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Chapter 17 Statement of Cash Flows Slides Authored by Brian Leventhal University of Illinois at Chicago FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS.

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Presentation on theme: "Chapter 17 Statement of Cash Flows Slides Authored by Brian Leventhal University of Illinois at Chicago FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS."— Presentation transcript:

1 Chapter 17 Statement of Cash Flows Slides Authored by Brian Leventhal University of Illinois at Chicago FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS – JOHNSON

2 FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS – JOHNSON I. General 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.

3 FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS – JOHNSON I. General Format A. The purpose of this statement is to explain the sources and uses of cash from three distinct types of activities: 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 and divestitures of other companies.

4 FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS – JOHNSON I. General Format A. The purpose of this statement is to explain the sources and uses of cash from three distinct types of activities: 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 and repaying amounts borrowed.

5 FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS – JOHNSON I. General Format B. SFAS No. 95 allows firms the option of choosing between two alternative formats for presenting cash flows from operating activities: 1 the direct approach, and 2 the indirect approach.

6 FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS – JOHNSON II. The Direct Approach A. Exhibit 17.1 in the text presents the 1999 Statement of Cash Flows for ABM Industries. B. The direct approach requires that firms report major classes of gross cash receipts (cash revenues) and gross cash payments (cash expenses).

7 FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS – JOHNSON III. The Indirect Approach A. The indirect approach 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. Non-cash revenues or gains (e.g., revenues earned but not received in cash, and gains on disposal of fixed assets). b. Non-cash expenses or losses (e.g., depreciation and amortization, provision for bad debt expense, and expenses accrued but not paid in cash).

8 FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS – JOHNSON III. The Indirect Approach A. The indirect approach begins with the accrual basis net income (before extraordinary items) and adjusts for: 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).

9 FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS – JOHNSON III. The Indirect Approach B. The indirect approach for reporting cash provided by operating activities is used by 98.8 percent of the 600 companies included in the AICPA's annual financial reporting survey. 1. The indirect approach is easier for firms to implement because it relies exclusively on data already available in the accrual accounts. 2. The indirect approach is more familiar to many accountants because this format was widely used in the changes in working capital statement that preceded SFAS No. 95.

10 FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS – JOHNSON III. The Indirect Approach C. The indirect approach reconciles accrual accounting net income with cash flows from operations. 1. Noncash adjustments such as depreciation and amortization, equity in the net (income) loss of affiliated companies, (gains) losses 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.

11 FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS – JOHNSON III. The Indirect Approach C. The indirect approach reconciles accrual accounting net income with cash flows from operations. 2. (Increases) decreases in current asset are (subtracted from) added 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.

12 FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS – JOHNSON III. The Indirect Approach D. Both the direct and indirect approaches for computing net cash provided by operating activities will report the same amount. 1. Those who prefer the direct approach justify their preference because this method discloses operating cash flows by category—inflows from customers, outflows to suppliers, etc.—facilitating cash flow predictions.

13 FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS – JOHNSON III. The Indirect Approach D. Both the direct and indirect approaches for computing net cash provided by operating activities will report the same amount. 2. Analysts who prefer the indirect approach 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.

14 FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS – JOHNSON III. The Indirect Approach D. Both the direct and indirect approaches for computing net cash provided by operating activities will report the same amount. 3. For comparability purposes, the FASB requires firms using the direct approach to reconcile accrual earnings and operating cash flows as would occur under the indirect approach. 4. Firms using the indirect approach are required to separately disclose the amount of interest paid and income taxes paid.

15 FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS – JOHNSON III. The Indirect Approach D. Both the direct and indirect approaches for computing NCPOA will be the same amount. 5. The entire amount of cash taxes paid is included in the cash flows from operating activities computation, even though some of the taxes relate, for example, to gains on sales of assets whose gross cash flows are included in the cash flows from investing activities section of the statement. a. On the income statement, items not included in the computation of income from continuing operations such as extraordinary items and cumulative effects of changes in accounting principles are reflected net of their associated income tax effects to facilitate predictions by statement users.

16 FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS – JOHNSON III. The Indirect Approach D. Both the direct and indirect approaches for computing NCPOA will be the same amount. 5. The entire amount of cash taxes paid is included in the cash flows from operating activities computation, even though some of the taxes relate, for example, to gains on sales of assets whose gross cash flows are included in the cash flows from investing activities section of the statement. 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.

17 FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS – JOHNSON III. The Indirect Approach D. Both the direct and indirect approaches for computing NCPOA will be the same amount. 5. The entire amount of cash taxes paid is included in the CFOA …….. c. Regrettably, SFAS No. 95 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.

18 FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS – JOHNSON III. The Indirect Approach 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.

19 FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS – JOHNSON III. The Indirect Approach E. Other elements of the cash flow statement: 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, SFAS No. 95 does not include either the increase in the investment or the increase in the financing within the statement of cash flows. b. These transactions must be disclosed in a separate schedule or as a footnote to the statement of cash flows.

20 FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS – JOHNSON IV. 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 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.

21 FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS – JOHNSON IV. Preparing the Cash Flow Statement B. Comparative balance sheets and an income statement will provide much of the information necessary to use the three-step approach.

22 FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS – JOHNSON V. Cash Flows from Operations A. The purpose of this section is to reconcile net income to cash from operations. B. Noncash items are added to (subtracted from) net income to reconcile to cash from operations. C. Noncash components of working capital are added to (subtracted from) net income to reconcile to cash from operations.

23 FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS – JOHNSON VI. Cash Flows from Investing Activities A. This section shows component increases and decreases in long-term asset accounts.

24 FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS – JOHNSON VI. Cash Flows from Investing Activities B. Sales of equipment are shown at the cash transaction price. 1. A loss on sale occurs when book value exceeds the cash proceeds. 2. The loss is added back to cash flows from operations since it is a nonoperating loss. 3. The loss is then subtracted from the book value of the item(s) sold so that the cash proceeds are reported. 4. The converse holds for gains on sales of long- term assets.

25 FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS – JOHNSON VI. Cash Flows from Investing Activities C. Purchases of long-term assets with debt issuances are not shown in the statement of cash flows.

26 FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS – JOHNSON VII. Cash Flows from Financing Activities A. This section reports cash flow effects of transactions affecting long-term liability and owners’ equity accounts. B. Net income, which is one component of the change in retained earnings, is reported in the operating section. C. Component increases and decreases in these accounts are reported separately.

27 FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS – JOHNSON VIII. Reconciling 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.

28 FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS – JOHNSON VIII. Reconciling Between Statements: Some Complexities B. These differences arise for at least three reasons: 1. Asset write-offs due to impairment, corporate restructuring or retirement. 2. Translation adjustments on assets held by foreign subsidiaries. 3. Acquisitions and divestitures of other companies.

29 FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS – JOHNSON VIII. Reconciling Between Statements: Some Complexities 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.

30 FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS – JOHNSON IX. Analytical Insights: Cash Burn Rates of Internet Stocks A. The ability to generate positive operating cash flows is critical to the survival and success of any company.

31 FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS – JOHNSON IX. Analytical Insights: Cash Burn Rates of Internet Stocks B. The cash burn rate is a popular metric for assessing how quickly internet firms are using up their cash reserves. 1. May be calculated as cash used for operations plus cash used for capital expenditures and purchases of on-going businesses divided by the number of months covered by the cash flow statement. 2. Alternatively, this may be calculated as earnings before interest, taxes, depreciation and amortization (EBITDA) adjusted for non-recurring gains and losses divided by number of months covered by the income statement.

32 FINANCIAL REPORTING & ANALYSIS 2e REVSINE – COLLINS – JOHNSON IX. Analytical Insights: Cash Burn Rates of Internet Stocks C. A related measure is months to burnout. 1. This measure provides an estimate of how much longer a company can survive without an infusion of external capital. 2. Calculated as cash, cash equivalents, and short-term marketable securities divided by the cash burn rate.


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