Statement of Cash Flows Revsine/Collins/Johnson/Mittelstaedt: Chapter 17 McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights.

Statement of Cash Flows

Revsine/Collins/Johnson/Mittelstaedt: Chapter 17

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning objectives

1. The major sources and uses of cash—operating, investing, and financing.

2. Why accrual net income and operating cash flows differ, and the factors that explain this difference.

3. The difference between the direct and indirect methods of determining cash flow from operations.

4. How to prepare a statement of cash flows from comparative balance sheet data, an income statement, and other information.

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Learning objectivesConcluded

5. Why changes in balance sheet accounts over a year may not reconcile to the corresponding changes included in the statement of cash flows.

6. How operating cash flows can be distorted.

7. Differences between reporting interest and dividends received and interest and dividends paid on statement of cash flows under IFRS rules vs. U.S. GAAP.

8. Proposed changes that IASB and FASB are considering for the format and content of the statement of cash flows.

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Why cash flows are important

Accrual earnings may not always provide a reliable measure of enterprise performance and health.

Accrual accounting relies on subjective judgments that may introduce measurement error and uncertainty into reported earnings.

One-time write-offs and restructuring charges can reduce the quality of reported earnings.

Management can readily manipulate accrual income.

For these reasons, analysts scrutinize a firm’s cash flows—not just its accrual earnings—to evaluate performance and creditworthiness.

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Statement format

Result from events or transactions that enter into the determination of net income; i.e., the cash-based revenues and expenses of a company.

Result from the purchase or sale of productive assets like plant and equipment, marketable securities, and from acquisitions and divestitures.

Result when a company sells its own stocks or bonds, pays dividends or buys back its own shares, or borrows money and repays the amounts borrowed.

Changes in cash

Operating cash flows

Investingcash flows

Financing cash flows

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Statement format:The Indirect Method

Operating cash flows

Accrual net income

Items included in accrual net income

but did not affect cash in the period

Items excluded from accrual net income

that did affect operating cash in the period

Non-cash revenues and gains

Non-cash expenses and losses

Cash inflows received but not recognized as earned

Cash outflows paid but not recognized for accrual purposes

-

+

+

-

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Preparing the cash flow statement:Overview

The purpose of the cash flow statement is to explain the underlying causes for the change in the cash balance.

A three-step process:

1. Identify the journal entry that led to the reported change in each non-cash balance sheet account.

2. Determine the net cash flow effect of the journal entry.

3. Compare the financial statement effect of the entry (Step 1) with its cash flow effect (Step 2) to determine what cash flow statement treatment is needed.

Changes in cash

Operating

Investing

Financing

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Reconciling between statements:Source of complexities

There are at least four reasons why changes in working capital accounts (like inventory) and fixed assets don’t correspond to the changes shown on the cash flow statement:

1. Asset write-offs due to impairment, restructuring or retirement.

2. Translation adjustments on assets and liabilities held by foreign subsidiaries.

3. Acquisition and divestitures of other companies.

4. Simultaneous investing and financing activities not directly affecting cash.

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Reconciling between statements:Inventories—other complexities

Translation adjustments

Acquisitions and divestitures

Balance sheetinventory change

Cash flowsinventory change

Balance sheetinventory change

Cash flowsinventory change

• Computed using BOP and EOP foreign exchange rates.

• Computed by comparing purchases with cost of goods sold.

• Translated amounts are used for foreign subsidiaries.

• Includes the effects of acquisitions and divestitures.

• Includes cash flows from business segments owned at both the start and end of period.

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Reconciling between statements:Plant and equipment—other complexities

Foreign currency translation adjustments:

Changes in the balance sheet accounts that are due to foreign currency exchange rate fluctuations are not reflected in the cash flow statement.

Acquisitions and divestitures:

Changes in the balance sheet accounts that arise from acquisitions are often shown on a line separate from “Capital expenditures”.

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Reconciling between statements:Simultaneous non-cash investing & financing

Some investing and financing activities occur simultaneously as part of a single transaction:

Buy a building and borrow the full amount as a mortgage.

Acquire an asset by entering into a capital lease.

Issue stock for non-cash assets as part of a business combination.

GAAP requires firms to disclose these non-cash simultaneous investing and financing activities.

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Global Vantage Point

Like U.S. GAAP, IFRS rules require the statement of cash flows to be broken down into three categories – operating, investing and financing. IFRS allows the use of either the direct or indirect method but does not require a reconciliation if the direct method is used.

Under IFRS rules, nonfinancial firms may report interest and dividends received as either operating or investing activities and interest paid as either operating or financing.

Cash flows from income taxes are to reporting as an operating activity unless they can be specifically identified with financing and investing activities.

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Summary

The statement of cash flows helps readers gauge the firm’s ability to generate sufficient cash to pay for operating expenses, capital improvements, and currently maturing obligations.

Firms that generate consistently strong positive cash flows from operations are considered better credit risks and benefit from a lower cost of capital.

The two alternative methods for presenting the operating section of a cash flow statement are the direct approach and the indirect approach.

Most firms use the indirect approach.

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Summary concluded

Changes in non-cash balance sheet accounts may not correspond to the adjustments shown on the cash flow statement because of:

Asset write-offs due to impairment, restructuring, or retirement Translation adjustments on assets and liabilities held by foreign

subsidiaries. Acquisitions and divestitures of other companies. Simultaneous investing and financing activities.

IFRS rules allow firms greater flexibility relative to U.S. GAAP in how interest and dividends received and interest and dividends paid are reported on the statement of cash flows.

A recent Exposure Draft issued by the FASB and IASB would bring greater convergence of reporting of cash flow information under U.S. GAAP and IFRS.

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