesExamples of related assets are:

-Accounts Receivable

Dividends Receivable (relates to dividend income)

Trade Notes Receivable (short and long term)

Inventories

Prepaid Expenses

Deferred Tax Assets (because this relates to

income tax expense)

Trading Investments (because they relate to

unrealized gains and losses on the income

statement as well as gains and losses on sale)

Equity Investments (because this relates to

“Income from Investment”)

Indirect Method Change in Related Assets and Liabilities

-Examples of related liabilities include:

Accounts Payable.

Interest Payable.

Income Tax Payable.

Other Current Liabilities.

Trade Notes Payable (short and long term)

Unearned Revenues (short and long term).

Deferred Tax Liabilities (because this relates to

income tax expense).

Figure 14-5

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Figure 14-17

Direct Method

Indirect Method

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