Statement of Cash Flows Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 17 Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education

Learning objectives 1.The major sources and uses of cash—operating, investing, and financing. 2.Why accrual net income and operating cash flows differ, and the factors that explain this difference. 3.The difference between the direct and indirect methods of determining cash flow from operations. 4.How to prepare a statement of cash flows from comparative balance sheet data, an income statement, and other financial information. 17-2

Learning objectives Concluded 5.Why changes in balance sheet accounts over a year may not reconcile to the corresponding changes included in the statement of cash flows. 6.How operating cash flows can be distorted. 7.Differences between reporting interest and dividends received and interest and dividends paid on statement of cash flows under IFRS rules vs. U.S. GAAP. 17-3

Why cash flows are important  Accrual earnings may not always provide a reliable measure of enterprise performance and health. Accrual accounting relies on subjective judgments that may introduce measurement error and uncertainty into reported earnings. One-time write-offs and restructuring charges can reduce the quality of reported earnings. Management can readily manipulate accrual income.  For these reasons, analysts scrutinize a firm’s cash flows—not just its accrual earnings—to evaluate performance and creditworthiness. 17-4

Statement format Result from events or transactions that enter into the determination of net income; i.e., the cash-basis revenues and expenses of a company. Operating cash flows Result from the purchase or sale of productive assets like plant and equipment, marketable securities, and from acquisitions and divestitures. Investing cash flows Result when a company sells its own stocks or bonds, pays dividends or buys back its own shares, or borrows money and repays the amounts borrowed. Financing cash flows Changes in cash 17-5

Statement format: The Direct Method 17-6

Statement format: The Direct Method continued 17-7

Statement format: Consolidated Statements of Operations 17-8

Statement format: Reconciling cash flows and net income 17-9

Statement format: Special disclosure rules  Current GAAP allows a choice between the direct and indirect method for the cash flow statement.  Firms using the direct method are also required to provide a reconciliation between accrual earnings and operating cash flow, and to separately disclose income taxes paid.  Firms using the indirect method are required to separately disclose interest paid and income taxes paid

Statement format: The Indirect Method Accrual-basis net income Operating cash flows Items included in accrual-basis net income but did not affect cash in the period Items excluded from accrual-basis net income that did affect operating cash in the period Non-cash revenues and gains Non-cash expenses and losses - + Cash inflows received but not recognized as earned Cash outflows paid but not recognized for accrual purposes

Preparing the cash flow statement: Overview  The purpose of the cash flow statement is to explain the underlying causes for the change in the cash balance. A three-step process: 1.Identify the journal entry that led to the reported change in each non-cash balance sheet account. 2.Determine the net cash flow effect of the journal entry. 3.Compare the financial statement effect of the entry (Step 1) with its cash flow effect (Step 2) to determine what cash flow statement treatment is needed. Changes in cash Operating Investing Financing 17-12

Preparing the cash flow statement: Burris Products Illustration 17-13

Preparing the cash flow statement: Burris Products Illustration 17-14

Preparing the cash flow statement: Burris Products solution 17-15

Preparing the cash flow statement: Burris Products solution 17-16

Preparing the cash flow statement: Burris Products—depreciation Step 1:The journal entry that generated the account change was: Step 2:Neither of these two accounts involve cash. Step 3: Because depreciation expense was included in the determination of net income but does not represent a cash outflow, the expense must be added back to net income

Preparing the cash flow statement: Burris Products—gain on equipment sale Step 1:The journal entry was: Step 2:The sale resulted in a cash inflow of $57,000. Step 3: The recognized accrual gain ($17,000) does not correspond to the cash inflow ($57,000). The gain is removed from income, and the cash inflow is shown as an investing activity

Preparing the cash flow statement: Burris Products—amortization of bond discount Step 1:The journal entry to record interest expense was: Step 2:The cash outflow was only $40,000. Step 3: Because interest expense ($44,000) exceeds the cash outflow ($40,000), the $4,000 difference is added back to net income

Preparing the cash flow statement: Burris Products—deferred income taxes Step 1:The journal entry to record tax expense was: Step 2:The cash outflow for taxes was only $96,375. Step 3: Because the income statement expense is larger than the cash outflow, the $6,000 difference must be added in the operating activities section of the cash flow statement

Preparing the cash flow statement: Burris Products—accounts receivable Step 1:The two journal entries associated with the account were: Step 2:The amount of cash collections ($3,039,000) exceeded the amount of accrual revenues included in income ($3,030,000). Step 3: The $9,000 excess of cash collections over accrual revenue is added back to net income to obtain cash from operations

Preparing the cash flow statement: Burris Products—customer advance deposits Step 1:The journal entry for this account was: Step 2:There was no corresponding cash flow effect. Step 3: Because revenues exceed 2014 cash inflows by $11,000, this amount must be deducted in the operating section of cash flow statement

Preparing the cash flow statement: Burris Products—inventories Step 1:The journal entries associated with this account were: Step 2:The cost-of-goods-sold deduction from net income ($2,526,625) is $12,000 lower than the cash outflow to buy inventory. Step 3: Because net income understates cash flow to buy inventory, $12,000 must be deducted in the computation of operating cash flow

Preparing the cash flow statement: Burris Products—accounts payable Step 1: The inventory adjustment was computed under the assumption that all inventory was purchased for cash. We now relax that assumption, and note that accounts payable increased by $3,000 during the year. Step 2: This accounts payable increase means that $3,000 of the $12,000 inventory increase was not paid for in cash. Step 3: Therefore, $3,000 is added to net income in the cash flow statement

Preparing the cash flow statement: Burris Products—accounts payable 17-25

Preparing the cash flow statement: Operating cash flow summary 17-26

Preparing the cash flow statement: Burris Products—land Step 1:The journal entry to reflect the increase in land was: Step 2:This transaction represents an $86,000 cash outflow. Step 3: The cash outflow is categorized as an investment outflow

Preparing the cash flow statement: Burris Products—Buildings and equipment Step 1:The changes in this account are summarized by : Step 2:The transaction represents a $261,000 cash outflow. Step 3: The outflow is again categorized as an investment outflow

Preparing the cash flow statement: Burris Products—stock sale and dividend paid Step 1:The journal entries were: Step 2:The cash effects involve a $50,000 inflow and a $90,000 dividend outflow. Step 3: Both the cash inflow and cash outflow are shown as financing activities

Reconciling between statements: Some complexities 17-30

Reconciling between statements: Some complexities 17-31

Reconciling between statements: Source of complexities There are at least four reasons why changes in working capital accounts (like inventory) and fixed assets don’t correspond to the changes shown on the cash flow statement: 1. Asset write-offs due to impairment, restructuring or retirement. 2. Translation adjustments on assets and liabilities held by foreign subsidiaries. 3. Acquisition and divestitures of other companies. 4. Simultaneous investing and financing activities not directly affecting cash

Reconciling between statements: Inventories—other complexities  Translation adjustments  Acquisitions and divestitures Balance sheet inventory change Cash flows inventory change Balance sheet inventory change Cash flows inventory change Computed using foreign exchange rates in effect at the time of the transaction. Computed by comparing purchases with cost of goods sold. Translated amounts are used for foreign subsidiaries. Includes the effects of acquisitions and divestitures. Includes cash flows from business segments owned at both the start and end of period

Reconciling between statements: Plant and equipment—retirements  The journal entry to record a retirement is:  It is often not possible for statement readers to determine the exact dollar amount of retirements

Reconciling between statements: Plant and equipment—other complexities  Foreign currency translation adjustments: Changes in the balance sheet accounts that are due to foreign currency exchange rate fluctuations are not reflected in the cash flow statement.  Acquisitions and divestitures: Changes in the balance sheet accounts that arise from acquisitions are often shown on a line separate from “Capital expenditures”

Reconciling between statements: Simultaneous non-cash investing & financing  Some investing and financing activities occur simultaneously as part of a single transaction: Buy a building and borrow the full amount as a mortgage. Acquire an asset by entering into a capital lease. Issue stock for non-cash assets as part of a business combination.  GAAP requires firms to disclose these non-cash simultaneous investing and financing activities

Reconciling between statements: Simultaneous non-cash investing & financing 17-37

Reconciling between statements: Simultaneous non-cash investing & financing 17-38

Analytical Insights: Ways Operating Cash Flows can be Distorted or Manipulated Healthy firms generate cash from their day to day operating activities  Changes in Working Capital Account  Accounts Receivable Sale versus Collateralized Borrowing  Capitalizing versus Expensing  Software Development Costs  Capital versus Operating Leases  Cash Flow Effect of Stock Option Expensing Firms that can’t generate cash internally jeopardize their operations and risk loan default or even bankruptcy Because cash flow from operations is such a carefully monitored number, firms have incentives to make this number look as strong as possible. Therefore, it is possible to find ways in which operating cash flows can be distorted or “legitimately” managed. These ways include:

Global Vantage Point  Like U.S. GAAP, IFRS rules require the statement of cash flows to be broken down into three categories – operating, investing and financing. IFRS allows the use of either the direct or indirect method but does not require a reconciliation if the direct method is used, but many firms provide one anyway.  Under IFRS rules, nonfinancial firms may report interest and dividends received as either operating or investing activities and interest paid as either operating or financing activites.  Cash flows from income taxes are to reported as an operating activity unless they can be specifically identified with financing and investing activities

Summary  The statement of cash flows helps readers gauge the firm’s ability to generate sufficient cash to pay for operating expenses, capital improvements, and currently maturing obligations.  Firms that generate consistently strong positive cash flows from operations are considered better credit risks and benefit from a lower cost of capital.  The two alternative methods for presenting the operating section of a cash flow statement are the direct and the indirect methods.  Most firms use the indirect method

Summary concluded  Changes in non-cash balance sheet accounts may not correspond to the adjustments shown on the cash flow statement because of: Asset write-offs due to impairment, restructuring, or retirement Translation adjustments on assets and liabilities held by foreign subsidiaries. Acquisitions and divestitures of other companies. Simultaneous investing and financing activities.  Operating cash flows can sometimes be distorted or legitimately managed.  IFRS rules allow firms greater flexibility relative to U.S. GAAP in how interest and dividends received and interest and dividends paid are reported on the statement of cash flows