THE STATEMENT OF CASH FLOWS REVISITED Chapter 21 THE STATEMENT OF CASH FLOWS REVISITED Chapter 21: The Statement of Cash Flows Revisited

Business CASH INFLOWS CASH OUTFLOWS Investing Activities Operating Activities Financing Activities Sale of operational assets Sale of investments Collections of loans Cash received from revenues Issuance of stock Issuance of bonds and notes Many decisions benefit from information about the company’s underlying cash flow process. Cash continually flows into and out of an active business. This graphic illustrates several examples of cash inflows and outflows classified as operating, investing and financing activities. Take a few minutes to review these examples. Purchase of operational assets Purchase of investments Loans to others Cash paid for expenses Payment of dividends Repurchase of stock Repayment of debt

Role of the Statement of Cash Flows The Statement helps users assess . . . a firm’s ability to generate cash. a firm’s ability to meet its obligations. the reasons for differences between income and associated cash flows. the effect of cash and noncash investing and financing activities on a firm’s financial position. The statement of cash flows provides information about cash flows that is lost when reported only indirectly by the balance sheet and the income statement. The statement of cash flows helps users assess . . . a firm’s ability to generate cash. a firm’s ability to meet its obligations. the reasons for differences between income and associated cash flows. And the effect of cash and noncash investing and financing activities on a firm’s financial position.

Role of the Statement of Cash Flows Lists inflows and outflows of cash and cash equivalents by category Explains the change in cash during the period The statement of cash flows lists inflows and outflows of cash and cash equivalents by category: operating, investing or financing. It explains the change in cash during the period and is required by Statement of Financial Accounting Standards Number 95. Required by SFAS No. 95

Cash and Cash Equivalents Short-term, highly liquid investments. Readily convertible into known, fixed amounts of cash. So near maturity that there is insignificant risk of market value fluctuation from interest rate changes. Resources immediately available to pay obligations. There is no differentiation between amounts held as cash and amounts held in cash equivalent investments. Cash equivalents include short-term, highly liquid investments that are readily convertible into known, fixed amounts of cash and that are so near maturity that there is insignificant risk of market value fluctuation from interest rate changes. Each firm’s policy regarding which short-term, highly liquid investments it classifies as cash equivalents should be disclosed in the notes to the financial statements.

Primary Elements of the Statement of Cash Flows (SCF) Operating Activities Investing Activities Reconciliation of the Net Increase or Decrease in Cash with the Change in the Balance of the Cash Account Financing Activities The three primary activity classifications on the statement of cash flows are (1) operating activities, (2) investing activities, and (3) financing activities. Two other requirements are (1) the reconciliation of the net increase or decrease in cash with the change in the balance of the cash account, and (2) noncash investing and financing activities. Noncash Investing and Financing Activities

Primary Elements of the Statement of Cash Flows (SCF) Reports the cash effects of the elements of net income. Operating Activities Investing Activities Reports the cash effects of the acquisition and disposition of assets (other than inventory and cash equivalents). Part I The operating activities section reports the cash effects of the elements of net income. Part II The investing activities section reports the cash effects of the acquisition and disposition of assets (other than inventory and cash equivalents). Part III The financing activities section reports the cash effects of the sale or repurchase of shares, the issuance or repayment of debt securities, and the payment of cash dividends. We will discuss each of these sections in more detail in the next few slides. Financing Activities Reports the cash effects of the sale or repurchase of shares, the issuance or repayment of debt securities, and the payment of cash dividends.

Cash Flows from Operating Activities Inflows from: Sales to customers. Interest and dividends received. + Cash Flows from Operating Activities _ Outflows to: Purchase of inventory. Salaries, wages, and other operating expenses. Interest on debt. Income taxes. Cash flows from operating activities are both inflows and outflows of cash that result from activities reported on the income statement. In other words, this classification of cash flows includes the elements of net income, but reported on a cash basis. The cash flows in this section are illustrated in the examples in this slide.

Two Formats for Reporting Operating Activities Direct Method or Indirect Method of Reporting Cash Flows from Operating Activities Two Formats for Reporting Operating Activities Reports the cash effects of each operating activity Direct Method Starts with accrual net income and converts to cash basis Indirect Method There are two acceptable formats for presenting the cash flows from operating activities. The direct method reports the cash effects of each operating activity directly on the statement of cash flows. When using the indirect method, the operating section starts with accrual net income and coverts to cash basis. Note that no matter which format is used, the same amount of net cash flows operating activities is generated. Note that no matter which format is used, the same amount of net cash flows operating activities is generated.

Direct Method or Indirect Method of Reporting Cash Flows from Operating Activities The cash effect of each operating activity is reported directly on the statement of cash flows. The net cash increase or decrease from operating activities is derived indirectly by starting with reported net income on an accrual basis and working backwards to convert that amount to a cash basis. Part I Here is an example of the direct method of the operating section of a statement of cash flows. In the direct method, you can see that the cash effect of each operating activity is reported directly on the statement of cash flows. For example, it is clear that we received $98 from customers and paid $50 to suppliers. Part II Here is an example of the indirect method of the operating section of a statement of cash flows. In the indirect method, the net cash increase or decrease from operating activities is derived indirectly by starting with reported net income on an accrual basis and working backwards to convert that amount to a cash basis. Using either method we arrive at the same $22 of net cash flows from operating activities.

Cash Flows from Investing Activities Inflows from: Sale of long-term assets used in the business. Sale of investment securities (stocks and bonds). Collection of nontrade receivables. + Cash Flows from Investing Activities _ Outflows to: Purchase of long-term assets used in the business. Purchase of investment securities (stocks and bonds). Loans to other entities. Cash flows from investing activities are both inflows and outflows of cash caused by the acquisition and disposition of assets. Included in this classification are cash payments to acquire (1) property, plant and equipment and other productive assets (except inventories), (2) investment in securities (except cash equivalents and trading securities), and (3) nontrade receivables. When these assets later are liquidated, any cash receipts from their disposition also are classified as investing activities. The cash flows in this section are illustrated in the examples in this slide.

Cash Flows from Financing Activities Inflows from: Sale of shares to owners. Borrowing from creditors through notes, loans, mortgages, and bonds. + Cash Flows from Financing Activities Outflows to: Owners in the form of dividends or other distributions. Owners for the reacquisition of shares previously sold. Creditors as repayment of the principal amounts of debt. _ Cash flows from financing activities are both inflows and outflows of cash resulting from the external financing of a business. Included in this classification are cash inflows from (1)the sale of common stock, and (2)the issuance of bonds and other debt securities. Subsequent transactions related to these financing transactions, such as a buyback of stock, the repayment of debt, and the payment of cash dividends to shareholders, also are classified as financing activities. The cash flows in this section are illustrated in the examples in this slide.

Reconciliation with Change in Cash Balance The net amount of cash inflows and outflows reconciles the change in the company’s beginning and ending cash balances. For example, assume the net increase in cash is $9 million and the Cash beginning balance is $20 million. The cash reconciliation would be as follows: To reinforce the fact that the net amount of cash inflows and outflows explains the change in the cash balance, the statement of cash flows includes a reconciliation of the net increase or decrease in cash with the company’s beginning and ending cash balances. Review the example provided in this slide and notice that the net amount of of cash inflows and outflows reconciles the change in the company’s beginning and ending cash balances.

Noncash Investing and Financing Activities Significant investing and financing transactions not involving cash also are reported (usually in a disclosure note). Acquiring an asset by incurring a debt payable to the seller. Acquiring an asset by entering into a capital lease. Converting debt into common stock or other equity securities. Exchanging noncash assets or liabilities for other noncash assets or liabilities. Significant investing and financing transactions not involving cash also are reported in the Statement of Cash Flows. Examples of noncash transactions that would be reported include: Acquiring an asset by incurring a debt payable to the seller. Acquiring an asset by entering into a capital lease. Converting debt into common stock or other equity securities. Exchanging noncash assets or liabilities for other noncash assets or liabilities.

Preparation of the Statement of Cash Flows Reconstructing the events and transactions that occurred during the period helps identify the operating, investing and financing activities to be reported. We begin by entering the beginning and ending balances for each account on the comparative balance sheet and income statement. Here are the comparative balance sheets of United Brands Corporation for the years ended December 31, 2008 and 2009. All dollar amounts are expressed in millions. We begin by entering the beginning and ending balances for each account on the comparative balance sheet and income statement. The changes columns will be used later to explain the increase or decrease in each account balance. On the next slide, we will continue to look at the income statement accounts on the spreadsheet. The changes will be used later to explain the increase or decrease in each account balance.

Pg 1118  Dec. 31, 2009 Income Statement   Revenues: Sales revenue 100 Investment revenue 3 Gain on sale of land 8 Expenses: Cost of good sold (60) Salaries expense (13) Depreciation expense (3) Bond interest expense (5) Insurance expense (7) Loss on sale of equipment (2) Income tax expense (9) Net income 12 Here are the comparative balance sheets of United Brands Corporation for the years ended December 31, 2008 and 2009. All dollar amounts are expressed in millions. We begin by entering the beginning and ending balances for each account on the comparative balance sheet and income statement. The changes columns will be used later to explain the increase or decrease in each account balance. On the next slide, we will continue to look at the income statement accounts on the spreadsheet.

Let’s start by analyzing Sales Revenue and its related account Accounts Receivable by looking at the relationship in a T-account format. Let’s start by analyzing Sales Revenue and its related account Accounts Receivable by looking at the relationship in a T-account format. We had a beginning balance of $30, credit sales of $100, and an ending balance of $32. So, how much cash did we receive from customers?

We can see from this analysis that cash received from customers must have been $98 million. To make the account balance properly, we know that $98 million was the amount of cash received from customers during the period.

Here is the Statement of Cash Flows prepared using the direct method.

Preparing an SCF: The Indirect Method The indirect method derives the net cash increases or decreases from operating activities indirectly by starting with reported net income and “working backwards” to convert that amount to a cash basis. Here is the same information for the operating activities section presented using the indirect method. Remember that the indirect method derives the net cash increases or decreases from operating activities indirectly by starting with reported net income and “working backwards” to convert that amount to a cash basis.

Components of Net Income that Do Not Increase or Decrease Cash Depreciation Expense Loss on Sale of Equipment Adding these items back to net income restores net income to what it would have been had depreciation and the loss not been subtracted at all. Amounts that were subtracted in determining net income but did not reduce cash are added back to net income to reverse the effect of their having been subtracted. Examples of these amounts are depreciation expense and loss on sale of equipment. Similarly, amounts that were added in determining net income but did not increase cash are subtracted from net income to reverse the effect of their having been added. An example of this is the gain on sale of land. Subtracting the gain reverses the effect of the gain having been added to net income. Gain on Sale of Land

Components of Net Income that Do Increase or Decrease Cash For components of net income that increase or decrease cash, but by an amount different from that reported on the income statement, net income is adjusted for changes in the balances of related balance sheet accounts to convert the effects of those items to a cash basis. For components of net income that increase or decrease cash, but by an amount different from that reported on the income statement, net income is adjusted for changes in the balances of related balance sheet accounts to convert the effects of those items to a cash basis. The table on this slide illustrates when a change in current assets (other than cash and cash equivalents) and current liabilities should be added or subtracted to arrive at net cash flows from operating activities. For example, if accounts receivable increase during the year, the amount of the increase should be subtracted from net income. If accounts payable increase during the year, the amount of the increase should be added to net income. Note: Cash and cash equivalents, short-term investments in securities available for sale, dividends payable, and short-term payables to financial institutions are excluded from this category.

Comparison with the Direct Method This graphic compares the indirect method with the direct method using the data of United Brands Corporation. To better illustrate the relationship between the two methods, the adjustments to net income using the indirect method are presented parallel to the related cash inflows and cash outflows of the direct method. The income statement is included in the graphic to demonstrate that the indirect method also serves to reconcile differences between the elements of that statement and the cash flows reported by the direct method.

End of Chapter 21. End of Chapter 21