Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD Chapter 19 Reporting and Analyzing Cash Flow

In this chapter… Balance Sheet Current Assets Cash Chapter Current Liabilities Accounts Payable5000 Accounts Receivable20000 Wages Payable25000 Notes Receivable15000 Utilities Payable2000 Marketable Securities25000Long-Term Debt Inventory Notes Payable20000 Capital Assets Bonds Payable Equipment250000Owner’s Equity Buildings Common Stock Goodwill60000 Retained Earnings48000 Total Assets Total Liabilities + OE Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Purpose of the Cash Flow Statement Purpose: is to report detailed info about the major cash receipts and cash payments during the period Generally there are 3 types of activities that generate or consume cash –Operating –Investing –Financing Although one of the more complex statements, this Cash Flow Statement or the Statement of Changes in Financial Position (SCFP) is one of the most important statements Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Why is cash important? Cash is the grease that allows the company to move and articulate its resources to achieve goals Cash is needed to –Pay debts –Meet unexpected obligations –Pursue unexpected opportunities –Plan day-to-day operating activities –Make long-term investment decisions The Statement of Changes in Financial Position (SCFP) can help answer: –How does the company obtain cash –How does it spend cash –What is the change in the cash balance Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Cash and Cash Equivalents Lets also remember that this statement needs to cover both cash and cash equivalents: Cash Equivalents: –Assets that are readily convertible to a known amount of cash –Significantly close to maturity (within roughly 3 months) that its eventual cash value is determinable Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

3 Types of Activities: Operating Operating: the principal revenue generating activities of the business Examples: –Production of goods and services for sale –Purchase of raw materials and labour –Admin expenses, taxes –Collection of loan principal The above activities generate or consume cash as shown in Exhibit 19.1 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

3 Types of Activities: Operating Balance Sheet Current Assets Cash10000 Current Liabilities Accounts Payable5000 Accounts Receivable20000 Wages Payable25000 Notes Receivable15000 Utilities Payable2000 Marketable Securities25000Long-Term Debt Inventory Notes Payable20000 Capital Assets Bonds Payable Equipment250000Owner’s Equity Buildings Common Stock Goodwill60000 Retained Earnings48000 Total Assets Total Liabilities + OE Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

3 Types of Activities: Investing Investing: these are activities that generally affect long- term assets As shown in Exhibit 19.2, investing activities typically involve –Purchase or sale of capital assets –Purchase or sale of investments, other than cash equivalents –Lending and collecting on loans (long-term notes receivables that were created for activities other than operating activities) Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

3 Types of Activities: Investing Balance Sheet Current Assets Cash10000 Current Liabilities Accounts Payable5000 Accounts Receivable20000 Wages Payable25000 Notes Receivable15000 Utilities Payable2000 Marketable Securities25000Long-Term Debt Inventory Notes Payable20000 Capital Assets Bonds Payable Equipment250000Owner’s Equity Buildings Common Stock Goodwill60000 Retained Earnings48000 Total Assets Total Liabilities + OE Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

3 Types of Activities: Financing Financing: these are activities that affect a company's owners and creditors Financing activities include –Obtaining or disbursing cash as a result of debt incurred or debt paid off –Obtaining cash from or distributing cash to owners Note: –Interest expense usually incurred to support the company’s ability to generate revenue. Therefore it is deducted from revenue to get Net Income on the Income Statement. This is considered an Operating activity –Accounts payable are also incurred to purchase raw materials Therefore, paying AP is considered Operating activities Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

3 Types of Activities: Financing Balance Sheet Current Assets Cash10000 Current Liabilities Accounts Payable5000 Accounts Receivable20000 Wages Payable25000 Notes Receivable15000 Utilities Payable2000 Marketable Securities25000Long-Term Debt Inventory Notes Payable20000 Capital Assets Bonds Payable Equipment250000Owner’s Equity Buildings Common Stock Goodwill60000 Retained Earnings48000 Total Assets Total Liabilities + OE Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Format of the SCFP Page 960 shows you a typical SCFP The SCFP is a cash flow statement that illustrates the activities that occurred during a period, –such that it explains how transactions affect the beginning period cash balance to produce the end of period cash balance Operating Activities are listed first with a Net Cash Inflow (Outflow) for the period Investing Activities are listed second with a Net Cash Inflow (Outflow) for the period Financial Activities are listed last with a Net Cash Inflow (Outflow) for the period Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

5 Easy Steps to create a SCFP Calculate the net increase or decrease in cash and cash equivalents from current year and prior year BS Calculate the net cash inflows (outflows) from operating activities using the Direct Method –Note: See next slide: The book uses the Indirect Method to calculate the cash from Ops activities. On the exam, we will use the Direct Method Calculate the net cash inflows/outflows from investing activities Calculate the net cash inflows/outflows from financing activities Sum up the net cash inflows (outflows) from each of the above, then add this amount to the beginning period cash balance to show the end of period cash balance Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

About the 2 Methods for Ops Activities Both the indirect method and the direct method are used by companies, –although most companies seem to prefer the indirect method –Its easier to do The direct method is “encouraged” (but not required) by IFRS –And will likely be the requirement in the future For the purposes of this course, –we will use the Direct method –The final exam will require you to use the Direct method The indirect method will be given no points The book covers the indirect method in the main body of the chapter and the direct method in the Appendix to the chapter Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Lets try it out… Lets see how we can generate the SCFP for Genesis Corp on page 932. Step 1: Look at the 2011 and 2010 Balance Sheet and calculate the change in cash: –$17000-$12000 = $5000 increase Step 2: This step is about restating Net Income from the Income Statement from accrual basis to cash basis –We’ll use the Direct Method only. Using the Indirect method will be marked wrong!!! –In using the Direct Method, we use the difference shown between the Year 1 balance and Year 2 balance of balance sheet accounts and apply that difference to the related Income Statement account to get an idea of cash paid or generated from that activity Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Lets try it out… Faithfully follow the process… –“Only in the leap from the lion's head will he prove his worth." – Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Direct Method A good way to start thinking about the Direct Method is simply to look a your Cash T-account once you have journalized and posted transactions affecting cash to its T- account Again, note: using the Indirect method will be marked wrong Then, you can generally take these postings and break them into these categories –Cash received from customers –Cash paid for merchandise –Cash paid for wages –Cash paid for operating expenses –Cash paid for interest –Cash paid for taxes Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Cash received from customers If all sales are paid by cash, then –Cash received from customers (cash sales) = Sales But most times, companies permit customers to pay on credit (AR). Therefore, –Cash received from customers (credit sales) = Credit Sales + AR in Yr 1 – AR in Yr 2 Therefore Cash received from Customers = Cash received from cash sales + cash received from credit sales If you like T-accounts, look at T-account versions throughout the chapter You can also receive cash for other reasons (rent, interest, etc) You can use a similar formula as above to calculate the affect on cash: –Cash received from customers = Rent Income + Rent Receivable in Year 1 – Rent Receivable in Year 2 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Operating Cash Payments There are many areas that could cause a cash outflow from operating activities. We’ll cover some common ones –Note that these will all show as a negative number in the SCFP Cash paid for merchandise is usually cash paid for raw materials that form the basis for the final product We can use a similar analysis to our previous Cash received from customers to produce Cash paid for merchandise Cash paid for merchandise uses a 2 step approach. –First, it examines changes to the inventory asset account to see how they affect COGS –Second, it examines changes to AP to determine Cash paid for merchandise Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Cash paid for merchandise First, looking at the Inventory account –Cost of purchases = COGS + Inv in Year 2 – Inv in Year 1 Then, using AP and purchases calculated above –Cash paid for merchandise = Cost of Purchases + AP in Year 1 – AP in Year 2 Of course, Cash paid for merchandise represents an outflow of cash, so it is shown as a negative number Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Cash paid for wages, interest, taxes In the example of Genesis, they have combined wages with other operating expenses. Generally, the following analysis is applied to any expense affecting cash Cash paid for Wages = Wages Expense + Wages Payable in Year 1 – Wages Payable in Year 2 Cash paid for Interest = Interest Expense + Interest Payable in Year 1 – Interest Payable in Year 2 Cash paid for Taxes = Taxes Expense + Taxes Payable in Year 1 – Taxes Payable in Year 2 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Other Operating Expenses Amortization Expenses: These are non-cash expenses which represent the allocation of capital assets to revenue generated over time. Since the cash affects of capital assets are covered in the Investing activities we ignore Amortization in the Operating section Gain/Loss on Sale of Assets: regardless of a loss or gain, the actual cash received from a sale or purchase is recorded in the Investing activities section Bond Retirements: Shown under Financing activities Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Cash Flows from Investing Activities Step 3: Calculate net cash inflows (outflows) from Investing activities You’ll recall that these are activities that generally affect long-term assets As shown in Exhibit 19.2, investing activities typically involve –Purchase or sale of capital assets –Purchase or sale of investments, other than cash equivalents –Lending and collecting on loans (long-term notes receivables that were created for activities other than operating activities) Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Cash Flows from Investing Activities We use a 3 step process to determine cash inflows (outflows) from investing activities –Identify changes in investing activities accounts –Explain these changes using reconstruction analysis –Report the cash flow effects Investing activities accounts are –Any long-term asset account, like capital assets, property, plant and equipment, trucks, cars, buildings, etc Reconstruction analysis is the artist’s impression of what the journal entry might have been to cause the change Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Cash Flows from Investing Activities Example, cash from sale of a fixed asset DateAccount Titles and explanationPRDebitCredit July 25Cash Accum Amort - Building40000 Gain on sale of Building30000 Building Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Cash Flows from Investing Activities So, in the Investing Section of the SCFP, you would see something like the top example on page 960 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Cash Flows from Financing Activities Step 4: Calculate net cash inflows (outflows) from Financing activities These are activities that affect a company's owners and creditors We can get a good idea of where to start by examining the activity in the following accounts –Long-Term Debt, Bonds Payable –Notes Payable –Owner’s Equity –Common Shares –Preferred Shares –Retained Earnings Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Cash Flows from Financing Activities Again,we use a 3 step process to determine cash inflows (outflows) from financing activities –Identify changes in financing activities accounts –Explain these changes using reconstruction analysis –Report the cash flow effects Here are some typical financing activities changes: Cash generated by issuing bonds DateAccount Titles and explanationPRDebitCredit Jun 31Cash Bonds Payable Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Cash Flows from Financing Activities Cash paid out by retiring bonds Cash generated by selling common shares DateAccount Titles and explanationPRDebitCredit July 25Bonds Payable34000 Gain on Bonds Retirement16000 Cash18000 DateAccount Titles and explanationPRDebitCredit Jun 31Cash Common Shares Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Cash Flows from Financing Activities Dividends paid to owners –Note, for the above example, we would need to examine the Net Income that went into Retained Earnings to help determine the cash for dividends that came out (see page 993) Cash paid for Dividends = Net Income – (Retained Earnings Yr 1- Retained Earnings Yr 2) + Dividends Payable Year 1 – Dividends Payable Year 2 DateAccount Titles and explanationPRDebitCredit Jun 31Retained Earnings10000 Cash10000 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Final Step: Proving the change in Cash We have now examined all the changes that could affect cash Now we simply sum up the inflows (outflows) in each of the 3 activities individually, then we sum the 3 up to get an overall increase or decrease in cash Then we find the beginning period cash balance, add the above increase or decrease and see if it results in the ending cash balance Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Demonstration Problem Lets go through the Demonstration Problem Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD