1. Intermediate Accounting
Chapter 21
The Statement of Cash Flows
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2. What Financial Statement Users Want to Know
What is the relationship between net income and cash provided by operations?
Were the company’s operations a source or a use of cash?
What investments and growth activities took place?
How were they financed?
What were the proceeds received from issuing capital stock or debt and how were the funds used?
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3. FASB Requirements
The FASB recognized the importance of providing answers to user’s questions by stating that financial reporting should provide information about a company’s:
Methods for obtaining and spending cash
Data on borrowing and repayment of debt
Capital transactions, including cash dividends and other distributions of resources to owners
Other factors that may affect its liquidity or solvency.
To satisfy these objectives, GAAP requires a company to present a statement of cash flows for the accounting period along with its income statement and balance sheet.
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4. What Information Does the Statement of Cash Flows Provide and How is it Reported?
The primary purpose of a company’s statement of cash flows is to provide relevant information about its cash receipts and cash payments during an accounting period.
The FASB states that the information in a statement of cash flows, if used with information in the other financial statements, helps external users assess:
a company’s ability to generate positive future net cash flows
a company’s ability to meet its obligations and pay dividends
company’s need for external financing
the reasons for differences between a company’s net income and related cash receipts and payments
both the cash and noncash aspects of a company’s financing and investing transactions during the accounting period
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5. How Does the Statement of Cash Flows Present Information?
According to GAAP, a company’s statement of cash flows for the accounting period must clearly show:
cash provided by or used in its operating activities
cash provided by or used in its investing activities
cash provided by or used in its financing activities
net increase or decrease in its cash, reconciling the change from the beginning cash balance to the ending cash balance reported on the year-end balance sheet
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6. Operating Activities
A company’s operating activities are part of the day-to-day business activities of a company—acquiring (purchasing or manufacturing), selling, and delivering goods and services to customers.
Cash inflows from operating activities include cash receipts from:
sale of goods or services to customers
collection of accounts receivable
collection of interest on loans
receipts of dividends on investments in equity securities
Cash outflows for operating activities include cash payments to:
suppliers for inventory and other goods and services used in operations
employees
government for taxes
lenders for interest (unless capitalized)
other suppliers for various expenses
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7. Investing Activities
A company’s investing activities are those transactions that involve acquiring and selling productive assets and investments needed to achieve the operating objectives of the business.
Investing activities include transactions involving cash receipts from:
sale of property, plant, and equipment
sale of investments classified as available for sale and held-to-maturity
repayment of principal from loans made to other companies
Cash outflows for investing activities include cash payments to:
acquire property, plant, and equipment
acquire investments classified as available for sale and held-to-maturity
make loans to other companies
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8. Financing Activities
A company’s financing activities include its transactions involving obtaining resources from owners and providing them with a return on their investment as well as borrowing money from creditors and repaying those obligations.
Cash inflows from financing activities include cash receipts from issuing:
equity securities (i.e., common stock and preferred stock)
financing instruments (i.e., bonds, short-term or long-term notes, mortgages, capital leases, and other short- or long-term borrowings)
Cash outflows for financing activities include cash payments for:
dividends
repurchase of the company’s equity securities
repayments of amounts borrowed through financing instruments
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9. Noncash Investing and Financing Activities
Most financing and investing activities of a company affect its cash; however, some transactions are ‘‘simultaneous’’ investing and financing activities that do not affect its cash.
Examples of these transactions include:
acquisitions of assets by issuing equity securities (noncash investing and financing activities)
acquisitions of assets by assuming liabilities such as capital lease obligations (noncash investing and financing activities)
exchanges of debt securities or preferred stock for equity securities such as the conversion of bonds or preferred stock for common stock (noncash financing activities)
exchanges of assets for assets (noncash investing activities)
exchanges of liabilities for liabilities (noncash financing activities)
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10. Cash and Cash Equivalents
Part of a company’s cash management procedures include investing its cash in short-term, highly liquid investments, such as treasury bills, commercial paper, and money market funds.
These investments are called cash equivalents and, instead of reporting ‘‘Cash’’ as a current asset on its balance sheet, the company reports ‘‘Cash and Cash Equivalents.’’
In this case, the company’s statement of cash flows explains the change during the accounting period in its cash and cash equivalents.
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11. What Company Information Does the Statement of Cash Flows Help Financial Statement Users Understand? (Slide 1 of 2)
Information from the statement of cash flows enables financial statement users to assess a company’s liquidity and risk.
The operating cash flow ratio provides a measure of resources generated over a period of time, which a company may be able to use to meet current liabilities and is computed as: Cash Flow from Operating Activities Average Current Liabilities
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12. What Company Information Does the Statement of Cash Flows Help Financial Statement Users Understand? (Slide 2 of 2)
Another cash flow ratio examined by analysts to assess risk is the operating cash flow to total liabilities ratio, which provides recognition of a company’s ability to generate cash flows from operations to pay its debt.
This ratio is computed as: Cash Flow from Operating Activities Average Total Liabilities
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13. Cash Inflows and Outflows
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14. Inflows of Cash
Decreases in Assets. The sale or other disposal of assets (other than cash) typically causes a direct increase in cash when cash is received or collected in exchange for the assets (such as selling an investment security for cash or collecting a receivable in cash). In some cases, however, a decrease in assets implies an increase (savings) in cash because the asset being consumed was purchased for cash in a prior period.
Increases in Liabilities. The issuance or incurrence of liabilities typically causes a direct increase in cash when cash is borrowed (such as issuing a note payable for cash). In some cases, the incurrence of a liability implies an increase in cash even though the cash flow may not have literally occurred during the period.
Increases in Shareholders’ Equity. Shareholders’ equity increases mainly because of net income and additional investments by owners. Additional investments cause an increase in cash because cash is received in exchange for the common stock issued.
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15. Outflows of Cash
Increases in Assets. The acquisition of assets (other than cash) typically causes a decrease in cash because cash is paid in exchange for the assets. Again, in some cases, however, an increase in assets implies a decrease (use) of cash, even though cash may not have literally been used to acquire the asset during the current period.
Decreases in Liabilities. The payment of liabilities typically causes a decrease in cash when cash is paid to satisfy the liabilities. Again, in some cases, the reduction of a liability implies a use in cash even though the cash flow may not have literally occurred during the period.
Decreases in Shareholders’ Equity. Shareholders’ equity may decrease as a result of several transactions. Two common transactions are the payment of dividends and the acquisition of treasury stock. In each case, a decrease in shareholders’ equity is accompanied by a decrease in cash.
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16. Relationship Between Accruals and Cash Flows
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17. Direct Method of Reporting Operating Activities
GAAP allows a company to choose one of two ways to report its net cash flow from operating activities on its statement of cash flows: the direct method or the indirect method.
Under the direct method, a company computes operating cash inflows and deducts its operating cash outflows to determine its net cash flow from operating activities.
A company’s operating cash inflows are:
collections from customers
collections of interest and dividends
other operating receipts
A company’s operating cash outflows are:
payments to suppliers
payments to employees
other operating payments
payments for interest
payments for income taxes
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18. Indirect Method of Reporting Operating Activities
Under the indirect method, a company’s net income is adjusted (reconciled) to its net cash flow from operating activities.
To do so, net income is listed first and then adjustments (additions or subtractions) are made to net income:
Add back noncash expenses, such as depreciation and amortization expense, deferred income taxes, and share based compensation expense.
Add back noncash charges, such as restructuring and impairment charges.
Subtract noncash revenues, such as equity method income and excess tax benefits from share based compensations awards.
Add back losses or subtract gains recognized in income from the sale of assets, so that the full amount of the proceeds from the sale can be reported in the investing activities section.
Subtract increases and add back decreases in current operating assets (other than cash) and add back increases and subtract decreases in current operating liabilities to adjust for accruals and deferrals effects on cash flows.
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19. Adjustments to Convert Net Income to Net Cash Flow from Operating Activities (Slide 1 of 2)
Plus
Decreases in Current Assets
Increases in Current Liabilities
Other Adjustments
Minus
Increases in Current Assets
Decreases in Current Liabilities
Equals Net Cash Flow from Operating Activities
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20. Adjustments to Convert Net Income to Net Cash Flow from Operating Activities (Slide 2 of 2)
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21. Visual Inspection Method of Preparing the Statement of Cash Flows (Slide 1 of 3)
There are two methods that you may use to prepare a company’s statement of cash flows: the visual inspection method or the spreadsheet method.
Under the visual inspection method, you review the company’s financial statements and prepare its statement of cash flows without using a spreadsheet.
This method may be used when a company’s financial statements are simple and when the relationships between changes in account balances can be easily analyzed.
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22. Visual Inspection Method of Preparing the Statement of Cash Flows (Slide 2 of 3)
There are four steps in the visual inspection method.
Step 1. Prepare the heading for the statement of cash flows and list the three sections:
Operating Activities, Investing Activities, and Financing Activities.
List the company’s net income as the first item in the operating activities section.
Step 2. Calculate the increase or decrease that occurred during the accounting period in each balance sheet account (except cash) and determine whether it caused an inflow or outflow of cash. If so, report it in the appropriate category: Operating Activities, Investing Activities, or Financing Activities.
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23. Visual Inspection Method of Preparing the Statement of Cash Flows (Slide 3 of 3)
Step 3. If no cash flow occurred in Step 2 determine whether the increase or decrease was (a) the result of a noncash income statement item or (b) a simultaneous investing and/or financing transaction.
If (a), then determine the adjustment (addition or subtraction) to convert net income to the net cash flow from operating activities.
If (b), then identify the components of the simultaneous investing and/or financing activity and report them in a separate note or schedule.
Step 4. Complete the various sections of the statement of cash flows (based on the analysis in Steps 2 and 3. Check that the sum of the three subtotals of the sections equals the net change in cash. Also check that the sum of the net change in cash and the beginning cash balance is equal to the ending cash balance reported on the balance sheet.
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24. Spreadsheet Method of Preparing the Statement of Cash Flows (Slide 1 of 3)
Companies usually use the spreadsheet method to prepare their statements of cash flows.
Under this method, a company uses a spreadsheet to:
record its cash receipts and payments according to the operating, investing, and financing sections of the statement of cash flows
record the investing and financing activities not affecting cash
account for the change in each asset, liability, and shareholders’ equity account
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25. Spreadsheet Method of Preparing the Statement of Cash Flows (Slide 2 of 3)
After gathering information from the financial statements and supplemental information from the accounting records, a company completes a series of four steps to prepare the spreadsheet and its statement of cash flows:
Step 1. Preparing the spreadsheet
Step 2. Completing the spreadsheet
Step 3. Preparing the final spreadsheet entry
Step 4. Preparing the statement of cash flows
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26. Spreadsheet Method of Preparing the Statement of Cash Flows (Slide 3 of 3)
There are three issues related to the spreadsheet method:
After starting with net income, there is no required order in which the spreadsheet entries are constructed, but most companies proceed line-by-line through each account on the balance sheet. You should develop a method to account for all the changes in the noncash accounts in an orderly way.
You may have to make more than one spreadsheet entry to reconcile the change in an account. For instance, the change in the Land account may be the result of both a sale and a purchase of land. In these cases, both the cash receipt and cash payment are accounted for and reported separately.
Remember that these spreadsheet entries are not posted to any accounts. They are recorded on the spreadsheet only to help prepare the statement of cash flows.
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27. How Are Special Items Accounting for in the Statement of Cash Flows?
Sale of a depreciable asset
Retirement of bonds
Interest Paid and Income Taxes Paid
Short-Term and Long-Term Investments
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28. Sale of Depreciable Assets
A company computes the gain or loss on the sale of a depreciable asset by subtracting the current book value of the asset from the selling price.
When the company records the transaction, it increases cash, eliminates the book value (cost and accumulated depreciation), and recognizes a gain or loss that it reports on its income statement.
On the statement of cash flows, the gain (loss) must be subtracted from (added back to) net income, and the total proceeds from the sale must be reported as a cash inflow in the investing section.
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29. Retirement of Bonds
A company computes the gain or loss on the retirement of bonds by comparing the current book value of the bonds payable to the retirement price.
When the company records the transaction, it decreases cash, eliminates the book value (face value and any related premium or discount), and recognizes a gain or loss that it reports on its income statement.
At the end of the year, this journal entry must be properly reconstructed on the spreadsheet to account for the changes in the various accounts.
On the statement of cash flows, the gain (loss) must be subtracted from (added back to) net income, and the total proceeds to retire the bonds be reported as a cash outflow in the financing section.
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30. Interest Paid and Income Taxes Paid (Slide 1 of 2)
GAAP requires a company using the indirect method of reporting its operating cash flows to also disclose its interest paid and income taxes paid.
This disclosure may be made in a separate schedule, narrative description, or the notes to the financial statements.
Interest expense is affected by the cash paid, accruals, any premium or discount amortizations on bonds (or notes) payable, and any amounts capitalized.
Income tax expense is affected by the cash paid, accruals, and changes in deferred income taxes.
The next slide illustrates the necessary adjustments to convert interest expense to interest paid and to convert income tax expense to income taxes paid.
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31. Interest Paid and Income Taxes Paid (Slide 2 of 2)
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32. Short-Term and Long-Term Investments
As discussed previously, a company recognizes investment securities as either
trading,
available-for-sale,
or held-to-maturity securities.
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33. Trading Securities
GAAP requires that a company report the cash flows from purchases, sales, and maturities of trading securities as either operating or investing cash flow activities, based on the nature and purpose for which the securities were acquired.
GAAP also requires a company to report investments in trading securities at their fair value and report any resulting unrealized holding gain or loss in net income.
Consequently, for reporting its operating cash flows under the indirect method, a company adds (deducts) an unrealized holding loss (gain) on trading securities to (from) net income to help adjust net income from an accrual basis to a cash basis.
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34. Available-for-Sale Securities
If a company uses an allowance account and an unrealized increase or decrease account to value the investment in available-for-sale securities, it must carefully analyze any changes in these accounts to determine the impact (if any) on its statement of cash flows.
The company reports an increase in the investment account due to the purchase of the securities on its statement of cash flows as a cash payment for an investing activity.
The entry on the spreadsheet to prepare the statement is also made in the usual manner.
The company does not report any changes in the allowance and the unrealized increase or decrease accounts resulting from a revaluation to fair value at year- end on its statement of cash flows. However, it must account for the changes on the spreadsheet.
The company reports a decrease in the investment account because of the sale of the securities on its statement of cash flows as a cash receipt from an investing activity in the usual manner. However, the spreadsheet entry must reconcile the changes in the investment, allowance, unrealized increase/decrease, and realized gain (or loss) accounts.
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35. Held-to-Maturity Securities
If a company makes a long-term investment in debt securities (e.g., bonds) that it expects to hold to maturity:
It must amortize any premium or discount each year as an adjustment to interest revenue, and report the investment at its amortized cost on the year-end balance sheet. For cash flow reporting purposes, it reports the purchase as a cash payment for investing activities.
The company must also add any premium amortization on this type of investment to net income in the operating activities section of the statement of cash flows because the amortization reduced interest revenue to an amount lower than the cash received.
The company subtracts any discount amortization from net income because the amortization increased interest revenue to an amount higher than the cash received.
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36. Equity Method Investments
The equity method of accounting for investments also creates a need for a noncash adjustment.
The equity method results in recognition of revenue and an increase in the investment account equal to the investor’s share of the investee’s net income or net loss.
In addition, the equity investment account is decreased (and the cash account is increased) for any share of the investee’s dividends received.
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37. Other Investment Related Events
Cash dividends declared
Cash flows for compensatory share option plans
Effects of foreign currency exchange rates
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