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BUSI0019E Intermediate Accounting I (Semester 1, 2011-12)

Dr. Winnie S.C. Leung

Chapter 5 Statement of Cash Flows and Articulation

Learning Objectives 1. Describe the circumstances in which the cash flow statement is a particularly important companion of 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. 3. Compute cash flow from operations using either the direct or the indirect method. 4. Prepare a complete statement of cash flows and provide the required supplemental disclosures. 5. Assess a firms financial strength by analyzing the relationships among cash flows from operating, investing, and financing and by computing financial ratios based on cash flow data. 6. Demonstrate how the three primary financial statements tie together, or articulate, in a unified framework.

OBJECTIVE 1: Describe the circumstances in which the cash flow statement is a particularly important companion of the income statement. We need the cash flow statement because: 1. Sometimes earnings fail. 2. Everything is on one page. 3. It is used as a forecasting tool. Sometimes Earnings Fail 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. 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 application Just before the initial public offering of stock

BUSI0019E Intermediate Accounting I (Semester 1, 2011-12)

Dr. Winnie S.C. Leung

Just before being bought out by another company Cash flow from operations, which is not impacted by accrual assumptions, provides an excellent reality check for earnings.

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 companys performance for the year is summarized in this one statement. 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.

OBJECTIVE 2: Outline the structure of and information reported in the three main categories of the cash flow statement: operating, investing, and financing. A statement of cash flows explains the change during the period in cash and cash equivalents. Cash Equivalent 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: Readily convertible into cash So near to its maturity that there is insignificant risk of changes in value due to changes in interest rates Three Categories of Cash Flows Operating activities include those transactions and events that enter into the determination of net income. Cash receipts from selling goods or from providing services. Receipts from Interest, dividends, and similar items. Payments to purchase inventory and to pay 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. In addition, investing activities include those transactions and events that involve the purchase and sale of financial instruments not intended for trading purposes, as well as making and collecting loans. 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.

BUSI0019E Intermediate Accounting I (Semester 1, 2011-12)

Dr. Winnie S.C. Leung

Cash Flow Pattern Most companies (73% in the United States in 2006) generate positive cash flow from operations. In normal times, most companies use cash 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). No general statement can be made about cash flow from financing activities.

BUSI0019E Intermediate Accounting I (Semester 1, 2011-12)

Dr. Winnie S.C. Leung

Noncash Investing and Financing Activities Noncash investing and financing activities affect an entitys financial position but not the entitys cash flow. Examples include: Equipment purchased with a note payable Land acquired by issuing stock Significant transactions should be disclosed separately. These transactions do not appear in the body of the statement of cash flows. Cash Flow Categories Under IAS 7 The provisions of IAS 7, Statement of Cash Flows, are more flexible than the U.S. rules contained in FASB ASC Section 230. A summary of these differences are shown next. Type of Cash Flow U.S. GAAP ASC Section 230 Operating activity IFRS IAS 7

Cash paid for interest (associated with interest expense) Cash paid for income taxes Operating (associated with income tax activity expense) Cash received from interest Operating (associated with interest activity revenue) Cash received from Operating dividends (associated with activity dividend revenue) Cash paid for dividends (not Financing an income statement item) activity

Operating or financing activity

Usually operating activity, but can be split among operating, investing, and financing depending on the nature of the transaction giving rise to the tax payment Operating or investing activity

Operating or investing activity

Financing or operating activity

OBJECTIVE 3: Compute cash flow from operations using either the direct or the indirect method.

BUSI0019E Intermediate Accounting I (Semester 1, 2011-12)

Dr. Winnie S.C. Leung

Operating Activities Section 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.

Operating Activities: Indirect Method 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. The adjustments for the indirect method are of three basic types: Revenues and expenses that do not involve cash inflow or outflow. Gains and losses associated with investing or financing activities. Adjustments for changes in current operating assets and liabilities that indicate noncash sources of revenues and expenses. Both the direct and indirect methods produce identical resultsthat is, the same amount of net cash provided by (or used in) operations.

BUSI0019E Intermediate Accounting I (Semester 1, 2011-12)

Dr. Winnie S.C. Leung

An Example

Using Direct Method: Sales and Cash Collected from Customers

Cost of Goods Sold and Cash Paid for Inventory

Wages Expense and Cash Paid for Wages

BUSI0019E Intermediate Accounting I (Semester 1, 2011-12)

Dr. Winnie S.C. Leung

Operating Activities Section of the Statement of Cash FlowsDirect Method

Using Indirect 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 from net income to show that $130 was collected on account. 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 suggestedadd $25 to net income. 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. Depreciation Expense The $30 depreciation expense is a noncash expense. It must be added back to net income because it was deducted from net income to determine the accrual net income.

BUSI0019E Intermediate Accounting I (Semester 1, 2011-12)

Dr. Winnie S.C. Leung

Important Points Depreciation is not a source of cash. 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. One advantage of the indirect method is that it highlights how cash flow can be improved in the short run by adjusting operating procedures.

BUSI0019E Intermediate Accounting I (Semester 1, 2011-12)

Dr. Winnie S.C. Leung

OBJECTIVE 4: Prepare a complete statement of cash flows and provide the required supplemental disclosures. Basic information to prepare the three sections of the cash flow statement comes from the balance sheet and income statement, as follows: Operatingincome statement adjusted for changes in current operating assets and liabilities. Investingchanges in long-term assets. Financingchanges in long-term liabilities and owners equity.

Step 1 Compute how much the cash balance changed during the year. 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.

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BUSI0019E Intermediate Accounting I (Semester 1, 2011-12)

Dr. Winnie S.C. Leung

Step 2 Convert the income statement from an accrual-basis to a cash-basis summary of operations. Start with depreciation. This is done in three steps: (a) Eliminate expenses that do not involve the outflow of cash, such as depreciation expense.

(b) Eliminate gains and losses associated with investing or financing activities to avoid counting these items twice.

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BUSI0019E Intermediate Accounting I (Semester 1, 2011-12)

Dr. Winnie S.C. Leung

(c) Adjust for changes in the balances of current operating assets and operating liabilities.

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BUSI0019E Intermediate Accounting I (Semester 1, 2011-12)

Dr. Winnie S.C. Leung

Because an interest payable account does not exist, we can safely assume that all interest expense was paid for in cash. Therefore, there is no need for an adjustment.

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BUSI0019E Intermediate Accounting I (Semester 1, 2011-12)

Dr. Winnie S.C. Leung

Step 3 Analyze the long-term assets to identify the cash flow effects of 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 Orchard Blossom reports two long-term asset accounts: Land and Buildings.

The land account increased by $15 during the year. Because there is no indication of a land sale, we conclude that the $15 represents the price of new land purchased during the year.

The building account increased $40 during the year. In the absence of any other information, this increase would suggest that Orchard Blossom purchased buildings with a cost of $40. Now suppose additional information reveals that buildings were sold for $32 during the year. The $32 cash proceeds from the sale is a cash inflow from investing activities. According to this information, it is calculated that building(s) costing $76 must have been purchased during the year. Do you know why?

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BUSI0019E Intermediate Accounting I (Semester 1, 2011-12)

Dr. Winnie S.C. Leung

Buildings

Accumulated Depreciation - Buildings

Step 4 Analyze the long-term debt and stockholders equity accounts to determine the cash flow effects of any financing transactions. Cash Inflow Issuance of own stock Borrowings Cash Outflow Dividend payments Repaying principal on borrowing Treasury stock purchase

We can infer that Orchard Blossom repaid $21 in long-term loans during the year. Are there any dividends paid to shareholders during the year? Which account will you use to determine the dividends paid?

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BUSI0019E Intermediate Accounting I (Semester 1, 2011-12)

Dr. Winnie S.C. Leung

Step 5 Prepare a formal statement of cash flows. 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.

Step 6 Prepare supplemental disclosures. Cash paid for interest and income taxes Noncash investing and financing activities

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BUSI0019E Intermediate Accounting I (Semester 1, 2011-12)

Dr. Winnie S.C. Leung

OBJECTIVE 5: 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. It is possible to gain useful insights about a company by analyzing the relationships among the three cash flow categories. Exhibit 5-9 shows the eight different possible patterns.

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BUSI0019E Intermediate Accounting I (Semester 1, 2011-12)

Dr. Winnie S.C. Leung

Cash Flow Ratios

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

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.

Measures interest-paying ability Generally, a higher ratio indicates more solvency

OBJECTIVE 6: Demonstrate how the three primary financial statements tie together, or articulate, in a unified framework. 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 companys financial health.

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BUSI0019E Intermediate Accounting I (Semester 1, 2011-12)

Dr. Winnie S.C. Leung

Reference Readings (for your interest only, will not be tested in the mid-term test and final exam) 1. HKICPA HKAS7 Statement of Cash Flows http://app1.hkicpa.org.hk/hksaebk/HKSA_Members_Handbook_Master/volumeII/hkas07.pdf 2. KPMG IAS7 (AC118) Statement of Cash Flows (2010) http://www.kpmg.com/ZA/en/IssuesAndInsights/ArticlesPublications/IFRSGAAP/Documents/IAS%207%20(AC118)%20Statement%20of%20Cash%20Flows.pdf Assignment Question Please download the assignment questions from MOODLE and submit your completed assignments on or before the end of the tutorial on March 23, 2012. Please remember to handwrite your answers in A4 paper.

~~ End of Chapter Five ~~