Statement of Cash Flows Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 17 Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction.

Statement of Cash Flows

Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 17

Copyright  © 2015 McGraw-Hill Education.  All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education

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 financial information.

17-2

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.

17-3

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.

17-4

Statement format

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

Operating cash flows

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

Investingcash flows

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.

Financing cash flows

Changes in cash

17-5

Statement format:The Direct Method

17-6

Statement format:The Direct Method continued

17-7

Statement format:Consolidated Statements of Operations

17-8

Statement format:Reconciling cash flows and net income

17-9

Statement format:Special disclosure rules

Current GAAP allows a choice between the direct and indirect method for the cash flow statement.

Firms using the direct method are also required to provide a reconciliation between accrual earnings and operating cash flow, and to separately disclose income taxes paid.

Firms using the indirect method are required to separately disclose interest paid and income taxes paid.

17-10

Statement format:The Indirect Method

Accrual-basis net income

Operating cash flows

Items included in accrual-basis net income

but did not affect cash in the period

Items excluded from accrual-basis 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

+

-

17-11

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

17-12

Preparing the cash flow statement:Burris Products Illustration

17-13

Preparing the cash flow statement:Burris Products Illustration

17-14

Preparing the cash flow statement:Burris Products solution

17-15

Preparing the cash flow statement:Burris Products solution

17-16

Preparing the cash flow statement:Burris Products—depreciation

Step 1: The journal entry that generated the account change was:

Step 2: Neither of these two accounts involve cash.

Step 3: Because depreciation expense was included in the

determination of net income but does not represent a cash

outflow, the expense must be added back to net income.

17-17

Preparing the cash flow statement:Burris Products—gain on equipment sale

Step 1: The journal entry was:

Step 2: The sale resulted in a cash inflow of $57,000.

Step 3: The recognized accrual gain ($17,000) does not correspond

to the cash inflow ($57,000). The gain is removed from

income, and the cash inflow is shown as an investing activity.

17-18

Preparing the cash flow statement:Burris Products—amortization of bond discount

Step 1: The journal entry to record interest expense was:

Step 2: The cash outflow was only $40,000.

Step 3: Because interest expense ($44,000) exceeds the cash

outflow ($40,000), the $4,000 difference is added back to

net income.

17-19

Preparing the cash flow statement:Burris Products—deferred income taxes

Step 1: The journal entry to record tax expense was:

Step 2: The cash outflow for taxes was only $96,375.

Step 3: Because the income statement expense is larger than the

cash outflow, the $6,000 difference must be added in the

operating activities section of the cash flow statement.

17-20

Preparing the cash flow statement:Burris Products—accounts receivable

Step 1: The two journal entries associated with the account were:

Step 2: The amount of cash collections ($3,039,000) exceeded the

amount of accrual revenues included in income ($3,030,000).

Step 3: The $9,000 excess of cash collections over accrual revenue is added back to net income to obtain cash from operations.

17-21

Preparing the cash flow statement:Burris Products—customer advance deposits

Step 1: The journal entry for this account was:

Step 2: There was no corresponding cash flow effect.

Step 3: Because revenues exceed 2014 cash inflows by $11,000,

this amount must be deducted in the operating section of

cash flow statement.

17-22

Preparing the cash flow statement:Burris Products—inventories

Step 1: The journal entries associated with this account were:

Step 2: The cost-of-goods-sold deduction from net income ($2,526,625)

is $12,000 lower than the cash outflow to buy inventory.

Step 3: Because net income understates cash flow to buy inventory, $12,000 must be deducted in the computation of operating

cash flow.

17-23

Preparing the cash flow statement:Burris Products—accounts payable

Step 1: The inventory adjustment was computed under the

assumption that all inventory was purchased for cash. We

now relax that assumption, and note that accounts payable

increased by $3,000 during the year.

Step 2: This accounts payable increase means that $3,000 of the

$12,000 inventory increase was not paid for in cash.

Step 3: Therefore, $3,000 is added to net income in the cash flow statement.

17-24

Preparing the cash flow statement:Burris Products—accounts payable

17-25

Preparing the cash flow statement:Operating cash flow summary

17-26

Preparing the cash flow statement:Burris Products—land

Step 1: The journal entry to reflect the increase in land was:

Step 2: This transaction represents an $86,000 cash outflow.

Step 3: The cash outflow is categorized as an investment outflow.

17-27

Preparing the cash flow statement:Burris Products—Buildings and equipment

Step 1: The changes in this account are summarized by :

Step 2: The transaction represents a $261,000 cash outflow.

Step 3: The outflow is again categorized as an investment outflow.

17-28

Preparing the cash flow statement:Burris Products—stock sale and dividend paid

Step 1: The journal entries were:

Step 2: The cash effects involve a $50,000 inflow and a $90,000

dividend outflow.

Step 3: Both the cash inflow and cash outflow are shown as financing

activities.

17-29

Reconciling between statements:Some complexities

17-30

Reconciling between statements:Some complexities

17-31

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.

17-32

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 foreign exchange rates in effect at the time of the transaction.

• 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.

17-33

Reconciling between statements:Plant and equipment—retirements

The journal entry to record a retirement is:

It is often not possible for statement readers to determine the exact dollar amount of retirements.

17-34

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”.

17-35

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.

17-36

Reconciling between statements:Simultaneous non-cash investing & financing

17-37

Reconciling between statements:Simultaneous non-cash investing & financing

17-38

Analytical Insights:Ways Operating Cash Flows can be Distorted or Manipulated

Healthy firms generate cash from their day to day operating activities.

17-39

Changes in Working Capital Account

Accounts Receivable Sale versus Collateralized Borrowing

Capitalizing versus Expensing

Software Development Costs

Capital versus Operating Leases

Cash Flow Effect of Stock Option Expensing

Firms that can’t generate cash internally jeopardize their operations and risk loan default or even bankruptcy

Because cash flow from operations is such a carefully monitored number, firms have incentives to make this number look as strong as possible. Therefore, it is possible to find ways in which operating cash flows can be distorted or “legitimately” managed. These ways include:

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, but many firms provide one anyway.

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 activites.

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

17-40

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 and the indirect methods.

Most firms use the indirect method.

17-41

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.

Operating cash flows can sometimes be distorted or legitimately managed.

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.

17-42