A Review of the Accounting Cycle

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chapter 5
The Statement of Cash Flows
An electronic presentation by Douglas Cloud
Pepperdine University
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Learning Objectives

• 1. Describe the circumstances in which the cash
  flow statement is a particularly important
  companion to the income statement.
• 2. Outline the structure of and information
  reported in the three main categories of the cash
  flow statement operating, investing, and
  financing.

Continued
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Learning Objectives
3. Compute cash flow from operations using either
the direct or indirect method. 4. Prepare a
complete statement of cash flows and provide the
required supplemental disclosures. 5. Understand
the differences among cash flow statements
prepared according to U.S. GAAP, U.K. GAAP, and
international accounting standards.
Continued
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Learning Objectives

• 6. Assess a firms financial strength by
  analyzing the relationships among cash flows from
  operating, investing, and financing activities
  and by computing financial ratios based on cash
  flow data.
• 7. Use knowledge of how the three primary
  financial statements tie together in order to
  prepare a forecasted statement of cash flows.

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What Good Is a Cash Flow Statement?
Does a statement of cash flows tell us anything
we dont already know from other statements?
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What Good Is a Cash Flow Statement?
Yes, because there are situations where net
income does not give us an accurate picture.
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What Good Is a Cash Flow Statement?
Also, everything you want to know about a company
is summarized in this one statement.
Finally, a statement of cash flows is an
excellent forecasting tool.
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Structure of the Cash Flow Statement
It must be readily convertible to cash and it
must be so near to maturity that there is
insignificant risks of changes in value due to
changes in interest rate.
It is a short-term, highly liquid investment.
What is a cash equivalent?
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Structure of the Cash Flow Statement
CASH INFLOWS
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Cash Flow Patterns

• Operating ActivitiesTransactions and events that
  enter into the determination of net income.
• Investing ActivitiesTransactions and events that
  involve the purchase and sale of securities,
  property, plant, equipment, and other assets not
  generally held for resale, and the making and
  collecting of loans.
• Financing ActivitiesTransactions and events
  whereby resources are obtained from or repaid to
  owners and creditors.

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Cash Flow Patterns
Over the Life of a Company
Start-up, High-Growth Company
Financing
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Cash Flow Patterns
Over the Life of a Company
Steady-State Company
Operating
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Cash Flow Patterns
Over the Life of a Company
Cash Cow
Financing
Operating
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Noncash Transactions

• Investing and financing activities that do not
  affect cash.
• Significant transactions should be disclosed
  separately.
• These transactions do not affect the statement of
  cash flows.

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Reporting Cash Flows from Operations

• Direct MethodA method of reporting net cash
  flows from operations that shows cash receipts
  and payments for a period of time. This method
  is more straight forward.
• Indirect MethodA method of reporting net cash
  flow from operations that involves reconciling
  net income to a cash basis. It shows how noncash
  flows affect net income.

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The Direct Method

• This method reports directly the major classes of
  operating cash receipts and payments of an entity
  during a period.
• Accrual-basis revenues and expenses must be
  converted to equivalent cash receipts and
  payments.
• The amount of cash actually collected or paid is
  determined.

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Indirect Method
The indirect method makes the following
adjustments

• Adjustments for receivables and other current
  operating assets.
• Adjustments for payables and other current
  liabilities.
• Adjustments for depreciation and other noncash
  items.
• Adjustments for gains and losses.

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Operating Activities

• Cash Inflow
• Cash receipt of sales
• Collection of receivables
• Interest revenue
• Dividend revenue

• Cash Outflow
• Inventory payments
• Interest payments
• Wages
• Utilities
• Rent

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Relationship Between Net Income and Operating
Cash Flow
Business engages in operating activities
Net income
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Example of Operating Activities Section for the
Direct Method
Sales and Cash Collected from Customers
Beginning accounts receivable 40 Sales
150 Cash available for collection 190 Endin
g accounts receivable 60 Cash Collected
from Customers 130
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Example of Operating Activities Section for the
Direct Method
Cost of Goods Sold and Cash Paid for
Inventory Ending inventory 75 Cost of
goods sold 80 Required inventory 155 Beginnin
g inventory 100 Cash paid for inventory this
year 55
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Example of Operating Activities Section for the
Direct Method
Wages Expense and Cash Paid for Wages Beginning
wages payable 7 Wages expense 25 Total
obligation to employee 32 Ending wages
payable 10 Cash paid for wages 22
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Adjustments for Gains and Losses
Gains or losses do not represent the cash effect
of the transaction.
Adjustment to Account Net
Income Losses Gains
These adjustments are made to net income since
the sale of an investment is an investing
activity, not an operating activity.
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Adjustments for Receivables
Changes in accounts directly affect revenues
recorded on an accrual basis.
Account Adjustment to Account Change Net
Income Accounts Receivable Accounts
Receivable Inventory
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Adjustments for Payables
Changes in liabilities mean the reverse of
changes in current operating asset accounts.
Account Adjustment to Account Change Net
Income Accounts Payable Wages Payable
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Noncash Adjustments

• Depreciation and similar noncash items do not
  affect cash and are not reported on the statement
  of cash flows.
• Any noncash item that reduces net income should
  be added back to net income in the indirect
  method.
• Any noncash item that increases net income should
  be subtracted from net income in the indirect
  method.

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Investing Activities

• Cash Inflow
• Sale of plant assets
• Sale of securities, other than
  trading securities
• Collection of principal on loans

• Cash Outflow
• Purchase of plant assets
• Purchase of securities, other than trading
  securities
• Making of loans with other entities

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Financing Activities

• Cash Inflow
• Issuance of own stock
• Borrowings

• Cash Outflow
• Dividend payments
• Repaying principal on borrowing
• Treasury Stock purchase

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Differences between Income and Cash from
Operations
Cash from
Net Company Name Operations
Income Difference
General Motors 19,750 4,452 (15,298 ) Lehman
Brothers (14,733 ) 1,775 16,508 Ford
Motors 33,764 3,467 (30,297 ) Citigroup 2,673 13
,519 10,846
Year 2000 (All amounts are in millions)
SOURCE Standard and Poor COMPUTSTAT
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General Format of aStatement of Cash Flows

• Cash Provided by (Used for)
• Operating Activities XXX
• Investing Activities XXX
• Financing Activities XXX
• Net Increase (Decrease) in Cash XXX
• CashBeginning of Year XXX
• CashEnd of Year XXX

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Preparing aCash Flow Statement

• 1. Compute how much the cash balance changed
  during the year.
• 2. Convert the income statement from an
  accrual-basis to a cash-basis summary of
  operations.

a. Eliminate expenses that do not involve the
outflow of cash, such as depreciation. b. Elimina
te gains and losses associated with investing or
financing activities. c. Adjust for changes in
the balances of current assets and current
liabilities.
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Preparing aCash Flow Statement
3. Analyze the long-term assets to identify the
cash flow effects of investing activities. 4. Anal
yze the long-term debt and stockholders equity
account to determine the cash flow effects of any
financing transactions. 5. Make sure that the
total new cash flow from operating, investing,
and financing activities is equal to the net
increase or decrease in cash as computed in Step
1, then prepare a formal statement. 6. Prepare
supplement disclosure of significant noncash
transactions.
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Example ComparativeBalance Sheet
2005
2004
Assets
Cash and Cash Equivalents Accounts
Receivable Inventory Equipment Accumulated
Depreciation Total Assets
40 150 200 140 (60) 470
82 180 170 200 (72) 560
Liabilities and Equity
80 50 250 90 470
100 100 250 110 560
Accounts Payable Long-term Notes Payable Common
Stock Retained Earnings Total Liabilities and
Equity
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Income Statement, 2005
Sales Expenses Cost of goods sold
Selling and general expense Depreciation
Interest expense Operating income Gain from sale
of equipment Income before income taxes Income
tax expense Net income
345 120 58 20 2
(200 ) 145 5 140 30
110

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Step 1
Determine change in cash and cash equivalents

• Cash 2004........................... 40
• Cash 2005........................... 82
• Change in Cash................... 42

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Step 2
Convert from an accrual-basis to a cash-basis
summary of operations
EXAMPLE Eliminate depreciation expense, 44,
because it does not require the use of cash.
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Step 2
Convert from an accrual-basis to a cash-basis
summary of operations
EXAMPLE Eliminate the 5 gain from selling
equipment.
Cash 33 Accumulated Depreciation 32 Equipment 60
Gain on Sale of Equipment 5
Add back 5 to cash provided by operations.
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Step 3
Analyze the long-term assets to identify the ash
flow effects of investing activities.
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Step 4
Analyze the long-term debt and stockholders
equity accounts to determine the cash flow
effects of any financing transactions
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Step 4
Analyze the long-term debt and stockholders
equity accounts to determine the cash flow
effects of any financing transactions
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Steps 5 and 6
Steps 5 and 6 relate to actually preparing the
formal and supplementary statements.
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Operating Activities Section Indirect Method
Cash Flows from Operating Activities Net
income 110 Adjustments Depreciation
expense 44 Gain on sale of equipment
(5 ) Increase in accounts receivable
(30 ) Decrease in inventory 30
Increase in accounts payable 20 Net Cash
Provided by Operating Activities 169
Continued
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Operating Activities Section Direct Method
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• Cash Flows from Operating Activities
• Cash Collected from Customers 414
• Cash Payments for
• Inventory (155 ) Selling General Expenses
  (58 )
• Interest (2 )
• Income Taxes (30 ) (245 )
• Net Cash Provided by Operating
• Activities 169

Continued
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Operating Activities Section Direct Method
The investing and financing sections are the same
whether the direct or indirect approach is used.
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Investing and Financing Activities Sections
Cash Flows from Investing Activities Proceeds
from sale of equipment 33 Purchase of
equipment (120 ) Net cash provided by
investing activities (87 ) Cash Flows from
Financing Activities Issuance of long-term
notes payable 50 Payment of cash
dividends (90 ) Net cash used for financing
activities (40 ) Net increase in cash 42 Cash,
January 1, 2005 40 Cash, December 31, 2005 82

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Investing and Financing Activities Sections
Cash Flows from Investing Activities Proceeds
from sale of equipment 33 Purchase of
equipment (120 ) Net cash provided by
investing activities (87 ) Cash Flows from
Financing Activities Issuance of long-term
notes payable 50 Payment of cash
dividends (90 ) Net cash used for financing
activities (40 ) Net increase in cash 42 Cash,
January 1, 2005 40 Cash, December 31, 2005 82

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Quick Review
Which of the following items would be listed
under Cash Provided by Investing Activities?
Paid cash dividend Issued preferred stock Sold
merchandise for cash Sold equipment at book value
Click the bulls nose to skip Quick Review
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Quick Review
Which of the following items would be shown under
Cash Provided by Operating Activities?
Issued bonds to finance new construction Purchased
treasury stock Paid the weekly payroll Declared
and paid a cash dividend
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Quick Review
Which of the following items would be shown under
Cash Provided by Financing Activities?
Payment of a cash dividend Recorded depreciation
for the period Received cash on account from a
customer Payment of cash to acquire land
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Which of the following statement is true
concerning preparing the statement of cash flows
using the indirect method?
A loss from the sale of equipment is added to net
income under the cash provided by operating
activities category.
A gain on sale of land is an investing activity
because a noncurrent asset is involved.
Issuing common stock to purchase land is both a
financing activity and an investing activity.
An increase in Accounts Payable results in a
decrease in the adjusted cash-basis net income.
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International Cash Flow Statements
In 1987, the United States led the world
concerning the statement of cash flows by issuing
SFAS No. 95.
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International Cash Flow Statements
In 1992, the IASC issued IAS 7 which closely
matched the provisions of SAFS No. 7. The
international standard was more flexible in
classification of certain transactions.

• Interest and dividends received can be classified
  as either operating or investing.
• Interest and dividends paid can be classified as
  operating or investing.
• Income taxes will be classified as operating
  unless specifically related to financing or
  investing transactions.

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International Cash Flow Statements

• Operating activities
• Returns on investments and servicing of finance
• Taxation
• Capital expenditures and financial investment
• Acquisition and disposal
• Equity dividend paid
• Management of liquid resources
• Financing

In 1991, the United Kingdom issued FRS 1. It
specified eight categories for classifying cash
flows.
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Assessing Financial Strength
Financial strength is a function of
Liquidity Profitability Growth potential Risk
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Assessing Financial Strength
Cash flow-to-net income

• Measure of earnings quality
• Tends to be greater than 1
• Should remain fairly stable for the years for a
  specific company

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Assessing Financial Strength
Cash flow adequacy

• Measures relationship between investment spending
  and cash generated by operations
• Indicate a companys attitude towards
  reinvestment in long-lived production assets
• When ratio is small it indicates that cash flows
  from operations fall short of funding growth

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Assessing Financial Strength
Cash times interest earned

• Measures ability to service debt
• Generally, a higher ratio indicates more solvency

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Forecasted Statement of Cash Flows
Six Steps
1. Compute the change in cash. 2. Convert the
income statement from an accrual to cash
basis. 3. Analyze the long-term asset
accounts. 4. Analyze the long-term debt and
stockholders equity. 5. Prepare the forecasted
statement of cash flows. 6. Disclose noncash
activities.
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chapter 5
The End
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