Chapter 12 PDF

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Chapter notes for financial accounting with David Deeds...

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Chapter 12: Reporting and Analyzing Cash Flows

Purpose of the Statement of Cash Flows

● Statement of cash flows: report cash receipts (inflows) and cash payments (outflows) during a period ● This statement includes separately identifying the cash flows related to operating, investing, and financing ● Detailed disclosure of individual sources and uses of cash that makes this statement useful to users ● The statement of cash flows answers these questions: ○ What explains the change in the cash balance? ○ Where does a company spend its cash? ○ How does a company receive its cash? ○ Why do income and cash flows differ? ○ How much is paid in dividends? ○ Is there a cash shortage? ● Internal users rely on the statement of cash flows to make investing and financing decisions ● External users rely of this statement to assess the amount and timing of a company’s cash flows Importance of Cash Flows ● Information about cash flows helps users decide whether a company has enough cash to pay its existing debts as they mature ● Evaluates a company’s ability to meet unexpected obligations and pursue unexpected opportunities ● External users want to use cash flows to assess a company’s ability to take advantage of new business opportunities ● Internal users like managers use cash flow information to plan day-to-day operating activities and make long-term investment decisions Measurement of Cash Flows ● Cash flows include both cash and cash equivalents ● The statement of cash flows explain the difference between the beginning and ending balance of cash and cash equivalents ● Cash equivalents must satisfy two criteria:

○ Be readily convertible to a known amount of cash ○ Be sufficiently close to its maturity so its market value is unaffected by interest rate changes Classification of Cash Flows ● Statement of cash flows does not report transactions between cash and cash equivalents ● Cash receipts and cash payments are reported on the statement in three categories: ○ Operating ○ Investing ○ Financing ● Individual cash receipts and payments for each of these three categories are labeled to identify their originating transactions or events ● Net cash inflow (source): occurs when the receipts in a category exceed the payments ● Net cash outflow (use): occurs when the payments in a category exceed the receipts Operating Activities ● Operating activities include those transactions and events that determine net income ● Examples: ○ Purchase of inventory ○ Sale of goods and services to customers ○ Expenditures to operate the business ○ Income statement items not affecting cash: ■ Gains ■ Losses

Investing Activities ● Include those transactions and events that affect long-term assets, mainly the purchase and sale of long-term assets ● Investing activities also include: ○ Purchase and sale of short-term investments in the securities of other entities, except trading securities ○ Lending and collecting money for notes receivable ● Cash from collecting the principal amounts of notes that result from a loan to another party are classified as investing ● The FASB requires that the collection of interest on notes be reported as an operating activity and if a note results from sales to customers, it is classified as operating

Financing Activities ● Include those transactions and events that affect long-term liabilities and equity ● Examples include: ○ Obtaining cash from issuing debt and repaying the amounts borrowed ○ Receiving cash from or distributing cash to owners ● These activities involve transactions with a company’s owners and creditors ● Also involve borrowing and repaying principal amounts relating to both short and long term debt ● GAAP requires that payments of interest expense be classified as operating activities

Link between Classification of Cash Flows and the Balance Sheet ● Operating activities are affected by changes in current assets and current liabilities (and the income statement) ● Investing activities are affected by changes in long-term assets ● Financing activities are affected by changes in long-term liabilities and equity ● Exceptions to these links are: ○ Current assets unrelated to operations, which are treated as investing ■ Short-term notes receivable from non-customers and marketable (not trading) securities, which are considered investing transactions ○ Current liabilities unrelated to operations, which are treated as financing ■ Short-term notes payable ■ Dividends payable

Noncash Investing and Financing ● Some important investing and financing activities do not affect cash receipts or payments ● Examples: ○ Purchase of long-term assets using a long-term note payable (loan) ■ This transaction involves both investing and financing activities but does not affect any (immediate) cash inflow or outflow, so it is not reported in any of the three sections on the statement of cash flows ● These transactions are reported at the bottom of the statement or in a note to the statement

Format of the Statement of Cash Flows ● Must report information about a company’s cash receipts and cash payments during the period ● The statement shows the net increase or decrease from the three activities ● Explains how transactions and events impact the prior period-end cash balance to produce its current period-end balance Preparing the Statement of Cash Flows ● Five Steps: 1. Compute the net increase or decrease in cash 2. Compute and report the net cash provided or used by operating activities (using direct or indirect method) 3. Compute and report the net cash provided or used by investing activities 4. Compute and report the net cash provided or used by financing activities 5. Compute and report the net cash flow by combining net cash provided or used by operating, investing, and financing activities, and the prove it by adding it to the

beginning cash balance to show it equals the cash balance ● Net increase or decrease in cash = current period’s cash balance minus the prior period’s cash balance Analyzing the Cash Account ● A company’s cash receipts and cash payments are recorded in the cash account in its general ledger ● The cash account has information about cash flows from operating, investing, and financing activities Analyzing Noncash Accounts ● This is when a company records cash inflows and outflows with debits and credits to the Cash account, it is also recorded with credits and debits to noncash accounts (doubleentry accounting) ● Many of these noncash accounts are balance sheet accounts (e.g. sale of land for cash) ● Other accounts are revenue and expense accounts that are closed to equity ● All transactions eventually affect noncash balance sheet accounts ● We can determine cash inflows and outflows by analyzing changes in noncash balance sheet accounts ● We can prepare a statement of flows by analyzing noncash balance sheet accounts Information to Prepare the Statement ● Information to prepare statement of cash flows usually comes from three sources: ○ Comparative balance sheets ■ Used to compare changes in noncash accounts from the beginning to the end of a period ○ Current income statement ■ Used to help compute cash flows from operating activites ○ Additional information ■ Includes details on transactions and events that help explain both the cash flows and noncash investing and financing activities Cash Flows from Operating Indirect and Direct Methods of Reporting ● Cash flows provided (used) by operating activities are reported through the direct

method and indirect method ○ *note: only applies to the operating activities section* ● Direct method: ○ Lists each major item of operating cash receipts and each major item of operating cash payments ○ Cash payments are subtracted from cash receipts to determine net cash provided (used) by operating activities ● Indirect method: ○ Reports net income and then adjusts it for items necessary to obtain net cash provided or used by operating activities ○ Does not report any individual items of cash inflows and cash outflows from operating activities ○ Instead, it reports necessary adjustments needed to reconcile net income to net cash provided or used by operating activities ● The net cash amount provided by operating activities is identical under the direct and indirect methods ● The difference between the methods is the computation and presentation of the net cash amount ● FASB recommends the direct method, but the indirect method is easier to compute, so nearly all companies report operating cash flows using the indirect method Applying the Indirect Method of Reporting ● Using the indirect method, you must adjust net income to obtain the net cash provided or used by operating activities ● Must subtract noncash increases from net income and add noncash charges back to net income

Adjustments for Income Statement Items Not Affecting Cash ● Expenses and losses with no cash outflows are added back to net income: ○ Depreciation expense ○ Amortization expense ○ Depletion expense ○ Bad debts expense ○ Loss from an asset sale ○ Loss from retirement of notes payable ● All of these items have no cash effect and adding them back cancels their deductions ● For losses- since no operating cash flow effect occurs, we add it back to neet income to reverse the deduction ● When net income includes revenues that do not reflect cash inflows, such as gains, we subtract any revenues and gains with no cash inflow from net income Adjustments for Changes in Current Assets and Current Liabilities ● Adjustments for changes in current assets: ○ Decreases in current assets are added back to net income ○ Increases in current assets are subtracted from net income ● Adjustments for changes in current liabilities:

○ Increases in current liabilities are added to net income ○ Decreases in current liabilities are subtracted from net income

● Accounts receivable: the $20,000 increase is subtracted from net income because it implies that the company collects less cash than it is reported in sales ● Inventory: the $14,000 increase in inventory is subtracted from net income because it implies the company had greater cash purchases than cost of goods sold ● Prepaid expenses: the $2,000 increase in prepaid expenses is subtracted from income because the company’s cash payments exceed its recorded prepaid expenses ● Accounts payable: the $5,000 decrease in this current liability is subtracted from income because it implies that cash payments to suppliers exceed purchases ● Interest payable: the $1,000 decrease in interest payable is subtracted from income because it means that cash paid for interest exceeds interest expense

Summary Adjustments for Operating Activities- Indirect Method

Cash Flows from Investing ● Identify the changes in all noncurrent asset accounts (plant assets) ● Identify changes in notes receivable and investments in securities (excluding trading securities) ● Reporting of investing activities is identical under the direct and indirect method Three-Stage Process of Analysis ● Information to compute cash flows from investing activities is usually taken from beginning and ending balance sheets and the income statement ● Three steps ○ Identify changes in investing-related accounts ○ Explain these changes using reconstruction analysis ○ Report their cash flow effects Analyzing Noncurrent Assets (Plant Asset transactions) ● First stage in analyzing the plant assets account and its Accumulated Depreciation account is to identify any changes in these accounts from comparative balance sheets ● Second stage is to explain the changes, which use reconstructed entries from prior transactions to explain the changes ○ Reconstructed entries are not the actual entries by the preparer ● Third stage in analyzing the Plant Asset account looks back at the reconstructed entries to identify any cash flows

○ The cash flow effect is recorded as:

(re-read page 548)

Cash Flows from Financing ● Fourth major step in preparing the statement of cash flows is to compute and report cash flows from financing activities ● Identify changes in all noncurrent liability accounts (including the current portion of any notes and bonds) and the equity accounts ● Examples: ○ Long-term debt ○ Notes payable ○ Bonds payable ○ Common stock ○ Retained earnings ● Reporting of financing activities is identical under the direct and indirect method Three-Stage Process of Analysis 1. Identify changes in financing-related accounts 2. Explain these changes using reconstruction analysis 3. Report their cash flow effects Analyzing Noncurrent Liabilities ● First stage is to review the comparative balance sheet and find the changes in its current liabilities such as notes payable ● Second stage is to explain this change ○ Example: report that notes with a value of $34,000 are retired for $18,000 cash, resulting in a $16,000 gain ○ The reconstructed entry is:

● This entry reveals and $18,00 cash outflow for retirement of notes and a $16,000 gain from comparing the notes payable carrying value to the cash received ● The gain does not reflect any cash inflow or outflow (re-read page 550)

Reporting Cash Flows from Operating ● US GAAP requires that cash inflows from interest revenue and dividend revenue be classified as operating ○ IFRS permits this classification under operating or investing ● US GAAP requires cash outflows for interest expense be classified as operating ○ IFRS permits this classification under operating or financing Reporting Cash Flows from Investing and Financing ● US GAAP requires that cash outflows for income tax be classified as operating ○ IFRS permits the splitting of those cash flows among operating, investing, and financing depending on the sources of that tax Cash Flow on Total Assets ● This ratio reflects actual cash flows and is not affected b accounting income recognition and measurement ● Helps business decision makers estimate the amount and timing of cash flows when planning and analyzing operating activities Cash flow on total assets = cash flow from operations / average total assets

Cash coverage of growth = operating cash flow / cash outflow for plant assets ● A low ratio (less than 1) implies cash inadequacy to meet asset growth, and a high ratio implies cash adequacy to meet asset growth Operating cash flow to sales = operating cash flow / net sales ● This ratio substantially and consistently differs from the operating income to net sales ratio...