978-1259722660 Chapter 21 Lecture Note Part 1

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CHAPTER 21

THE STATEMENT OF CASH FLOWS REVISITED

Overview

The objective of financial reporting is to provide investors and creditors with useful

information, primarily in the form of financial statements. The balance sheet and the income

statement—the focus of your study in earlier chapters—do not provide all the information needed by

these decision makers. In this chapter, you will learn how the statement of cash flows fills the

information gap left by the other financial statements.

The statement lists all cash inflows and cash outflows during each reporting period, and

classifies them as cash flows from (a) operating, (b) investing, or (c) financing activities. Investing

and financing activities that do not directly affect cash also are reported.

Learning Objectives

After studying this chapter, you should be able to:

LO20–1 Explain the usefulness of the statement of cash flows.

LO20–2 Define cash equivalents.

LO20–3 Determine cash flows from operating activities by the direct method.

LO20–4 Determine cash flows from operating activities by the indirect method.

LO20–5 Identify transactions that are classified as investing activities.

LO20–6 Identify transactions that are classified as financing activities.

LO20–7 Identify transactions that represent noncash investing and financing activities.

LO20–8 Prepare a statement of cash flows with the aid of a spreadsheet or T-accounts.

LO20–9 Discuss the primary differences between U.S. GAAP and IFRS with respect to the

statement of cash flows.

Instructors Resource Manual 21-1

McGraw-Hill Education.

Lecture Outline

Part A: The Content and Value of the Statement of Cash Flows

I. Usefulness of Cash Flow Information

A. Investors and creditors analyze the prospects of receiving a cash return from their dealings

with a firm.

1. Cash flows to investors and creditors depend on the corporation generating cash

flows to itself.

2. Decision makers rely heavily on the information reported in periodic financial

statements to project a company’s cash-generating ability.

3. Some important questions are not easily answered from the information the balance

sheet and income statement provide.

II. Cash Inflows and Outflows

A. The statement of cash flows fills an information gap left by the balance sheet and the

income statement.

1. It presents information about cash flows that the other statements either (a) do not

provide or (b) provide only indirectly.

2. Cash continuously flows into and out of an active business.

3. The concept of the statement is quite simple: It provides a list of the cash inflows

and outflows that occurred during the reporting period. Before seeing how the

statement of cash flows is prepared from the information typically available for this

purpose, the basic structure and composition of the statement is overviewed in

Illustration 21–2.

III. Structure of the Statement of Cash Flows

A. The requirement that companies present the statement of cash flows is relatively recent.

1. During the early 1900s and continuing into the mid-1930s, the cash basis was a

widely used means of financial reporting.

2. Early efforts to create the standard of accrual accounting intentionally suppressed

the widespread practice of cash flow reporting.

3. Responding to the need for some type of funds flow reporting, funds statements

flourished, typically defining funds as working capital.

4. The current GAAP issued in 1988 completed a “full-cycle” movement of

accounting thought back to cash flow reporting, which, in different form, was

common practice several decades ago.

IV. Cash, Cash Equivalents, and Restricted Cash

A. Cash includes “cash equivalents.” The statement of cash flows does not differentiate

between amounts held as cash and amounts held in cash equivalent investments.

Instructors Resource Manual 21-2

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1. These are short-term, highly liquid investments that can readily be converted to

cash with little risk of loss.

2. Examples are money market funds, Treasury bills, and commercial paper.

3. These investments must have a maturity date not longer than three months from the

date of purchase. Companies establish a policy regarding which short-term, highly

liquid investments they classify as cash equivalents to be disclosed in the notes.

4. Transactions that involve merely transfers from cash to cash equivalents (such as

the purchase of a three-month treasury bill) are not reported on the statement of

cash flows because the total of cash and cash equivalents is not altered by such

transactions.

V. Cash Flows from Operating Activities

A. Cash flows from operating activities are both inflows and outflows of cash that result

from activities reported on the income statement.

B. The classification includes the elements of net income, but reported on a cash basis, such

as:

1. Cash received from customers rather than sales and service revenue.

2. Cash revenue received rather than investment revenue.

3. Cash paid to suppliers rather than cost of goods sold.

4. Cash paid to employees rather than salaries expense.

5. Cash paid to the government rather than income tax expense.

C. Noncash items reported on the income statement but not reported on the statement of

cash flows, such as:

1. Gain on sale of assets.

2. Loss on sale of assets.

3. Depreciation.

4. Amortization.

VI. Cash Flows from Investing Activities

A. Cash flows from investing activities are related to the acquisition and disposition of

assets, other than (a) inventory and (b) assets classified as cash equivalents.

B. The classification includes the acquisition of:

1. Property, plant and equipment and other productive assets [except inventories].

2. Investments in securities [except cash equivalents and trading securities].

3. Nontrade receivables.

C. The classification also includes any cash receipts from their disposition, such as:

1. The sale of property, plant, and equipment.

2. The sale of investments in securities.

3. The collection of nontrade receivables.

Instructors Resource Manual 21-3

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VII. Cash Flows from Financing Activities

A. Cash flows from financing activities result from the external financing of a business.

B. The classification includes:

1. The sale or repurchase of shares.

2. The issuance or repayment of debt securities.

3. The payment of cash dividends.

C. The classification also includes subsequent transactions related to these, such as:

1. The repurchase of common or preferred stock (to retire the stock or as treasury

stock).

2. The repayment of debt.

3. The payment of cash dividends to shareholders.

VIII. Noncash Investing and Financing Activities

A. Noncash investing and financing activities, such as acquiring equipment (an investing

activity) by issuing a long-term note payable (a financing activity) must be disclosed also.

B. Examples of transactions that do not increase or decrease cash, but which result in

significant investing and financing activities are:

1. Acquiring an asset by incurring a debt payable to the seller.

2. Acquiring use of an asset by entering into a lease agreement.

3. Converting debt into common stock or other equity securities.

4. Exchanging noncash assets or liabilities for other noncash assets or liabilities.

C. Noncash transactions that do not affect a company’s assets or liabilities, such as the

distribution of stock dividends, are not considered investing or financing activities and

are not reported.

D. Noncash investing and financing activities are reported either on the same page as the

statement of cash flows or in a related schedule or note.

E. Both U.S. GAAP and IFRS require a statement of cash flows that classifies cash flows

into operating, investing, or financing activities. A difference, though, is that U.S. GAAP

designates (a) interest payments and interest received as operating cash flows and (b)

dividend payments as financing cash flows and dividends received as operating cash

flows. IAS No. 7, on the other hand, allows more flexibility. Companies can report

interest and dividends received and paid as operating, investing, or financing cash flows,

provided that they are classified consistently from period to period. Interest payments

usually are reported as operating activities. Dividend payments usually are reported as

financing activities as under U.S. GAAP. However, interest received and dividends

received normally are classified as investing activities.

Instructors Resource Manual 21-4

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Part B: Preparing the SCF: Direct Method of Reporting Cash Flows from

Operating Activities

I. Using a Spreadsheet

A. A spreadsheet offers a systematic method of preparing a statement of cash flows.

1. It allows us to analyze available data to ensure that all operating, investing, and

financing activities are detected.

2. We use it to record spreadsheet entries that explain account balance changes and

simultaneously identify and classify the activities to be reported on the statement of

cash flows.

3. It relies on the fact that, for cash to increase or decrease, there must be a

corresponding change in a noncash account. Thus, if we can identify the events and

transactions that caused the change in each noncash account during the year, we

will have identified all the operating, investing, and financing activities that

occurred.

B. Procedure:

1. Enter the beginning and ending balances of each account by transferring the

comparative balance sheets and income statement to a blank spreadsheet.

2. Following the balance sheets and income statement, we allocate space on the

spreadsheet for the statement of cash flows.

3. Enter spreadsheet entries that duplicate the actual journal entries used to record the

transactions as they occurred during the year.

4. When a transaction being entered on the spreadsheet includes an operating,

investing, or financing activity, enter that portion of the entry under the

corresponding heading of the statement of cash flows section of the spreadsheet.

5. Since there can be no operating, investing, or financing activity without a

corresponding change in one or more of the noncash accounts, once all noncash

account balance changes are “explained” we should feel confident that we have

identified all of the activities that should be reported on the statement of cash flows.

6. To check the accuracy of the analysis, compare the change in the balance of the

cash account with the net change in cash flows produced by the activities listed in

the statement of cash flows section of the spreadsheet.

7. The spreadsheet is now complete. The statement of cash flows can now be prepared

directly from the spreadsheet simply by presenting the items included in the

statement of cash flows section of the spreadsheet in the appropriate format of the

statement.

Instructors Resource Manual 21-5

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Part C: Preparing the SCF: Indirect Method of Reporting Cash Flows from

Operating Activities

I. Getting There through the Back Door

A. Either the direct or the indirect method can be used to calculate and present the net cash

increase or decrease from operating activities.

B. Unlike the direct method, which directly lists cash inflows and outflows, the indirect

method derives cash flows indirectly, by starting with reported net income and “working

backwards” to convert that amount to a cash basis.

C. The indirect method yields the same net cash flows from operating activities as does the

direct method. The indirect method simply reverses the differences between the

accrual-based income statement and “cash flows from operating activities.”

Decision Makers’ Perspective—Cash Flow Ratios

A. Some analysts supplement their analysis with cash flow ratios.

1. Some cash flow ratios are derived by simply substituting “Cash flow from

operations” in place of net income in many ratios, not to replace those ratios but to

complement them.

2. Cash flow ratios offer insight in the evaluation of a company’s profitability and

financial strength.

Instructors Resource Manual 21-6

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PowerPoint Slides

Three PowerPoint presentations of the chapter are available in the Connect Library:

1. With “Concept Checks” useful for classroom presentation, permitting the

instructor to intersperse in the presentation short exercises students can be asked

to solve individually or in small groups before the solution is “revealed” by the

instructor. {These are available only within Instructor Resources.}

2. Without the “Concept Checks” so students don’t have the solutions before being

asked to solve individually or in small groups.

3. Accessible PowerPoint Presentations. Accessibility is becoming even more

important in the education marketplace. Students and instructors with

disabilities use many different assistive technologies, and McGraw-Hill

Education is working to increase compatibility and access that will not only

help those with disabilities achieve better learning outcomes, but also serve the

institutions that are teaching these students. Accessible PowerPoint allows slide

content to be read by a screen reader and provides alternative text descriptions

for any image files used that enrich the learning experience. Accessible

PowerPoint is also designed with high-contrast color palettes and uses texture

when possible, instead of color to denote different aspects of the imagery used

within the slide.

Note: The slides are intended to provide comprehensive coverage of the chapter, but

they can be easily edited to allow instructors to change numbers and content in

illustrations or to delete slides pertaining to topics they choose to omit or

deemphasize. (Using your students’ names for company names in the Concept

Checks or Illustrations can be fun.)

Instructors Resource Manual 21-7

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Suggestions for Class Activities

1. Critical Thought Activity

Students often are lulled into believing that there is only one “right” way to report a transaction.

Accounting for cash flows provides and opportunity to consider supportable alternatives.

Suggestions:

Ask your students to consider the appropriate way to report cash payments for dividends in a

statement of cash flows.

Next, ask them to consider the appropriate way to report cash dividends received in a statement of

cash flows.

In both instances ask them to provide conceptual support for their decisions and to avoid basing

decisions on current GAAP.

Points to note:

GAAP designates cash outflows for interest payments and cash inflows from interest and divi-

dends received as operating cash flows. Dividends paid to shareholders are classified as financing

cash flows. Some feel it is inconsistent to classify the payment of cash dividends to shareholders as a

financing activity when paying interest to creditors is classified as an operating activity. Others may

note that under U.S. GAAP, cash flows from operating activities should reflect the cash effects of

items that enter into the determination of net income. Interest expense is a determinant of net in –

come. A dividend, on the other hand, is a distribution of net income and not an expense.

Some students will suggest that dividends received are a result of investing in securities that pay

dividends and thus should be reported as investing activities. This reasoning, in fact, is consistent

with the way companies report using IFRS. Under international standards, interest and dividend pay-

ments usually are reported as financing activities. Interest and dividends received normally are clas-

sified as investing activities.

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2. Real World Scenario

Students learn in the text that footnote disclosure provides useful information related to the statement

of cash flows, often in the form of non-cash information. The following disclosure from HP offers a

fairly complete example of that type of disclosure.

HEWLETT-PACKARD COMPANY

CONSOLIDATED STATEMENT OF CASH FLOWS (in part)

Note 5: Supplemental Cash Flow Information

Supplemental cash flow information to the Consolidated Statements of Cash Flows was as

follows for the following fiscal years ended October 31:

In millions

Cash paid for income taxes, net $ 1,293 $ 643 $ 1,136

Cash paid for interest $ 384 $ 572 $ 426

Non-cash investing and financing activities:

Issuance of common stock and stock awards assumed in business acquisitions $ 93 $ — $ 316

Purchase of assets under financing arrangements $ — $ 283 $ —

Acquisition of asset use under lease agreements $ 122 $ 131 $ 30

Suggestions:

Have your students find this information on the Internet or provide it to them. Would the

information about cash for interest and taxes be needed if HP reported operating activities by the

direct method?

You might ask them to reconstruct the journal entries for the acquisitions and sales reported. Why

is this information reported?

Points to note:

If HP reported operating activities by the direct method, the information about cash for interest

and taxes would be line items on the statement itself. Because a primary benefit of the statement of

cash flows is its reporting of all significant investing and financing activities, even when such

activities involve no cash or only part cash, they should be reported as HP did here.

Instructors Resource Manual 21-9

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