FINANCIAL ACCOUNTING WEEK 12 STATEMENT OF CASH FLOWS. A. Understand the basic structure and format of the statement of cash flows.

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1 FINANCIAL ACCOUNTING WEEK 12 STATEMENT OF CASH FLOWS I. LEARNING OBJECTIVES - STATEMENT OF CASH FLOWS A. Understand the basic structure and format of the statement of cash flows. B. Distinguish cash flows from operating, investing, and financing activities. C. Explain how the statement of cash flows complements the other financial statements and how it can be used by those interested in the financial condition of a company. D. Identify the important investing and financing transactions that do not appear on the statement of cash flows, and describe how they are reported. E. Understand the economic consequences associated with the statement of cash flows. II. Purpose of Statement of Cash Flows A. To explain the change in the cash balance during the accounting period associated with operating, investing, and financing activities. For purposes of the statement of cash flows, cash can be defined as: 1. Cash only. That is, coin, currency, money orders, certified checks, cashiers' checks, personal checks, bank drafts, and so forth. 2. Cash plus cash equivalents. Cash equivalents are usually defined as investments, such as commercial paper, that have maturities of less than three months or original maturities of three months or less. B. To provide information about the cash flows during the period associated with operating activities, investing activities, and financing activities. C. Lawson III. Overview of the Statement of Cash Flows A. The change in cash can be explained by summarizing the cash flows from: 1. Operations a. Operating activities are associated with 1

2 acquiring and selling inventories and services. That is, those activities that are part of the company's ongoing central activities. b. In general, items included in the operating section of the income statement are considered to be operating activities. c. Interest Income and Expense and Taxes must be separately disclosed, somehow. 2. Investing activities are associated with the purchasing and selling of nonoperating (noncurrent) assets. Investing activities include purchasing or selling long-lived assets, long-term investments, and intangible assets. 3. Financing activities are associated with cash flows from nonoperating debt and stockholders' equity. Financing activities include issuing or selling long-term debt or shares of stock, retiring longterm debt, repurchasing shares of stock, and paying cash dividends. 4. E14-2; P14-2; P14-5. B. Methods of presenting the statement of cash flows. 1. Direct method a. Cash flows and inflows from operating activities can be traced directly to the cash account in the general ledger. The actual cash inflow and outflow associated with each income statement item is disclosed on the face of the statement of cash flows. b. Accrual income statement amounts are reported in the body of the statement of cash flows at their cash amounts. That is, the actual cash inflows and cash outflows from individual operating activities are reported on the face of the statement of cash flows. c. A schedule that reconciles net income to net cash flow from operating activities must accompany the statement of cash flows. d. Examples (1) Text - pp. 642/660 (2) AST, if available. 2

3 e. E Indirect method a. Cash flows from operating activities are computed indirectly by adjusting net income. b. Net income is adjusted from an accrual amount to net cash flow from operating activities on the face of the statement of cash flows. Accrual net income is adjusted for: (1) Noncash charges to noncurrent accounts, like depreciation expense. (2) Changes in current accounts other than cash, like an increase or decrease in accounts receivables. c. Text - p. 643/661 d. Examples (1) Text - pp. 645, 758. (2) Lawson (3) AAA e. Under both methods: (1) The dollar amount reported for net cash flow from operating activities is identical under the direct and indirect methods. (2) The presentation of the investing activities and financing activities is identical under the direct and indirect methods. (3) Text - p. 642 & 660. f. ID7-8. IV. Relation of statement of cash flows to other financial statements. (p. 53) A. To the Income Statement 1. The operating section of the statement of cash flows and the income statement both provide a measure of the company's operating performance. 3

4 2. The income statement measures operating performance on an accrual basis while the operating activities section of the cash flow statement measures operating performance on a cash basis. B. To the Balance Sheet 1. The statement of cash flows and the balance sheet both provide information about a company's operating, investing, and financing activities. 2. The information reported in the balance sheet is based on accrual accounting while the information reported in the operating, investing, and financing sections of the cash flow statement is based upon cash inflows and outflows. V. Using the statement of cash flows. A. Assessing a company's ability to generate cash. The ability to generate cash is a function of: 1. The strength of a company's operating activities. 2. A company's capacity to borrow, issue equity, and sell nonoperating assets - the company's financial flexibility. B. Assessing a company's effectiveness at managing its cash. Effective cash management entails: 1. Maintaining solvency 2. Making idle cash productive. C. Disclosing cash usage D. Homework 1. ID ID2-1. VI. Economic consequences of the statement of cash flows. A. Importance of cash flow statements in assessing potential investments. B. Incentives to window dress the statement of cash flows. C. Ease of manipulating cash flows. D. Reasons not to manipulate cash flows. 4

5 VII. Operating, investing, or financing activities not involving cash flows. See page 648. A. Because the statement of cash flows reports only on cash inflows and outflows, significant operating, investing, or financing activities that do not involve cash flows are not reported in the body of the statement of cash flows. For example, Acme Corp. buys a plant with $0 cash and $10 million note payable. How does it show up on the Statement of Cash Flows? B. Significant noncash investing and financing activities should be described clearly in the footnotes to the financial statements or in a supplemental schedule to the statement of cash flows. C. Significant noncash operating activities can be determined by analyzing the adjustments reconciling net income and net cash flow from operations. VIII. Looking at the statement with an international perspective A. The statement of cash flows is now required under IFRS. Also, terminology may be different, the information is the same. (See ID14-7.) B. The reporting of foreign currency gains and losses are being disclosed on the statement of cash flow even though no cash flow is involved. C. Example - Lawson 5

6 IX. Analysis A. p Operating Investing Financing These eight outcomes are all of the possible outcomes on the Statement of Cash Flows. Each outcome conveys a separate message about a firm's cash flow for the period in question. B. Homework: ID2-4. C. Homework: ID2-5; ID5-15. X. Review of Learning Objectives - Statement of Cash Flows 6