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Chapter 10

The Statement of Cash Flows

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Chapter 10’s Learning Objectives

1. Explain the uses of the statement of cash flows


2. Explain and classify cash flows from operating, investing,
and financing activities
3. Prepare a statement of cash flows using the indirect method
of determining cash flows from operating activities

• .

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Learning Objective One

Explain the uses of the statement of cash


flows

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Definition of Cash

• On the statement of cash flows,, the definition of cash includes:


1. Cash, and
2. Cash equivalents – short term highly liquid investments (e.g.,
treasury bills, money market funds, and etc.)
• Readily convertible to known amounts of cash, and
• Usually matures in 3 months or less (thus generally
unaffected by fluctuations in interest rate).

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Why should we care about cash?

Without cash, a company cannot:


• Expand operations
• Replace/acquired needed assets
• Pay salaries and bills
• Repay debt
• Pay dividends to owners
 Without sufficient cash flows, businesses can’t continue to
operate. Therefore, how a company generates/uses cash is
important.
 Company needs both net income and strong cash flow to
succeed.
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Uses of the Statement of Cash Flows

• The balance sheet reports the financial position of the company at


a point in time, and comparison of the balance sheets from two
periods show whether cash increased or decreased. But that
doesn’t tell why the cash balance changed.

• The income statement reports the company’s operational


performance and offers clues about cash, but it doesn’t tell how the
operations affected cash because the income statement is
prepared using accrual accounting rules that ignore the timing of
receipt or payment of cash. (Net income ≠ cash flow)

• Hence, we need another financial statement – statement of cash


flows.

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Canadian Tire Statement of Cash Flows (p.482-483)

Net income ≠ cash generated from operating activities


Net income ≠ Cash generated in the year

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Uses of the Statement of Cash Flows

• The statement of cash flows reports details about a company’s cash


receipts and cash disbursements from operating, investing, and
financing activities.
• It permits a user to determine exactly what caused the company’s
cash balance to increase or decrease during the period.
(Exhibit.1-6, p.12)

Increase in
cash =
$18.9M

• The statement covers a span of time and therefore is dated “Year


Ended” (e.g., December 31, 2017) or “Month Ended” (E.g., June 30,
2017) as opposed to “As At”.

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Cash Flow Statement - Format

ABC Inc.
Pay attention Consolidated Statement of Cash Flows
to the heading For the Year Ended June 30, 2017
(Thousands of Canadian dollars)

Cash flows from operating activities $xxx


Cash flows from investing activities xxx
Cash flows from financing activities xxx
Elements

Net increase (decrease) in cash xxx


Cash, beginning of year xxx
$xxx
Cash, end of year
This ending cash balance should agree with the
cash account balance on the Balance Sheet. 9
Timing of the Financial Statements

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Purposes of Cash Flow Statements

This statement helps managers, investors, and creditors to:


1. Predict future cash flows
2. Evaluate management decisions
3. Determine ability to pay dividends and interest
4. Asses the relationship between net income and cash flows
5. Compare the operating performance of different companies
(i.e., using “Cash” income as opposed to “Accrual” income).

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Learning Objective Two

Explain and classify cash flows from


operating, investing, and financing
activities

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Cash Flows Categories

Statement of cash flows reports cash flows for the 3 types of


business activities:

1. Operating Activities

2. Investing Activities

3. Financing Activities
Operating Activities

 Operating activities include the main revenue-producing


activities of a business
 Companies need to generate sufficient cash from their operating
activities to fund capital expenditures, pay dividends and their
day-to-day operations.
 Companies that do not regularly generate sufficient cash flow
from operations will eventually suffer liquidity and solvency
problems.

• Example:
– cash receipts from a company’s sales of its primary
goods/services, and
– cash payments to suppliers and employees for goods/services
they provide the company to generate revenue.

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Investing Activities

• Investing activities include transactions that results in cash flows


related to resources used to generate future income and cash
flows.
• Example:
– cash flows from purchase and sale of tangible and intangible
long-lived assets,
– cash flows from purchase and sale of equity and debt
instruments of other companies (e.g., Facebook invests in
Tesla’s shares)
– cash flows related to advances and loans made to other entities
(Facebook lends money to ABC Inc.).

• Note: cash flow from purchase and sale of Inventory is an


operating activity.

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Financing Activities

• Financing activities include transactions that result in changes in


the size and composition of a company’s contributed equity and
borrowings:
• Example:
– issuance and acquisition of a company’s own shares,
– payment of cash dividends,
– cash proceeds from loans, bonds, and notes, and
– payment on the loan principal.

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Classifying Interest and Dividends – IFRS vs. ASPE

ASPE IFRS
• Interest paid, and interest and • Interest and dividends paid may
dividends received are operating be classified as either operating
activities. or financing activities.
• Dividends paid are financing • Interest and dividends received
activities. may be classified as either
operating or investing cash
private can choose flows.
PUBLIC-----IFRS • Whichever classification the
company chooses, it must use the
classification consistently.

In this introductory course, however, we classify:


– Interest paid, and interest and dividends received as Operating
activities, and
– Dividends paid as a Financing activity.
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Relationship to Balance Sheet

Assets = Liabilities + Shareholders’


equity

Current + Non-current = Current + Non-current + Shareholders’


assets assets liabilities liabilities equity

Operating Investing Operating Financing

Net income, although it aFfects retainer earnings which is part of SHE, is


part operating activities as net income mostly comprises of the core
operating activities of the firm.
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Cash Flow Categories – Example 1

1 Purchase of long-term I 8 Depreciation and O


investments amortization(due to day to
day)
2 Net earnings(net income) O 9 Issuance of shares F
3 Changes in trade receivables( O 10 Cash received from bank F
current assets) borrowing (loan)
4 Changes in prepayments and O 11 Cash paid for interest O
other current assets(change in
current assets).
5 Changes in inventories O 12 Cash paid for taxes O
6 Changes in trade payables O 13 Cash paid for dividends F
7 Additions to PP&E I

Note: Cash received/paid for loan principle is (F), while cash paid for loan
interest is (O).
Cash Flows from Operating Activities
There are two methods of determining cash flows from operating
activities:
1. Direct Method:
 Subtracts operating cash disbursements (outflows) from cash
collections (inflows). cash paid, cash received.
2. Indirect Method:
 Adjusts the previously calculated accrual net income from the
income statement to compute cash net income.
 Note, these methods only apply to the operating activities section.
The investing and financing activities sections are identical under
the two methods.
 We will focus on the indirect method as this is the most
commonly used method in companies.
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Direct Method vs. Indirect Method

• Regardless of which method is used, the total net cash flow from
operating activities will ALWAYS be the same. It is only the
presentation of the data that differs.
• The direct method provides more details about cash from operating
activities.
• The IFRS prefers the direct method but almost all companies use the
indirect method. Why? (see next slide)

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Direct Method vs. Indirect Method (cont’d)

Most companies prefer the indirect method because it:

1. It is easier and cheaper to prepare,

2. It focuses on the differences between net earnings and net


cash flow from operating activities(highlight accurals), and

3. It reveals less company information to competitors.

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Learning Objective Three
Prepare a statement of cash flows using
the indirect method of determining cash
flows from operating activities

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Indirect Method - Concept

• Why does accrual net income differ from cash-basis net income
(CFO)?

 Because Income Statement is prepared using the accrual


principles.

• Indirect method: the operating section of the statement of cash


flows begins with net income (accrual income) taken from the
income statement (exhibit 10-5 on page 491) and makes
adjustments to it for deferrals and accruals and non-operating
elements to convert accrual income to cash-basis operating income
(net cash flow from operating activities) (Exhibit 10-6 on page 492).

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Indirect Method – General Rules
To reconcile accrual income (net income) to cash-basis income (net
cash flow from operating activities):
1. Add Depreciation/Amortization expense (non-cash expense).
2. Add losses and subtract gains on the sale of long-term assets
(non-operating activities)
3. Add/subtract changes in non-cash operating working capital:
i. For Current Assets (other than cash):
• Subtract increases.
Change Change in Impact of change
• Add decreases. in Assets Liabilities on cash flows
ii. For Current Liabilities: - + Increase
• Add increases. + - Decrease
• Subtract decreases.

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Indirect Method – Change in Account Receivable

Increase in accounts receivable:

 AR increases when a company makes a sale on credit.


 ↑ Revenue → ↑ Net income, but not cash!
 Back out this non-cash revenue by deducting the increase in AR.

Decrease in accounts receivable:


 AR decreases when a customer pays down their account.
 ↑ Cash, but no impact on net income! (Affected net income when the
revenue was earned, which is before cash collection)
 Record this cash inflow by adding the decrease in AR.

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Indirect Method – Change in Inventory

Increase in inventory:

 Inventory increases when a company purchases inventory.


 ↓ Cash, but no impact on net income! (will affect net income via cost of
goods sold (COGS) when the inventory is sold later)
 Record this cash outflow by deducting the increase in inventory.

Decrease in inventory:
 Inventory decreases when the inventory is sold.
 ↑ COGS → ↓ Net income, but cash is not affected!
 Back out this non-cash expense by adding the decrease in inventory.

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Indirect Method – Change in Prepaid Expense

Increase in prepaid expense:

 Prepaid expense increases when a company prepays an expense.


 ↓ Cash, but no impact on net income! (will affect net income when the
expense is incurred)
 Record this cash outflow by deducting the increase in prepaid expense.

Decrease in prepaid expense :


 Prepaid expense decreases when the expense is incurred.
 ↑ expense → ↓ Net income, but cash is not affected!
 Back out this non-cash expense by adding the decrease in prepaid
expense.

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Indirect Method – Change in Accounts Payable and
Accrued Liabilities

Increase in accounts payable and accrued liabilities:

 Accounts payable and accrued liabilities increase when a company incurs


an expense but does not pay for it in cash until later.
 ↑ Expense → ↓ Net income, but cash is not affected!
 Back out this non-cash expense by adding the increase in accounts
payable and accrued liabilities.
 因为本来不是cash的不应该记在statement of cash flow 上,但是Begin
with income statement, so deduct the amount of non-cash transactions。

Decrease in accounts payable and accrued liabilities:


 Accounts payable and accrued liabilities decrease when the company
pays the debt
 ↓ Cash, but no impact on net income!
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Indirect Method – Change in Unearned Revenue

Increase in unearned revenue:

 Unearned revenue increases when a customer pays the company before


the goods/services are delivered.
 ↑ Cash, but no impact on net income! (will affect net income when the
revenue is earned later)
 Record this cash inflow by adding the increase in unearned revenue

Decrease in unearned revenue :


 Unearned revenue decreases when the company delivers the
goods/services (i.e., earns the revenue)
 ↑ Revenue → ↑ Net income, but cash is not affected!
 Back out this non-cash revenue by deducting the decrease in unearned
revenue.
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Indirect Method – General Rules Illustration
Indirect method starts with net income and then removes the non-cash and
non-operating elements to compute the net cash flow from operating activities.
Cash flows from operating activities:

Net income
Adjustments to reconcile net income to net cash provided by operating
activities:
+ Depreciation(non-cash, so add back)
Loss on sale of long-term assets(non-operating activities,so add
+ up)
- Gain on sale of long-term assets()
- Increases in current assets (other than cash)
+ Decreases in current assets (other than cash)
+ Increases in current liabilities
- Decreases in current liabilities
= Net cash provided by operating activities

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Sources for preparing the Operating Activities
Section – Indirect Method
1. Comparative balance sheets (current and prior period):
– Increase or decrease in each current asset account (other
than cash)
– Increase or decrease in each current liability account
2. Current income statement
– Net income
– Depreciation and amortization expense
– Gains and losses on sales of long-term assets
– Gains and Loss goes into Operating section.

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Income Statement
Bradshaw Corporation
For the Year Ended December 31, 2017
(in thousands)
Revenues and gains:
Sales revenue $284
Interest revenue 12
Dividend revenue 9
Gain on sale of prop, plant & equip 8 Subtract
Total revenues and gains $313
Expenses:
Cost of goods sold $150
Salary and wages expense 56
Amortization expense 18 Add
Other operating expense 17
Interest expense 16
Total expenses 272
Net income Starting
$ 41
point

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Bradshaw Corporation – December 31
(in thousands) 2017 2016 Increase
(Decrease)
Comparative Balance Sheets
Assets
Current:
Changes Cash $ 22 $ 42 $ (20)
in Accounts receivable 93 80 13 O-
current
Interest receivable 3 1 2 O-
assets
except Inventory 135 138 (3) O+
cash Prepaid expenses 8 7 1 O-
Long-term receivable 11 – 11
Prop, plant & equip, net 353 219 134
Total $625 $487 $138
Liabilities

Changes Current:
in Accounts payable $ 91 $ 57 $ 34 O+
current Salary & wages payable 4 6 (2) O-
liabilities
Accrued liabilities 1 3 (2) O-
Long-term debt 160 77 83
Shareholders’ equity
Common shares 259 258 1
Retained earnings 110 86 24
Total $625 $487 $138

• Note: line items in red are operating activities.


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Statement of Cash Flows: Operating Activities
CFO activities section of Exhibit 10-8 on page 495

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Mid-Chapter Summary Problem

• Carefully study the Mid-chapter summary problem on page 495.

• Then, try to solve it on your own without looking at the solution.

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