Module 13 The Cash Flow Statement PDF

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York university ADMS 2500: Introduction to Financial accounting summary notes. Prof was John K....

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March 27, 2015

Module 13: The Cash Flow Statement - Cash flow statements help users assess the amount, timing and uncertainty of future cash flows, and evaluate financial flexibility and the “quality” of reported earnings. - The cash flow statement shows how solvent a company is. - A company could have a negative income, but a positive cash flow. - This statement doesn’t only explain the change in a firm’s cash, but also cash equivalents. Cash equivalents are the short-term, highly liquid investments that firms acquire with cash in excess of their immediate needs. Examples of cash equivalents are T-bills, commercial paper, and money market funds. When preparing the cash flow statement, the cash plus cash equivalents (minus short-term bank borrowings) are treated as a single sum. The Cash Flow Statement equation: Opening Balance of Cash + Additions for the period – Deductions for the period = Ending cash balance - This equation is divided into operating, investing, and financing sections. - Operations are all the activities associated with buying/manufacturing product and rendering services. - For a firm to be a success, it must generate the bulk of its cash from operations. - Investing activities change the physical infrastructure. - Financing activities: Raising capital from investors or creditors. What new businesses rely on. For the purpose of this statement, the CICA defines cash as (Cash + Cash equivalents – short term bank borrowing) Cash equivalents are what can be converted into cash within a 24 hour period. How a firm raises cash: Operations: Sell inventory and services Investing: Sell non-current assets. Financing: Sell stock or issue long term debt. How a firm spends cash: Operations: Expenses of running the business Investing: Buy non-current assets Financing: Retire debt or retire stock. (dividends also)

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operating cash flows - the excess of cash received from customers over the amount of cash paid to suppliers, employees and others in carrying out an enterprise's operating activities; investing activities - the acquisition and sale of non- current assets - the land, buildings, equipment and other non-current assets needed to maintain or grow current operating levels; and financing activities - obtaining funds through long-term borrowing and share issue, repaying long-term debt and paying dividends to shareholders

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- Although each company’s cash increased by $100,000, only Firm A’s cash came from operating activities. Therefore most creditors would feel most comfortable lending money to A. - Up until this point in the course, we have prepared cash flow statements by reviewing the transactions in the Cash account and classifying them as operating activities, financing and investing activities. Since most businesses transact hundreds, thousands and even millions of cash transactions daily, this method of construction is not practical. - Instead, accountants compute cash flows by analyzing the changes in income statement and balance sheet amounts. In other worlds, cash flow statement amounts may be derived by analyzing the changes in income statement and balance sheet accounts. Example: Compute the amount paid to employees during May if the Wage Expense is $4,000 in May, the Wages Payable balance is $3,500 on April 30th and the Wages Payable balance is $3,700 on May 31st.

Converting Accrual Measures to Cash Flow Information

Conundrum Company had the following transactions during 2005: (1) Made sales on account of $250,000. (2) Collected accounts receivable of $245,000. (3) Purchased merchandise on account of $134,000. (4) Determined cost of goods sold was $140,000. (5) Paid accounts payable (for merchandise purchased) of $143,000.

March 27, 2015 Paid wages to employees of $52,500. Accrued wages expense (and wages payable) of $1,500 at December 31, 2004. Paid insurance premium of $18,000 to extend coverage for three years. Allocated $5,000 of prepaid insurance to insurance expense. Paid income taxes to government of $11,500 (this represents the final portion of 2004 taxes (10) and initial installments of 2005 taxes). (11) Recorded 2005's total income tax expense (and income tax payable) of $13,000. - As a result of the transactions itemized for Conundrum in 2005, Conundrum's 2005 Income Statement and its December 31, 2005 Balance Sheet would be as presented here: (6) (7) (8) (9)

- A review of Conundrum's 2004 transactions shows that transactions (2), (5), (6), (8), and (10) reflect the cash receipts and disbursements from its operating activities. The cash-basis income statement method presents the net cash flow from operating activities by reporting these cash receipts and payments as follows:

* For the following, make t-charts for better understanding like the previous example: (for the direct method)

March 27, 2015 Convert Sales to Cash from Customers: During 2005, accounts receivable increased by $5,000. This increase means that cash collections on account (which decrease accounts receivable) were less than credit sales (which increase accounts receivable). Sales + Beginning Accounts Receivable - Ending Accounts Receivable = Cash Received from Customers

$250,000 34,000 (39,000) $245,000

Convert Cost of Goods Sold to Cash Paid to Suppliers: The conversion of cost of goods sold to cash paid to suppliers is a two-step process. First, cost of goods sold is adjusted for the change in inventory to determine the amount of purchases during the year. Then, the purchases amount is adjusted for the change in accounts payable to derive the cash paid to suppliers. Inventory decreased from $60,000 to $54,000 during 2005. This $6,000 decrease indicates that the cost of goods sold exceeded the cost of goods purchased during the year. The year's purchases amount is computed as:

During 2005, accounts payable decreased $9,000.

Convert Wages Expense to cash paid to employees: Wages payable decreased from $4,000 at December 31, 2004 to $1,500 at December 31, 2005.

*Convert Insurance Expense to Cash Paid for Insurance: Prepaid insurance increased $13,000 during 2005.

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Prepaid can be challenging using t-account way. Just use this formula on exam.

Converting Income Tax Expense to Cash Paid for Taxes: The increase in income tax payable from $1,000 at December 31, 2004 to $2,500 at December 31, 2005 means that 2005's income tax expense (which increases income tax payable) was $1,500 larger than 2005's tax payments (which decrease income tax payable). If we start with income tax expense, then we calculate cash paid for taxes in the manner shown as follows:

Eliminate Depreciation Expense: - Depreciation expense is a non-cash expense. Because it does not represent a cash payment, depreciation expense is completely eliminated when we convert accrual expense amounts to the corresponding amounts of cash payments. Amortization expense is also eliminated for the same reason. The amortization of an intangible asset is entirely a non-cash expense. Summary:

- There are two alternative methods of constructing cash flow statements. The difference is how the operations section is presented. The Direct Method

March 27, 2015 - Income statement and balance sheet is used. - Present specific sources and uses of cash in the operating section. This is the method used by Conundrum Company and is believed to be the best preparation method due to its simplicity and understandability. - The CICA Handbook recommends that net cash flow from operating activities be reconciled to the net income figure to show readers the linkage with the income statement. - The direct method does not provide any income statement linkage. No cash flow component under the cash basis income statement necessarily agrees with any amount in the income statement. This is why a reconciliation of net income is provided as a footnote when this method is used.

- The details of reconciling net income to cash from operations are best placed in a footnote or separate schedule to keep things tidy and clear. - A reconciliation of operating cash flow to net income as a footnote is required when the direct method is used. - The direct method may cost a little more, which explains why the indirect method is still used. The Indirect Method - Net income amount and balance sheet is used. (not the entire income statement) - The indirect method begins with the accrual-basis net income and applies a series of adjustments to convert this income to an operating cash flow. How do you convert an accrual based income statement into cash basis? 1) Identify all revenues and gains that didn’t bring in cash and remove them. 2) Identify all expenses and losses and didn’t consume cash and remove them. - The adjustments to accrual basis net income consist of the adjustments we just reviewed in converting individual revenue and expense amounts to a cash basis. However, the adjustments are applied to net income rather than to the individual revenues and expenses. Also, to be more efficient, just the changes in the balance sheet accounts are used rather than using both the beginning and ending account balances.

March 27, 2015 - The indirect method provides a clear linkage with the income statement. It begins with the net income. - The Uncollectible Accounts Expense can be ignored because the method will already take care of it by using the change in net accounts receivable. - The chart here shows the conversion formula. Notice the pattern. - If current asset accounts have a net decrease during the period, we add this decrease to accrual income to convert to cash income. - Conversely, if the current asset account has a net increase during the period, we deduct this net change from accrual income to get cash income. - The pattern reverses for liabilities. Increases in account balances are added to accrual income and decreases are deducted. Account

add to accrual income if there is a net…

Deduct from accrual income if there is a net

Accounts Receivable

Decrease

Increase

Inventory

Decrease

Increase

Prepaid Expenses Accounts Payable Other Accrued Liabilities

Decrease Increase Increase

Increase Decrease Decrease

- The presentation of the Operating Activities under the indirect method is the same as the footnote reconciliation of cash from operations to net income required under the direct method. - To recap, under the accrual-basis income statement method, non-cash expenses such as depreciation and amortization are added to net income to eliminate the effects they had on net income. - Changes during the year in accounts receivable, inventory, prepaid expenses, accounts payable, and accrued liabilities (such as wages payable and income tax payable) are either added to or subtracted from net income, depending on which account we are analyzing and whether the change was an increase or a decrease. - It is possible for the net amount of add-backs to exceed the loss so that there is a positive cash flow from operating activities even when there is an accrual basis net loss. Accrual Basis Net Income + Depreciation, Amortization and Similar Write-offs +/- Changes in A/R, Inventory, Prepaid Expenses, A/P, and Accrued Liabilities = Net Cash Flow from Operating Activities The direct method shows the specific sources and uses of cash from operating activities whereas the indirect method does not.

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Steps: The following steps are followed to prepare a cash flow statement using the direct method: (1) Compute the change in all balance sheet accounts from the Comparative Balance Sheet (2) Write the change in Cash and Cash Equivalents near the bottom of the cash flow statement this is the amount to which the total of the operating cash flows, investing cash flows and financing cash flows must agree … when they agree you are done. (3) Use the changes in the working capital accounts (current assets and current liabilities) to convert the income statement amounts to line items in the operating activities section (4) Reconcile net income to the total of the operating cash flows computed in (3) [required for footnote disclosure] (5) Compute financing and investing cash inflows (6) Check that the total operating, financing and investing cash flows agrees to the change in cash and cash equivalents (7) Prepare the cash flow statement If the indirect method is used, step (3) above is skipped and the footnote disclosure prepared in step (4) is used for the operating activities section of the cash flow statement. Investing Cash Flows: - As is the case for financing cash flows, if the change in a capital assets on the balance sheet is the net amount of an acquisition of a new asset and a disposition of an old asset, information about either the cost of the addition or the original cost of the asset disposed of would be required in addition to the comparative balance sheet information to compute the cash flows. Financing Cash Flows: - With the exception of increased Retained Earnings from net income, whenever shareholders’ equity or a long-term liability amount has increased or decreased, the amount of the related financing cash flow should be computed. - While principal payments on loans are considered financing cash flows, interest payments on outstanding loan balances are considered operating cash flows. - If a change in a long-term liability or shareholders’ equity account is the net change of both issuing and retiring debt and equity, information about the issue and retirement amounts would be required in addition to the comparative balance sheet information to compute the cash flows....