Prepared by: Keri Norrie, Camosun College ACCOUNTING PRINCIPLES Third Canadian Edition Prepared by: Keri Norrie, Camosun College

THE CASH FLOW STATEMENT CHAPTER 17 THE CASH FLOW STATEMENT

USEFULNESS OF THE CASH FLOW STATEMENT The cash flow statement helps users assess: The company’s ability to pay dividends and meet obligations. The company’s ability to generate future cash flow. The reason for the difference between net income and cash provided (used) by operating activities. The investing and financing transactions during the period.

DEFINITION OF CASH “Cash” can include cash equivalents Cash equivalents are short-term, highly liquid investments that are both: readily convertible to known amounts of cash so near to their maturity that their market value is relatively insensitive to changes in interest rates Because the definition of “cash” varies, companies must clearly define cash equivalents.

CLASSIFICATION OF CASH FLOWS Operating activities include the cash effects of transactions that create revenue and expenses Income statement items must be adjusted for noncash transactions and for certain noncash working capital accounts

CLASSIFICATION OF CASH FLOWS Investing activities: Include acquiring and disposing of investments and long-lived assets and lending money and collecting loans Affect temporary investments that are not cash equivalents and long-term asset accounts

CLASSIFICATION OF CASH FLOWS Financing activities: Include obtaining cash from issuing debt or from shareholders, repaying the amount borrowed, and paying dividends Affect short-term notes payable and long-term liability and equity accounts

SIGNIFICANT NONCASH ACTIVITIES If it does not affect cash, do NOT report it in the body of the cash flow statement Report it in a separate note to the financial statements Common Shares Not reported on cash flow statement.

FORMAT OF CASH FLOW STATEMENT (ILLUSTRATION 17-3) COMPANY NAME Cash Flow Statement Period Covered Operating activities (List of individual inflows and outflows) XX Net cash provided (used) by operating activities XXX Investing activities (List of individual inflows and outflows) XX Net cash provided (used) by investing activities XXX Financing activities Net cash provided (used) by financing activities XXX Net increase (decrease) in cash XXX Cash at beginning of period XXX Cash at end of period XXX Note x: Noncash investing and financing activities (List of significant noncash transactions) XXX

PREPARATION OF THE CASH FLOW STATEMENT The cash flow statement is prepared differently from the other financial statements It is not prepared from the adjusted trial balance, rather, the information to prepare this statement usually comes from three sources Comparative balance sheet Current income statement Additional information The accrual concept is not used, since the cash flow statement deals with cash receipts and payments.

STEP 1: PREPRATION OF THE OPERATING ACTIVITIES SECTION Net income must be converted from an accrual basis to a cash basis in the operating activities section Conversion may be done by one of two methods: Indirect Direct

INDIRECT AND DIRECT METHODS Both methods arrive at the same total amount of cash provided (used) by operating activities Methods differ in disclosing the items that make up the total amount Choice of methods affects only the operating activities section; the investing and financing activities sections are the same

STEPS IN PREPARING THE CASH FLOW STATEMENT (ILLUSTRATION 17-4) Step 1: Determine the net cash provided (used) by operating activities by converting net income from an accrual basis to a cash basis. Analyse the current year’s income statement, comparative balance sheet, and selected additional data. Step 2: Determine the net cash provided (used) by investing activities by analysing changes in temporary investment and long-term asset accounts. Analyse the comparative balance sheet and selected additional data for their effects on cash.

STEPS IN PREPARING THE CASH FLOW STATEMENT (ILLUSTRATION 17-4) Step 3: Determine the net cash provided (used) by financing activities by analysing changes in short-term notes payable and long-term liability and equity accounts. Analyse the comparative balance sheet and selected additional data for their effects on cash. Step 4: Determine the net increase (decrease) in cash. Compare the net change in cash with the change in cash reported on the balance sheet to make sure the amounts agree. Calculate the difference between the beginning and ending cash balance from the comparative balance sheet.

INDIRECT METHOD Section 1

STEP 1: OPERATING ACTIVITIES (ILLUSTRATION 17-6) ADJUSTMENTS TO CONVERT NET INCOME TO NET CASH PROVIDED BY OPERATING ACTIVITIES Net Cash Provided (Used) by Operating Activities Net Income +/– Adjustments = + Add back noncash expenses such as amortization expense +/– Add back losses and deduct gains that result from investing and financing activities +/– Analyse changes to noncash current asset and current liability accounts and adjust accordingly

STEP 1: OPERATING ACTIVITIES (ILLUSTRATION 17-7) NET CASH PROVIDED BY OPERATING ACTIVITIES — INDIRECT METHOD

SUMMARY OF ADJUSTMENTS TO CONVERT NET INCOME TO NET CASH PROVIDED BY OPERATING ACTIVITIES (ILLUSTRATION 17-8) Adjustment Required to Convert Net Income to Net Cash Provided (Used) by Operating Activities Noncash charges Amortization expense Add Gains and losses Gain on sale of asset Loss on sale of asset Deduct Changes in noncash current asset and current liability accounts Increase in current asset account Decrease in current asset account Increase in current liability account Decrease in current liability account

STEP 2: INVESTING ACTIVITIES Study the balance sheet to determine changes in temporary investments and long-term assets Changes in each account are analysed using selected transaction data to determine the effect, if any, the changes had on Cash

STEP 3: FINANCING ACTIVITIES Study the balance sheet to determine changes in short-term notes payable and long-term liability and equity accounts Changes in each account are analysed using selected transaction data to determine the effect, if any, the changes had on Cash

CASH FLOW STATEMENT INDIRECT METHOD (ILLUSTRATION 17-9) Operating activities provided $172,000 cash, investing activities used $141,000 cash, and financing activities used $9,000 cash.

DIRECT METHOD Section 2

STEP 1: OPERATING ACTIVITIES DETERMINE NET CASH PROVIDED (USED) BY OPERATING ACTIVITIES BY CONVERTING NET INCOME FROM AN ACCRUAL BASIS TO A CASH BASIS The direct method calculates net cash provided (used) by operating activities by adjusting each item on the income statement from the accrual basis to the cash basis Only major classes of operating cash receipts and cash payments are reported

MAJOR CLASSES OF CASH RECEIPTS AND CASH PAYMENTS (ILLUSTRATION 17-11)

STEP 1: OPERATING ACTIVITIES CASH RECEIPTS FROM CUSTOMERS The relationships among cash receipts from customers, revenues from sales, and changes in accounts receivable is: Cash receipts from customers = Revenues from sales { + Decrease in accounts receivable or – Increase in accounts receivable

STEP 1: OPERATING ACTIVITIES CASH PAYMENTS TO SUPPLIERS The relationship among cash payments to suppliers, cost of goods sold, changes in inventory, and changes in accounts payable is: Cash payments to suppliers = Cost of goods sold { + Increase in inventory or – Decrease in inventory + Decrease in accounts payable or – Increase in accounts payable

STEP 1: OPERATING ACTIVITIES CASH PAYMENTS FOR OPERATING EXPENSES The relationship among cash payments for operating expenses, changes in prepaid expenses, and changes in accrued expenses payable is: Cash payments for services + Increase in prepaid expenses or – Decrease in prepaid expenses + Decrease in accrued expenses payable or – Increase in accrued expenses payable = Operating expenses { {

STEP 1: OPERATING ACTIVITIES CASH PAYMENTS FOR INCOME TAX The relationships among cash payments for income tax, income tax expense, and changes in income tax payable is: Cash payments for income tax { = Income tax expense + Decrease in income tax payable or – Increase in income tax payable

STEP 1: OPERATING ACTIVITIES NET CASH PROVIDED BY OPERATING ACTIVITIES DIRECT METHOD (ILLUSTRATION 17-17)

STEP 2: INVESTING ACTIVITIES Study the balance sheet to determine changes in temporary investments and long-term assets Changes in each account are analysed using selected transaction data to determine the effect, if any, that the changes had on Cash

STEP 3: FINANCING ACTIVITIES Study the balance sheet to determine changes in short-term notes payable and long-term liability and equity accounts Changes in each account are analysed using selected transaction data to determine the effect, if any, that the changes had on Cash

CASH FLOW STATEMENT—DIRECT METHOD (ILLUSTRATION 17-18) Operating activities provided $172,000 cash, investing activities used $141,000 cash, and financing activities used $9,000 cash.

USING THE INFORMATION IN THE FINANCIAL STATEMENTS Earnings before interest, tax, depreciation, and amortization (EBITDA) Free cash flow

EBITDA EBITDA (earnings before interest, tax, depreciation, and amortization) is a measure of a company’s ability to generate cash from operating activities Canadian companies generally use the term “amortization” rather than “depreciation” Income Tax Expense Net Income Interest Expense + + Amortization Expense + = EBITDA

Cash Provided (Used) by Operating Activities Net Capital Expenditures FREE CASH FLOW Free cash flow calculates the cash remaining from operating activities after adjustments for capital expenditures and dividends Investors and creditors use it to assess a company’s discretionary cash flow Cash Provided (Used) by Operating Activities Net Capital Expenditures – – Dividends Paid = Free Cash Flow

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