Chapter Outline

Notes

I.          Basics of Cash Flow Reporting

A.  Purpose of a Statement of Cash Flows
To report all major cash receipts (inflows) and cash payments (outflows) during a period. This report classifies cash flows into operating, investing, and financing activities. It answers important questions such as:

1.   How does a company obtain its cash?

2.   Where does a company spend its cash?

3.   What is the change in the cash balance?

B.   Importance of Cash Flows
Information about cash flows, and its sources and uses, can influence decision makers in important ways.

C.   Measurement of Cash Flows
The phrase, cash flows refers to both cash and cash equivalents. A cash equivalent must satisfy two criteria:

1.   Be readily convertible to a known amount of cash.

2.   Be sufficiently close to its maturity date so its market value is unaffected by interest rate changes.

D.  Classification of Cash Flows
Cash receipts and cash payments are classified and reported in one of three categories:

1.   Operating activities include transactions and events that determine net income (with some exceptions such as unusual gains and losses). Specific examples:

a.   Cash inflows from cash sales, collections on credit sales, receipts of dividends and interest, sale of trading securities, and settlements of lawsuits.

b.   Cash outflows for payments to suppliers for goods and services, to employees for wages, to lenders for interest, to government for taxes, to charities, and to purchase trading securities.

2.   Investing activities include transactions and events that affect long-term assets. Specific examples:

a.   Cash inflows from selling long-term assets, selling short-term investments other than cash equivalents, and collecting money the company has loaned to others.

b.   Cash outflows from purchasing long-term assets, purchasing short-term investments other than cash equivalents, and lending money to others.

3.   Financing activities includes transactions and events that affect long-term liabilities and equity:

a.   Cash inflows from issuing debt and obtaining cash from owners.

b.   Cash outflows from repaying amounts borrowed and distributing cash to owners.

E.   Noncash Investing and Financing Activities
Noncash investing and financing activities do not affect cash receipts or payments; however, they are disclosed at the bottom of the statement of cash flows or in a note to the statement because of their importance and the full disclosure principle.

F.   Format of the Statement of Cash Flows

1.   Lists cash flows by categories (operating, financing and investing) and identifies the net cash inflow or outflow in each category.

2.   Combines the net cash flow in each of the three categories and identifies the net change in cash for the period.

3.   Combines the net change in cash with the beginning cash to prove the ending cash.

4.   Contains a separate schedule at bottom (or notes) to report the noncash financing and investing activities.

G.   Preparing the Statement of Cash Flows

1.   Five steps:

a.   Compute the net increase or decrease in cash.

b.   Compute net cash provided (used) by operating activities

c.   Compute net cash provided (used) by investing activities.

d.   Compute net cash provided (used) by financing activities.

e.   Compute net cash flows by combining the net cash provided (used) by operating, investing, and financing activities and then prove it by adding it to the beginning cash to show that it equals the ending cash.

2.   Sources of information for preparing the statement of cash flows:

a.   Comparative balance sheets.

b.   The current income statement.

c.   Other information—generally derived from analyzing noncash balance sheet accounts.

II.        Cash Flows from Operating

A.  Reporting Operating Cash Flows

1.       Can be reported in one of two ways—the direct method or the indirect method.

2.       Amount of net cash provided (used) by operating activities is identical under both the direct and indirect methods.

B.   Indirect and Direct Methods of Reporting

1.   The indirect method reports net income and then adjusts it for items necessary to obtain net cash provided (used) by operating activities.

a.   Add, as adjustments to net income: noncash expenses (e.g., depreciation), decreases in current assets, increases in current liabilities, and losses.

b.   Subtract, as adjustments to net income: increases in current assets, decreases in current liabilities, and gains.

c.   Does not report individual items of cash inflows and cash outflows from operating activities.

d.   This is the method most widely used.

e.   Exhibit 12-12 summarizes the adjustments for the indirect method.

III.       Cash Flows from Investing
Three-stage process is used to determine cash provided (used) by investing activities: (1) Identify changes in investing-related accounts, (2) explain these changes using reconstruction method, and (3) report their cash flow effects.

A.  Analysis of Noncurrent Assets

1.   Determine changes in all noncurrent asset accounts (plant assets, intangible assets, investments)

2.   Analyze changes in these accounts using available information to determine their effect, if any, on cash.

B.     Analysis of Other Assets

1.       Certain other asset transactions such as those involving current notes receivable and investments in debt and equity securities (excluding trading) are considered investing activities.

2.       Analyze using same process used for noncurrent asset accounts.

IV.       Cash Flows from Financing
Three-stage process is used to determine cash provided (used) by investing activities: (1) Identify changes in financing-related accounts, (2) explain these changes using reconstruction method, and (3) report their cash flow effects.

A.  Analysis of Noncurrent Liabilities

1.   Determine changes in noncurrent liability accounts (e.g., long-term debt, notes payable, bonds payable).

2.   Analyze changes in these accounts using available information to determine their effect, if any, on cash.

B.   Analysis of Equity

1.   Determine changes in equity accounts (e.g., owner's capital, all stock accounts, and retained earnings).

2.   Analyze changes in these accounts using available information to determine their effect, if any, on cash.

V.         Decision Analysis—Cash Flow Analysis

A.  Analyzing Cash Sources and Uses

1.   Managers stress understanding and predicting cash flows for business decisions.

2.   Creditor and investor decisions are also based on a company's cash flow evaluations.

3.   Operating cash flows are generally considered to be most significant because they represent results of ongoing operations.

B.   Cash Flow on Total Assets

1.   The cash flow on total assets ratio is similar to return on total assets except the return is analyzed based on operating cash flows rather than net income.

2.   It is calculated by dividing operating cash flows by average total assets.

VI.       Spreadsheet Preparation of the Statement of Cash Flows (Appendix 12A)
A spreadsheet approach may be used to organize and analyze the information to prepare a statement of cash flows by the indirect method, including the supplemental disclosures of noncash investing and financing activities.

A. The spreadsheet has four columns containing dollar amounts.

1.       Columns one and four contain the beginning and ending balances of each balance sheet account.

2.       Columns two and three are for reconciling the changes in each balance sheet account.

B.   Separate sections on the working paper present (a) balance sheet items with debit balances; (b) balance sheet items with credit balances; (c) cash flows from operating activities, starting with net income; (d) cash flows from investing activities; (e) cash flows from financing activities; and (f) noncash investing and financing activities.

C.   Information for sections (c) - (f) is developed in four steps in the Analysis of Changes columns:

1.   By adjusting net income for the changes in all noncash current asset and current liability account balances. This reconciles the changes in these accounts.

2.   By eliminating from net income the effects of all noncash revenues and expenses. This begins the reconciliation of noncurrent assets.

3.   By eliminating from net income any gains or losses from investing and financing activities. This involves the reconciliation of noncurrent assets and noncurrent liabilities and perhaps the recording of disclosures.

4.   By entering any remaining items, such as dividend payments, which are necessary to reconcile the changes in all balance sheet accounts.