Intermediate accounting 19th by stice stice chapter 05

Everything is on One Page• The cash flow statement includes information on operating, investing, and financing activities.. It is Used as a Forecasting ToolA pro forma cash flow statem

Intermediate

Accounting

James D Stice Earl K Stice

PowerPoint presented by Douglas Cloud Professor Emeritus of Accounting, Pepperdine

Statement of Cash Flows and Articulation

Chapter 5

19 th

Edition

What Good is a Cash

Flow Statement?

We need the cash flow statement

because:

The Big Loss Scenario

When a company reports large noncash

expenses such as:

- write-offs

- depreciation

- provisions for future obligations

… earnings may give a gloomier picture

of current operations than warranted.

(continued)

The Rapid Growth Scenario

• Rapidly growing firms use large

amounts of cash to expand inventory.

• Cash collections on the growing

accounts receivable often lag behind the need to pay creditors.

• Reported earnings may be positive, but operations are actually consuming

rather than generating cash.

The Reality Check Scenario

√ Companies entering phases in which it is

critical that reported earnings look good,

accounting assumptions can be stretched

• Just before making a large loan

• Cash flow from operations, which is not

impacted by accrual assumptions,

provides an excellent reality check for

earnings.

(continued)The Reality Check Scenario

Everything is on One Page

• The cash flow statement includes

information on operating, investing, and

financing activities.

• Everything you ever wanted to know about

a company’s performance for the year is

summarized in this one statement.

(continued)

It is Used as a Forecasting Tool

A pro forma cash flow statement is a prediction of what the actual cash flow statement will look like in future years if the operating, investing, and financing plans are implemented.

Statement of Cash Flows

A statement of cash flows explains

the change during the period in cash

and cash equivalents.

What is this?

(continued)

• A cash equivalent is a short-term, highly liquid investment that can be converted

easily into cash.

• To qualify as a cash equivalent, an item must be:

insignificant risk of changes in value

due to changes in interest rates

Cash Equivalent

• Operating activities include those

transactions and events that enter into the

determination of net income

wages, taxes, and similar expenses

• The primary investing activities are the

purchase and sale of land, buildings,

equipment, and other assets not generally

held for resale

transactions and events that involve the

purchase and sale of financial instruments

not intended for trading purposes, as well as making and collecting loans

Three Categories of

Cash Flows

(continued)

Financing activities include those transactions

and events whereby resources are obtained

from, or repaid to, owners (equity financing) and creditors (debt financing):

• Cash proceeds from issuing stocks or bonds.

• Payments to reacquire stock (treasury stock)

or to retire bonds.

• Payment of dividends.

(continued)Three Categories of

Cash Flows

• Most companies (73% in the United States

in 2006) generate positive cash flow from

operations

to expand or enhance long-term assets, so cash from investing activities is usually

negative (83% of the time in the United

States in 2006)

cash flow from financing activities

Cash Flow Patterns

(continued)

Noncash Investing and Financing Activities

• Noncash investing and financing activities

affect an entity’s financial position but not the entity’s cash flow Examples include:

separately

statement of cash flows

Operating Activities: Direct Method

• The direct method is essentially a

reexamination of each income

statement item with the objective of

reporting how much cash was received

or disbursed in association with the

item.

• To prepare the operating section, each

income statement item must be adjusted for the effects of accruals.

• The indirect method begins with net

income as reported on the income

statement and adjusts the accrual

amount for any items that do not affect

cash flow.

• Both the direct and indirect methods

produce identical results—that is, the

same amount of net cash provided by

(or used in) operations.

(continued)Operating Activities: Indirect Method

The adjustments for the indirect method are of three basic types:

cash inflow or outflow

or financing activities

operating assets and liabilities that indicate

noncash sources of revenues and

expenses

Operating Activities: Indirect Method

Cost of Goods Sold and Cash

Paid for Inventory

Cost of Goods Sold and Cash

Paid for Inventory

Wages Expense and Cash Paid for Wages

Wages Expense and Cash Paid for Wages

10

(continued)Operating Activities: Direct Method

Depreciation Expense

Depreciation ExpenseOperating Activities: Direct Method

Sales

The $20 increase in accounts receivable

means that cash collected is $20 less than the $150 the sales number indicates So,

the necessary adjustment is to subtract

the $20 to show that $130 was collected

on account.

(continued)Operating Activities: Indirect Method

Cost of Goods Sold

Cost of Goods Sold

The $25 decrease in inventory means that although cost of good sold of $80 is

included in the income statement, less

cash was used to purchase inventory than suggested— add $25 to net income.

(continued)Operating Activities: Indirect Method

Wages Expense

Wages Expense

The $3 increase in wages payable

indicates that only $22 of the $25 expense was paid in cash The $3 increase in

wages payable is added to net income.

(continued)Operating Activities: Indirect Method

Depreciation Expense

Depreciation Expense

The $30 depreciation expense is a noncash expense Because it was subtracted in

computing net income, it must be added

back to net income because it was

deducted from net income to determine the accrual net income.

(continued)Operating Activities: Indirect Method

• Depreciation is not a source of cash

Because you added depreciation back to net income as an adjustment using the indirect

method does not mean that there is an inflow

of cash However, depreciation does lower

the amount of income taxes paid

it highlights how cash flow can be improved

in the short run by adjusting operating

procedures

Important

Comparison of Direct and

With the indirect method, only net income and the

adjustments are reported The Operating Activities

section of the statement of cash flows includes the

shaded information above.

Preparing a Complete Statement of Cash Flows

changes in current operating assets and

liabilities

and owners’ equity

Basic information to prepare the three sections

of the cash flow statement comes from the

balance sheet and income statement, as follows:

(continued)

The statement of cash flow is not complete until the sum of cash from operating,

investing, and financing activities exactly

matches the total change in the cash balance during the year.

Step 1: Compute How Much the Cash Balance

Changed During the Year

Step 1: Compute How Much the Cash Balance

Changed During the Year

Preparing a Complete Statement of Cash Flows

This is done in three steps:

(a) Eliminate expenses that do not

involve the outflow of cash, such as

depreciation expense.

Step 2: Convert the Income Statement from an

Accrual-Basis to a Cash-Basis Summary of Operations

Step 2: Convert the Income Statement from an

Accrual-Basis to a Cash-Basis Summary of Operations

Preparing a Complete Statement of Cash Flows

(b) Eliminate gains and losses

associated with investing or financing

activities to avoid counting these

items twice.

Step 2: Continued

Step 2: Continued

Preparing a Complete Statement of Cash Flows

(c) Adjust for changes in the balances of

current operating assets and

operating liabilities.

Step 2: Continued

Step 2: Continued

Preparing a Complete Statement of Cash Flows

• Orchard Blossom reports two long-term

asset accounts: Land and Buildings.

Step 3: Analyze the Long-Term Assets to

Identify the Cash Flow Effects of Investing Activities

Step 3: Analyze the Long-Term Assets to

Identify the Cash Flow Effects of Investing Activities

Preparing a Complete Statement of Cash Flows

Step 4: Analyze the Long-Term Debt and

Stockholders’ Equity Accounts to Determine the Cash Flow Effects of Any Financing Transactions

Step 4: Analyze the Long-Term Debt and

Stockholders’ Equity Accounts to Determine the Cash Flow Effects of Any Financing Transactions

Preparing a Complete Statement of Cash Flows

• Repaying principal on borrowing

• Treasury stock purchase

Based on our analyses of the income

statement and balance sheet accounts, we have identified all inflows and outflow of cash for Orchard Blossom for the year, and we

have categorized those cash flows based on the type of activity.

• Cash paid for interest and income taxes

• Noncash investing and financing

activities

Step 6: Prepare Supplemental Disclosure

Step 6: Prepare Supplemental Disclosure

Preparing a Complete Statement of Cash Flows

Cash Flow to Net Income Ratio

Cash Flow to Net Income Ratio

years for a specific company

Cash Flow Ratios

Cash from operations

Net income

(continued)

Cash Flow Adequacy Ratio

Cash Flow Adequacy Ratio

• A cash cow is a business that is generating

enough cash from operations to completely pay for all new plant and equipment purchases with cash left over to repay loans or distribute to owners.

• This ratio indicates whether a business is a cash cow.

Cash from operationsCapital expenditures and acquisitions

Cash flow

(continued)Cash Flow Ratios

• Measures interest-paying ability

Cash Flow Ratios

Cash Times Interest Earned

Cash Times Interest Earned

Articulation: How the Financial

Statements Tie Together

In an accounting context, articulation

means that the three primary financial

statements are not isolated lists of

numbers but are an integrated set of

reports on a company’s financial health.

1 Compute the change in cash.

2 Convert the income statement from an

accrual basis to a cash basis.

3 Analyze the long-term asset accounts.

4 Analyze the long-term debt and

stockholders’ equity accounts.

5 Prepare the statement of cash flows.

6 Disclose any significant noncash

activities.

Forecasted Statement of

Cash Flows