Principles of financial accounting 12e by needles crosson chapter 15

Concepts Underlying the Statement of Cash Flows  Cash equivalents should not be confused with short-term investments, also called maturity of more than 90 days but are intended to be

15C H A P T E R

Concepts Underlying the

Statement of Cash Flows

 The s tate me nt o f cas h flo ws shows how a

company’s operating, investing, and financing

activities have affected cash during a period It

explains the net increase (or decrease) in cash

during the period

 Cas h is defined as including both cash and cash

equivalents

– Cas h e quivale nts are investments that can be quickly

converted to cash They have a maturity of 90 days or less when they are purchased and include the following:

 Money market accounts

 Commercial paper (short-term corporate notes)

 U.S Treasury bills

Concepts Underlying the

Statement of Cash Flows

 Cash equivalents should not be confused

with short-term investments, also called

maturity of more than 90 days but are

intended to be held only until cash is needed for current operations.

– Purchases of marketable securities are treated as cash outflows, and sales of marketable securities are treated as cash inflows

– Transfers between the Cash account and cash

equivalents are not treated as cash inflows or

Relevance of the Statement of Cash Flows

 The statement of cash flows provides information

about a company’s cash receipts and cash payments during a period

 Management uses the statement of cash flows to:

assess liquidity; determine dividend policy; evaluate the effects of major policy decisions involving

investments and financing needs

 Investors and creditors use the statement of cash

flows to assess a company’s ability to: manage cash flows; generate positive future cash flows; pays its

liabilities; pay dividends and interest; anticipate the need for additional financing

Classification of Cash Flows

 Ope rating activitie s —involve the cash inflows and outflows from activities that enter into the

determination of net income

– Cash inflows include:

 Cash receipts from the sale of goods and services

 Cash receipts from the sale of trading s e curitie s—marketable securities that a company buys and sells for making a profit in the near term as opposed to holding them indefinitely for investment purposes.

 Interest received on loans and dividends received on investments

– Cash outflows include:

 Cash payments for wages, inventory, expenses, interest, and taxes

 Purchases of trading securities

Classification of Cash Flows

 Inve s ting ac tivitie s —involve the acquisition and

sale of property, plant, and equipment and other

long-term assets, including long-term investments

– Cash inflows include cash received from:

 Selling marketable securities, other than trading securities

 Selling long-term assets

 Collecting on loans

– Cash outflows include:

 Cash expended on purchasing securities and assets

 Cash lent to borrowers

Classification of Cash Flows

 Financ ing activitie s —involve obtaining resources from stockholders and creditors

– Cash inflows include:

 Proceeds from stock issues

 Short-term and long-term borrowing

– Cash outflows include:

 Repayments of loans (excluding interest)

 Payments to owners, including cash dividends

– Treasury stock transactions are also considered financing activities.

– Repayments of accounts payable or accrued liabilities are

not considered repayments of loans and are classified as cash outflows under operating activities.

Required Disclosure of Noncash Investing and Financing Transactions

 Companies occasionally engage in

significant noncas h inves ting and

– These transactions involve only long-term assets,

long-term liabilities, or stockholders’ equity

– Although noncash transactions represent

significant investing and financing activities, they are not reflected in the body of the statement of cash flows because they do not affect current cash inflows and outflows

– They will, however, affect future cash flows, so

they must be disclosed in a separate schedule,

usually following the statement of cash flows

Alternate Presentations of Operating Activities

the income statement from the accrual basis

to the cash basis

Alternate Presentations of Operating Activities

conversion of each item on the income

statement.

– It lists only the items necessary to convert net

income to cash flows from operations

– Both analysts and companies overwhelmingly

prefer the indirect method, which is easier to prepare

Preparation of the Statement of Cash Flows

 Preparing a statement of cash flows involves four steps:

 Determine Cash Flows from Operating Activities

 Determine Cash Flows from Investing Activities

 Determine Cash Flows from Financing Activities

 Prepare the Statement of Cash Flows

Step One: Determining Cash Flows from

Operating Activities

 Because the income statement is prepared on an

accrual basis, it does not reflect the inflow and

outflow of cash related to operating activities

– To ascertain cash flows from operations, the figures on the income statement must be converted from an accrual basis

to a cash basis.

– The indirect method focuses on adjusting items on the

income statement to reconcile net income to net cash flows from operating activities These items include:

 Depreciation, amortization, and depletion

 Gains and losses

 Changes in the balances of current assets and current liabilities

Step Two: Determining Cash Flows from

Investing Activities

 In this step, accounts involving cash receipts and

cash payments from investing activities are

examined individually The object is to explain the

change in each account balance from one period to the next

– The following transactions pertain to Eureka’s investing

activities in 2014:

1 Purchased investments in the amount of $78,000.

2 Sold for $102,000 investments that cost $90,000.

3 Purchased plant assets in the amount of $120,000.

4 Sold for $5,000 plant assets that cost $10,000 and that had accumulated depreciation of $2,000.

5 Issued $100,000 of bonds at face value in a noncash exchange for

Step Three: Determining Cash Flows from

Financing Activities

 Determining cash flows from financing activities is very similar to determining cash flows from investing activities, but the accounts analyzed relate to short-term borrowings, long-term liabilities, and

2 Repaid $50,000 of bonds at face value at maturity.

3 Issued 15,200 shares of $5 par value common stock for

$175,000.

4 Paid cash dividends in the amount of $7,000.

5 Purchased treasury stock for $25,000.

Cash Flow Ratios

 Cash flows from operating activities represent the

cash generated from current or continuing

operations

– They are a measure of the ability to pay bills on time and to meet unexpected needs for cash, as well as how

management spends the company’s cash.

 The focal point of cash flow analysis is on cash

inflows and outflows from operating activities

– These cash flows are used in ratios that measure c as

h-ge ne rating e ffic ie nc y, which is a company’s ability to generate cash from its current or continuing operations.

Cash Flow Yield

from operating activities to net income.

Cash Flows to Sales

flows from operating activities to net sales.

Cash Flows to Assets

flows from operating activities to average

total assets

Free Cash Flow

 Fre e cas h flo w is the amount of cash that remains after deducting the funds a company must commit to continue operating at its planned level

– Free cash flow can be positive or negative:

its planned cash commitments and has cash available to reduce debt or to expand.

sell its investments, borrow money, or issue stock in the short term to continue at its planned level If a company’s free cash flow remains negative for several years, it may not be able to raise cash by issuing stocks or bonds.

Asking the Right Questions About the

Statement of Cash Flows

 In interpreting a statement of cash flows, it pays to

know the right questions to ask

– Cash Flows and Net Income: What are the primary reasons

that the company’s cas h flows from ope rating activitie s diffe re d from ne t income ?

– Investing Activities: What were the company’s most

im portant inve sting activitie s othe r than capital

e xpe nditure s ?

– Financing Activities: How did the company manage its

financing activitie s during the ye ar?

– Cash Flow Trends: What has been the trend of cash flows

for the com pany?

Ethical Considerations in Analyzing the

Statement of Cash Flows

 Because of the emphasis on cash flows as an

important measure of performance, an incentive

exists to overstate these cash flows

 A company may show an apparent (but false)

improvement in its performance:

– by classifying payments of operating expenses as

investments on the statement of cash flows.

– through lack of transparency, or lack of full disclosure, in its financial statements—such as by netting the proceeds of securitization against the accounts receivable in the

operating activities section of the statement of cash flows.