The Statement of Cash Flows

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1 Chapter 12 The Statement of Cash Flows Key Concepts What is the purpose of the statement of cash flows? What is the difference between cash and cash equivalents? How are operating, investing, and financing activities distinguished? What is the difference between the direct and the indirect methods of presenting cash flow from operating activities? How are a statements of cash flows prepared? What is the work sheet method of preparing a statement of cash flows? Harcourt, Inc. 12-1

2 FINANCIAL ACCOUNTING INSTRUCTOR S MANUAL Chapter Outline Cash Flows and Accrual Accounting A company with a profitable year does not necessarily increase its cash; a company with a losing year does not necessarily experience a decrease in cash (Exhibit 12-1). LO 1 LO 2 LO 3 Purpose of the Statement of Cash Flows Statement of cash flows reports the changes in cash over a period of time and explains these changes. Complements accrual-based income statement by showing performance on a cash basis Summarizes operating, investing, and financing activities Statement of cash flows includes nonoperating sources and uses of cash Statement of cash flows must be: prepared for cash only divided into three categories: operating, investing, and financing The Definition of Cash: Cash and Cash Equivalents Certain items are recognized as being equivalent to cash. Must be readily convertible to a known amount of cash, with a maturity to the investor of three months or less Examples include commercial paper, money market funds, and Treasury bills For purposes of presentation on the balance sheet and statement of cash flows, their purchase is viewed as a transfer within cash, not as a cash outflow Classification of Cash Flows Three types of activities appear on statement of cash flows (Exhibit 12-6). Operating activities include acquiring and selling products and services, reported on a cash basis like an income statement, prepared on a cash basis cash effects of items that enter into the determination of net income usually relate to an increase or decrease in a current asset or liability Investing activities involve acquiring and disposing of long-term assets cash paid for plant and equipment referred to as capital expenditures usually the largest single item in the Investing Activities section of the statement Financing activities are the issue of stock and various forms of debt, and their repurchase or repayment, along with the payment of dividends to stockholders usually relate to long-term liabilities or stockholders' equity 12-2 Harcourt, Inc.

3 CHAPTER 12 THE STATEMENT OF CASH FLOWS Two Methods of Reporting Cash Flow from Operating Activities LO 4 Two acceptable methods of presenting cash from operating activities. Direct method reports major sources of cash receipts and cash payments preferred by Financial Accounting Standards Board (FASB) used less frequently examine each item on the income statement and decide how much cash it either generated or used for example, a net increase in accounts receivable must be deducted from sales to calculate how much cash sales generated cash actually expended is arrived at by deducting from expenses any increase in related liability accounts Indirect method adjusts net income for revenue items that did not provide cash or expense items that did not use cash in other words, accruals and deferrals are removed the first line is always the net income of the period deduct an increase in accounts receivable, for example, which indicates that sales were made, but not collected add back an increase in accounts payable because purchases were made but not as yet paid for Both methods arrive at the same amount of cash from operating activities The remainder of the statement of cash flows, cash flows from investing and financing activities, is the same, regardless of which method was used to arrive at cash flow from operating activities Noncash Investing and Financing Activities are important in substance, rather than form. Some material financing and investing activities may involve little or no cash for example, debt or stock may be exchanged for an asset Significant noncash transactions must be reported in a footnote to statement of cash flows How the statement of cash flows is put together: Emphasis is on why cash changed, not on the fact that it did change change can be found by comparing two balance sheets unlike income statement and balance sheet, which simply report account balances, statement of cash flows requires analysis and classification of items The accounting equation and the statement of cash flows: If Assets = Liabilities + Owners' Equity then cash + noncash current assets + long-term assets = current liabilities + long-term liabilities + capital stock + retained earnings And, isolating cash on one side, cash = current liabilities + long-term liabilities + capital stock + retained earnings noncash current assets long-term assets Thus, any change in cash (left side of the equation) must result in a change to a noncash account (right side of the equation) Harcourt, Inc. 12-3

4 FINANCIAL ACCOUNTING INSTRUCTOR S MANUAL LO 5 Preparing the Statement of Cash Flows: Direct Method Three schedules are set up: Cash flows from operating activities (Exhibit 12-13) Cash flows from investing activities (Exhibit 12-15) Cash flows from financing activities (Exhibit 12-16) Determine cash flows from operating activities: Analyze each item in the income statement, along with its related current asset(s) and/or current liability(ies) As operating cash flows are identified enter them on the operating activities schedule Examples illustrated (Exhibit 12-14) sales revenue and accounts receivable: an increase in accounts receivable indicates that more sales than collections were made; sales less the increase in accounts receivable equals the cash collected because there is no interest receivable account, the amount of interest revenue recorded is also the amount of cash collected the gain on the sale of a machine is ignored for this section because the machine is a long-term asset, and thus the sale belongs in the investing activities section cost of goods sold, inventory, and accounts payable cost of goods results in a decrease in inventory, but this is inventory sold, not purchased; inventory is analyzed to determine purchases, resulting in the conclusion that a decrease in inventory indicates that cost of goods sold exceeded purchases thus, cost of goods sold less decrease in inventory equals purchases purchases are normally on account, so accounts payable is analyzed to determine cash paid to suppliers purchases less the increase in accounts payable equals payments to suppliers salaries and wages expense, and salaries and wages payable: any decrease in the liability indicates that cash paid exceeded expense accrued; or, expense less decrease in liability equals cash paid depreciation expense, since it had no effect on cash, is not considered insurance expense and prepaid insurance: expense entry involves a decrease of the prepaid account; the net decrease in the prepaid account indicates that more was expensed than paid into it; thus cash payments equal expense less decrease in prepaid account balance interest expense: lacking an interest payable account, we conclude that the amount of expense recorded is equal to the amount paid income tax expense and income tax payable: as with other liabilities, the expense is reduced by the increase in the liability to determine the cash actually paid a loss on the retirement of bonds is reserved for consideration in the financing section of the statement, since it involves a long-term liability Determine cash flows from investing activities: Generally, long-term assets must be analyzed, along with any additional information provided Record the results of the analysis on the investments schedule. Examples covered: purchase of long-term investments for cash, found in supplemental information 12-4 Harcourt, Inc.

5 CHAPTER 12 THE STATEMENT OF CASH FLOWS purchase of land in exchange for a note payable: since this transaction involved no cash, but is considered significant, it is disclosed in a footnote to the statement of cash flows property and equipment: purchases and disposals are recorded separately, using figures from the supplemental information Determine cash flows from financing activities: In general, long-term liabilities and stockholders' equity will be analyzed, along with any supplemental information provided Record the results of the analysis on the financing activities schedule Examples covered: notes payable account was included in a footnote discussing the acquisition of land retirement of bonds for cash sale of stock for cash analysis of retained earnings, including net income for the period, shows dividends paid (provided there is no dividend payable account) Note that the separation of current accounts into the operating section and noncurrent into investing and financing are general rules, and that exceptions exist, which will not be covered. Preparing the Statement of Cash Flows: Indirect Method LO 6 Instead of reporting cash receipts and disbursements, the indirect method reconciles net income to net cash flow from operating activities. Investing and financing sections remain unchanged First line is net income assume that all revenues increase cash flow and all expenses decrease it, then record adjustments to this assumption to the extent that accounts receivable increased, sales, which were reported as a part of net income, did not result in cash, so an increase in accounts receivable is deducted from net income gain on sale of machine: it was the sale, not the gain on the sale, that generated cash; since the sale will be reported as an investing activity, the gain is deducted from net income, to remove it from the operating section decrease in inventory indicates that the company sold (and thus deducted, when calculating income) more than it purchased; the difference (the decrease in inventory) is added back to net income because it did not require cash increase in accounts payable indicates that purchases for the period exceeded cash payments for purchases; the increase is added back to net income because cost of goods sold includes items for which company has not yet expended cash decrease in salaries and wages payable: deducted from income to reflect the fact that payments were made in excess of the period's expense depreciation expense was deducted to arrive at net income, but required no cash, so it is added back decrease in prepaid insurance indicates that expenses were taken in excess of new payments made; since those expenses required no cash, the decrease is added back increase in income taxes payable, like the increase in accounts payable, indicates that expense exceeded cash paid, so this difference is added back to net income Harcourt, Inc. 12-5

6 FINANCIAL ACCOUNTING INSTRUCTOR S MANUAL loss on retirement of bonds: first, bonds are a financing activity, and the retirement is reported in that section; second, the actual cash paid to retire the debt, not the loss, is the cash effect of the transaction; thus this loss is added back to remove it from the calculation Comparison of two methods, direct and indirect FASB prefers direct, but allows indirect approach company using indirect must disclose payments for income taxes and interest separately Advocates of direct method cite user friendliness and ease of evaluating operating efficiency Advocates of indirect method believe direct method reveals too much about the company indirect method focuses attention on differences between accrual income and cash generated note that a company using the direct method must present a separate reconciliation of net income to net cash provided by operations in effect, this is the same schedule they would prepare if they used the indirect method, so companies argue that they see no reason to do both The use of cash flow information Cash flow adequacy: important to creditors as a measure of cash available to meet future debt obligations cash flow adequacy = cash flow from operating activities capital expenditures average amount of debt maturing over next five years cash flows from operating activities and investing activities provide numerator SEC required disclosure, contained in company s annual report, provides denominator Cash flow per share: a ratio of the net cash flow to the stock market price per share. companies are expressly prohibited by the accounting profession from reporting this information in the financial statements because it is not an acceptable alternative to earnings per share 12-6 Harcourt, Inc.

7 CHAPTER 12 THE STATEMENT OF CASH FLOWS Appendix 12 A A Work sheet Approach to the Statement of Cash Flows LO 7 Steps in completing a work sheet to prepare a statement of cash flows, using the indirect method to arrive at cash flow from operating activities (the direct method can also be used): Note example work sheet in text (Exhibit 12-19) balances of each account at the end (column 1) and the beginning (column 2) of the period are entered in the first two columns of the work sheet because the worksheet lists all balance sheet accounts, the total of the asset accounts must equal the total of the liabilities and shareholders equity accounts. additional information is used to record entries to the investing and financing activities columns, and corresponding amounts in the change column net income of $120,000 is entered as an addition to retained earnings in operating activities, and an increase in change column noncash revenues or expenses are entered on appropriate lines as additions or deductions for example, depreciation expense is added to accumulated depreciation in the change column and in the operating column changes in noncash current assets and liabilities are recorded in the change column and in the operating column column totals are calculated for operating, investing, and financing, as well as noncash activities net cash flow is determined by adding the totals of operating, investing, and financing columns, and posted to the line for cash in the change column the total for the change column should now be zero Harcourt, Inc. 12-7

8 FINANCIAL ACCOUNTING INSTRUCTOR S MANUAL Lecture Suggestions LO 1 Emphasize that the purpose of the Statement of Cash Flows is not to calculate the change in cash, which can easily be done from comparative Balance Sheets. The purpose is to explain this change. LO 3 Students may find it helpful to flag Exhibit 12-6 in their books, or even make a copy of it, for future reference as they prepare the actual statement of cash flows. LO 5 Problem 12-3 is similar to the chapter example, which students should have reviewed before class. This problem could be used for an in-class illustration, with students working together to calculate the necessary figures Harcourt, Inc.

9 CHAPTER 12 THE STATEMENT OF CASH FLOWS Projects and Activities Purpose of the Statement of Cash Flows LO 1 In-class discussion: Differences between income and cash flows IBM Corporation IBM Corporation had net income of $6,328 million in But their cash decreased that year by $1,731 million. Compare IBM's statement of cash flows in your textbook to their income statement summarized below. ($ millions) Total revenue $ 81,667 Total cost 50,795 Gross profit 30,872 Total operating expenses 21,708 Operating income 9,164 Other income, principally interest 589 Interest expense 713 Earnings before income taxes 9,040 Provision for income taxes 2,712 Net earnings $ 6,328 Solution Did IBM have positive or negative cash flow from operations? Did IBM have operating income or an operating loss? Should these be the same? Why or why not? Which nonoperating items were the primary users of cash? Are theses nonoperating items likely to be repeated in future periods? Why or why not? Which two items were the principal contributors to the difference between net income and net cash provided by operating activities? Are these items likely to be repeated in future periods? Why or why not? What was the chief source of cash from financing activities? From investing activities? How were capital investments paid for? IBM had positive cash flow from operating activities of $9,273 million. The income statement showed operating income of $9,164 million. These are not required to be the same because the income statement is an accrual statement, and the statement of cash flows is a cash basis statement. Many accrual expenses do not use cash, and some accrual revenues do not provide cash in the same period. Cash was used to purchase fixed assets ($6,520 million). This is a normal occurrence for a going concern. The acquisition of Tivoli Systems Inc. a nonrecurring item, used $250 million cash. Retirement of debt used $5,942 million cash. The retirement of some debt can be expected to occur routinely. However, it should be noted that this amount is partially balanced by cash inflow of $7,567 from the issue of new debt. 1 International Business Machines Corporation, 1998 Annual Report. Harcourt, Inc. 12-9

10 FINANCIAL ACCOUNTING INSTRUCTOR S MANUAL Net income included depreciation expense of $4,475 million, which required no cash and was added back on the statement of cash flows, as well as amortization of software of $517 million. The depreciation and amortization will continue, since IBM has substantial investments in long-lived assets. The chief source of cash from financing activities was the issue of new debt. Liquidation of marketable securities provided the primary cash inflow from investing activities. This question is intended to focus students attention on the fact that operations are the chief source of cash for new investments and debt repayments. LO 2 The Definition of Cash: Cash and Cash Equivalents In-class discussion: IBM short-term investments IBM Corporation's 1998 balance sheet 2 shows the following: Solution Cash and cash equivalents 5,375 Marketable securities 393 What is contained in cash and cash equivalents? Where are cash and cash equivalents found on the statement of cash flows? IBM in their notes to consolidated financial statements to their Annual Report 3 defines Cash Equivalents. All highly liquid investments with a maturity of three months or less at date of purchase are carried at fair value and considered to be cash equivalents. Marketable securities are all remaining short-term investments which because of either their liquidity, maturity, or whether their cash value can be estimated, cannot be classified as cash equivalents. IBM considers all of these to be available-for-sale. 4 The purpose of the statement of cash flows itself is to analyze the change in the combined cash and cash equivalents. LO 4 Two Methods to Report Cash Flow from Operating Activities Ethical decision: Reporting of noncash investing and financing activities When a significant liability is incurred to purchase an asset, the company must report this transaction in a footnote to the statement of cash flows, even though it involved no cash. Why do you think this is true? What impact does this transaction have on the company's present or future cash position? Suppose that the company believes the disclosure is important but prefers not to use a footnote to make this disclosure. They decide that even though the purchase of the asset in exchange for a liability was a single transaction, they will report it on the statement of cash flows as two transactions. In the investing section of the statement they will report the purchase of an asset as cash flow out. In the financing section they will report a cash inflow resulting from the issue of debt. Will this result in an incorrect total for the net increase or decrease in cash for the period? Explain why or why not. 2 Ibid. 3 Ibid. 4 Ibid Harcourt, Inc.

11 Solution CHAPTER 12 THE STATEMENT OF CASH FLOWS Will this treatment on the statement of cash flow distort, for the reader, the company's present or future cash position or commitments? Would it be dishonest, or unethical, to report the transaction in this way? Significant non-cash transactions are important because the debt involved may commit the company to material cash outflow in the future. Since the statement is intended not only to report the reasons for current changes in cash, but also to enable the reader to predict the company's future cash flows, this information is necessary, and is more likely to be seen in its proper context if it is presented with the statement of cash flows. The liability will involve both principal and interest payments in the future, potentially over a number of years. The reader concerned with the amount of principal and interest, and the terms of the liability, might want to read the footnote on long-term debt. The net increase or decrease in cash will be unchanged. An amount will be deducted from cash flow from investing activities, and an equal amount will be added to cash flow from financing activities, with net cash flow of zero. Unless the financing item was not described as debt, an unlikely event, there would be no distortion, since the reader would still learn about principal and interest commitments for the future. The company might even argue that the item is more likely to be noticed in the body of the statement than in a footnote. It is inaccurate to report one transaction as two, but it is probably not dishonest or unethical, since no material distortion results, and there is no attempt to hide the transaction or any of its attributes or effects. Food for thought: Depreciation and cash flows Your roommate, who has a basic knowledge of accounting, has been watching you solve a number of problems involving the indirect method at arriving at cash flow from operating activities. She suddenly has a flash of inspiration. Why don't more companies use accelerated depreciation? It could increase their cash flow from operations significantly during the first couple of years of every new asset's life. Is your roommate right or wrong? Explain this to your roommate, using a simple set of financial statements to prove your argument. Solution This simple problem often appears in one form or other, probably because so many people confuse depreciation with cash flow. It is not uncommon to see depreciation referred to as though it were a pot of cash stored somewhere. The error is in believing that the depreciation amount added back to net income in the calculation of cash flow from operating activities somehow stands in isolation. It does not. Suppose the company had the following income statement and cash flow from operating activities (indirect presentation): Income Cash flow Sales $ 1,000 Net income $ 300 Depreciation expense 200 Add: depreciation 200 All other (cash) expenses 500 Cash from operations $ 500 Net income $ 300 Harcourt, Inc

12 FINANCIAL ACCOUNTING INSTRUCTOR S MANUAL Suppose that if they used accelerated depreciation, their depreciation expense would double. Their statements would appear thus: Income Cash flow Sales $ 1,000 Net income $ 100 Depreciation 400 Add: depreciation 400 All other (cash) expenses 500 Cash from operations $ 500 Net income $ 100 The only items that would change are depreciation expense and net income. The changes in depreciation and net income cancel each other in the statement of cash flows, and cash flow from operating activities would remain the same as before. Depreciation does not provide cash. It is added back in exactly the amount that was deducted to arrive at net income because it did not use cash, and should therefore not be used in calculating cash flow out. LO 6 Preparing the Statement of Cash Flows: Indirect Method Outside assignment: Which method do users prefer, direct or indirect? Although the FASB prefers that companies use the direct method of arriving at cash flow from operating activities, the overwhelming majority of companies use the indirect method, for a variety of reasons. Do you yourself, after preparing and studying both, have a preference? Explain why. Which method do you think ordinary users of financial statements, if they had a choice in this matter, would prefer? Why not take your own informal survey to try to answer this question. If this is done as a class project, and everyone polls different people, you may be able to produce a useful guide to user preference. In order to avoid taking too much of anyone's time, you may want to ask for only four or five subjects from each member of the class. Everyone in the class will show a specified number of people two versions of the statement of cash flows, one with the cash flow from operations calculated by the direct method, and one that uses the indirect method. Ask each person surveyed which version of the statement is more understandable, and better fulfills the purpose of the statement. In order to ensure that everyone is surveying the same thing, you could agree, as a class, on guidelines. For instance: Everyone will use the same statement of cash flows. One possibility is to show each person surveyed the two versions, direct and indirect, of the statement for Boulder Company, the example in the textbook. Since your question centers on the operating section, you may elect to show only that portion of the statement, to simplify what the respondents see. On the other hand, you may think that it is important that they see the entire statement in order to put the operating section in perspective. Many readers of corporate annual reports are not trained in accounting. You may therefore want to specify that subjects used for the survey should have no accounting background (work or courses). Students can be reminded that their survey subjects need not be other students, either. Anyone willing to take the time to participate is a legitimate participant, as long as they have the ability to understand the basic concept. You may want to agree on a one- or two-sentence description to be given to each subject to describe the purpose of the statement of cash flows, so that every respondent is given the same information. Classify results very simply as number of respondents preferring direct method, preferring indirect method, finding both equally understandable, and finding both equally incomprehensible. You may want to leave room in your survey for comments. Afterwards, compile and compare results for the entire class. What conclusions did you reach? Harcourt, Inc.

13 Solution CHAPTER 12 THE STATEMENT OF CASH FLOWS Students are sometimes surprised to see how far they have come, and how much they understand about these concepts. When asked which method is easier to understand, they will preface an answer with of course or obviously, without thinking about whether it would be so obvious to someone who has not been studying accounting for three months. We've discussed this in class, but maybe it takes actually asking some people to really get a feel for how these statements are perceived. Save some inclass time by delegating an organization to the students, depending on the size of the group and their ability to manage the project. The survey results can be compiled outside class and then brought in by one or two designated students, who are assigned to compile results rather than doing any surveys themselves. The use of Cash Flow Information LO 6 Assignment: Cash flow adequacy for Whirlpool Using the information below, how comfortable is Whirlpool's debt position? Look at the same statistic for the competitor to Whirlpool, Maytag. How do they compare? Comment on the differences between the companies. Solution ($ millions) Cash from Capital Average Cash flow Operations Expenditures Maturities Adequacy Whirlpool $ 377 $ 418 $ 38.4 * Maytag * Capital expenditures exceeded cash flow from operations. Students may be concerned that Whirlpool appears unable to generate sufficient cash flow from operations to cover routine asset replacement, whereas Maytag has a comfortable 3.69 cash flow adequacy ratio. However, if students are encouraged to examine the statement of cash flows more carefully, they would see that a restructuring charge deducted from cash flow from operations, $119 million, if added back would yield cash flow from operations of $496 million. This is not a routine expenditure. Cash flow adequacy would still remain very low, but at least positive. Acquisitions of assets were also somewhat higher in the previous years. Whirlpool s cash flow adequacy has fluctuated greatly over the last five years due to a combination of variations in asset acquisitions, and corporate realignment. Harcourt, Inc

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