978-0078025679 Chapter 17 Lecture Note

Unlock access to all the studying documents.

View Full Document

Financial Reporting and Analysis 6e Statement of Cash Flows

CHAPTER 17

STATEMENT OF CASH FLOWS

CHAPTER OVERVIEW

The statement of cash flows provides information for assessing the the firm’s ability to

generate sufficient cash to pay operating expenses, pay for capital improvements, and currently

maturing obligations. Firms able to generate consistently strong positive cash flows from

operations are considered better credit risks and will 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 that begins with net

income and adjusts for depreciation, amortization, noncash gains and losses, and changes in

noncash working capital accounts other than short-term debt, which cause net income to differ

from operating cash flows for the period.

Frequently, changes in noncash working capital accounts shown on comparative balance

sheets may not reconcile with the adjustments shown on the cash flow statement. These

discrepancies may be attributable to (1) asset write-offs due to impairment, corporate restructuring,

or retirement, (2) translation adjustments on assets and liabilities held by foreign subsidiaries, (3)

acquisitions and divestitures of other companies or operating units, and/or (4) simultaneous

investing and financing activities not directly affecting cash. Failure to understand how these

events cause balance sheet accounts to differ from changes in account balances shown on the

cash flow statement can lead to incorrect interpretation of both statements.

Operating cash flows can sometimes be distorted or legitimately managed. One should be

aware of the ways this can occur and how to adjust reported operating cash flows to enhance the

comparability of this important number across firms and over time.

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. However, if adopted, the

proposal would significantly alter the format of the statement of cash flows, including where

certain types of cash flows would be reported within the statement.

CHAPTER OUTLINE

I. STATEMENT FORMAT

A. The purpose of this statement is to explain the sources and uses of cash from three

distinct types of activities:

1. Operating cash flows result from events or transactions that enter into the

determination of net income.

a. In other words, operating cash flows result from transactions related

to the production and delivery of goods and services to customers.

b. In effect, operating cash flows are the cash-basis revenues and expenses

of a company.

2. Investing cash flows result from the purchase or sale of productive assets like

plant and equipment, buying and selling marketable securities (government bonds

or stocks and bonds issued by other companies), and acquisitions or divestitures of

other companies.

3. Financing cash flows result from a company selling its own stocks or bonds,

paying dividends or buying back its own shares (treasury stock), borrowing money

Financial Reporting and Analysis 6e Statement of Cash Flows

and repaying amounts borrowed.

B. Current U.S. GAAP allows firms the option of choosing between two alternative

formats for

presenting cash flows from operating activities: (1) the direct method, and (2) the

indirect method.

C. The Direct Method: Exhibit 17.1 in the text presents the 2011 and 2012 Statement of

Cash Flows for Golden Enterprises.

1. The direct approach requires that firms report major classes of gross cash

receipts (cash revenues) and gross cash payments (cash expenses).

a. The cash received from various sources is calculated by using the income

statement amount and adjustments based on changes to current asset and

current liability accounts. The specific categories of cash inflows are:

i. Cash collected from customers (including lessees and licensees)

ii. Interest and dividends received

iii. Other operating cash receipts

b. The cash paid for various expense categories is calculated using the

income statement amount and adjustments based on changes to current

asset and current liability accounts. The specific categories of cash

outflows are: i. Cash paid to employees and other suppliers of goods and

services

ii. Interest paid

iii. Income taxes paid

iv. Other operating cash payments

c. A reconciliation of net income to net operating cash flow is required as a

supplemental disclosure for companies using the indirect method. It only

covers the operating activities section of cash flow statement.

D. The Indirect Method: The indirect method begins with the accrual basis net

income (before extraordinary items) and adjusts for:

1. Items included in accrual basis net income that did not affect cash in the current

period, such as:

a. Noncash revenues or gains (e.g., revenues earned but not received in cash, and

gains on disposal of fixed assets).

b. Noncash expenses or losses (e.g., depreciation and amortization, provision for

bad debt expense, and expenses accrued but not paid in cash).

2. Items excluded from accrual basis income that did affect operating cash flows

in the current period, such as:

a. Cash inflows (revenues) received but not recognized as earned in the current

period (e.g., rent received in advance and collections on account).

b. Cash outflows (expenses) paid but not recognized for accrual purposes in the

current period (e.g., prepaid insurance and payments on account).

B. The indirect method for reporting cash provided by operating activities is used by

an overwhelming majority of public companies. The indirect method is favored

for two reasons:

1. The indirect method is easier for firms to implement because it relies exclusively

on data already available in the accrual accounts.

2. The indirect method characterizes cash flow in a way that many analysts find

useful.

C. The indirect method reconciles accrual accounting net income with cash flows

from operations.

Financial Reporting and Analysis 6e Statement of Cash Flows

1. Noncash adjustments such as depreciation and amortization, equity in the net

(income) loss of affiliated companies, losses (gains) on disposals of fixed assets,

and deferred income tax provisions must be added to (subtracted from) net income

since they do not have a cash flow effect.

2. Decreases (Increases) in current asset are added (subtracted from) to net

income in reconciling to cash from operating activities.

3. Increases (decreases) in current liabilities are added to (subtracted from) net

income in reconciling to cash from operating activities.

4. In addition, firms using the indirect approach are required to disclose separately

the amount of interest and income tax paid.

5. GAAP does not require a separate disclosure of dividends and interest income

received for firms using the indirect method.

6. Both the direct and indirect methods for computing net cash provided by operating

activities will report the same amount.

7. Those who prefer the direct method justify their preference because this method

discloses operating cash flows by category—inflows from customers, outflows to

suppliers, etc.—facilitating cash flow predictions.

8. Analysts who prefer the indirect method do so because the size and direction of

the items reconciling income to operating cash flow provide a rough yardstick for

evaluating the quality of earnings.

9. For comparability purposes, the FASB requires firms using the direct method to

reconcile accrual earnings and operating cash flows as would be presented under

the indirect method.

10. The entire amount of cash taxes paid is included in the cash flows from operating

activities computation.

a. On the income statement, items not included in the computation of

income from continuing operations such as extraordinary items are

reflected net of their associated income tax effects to facilitate

predictions by statement users.

b. Therefore, tax expense associated with the presumably recurring income from

continuing operations is reported separately from the tax expense associated

with items appearing below income from continuing operations.

c. Regrettably, current GAAP does not treat cash outflows for income taxes in

the same way.

d. This failure to differentiate tax cash flows by type (those pertaining to

income from continuing operations versus other items) complicates forecasts

of future cash flows.

E. Other Elements of the Cash Flow Statement:

1. The investing activities and financing activities sections of the statement show

items that are relatively straightforward and there should be little difficulty in

interpreting these disclosures.

a. Investing activities are defined as the sources and uses of cash to sell and

purchase long-term assets.

b. Financing activities are defined as the receipt and payment of funds by a

corporation that are classified as long-term liabilities and/or owner’s equity.

2. Investing and financing transactions that do not directly and immediately affect

cash are not included in the statement of cash flows.

a. Because cash is initially unaffected, current GAAP does not include either

the increase in the investment or the increase in the financing within the

statement of cash flows.

Financial Reporting and Analysis 6e Statement of Cash Flows

b. These transactions must be disclosed in a separate schedule or as a footnote

or schedule to the statement of cash flows.

II. PREPARING THE CASH FLOW STATEMENT

A. The following three-step process is used to build the components of the statement:

1. Identify the journal entry or entries that led to the reported net balance sheet

change in each noncash account.

2. Determine the net cash flow effect of the journal entry (or entries) identified in

Step 1.

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 necessary for

each item.

B. Comparative balance sheets and a current year income statement will provide much

of the information necessary to use the three-step approach.

C. Cash Flows from Operating Activities:

1. The purpose of this section is to reconcile net income to cash from operations.

2. Noncash items (such as depreciation expense, and loss on sale of assets) are added

to or subtracted from net income to reconcile to cash from operations.

a. Changes in current assets and liabilities are added to or subtracted from net

income to reconcile to cash from operations.

D. Cash Flows from Investing Activities: This section shows component increases and

decreases in long-term asset accounts.

1. Sales of equipment are shown at the cash transaction price.

2. A loss on sale occurs when book value exceeds the cash proceeds.

3. The loss is added back to cash flows from operations since it is a nonoperating

loss when reported under the indirect method.

4. The loss is therefore subtracted from the book value of the item(s) sold so that the

cash proceeds are reported in the investing activities section.

5. The converse holds for gains on sales of long-term assets.

6. Purchases of long-term assets with debt issuances are not shown in the statement

of cash flows since they are not cash based.

E. Cash Flows from Financing Activities: This section reports cash flow effects of

transactions affecting long-term liability and owners’ equity accounts such as sale of

stock, and payment of dividends.

1. Net income, which is one component of the change in retained earnings, is

reported in the operating section.

2. Component increases and decreases in these accounts are reported separately.

III. RECONCILIATION BETWEEN STATEMENTS: SOME COMPLEXITIES

A. Users of financial statements frequently encounter situations where changes in balance

sheet accounts over the year do not reconcile to the corresponding account change

included in the statement of cash flows. While all accruals cause changes in balance

sheet accounts, not all changes in operating balance sheet accounts (e.g. receivables,

inventory, and payables) are caused by accruals.

B. These differences arise for at least four reasons:

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

2. Foreign currency translation adjustments on assets and liabilities held by foreign

subsidiaries.

Financial Reporting and Analysis 6e Statement of Cash Flows

3. Acquisitions and divestitures of other companies.

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

C. Footnote disclosures and information in the income statement and operating section of

the cash flow statement may be helpful in reconciling some of these differences.

D. Simultaneous Noncash Investing and Financing Activities such as the acquisition

of an asset with a long-term note payable, while having no effect on cash must be

disclosed either in a narrative or in a schedule that accompanies the statement of cash

flows.

IV. ANALYTICAL INSIGHTS: WAYS OPERATING CASH FLOWS CAN BE

DISTORTED OR MANIPULATED

B. Major discrepancies between accrual earnings and operating cash flows sometimes

can be used to identify instances where earnings have been managed upward.

C. The following topical areas explained throughout the text represent areas where this

discrepancy can occur.

1. Changes in working capital accounts

2. Accounts receivable sale (securitization) versus collateralized borrowing.

3. Capitalizing versus operating leases

4. Software development costs

5. Capital versus operating leases

6. Cash flow effect of stock option expensing

D. Analysts and other statement users should be aware of the techniques for enhancing the

comparability of operating cash flows both across firms and over time.

V. GLOBAL VANTAGE POINT

A. IAS 1, “Presentation of Financial Statements,” requires firms to provide a statement of

cash flows as part of complete financial statements for each period for which

statements are presented.

B. 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.

C. Some differences between IFRS rules and U.S. GAAP include:

1. IFRS rules permit bank overdrafts to be considered as cash and cash equivalents

while U.S. GAAP does not

2. Although firms are allowed either method or reporting cash flows, IFRS encourages

the use of the direct method though it is not required. U.S. GAAP requires firms

using the direct method to also provide a reconciliation of net income to cash flows

from operating activities (indirect method) – a reconciliation is not required under

IFRS rules.

3. Reporting of Interest Received and Paid, Dividends Received and Paid, and

Tax Refunds and Payments: U.S. GAAP requires that interest paid, interest and

dividends received, as well as income tax receipts and payments be reported as

operating activities. Dividends paid are classified as financing activities. IFRS rules

allow non-financial firms to report interest and dividends received as either operating or

investing activities and interest paid as either operating or financing activity. IFRS

rules also allow firms to classify dividends paid as a component of operating activities.

Cash flows from income taxes are to be reported separately as an operating activity

unless they can be specifically identified with financing and investing activities.

C. A recent Exposure Draft (May 2011) issued by the FASB and IASB would bring

greater convergence of reporting of cash flow information under U.S. GAAP and IFRS. If

Financial Reporting and Analysis 6e Statement of Cash Flows

adopted, the proposals would significantly alter the format and where certain types of cash

flows would be reported within the statement of cash flows. The FASB’s agenda lists this

project as “inactive” due to the many criticisms received about the proposed changes. The

two boards do not currently plan to pursue the proposal any further.

Financial Reporting and Analysis 6e Statement of Cash Flows

CHAPTER QUIZ

1. In a statement of cash flows, which of the following items is reported as a cash outflow

from financing activities?

I. Payments to retire mortgage notes.

II. Interest payments on mortgage notes.

III. Dividend payments.

a. I, II, and III.

b. II and III only.

c. I only.

d. I and III only.

2. Which of the following correctly characterizes the presentation of bonds issued at a discount

on the statement of cash flows?

a. The statement of cash flows correctly describes the economics of bonds issued at a

discount.

b. Operating cash flow is understated and financing cash flow is overstated by the amount

of discount amortization.

c. Operating cash flow is overstated and financing cash flow is understated by the amount

of discount amortization.

d. The cash flow classification of the debt payments depends on the market interest rate,

not the stated rate.

3. How should a gain from the sale of used equipment for cash be reported in the statement of

cash flows using the indirect method?

a. In investment activities as a reduction of the cash inflow from the sale.

b. In investment activities as a cash outflow.

c. In operating activities as a deduction from income.

d. In operating activities as an addition to income.

4. Carson Co. has provided the following account balances for the preparation of the annual

statement

of cash flows: January 1 December 31

Accounts receivable $23,000 $29,000

Allowance for uncollectible accounts 800 1,000

Prepaid rent expense 12,400 8,200

Accounts payable 19,400 22,400

Kresley’s net income for the period is $150,000. Net cash provided by operating activities

in the statement of cash flows should be:

a. $145,400.

b. $148,600.

c. $151,000.

d. $151,400.

5. The primary purpose of the statement of cash flows is to provide relevant information about:

a. Differences between net income and associated cash receipts and disbursements.

b. An enterprise’s ability to generate future positive net cash flows.

c. The cash receipts and cash disbursements of an enterprise during the period.

d. An enterprise’s ability to meet cash operating needs.

Financial Reporting and Analysis 6e Statement of Cash Flows

6. Using the indirect method for a statement of cash flow, cash flow from operations

a. can be calculated by adding to or deducting from net income changes in current assets

(other than cash) and current liabilities and noncash items on the income statement

b. can be calculated by adding to or deducting from net income changes in current assets

(other than cash) and current liabilities and cash items on the income statement

c. is equal to accrual based income

d. is always positive

7. Rosa Dairy has the following activities during 2015:

• Reported net income of $13,000.

• Received dividends of $2,500 on stock investments.

• Paid dividends of $3,000

• Recorded an increase in current assets other than cash of $6,000.

• Recorded a decrease in current liabilities of $5,000.

• Depreciation and amortization expense is equal to $7,000.

In Rosa’s 2015 statement of cash flows, cash flow from operations is equal to:

a. $8,500.

b. $11,500.

c. $9,000.

d. $21,000.

8. Financing activities of a corporation include all of the following except:

a. Principle paid on a long-term note payable.

b. Interest paid on a long-term note payable.

c. Dividends paid to preferred stockholders.

d. Treasury stock transactions.

9. Investing activities of a corporation include all of the following except:

a. Purchase of land for future plant expansion.

b. Depreciation on plant assets during the fiscal period.

c. Purchase of a wholly owned subsidiary.

d. Sale of a machine used in production.

10. The deferred tax liability of Craig Industries was listed in the financial statement for 2015 as

$250,000. During the year Craig has net income of $1,000,000 for book purposes. The

deferred tax liability at the end of 2016 was $300,000 and income tax payable for the fiscal

year increased by $20,000. Using an average tax rate of 15%, calculate the cash used for

taxes on the statement of cash flows.

a. $100,000

b. $200,000

c. $80,000

d. $120,000

Financial Reporting and Analysis 6e Statement of Cash Flows

QUIZ ANSWERS:

1. d. Financing activities include issuance of stock, payment of dividends and other

distributions to owners, treasury stock transactions, issuance of debt, receipt of donor-

restricted resources to be used for long-term purposes, and repayment or other settlement of

debt obligations. Thus, payment of principal of a note and payment of dividends are

outflows from financing activities.,

Financial Reporting and Analysis 6e Statement of Cash Flows

consent of McGraw-Hill Education.

7. c. Operating activities:

Net income $13,000

Deduct: increase in current assets other than cash ( 6,000)

Deduct decrease in current liabilities ( 5,000)

Add depreciation and amortization 7,000

$ 9,000

=======

8. c. Interest paid by a corporation is listed as an operating item for the statement of cash flow.

This was controversial when incorporated in to Statement of Financial Accounting

Standards number 95.

9. b. Depreciation is a noncash item and is not part of the investing section of the statement of cash

flows. When using the indirect method depreciation is added back to net income to eliminate its

effect on the cash flow from operations.

10. c. Income tax applicable to net income per books $1,000,000 times 15%=$150,000. The

cash paid is calculated as $150,000-50,000-20,000=$80,000.

RECOMMENDED EXHIBITS

Exhibit 17.1 – Consolidated Statement of Cash Flows (Direct Method)

Exhibit 17.3 – Consolidated Statement of Cash Flows (Indirect Method)

Exhibit 17.5 – 2014 Statement of Cash Flows