Chapter 12 - Reporting and Analyzing Cash Flows. Chapter Outline

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1 I. Basics of Cash Flow Reporting A. Purpose of the Statement of Cash Flows To report cash receipts (inflows) and cash payments (outflows) during a period. This report classifies cash flows into operating, investing, and financing activities. It answers important questions such as: 1. How does a company obtain its cash? 2. Where does a company spend its cash? 3. What is the change in the cash balance? B. Importance of Cash Flows Information about cash flows, and its sources and uses, can influence decision makers in important ways. This information helps users decide whether a company can pay its debts and other obligations, and its ability to take advantage of new business opportunities. C. Measurement of Cash Flows The phrase, cash flows refers to both cash and cash equivalents. A cash equivalent must satisfy two criteria: 1. Be readily convertible to a known amount of cash. 2. Be sufficiently close to its maturity date so its market value is unaffected by interest rate changes. D. Classification of Cash Flows Cash receipts and cash payments are classified and reported in one of three categories: 1. Operating activities include transactions and events that determine net income (with some exceptions such as unusual gains and losses). Specific examples: a. Cash inflows from cash sales, collections on credit sales, receipts of dividends and interest, sale of trading securities, and settlements of lawsuits. b. Cash outflows for payments to suppliers for goods and services, employees for wages, lenders for interest, government for taxes, charities, and purchase of trading securities. 2. Investing activities include transactions and events that affect long-term assets. Specific examples: a. Cash inflows from selling long-term assets, selling shortterm investments other than cash equivalents, and collecting money the company has loaned to others. b. Cash outflows from purchasing long-term assets, purchasing short-term investments other than cash equivalents, and lending money to others. 12-3

2 3. Financing activities include transactions and events that affect long-term liabilities and equity: a. Cash inflows from issuing debt and obtaining cash from owners. b. Cash outflows from repaying amounts borrowed and distributing cash to owners. E. Noncash Investing and Financing Activities Noncash investing and financing activities do not affect cash receipts or payments; however, they are disclosed at the bottom of the statement of cash flows or in a note to the statement because of their importance and the full disclosure principle. F. Format of the Statement of Cash Flows 1. Lists cash flows by categories (operating, financing and investing) and identifies the net cash inflow or outflow in each category. 2. Combines the net cash flow in each of the three categories and identifies the net change (increase or decrease) in cash for the period. 3. Combines the net change in cash with the beginning cash to prove the ending cash. 4. Contains a separate schedule at bottom (or notes) to report the noncash financing and investing activities. G. Preparing the Statement of Cash Flows 1. Five steps: a. Compute the net increase or decrease in cash. b. Compute net cash provided (used) by operating activities (using either the direct or indirect method). c. Compute net cash provided (used) by investing activities. d. Compute net cash provided (used) by financing activities. e. Compute net cash flows by combining the net cash provided (used) by operating, investing, and financing activities and then prove it by adding it to the beginning cash to show that it equals the ending cash. 2. Alternative approaches to preparing the statement: a. Analyzing the cash account natural place to look for information about cash flows; however, cash account usually does not have an adequate description to allow assignment to the correct activity. b. Analyzing noncash accounts when a company records cash inflows (debits) and outflows (credits) to the cash account, it also records credits and debits to noncash account. 12-4

3 II. III. 3. Information to Prepare the Statement a. Comparative balance sheets. b. The current income statement. c. Other information generally derived from analyzing noncash balance sheet accounts. Cash Flows from Operating cash flows from operating activities are reported in one of two ways the direct method or the indirect method. Amount is identical under both methods. A. Indirect and Direct Methods of Reporting 1. The direct method separately lists each major item of operating cash receipts and each major item of operating cash payments. (See illustration in Exhibit 12.7.) 2. The indirect method reports net income and then adjusts it for items necessary to obtain net cash provided (used) by operating activities. Reports the necessary adjustments to reconcile net income to net cash provided (used) by operating activities. (See illustration in Exhibit 12.9). This method is the most widely used. B. Application of the Indirect Method of Reporting a. Add, as adjustments to net income: noncash expenses (e.g., depreciation), decreases in current assets, increases in current liabilities, and losses. b. Subtract, as adjustments to net income: increases in current assets, decreases in current liabilities, and gains. c. Does not report individual items of cash inflows and cash outflows from operating activities. d. Exhibit summarizes the adjustments for the indirect method. Cash Flows from Investing Three-stage process is used to determine cash provided (used) by investing activities: (1) Identify changes in investing-related accounts, (2) explain these changes using reconstruction method, and (3) report their cash flow effects. A. Analysis of Noncurrent Assets 1. Plant Asset Transactions: determine changes in all noncurrent asset accounts (plant assets, intangible assets, investments) 2. Analyze changes in these accounts using available information to determine their effect, if any, on cash. 12-5

4 IV. B. Analysis of Other Assets 1. Certain other asset transactions such as those involving current notes receivable and investments in debt and equity securities (excluding trading) are considered investing activities. 2. Analyze using same process used for noncurrent asset accounts. Cash Flows from Financing Three-stage process is used to determine cash provided (used) by investing activities: (1) Identify changes in financing-related accounts, (2) explain these changes using reconstruction method, and (3) report their cash flow effects. A. Analysis of Noncurrent Liabilities 1. Determine changes in noncurrent liability accounts (e.g., longterm debt, notes payable, bonds payable). 2. Analyze changes in these accounts using available information to determine their effect, if any, on cash. B. Analysis of Equity 1. Common Stock Transactions: determine changes in equity accounts (e.g., owner's capital, all stock accounts, and retained earnings). 2. Retained Earnings Transactions: analyze changes in these accounts using available information to determine their effect, if any, on cash. C. Proving Cash Balances the last step in preparing the statement is to report the beginning and ending cash balances and prove that the net change in cash is explained by operating, investing, and financing cash flows. D. Global View 1. Reporting of Cash Flows from Operating Both GAAP and IFRS permit the reporting of cash flows from operating activities using either the direct or the indirect method and the basic requirements are fairly consistent across the two systems. a. There are some differences in reporting operating cash flows. GAAP requires cash inflows from interest and dividend revenue be classified as operating, but IFRS permits classification under operating, investing or financing provided that it is consistently applied across periods. b. GAAP requires cash outlows for interest expense be classified as operating, but IFRS permits classification under operating, investing or financing provided it is consistent across periods. 2. Reporting of Cash Flows from Investing and Financing GAAP and IFRS are similar in computing and classifying cash flows from investing and financing activities. One exception is that 12-6

5 GAAP requires cash outlows for income tax be classified as operating, but IFRS permits splitting of those cash flows among operating, investing, and financing depending on the sources of that tax. V. Decision Analysis Cash Flow Analysis A. Analyzing Cash Sources and Uses 1. Managers stress understanding and predicting cash flows for business decisions. 2. Creditor and investor decisions are also based on a company's cash flow evaluations. 3. Operating cash flows are generally considered to be most significant because they represent results of ongoing operations. VI. B. Cash Flow on Total Assets 1. The cash flow on total assets ratio is similar to return on total assets except the return is analyzed based on operating cash flows rather than net income. 2. Calculated by dividing cash flow from operations by average total assets. Spreadsheet Preparation of the Statement of Cash Flows (Appendix 12A) A spreadsheet approach may be used to organize and analyze the information to prepare a statement of cash flows by the indirect method, including the supplemental disclosures of noncash investing and financing activities. A. The spreadsheet has four columns containing dollar amounts. 1. Columns one and four contain the beginning and ending balances of each balance sheet account. 2. Columns two and three are for reconciling the changes in each balance sheet account. B. Separate sections on the working paper present (a) balance sheet items with debit balances; (b) balance sheet items with credit balances; (c) cash flows from operating activities, starting with net income; (d) cash flows from investing activities; (e) cash flows from financing activities; and (f) noncash investing and financing activities. C. Information for sections (c) - (f) is developed in four steps in the Analysis of Changes columns: 1. By adjusting net income for the changes in all noncash current asset and current liability account balances. This reconciles the changes in these accounts. 12-7

6 2. By eliminating from net income the effects of all noncash revenues and expenses. This begins the reconciliation of noncurrent assets. VII. 3. By eliminating from net income any gains or losses from investing and financing activities. This involves the reconciliation of noncurrent assets and noncurrent liabilities and perhaps the recording of disclosures. 4. By entering any remaining items, such as dividend payments, which are necessary to reconcile the changes in all balance sheet accounts. Direct Method of Reporting Operating Cash Flows (Appendix 12B) The direct method adjusts accrual-based income statement items to the cash basis. Usual approach is to adjust income statement accounts related to operating activities for changes in their related balance sheet accounts. Separately list each major item or class of operating cash receipts and cash payments. A. Operating Cash Receipts include cash received from sales, rent, interest, and dividends. B. Operating Cash Payments include cash paid suppliers, for wages and other operating expense, interest, and income taxes. C. Summary of Adjustments for the Direct Method Exhibit 12B.6 summarizes the common adjustments for the items making up net income to arrive at net cash provided (used) by operating activities under the direct method. D. Direct Method Format of Operating Activities 1. Major items of cash inflows and cash outflows are listed separately in the operating activities section. 2. The items to be listed are determined by adjusting individual accrual basis income statement items to cash basis items. This is done by determining the impact from changes in their related balance sheet accounts. 3. The operating cash outflows are subtracted from the operating cash inflows to determine the net cash provided (used) by operating activities. 4. This is the method recommended (but not required) by the FASB. 5. When the direct method is used, the FASB requires a reconciliation of net income to net cash provided (used) by operating activities. This is operating cash flows computed using the indirect method. 12-8

7 VISUAL #12-1 CLASSIFYING ACTIVITIES IN THE STATEMENT OF CASH FLOWS OPERATING ACTIVITIES Cash inflows from Cash outflows to Sale of goods or services Suppliers of goods and Interest services Dividends Salaries and wages Sale of trading securities Government for taxes Other operating receipts Lenders for interest Purchase trading securities Others for expenses INVESTING ACTIVITIES Cash inflows from Cash outflows to Sale of property, plant, Purchase property, plant, and equipment and equipment Sale of debt or equity securities Purchase debt or equity of other entities securities of other entities Collection of principal on loans Make loans to another entity to other entities Selling (discounting) of loans FINANCING ACTIVITIES Cash inflows from Cash outflows to Sale of capital stock (or owner Shareholders as dividends (or investment) owner s withdrawal) Issuance of debt (bonds and notes) Repay debts Issuing short-term liabilities Purchase treasury stock NONCASH INVESTING AND FINANCING ACTIVITIES Retirement of debt by issuing stock Conversion of preferred stock to common stock Purchase of a long-term asset by issuing a note payable Leasing of assets classified as a capital lease 12-9

8 VISUAL #12-2 STEPS TO DETERMINE INFORMATION STATEMENT OF CASH FLOWS 1. Find Change in Cash This is the target number. 2. Find Cash Flow From Operations (Using direct or indirect method) 3. Find Cash Flow from A. Financing and B. Investing Procedure: In real life: Using data from comparative balance sheets, trace changes through ledgers and journals probably using a worksheet to organize, analyze, and prove data disclosed. In the classroom: Determine the changes in noncurrent accounts and notes from comparative balance sheets. Use the relevant data the text provides that comes from the ledgers and the journals to systematically analyze the data using chart and/or reconstructing journal entries. 4. Combine cash flows from all three activities (from 2 and 3) to find net cash flow and prove change in cash. (Target number determined in Step 1). Note: Once the above information has been gathered, the statement can be prepared following the required format. If the direct method was used, GAAP requires a reconciliation of net income to cash provided from operations

9 VISUAL #12-2 Determining Cash Flows from Operating Activities Indirect Method START WITH NET INCOME OR (NET LOSS) Add Subtract 1. Write-offs or noncash 1. Gains expenses 2. Increases in current assets 2. Losses 3. Decreases in current 3. Decreases in current assets liabilities 4. Increases in current liabilities. RESULT CASH FLOWS FROM OPERATING ACTIVITIES 12-11

10 VISUAL #12-3 Determining Cash Flows from Operating Activities Direct Method (Appendix 12B) (Need income statement and balance sheet data) 1. Cash = Sales + Decrease in Receipts Accounts from Customers* Receivable or - Increase in Accounts Receivable 2. Cash = Cost of + Increase in + Decrease in Payments Goods Sold Inventory Accounts to Suppliers or Payable - Decrease in - Increase in Inventory Accounts Payable 3. Cash = Operating + Increase in + Decrease in - Depreciation Payments Expenses Prepaid Accrued and Other for Expenses Liabilities Noncash Operating** or or Expenses Expenses - Decrease in - Increase in Prepaid Accrued Expenses Liabilities 4. Cash = Income + Decrease in Payments Taxes Income for Expense Taxes Income Taxes Payable or - Increase in Income Taxes Payable 5. Cash = Interest + Decreases in Payments Expense Interest Payable for - Increase in Interest Interest Payable **Wage expense would be taken out if CP for wages was *use similar computations for to be reported separately. CR from Interest The related prepaids and CR from Dividends payables would be considered in the computation