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2 Chapter 14: Statement of Cash Flows Required for financial statements by SFAS 95 (1987). Primary purpose is to provide relevant information about cash receipts and cash disbursements of the company during the period. Serves to complement the other financial statements. Focus is on cash flows, not income. Reconciles the balance sheet and the income statement.

3 Content of Statement of Cash Flows Explains change in cash and cash equivalents. Cash equivalents are defined as short-term, highly liquid investments near to maturity. Examples of cash equivalents are Treasury bills and money market funds. Format of SCF includes the following three sections: - cash flow from operating activities. - cash flow from investing activities. - cash flow from financing activities.

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5 Cash Flows from Operating Activities CF from operating activities is based on the income statement, and converts income activity to a cash basis. There are two formats for the presentation of CF from operating activity: – direct method: this technique shows cash received from customers and cash paid to various entities for operating activities. – indirect method: this technique starts with net income and makes adjustments to net income to convert it to a cash basis.

6 Cash Flows from Operating Activities If the direct method is used, the indirect method must be presented in a supplementary schedule. The direct method is more informative, but the vast majority of companies present only the indirect method. FASB is considering a change to require the direct method.

7 Cash Flows from Investing Activities CF from investing activities explain the changes in cash from the purchase or sale of the company’s (primarily) long-term assets. Examples of investing activity includes: – cash paid for purchase of equipment, land, buildings, marketable securities (available-for-sale and equity), intangible assets, and most other long term assets. – cash received from sale of equipment, land, buildings, marketable securities (available-for-sale and equity), intangible assets, and most other long term assets. – cash paid for issue of non-trade notes receivable (both short-term and long-term). – cash received for repayment on non-trade notes receivable (both short-term and long-term).

8 Cash Flows from Investing Activities General rule for investing activity: – cash flows for purchase and sale of long-term assets. Exceptions to the rule: – Short term notes receivable (non-trade) are included in the investing section. – Long term notes receivable (trade) are not included in the investing section. Because they relate to trade, they are treated just like accounts receivable in the operating section. – The change in equity method investments is classified in the operating section of SCF, because the change deals with income. (Purchase and sale of equity investments are classified in investing.) Note: Trade receivables are created when inventory is sold on account. Non-trade receivables are created when a company loans cash to employees or others (no sale is involved).

9 Cash Flows from Financing Activities CF from financing activities explain the changes in cash from the issue or retirement of the company’s (primarily) long-term liabilities and equity. Examples of financing activity includes: – cash received from issue of bonds, mortgages and other long-term debt, – cash received from issue of common stock and preferred stock, – cash paid for the retirement of long-term debt, – cash paid for the repurchase of treasury stock, – cash paid for dividends, – cash received for issue of non-trade notes payable (both short-term and long-term), and – cash paid for retirement or repayment on non- trade notes payable (both short-term and long- term).

10 Cash Flows from Financing Activities Note that cash paid for dividends is classified as a financing activity, but cash paid for interest is classified as an operating activity. Note that cash received for dividends and cash received for interest are both classified as operating activities. How is the cash paid for dividends different from the other activities? Why did the FASB choose to classify it as a financing activity?

11 Cash Flows from Financing Activities General rule for financing activity: – cash flows for issue and retirement of long-term liabilities and equity. Exceptions to the rule: – Short term notes payable (non-trade) are included in the financing section. (Short term bank notes are very common examples.) – Long term notes payable (trade) are not included in the financing section. Because they relate to trade, they are treated just like accounts payable in the operating section. (LT trade N/P are rare.) Note: trade payables are created when inventory is purchased on a note. Non-trade payables are created when a company or borrows cash from a bank or others (no inventory purchase is involved).

12 CF from Operations (Indirect Method) To understand the adjustments to get from net income to CF from operations, we will classify the adjustments into 3 categories: (1) Items that affect income but not CFO (noncash items). (2) Double counted gains and losses. (3) Changes in related (accrual basis) assets and liabilities from: (a) Revenues recognized before cash is received. (b) Expenses recognized after cash is paid. (c) Revenues recognized after cash is received. (d) Expenses recognized before cash is paid. Remember: net income includes many activities that are noncash, or only partly cash.

13 (1) Indirect Method - Noncash Items Noncash activities include -Depreciation expense. For example: Depreciation Expensexx Accumulated Depreciationxx -Amortization expense on intangible assets such as patents and goodwill. Amortization Expensexx Goodwill xx -Bad debt expense on the estimation of uncollectibles: Bad Debt Expensexx Allowance for Doubtful Accts.xx Since these expenses originally reduced net income, the amount of these expenses would need to be added back to net income to get to cash from operations.

14 (1) Indirect Method - Noncash Items Another noncash activity deals with the amortization of premiums and discounts on bonds payable. These amortizations affect interest expense but not cash. There are two components to interest expense each period: (1) the cash paid for interest expense, and (2) the amortization of premiums or discounts (the noncash portion). To find the direction of the adjustment, isolate the noncash component (for amortization) of the interest expense entry: Interest expensexx Discount on B/Pxx or Premium on B/Pxx Interest expensexx

15 (2)Indirect Method - Double Counted Items The double counted items come from gains and losses on investing and financing activity. For example, assume that land is sold for $10,000 cash, and the original cost was $9,000: Cash10,000 Land9,000 Gain on Sale of Land1,000 In this case, the $10,000 cash received would be shown in Investing. However, if the gain is not adjusted out of net income, we would be “double counting” that effect.

16 (2)Indirect Method - Double Counted Items Therefore, any gains or losses from sale of investing assets (equipment, land, buildings, AFS and equity investments, intangibles). The adjustment to reverse out the effects would be: – add the amount of loss to net income. – subtract the amount of the gain from net income. The same holds true for gains and losses from the early extinguishment of debt (like the gains/losses from the retirement of bonds). – add the amount of loss to net income. – subtract the amount of the gain from net income.

17 (3) Indirect Method - Change in Related Assets and Liabilities The third category examines the change in the assets and liabilities that relate to the remaining income statement items, after the items in (1) and (2) have been removed. The adjustment for the effect of these changes is to effectively “squeeze” the income statement item from the accrual basis of accounting to the cash basis of accounting.

18 (3) Indirect Method - Change in Related Assets and Liabilities For example, assume that total sales revenue recognized for the year is $100,000. At the beginning of the year, A/R were $2,000; at the end of the year, A/R were $3,000. What amount of cash was collected from customers? To analyze this effect, we must analyze the A/R account, and how it is increased and decreased.

19 (3) Indirect Method - Change in Related Assets and Liabilities Accounts Receivable Cash Collection on A/R Beginning Balance Sales Ending Balance First assume that all sales are on account. Now note that the relationship can be expressed in a formula involving A/R and Sales: A/R Beginning + Sales - Cash Collections = A/R Ending Or: A/R Beginning + Sales - A/R Ending = Cash Collections

20 (3) Indirect Method - Change in Related Assets and Liabilities A/R B + Sales - A/R E = Cash Collections 2, , ,000 = Cash Collections 99,000 = Cash Collections Note that, to convert from accrual basis sales revenues to cash basis sales revenues, an increase in A/R should be subtracted from net income to convert net income to a cash basis. Correspondingly, a decrease in A/R should be added to net income to convert net income to a cash basis.

21 (3) Indirect Method - Change in Related Assets and Liabilities This pair of rules can be expanded to a general set of rules to convert NI from accrual to cash basis: Subtract increases in related assets. Add decreases in related assets. Add increases in related liabilities. Subtract decreases in related liabilities. The types of assets that relate to the income statement are primarily current assets, but not always. To decide, you must look at each asset and its related income statement component. Also, remember that we are looking at the remaining assets and liabilities (after the eliminations in part 1). Since we have already eliminated depreciation expense and amortization expense, etc., we would not include the changes in these related assets (Accum. Depr., Patents, etc.).

22 (3) Indirect Method - Change in Related Assets and Liabilities Examples of related assets are: Accounts Receivable. Dividends Receivable (relates to dividend income). Trade Notes Receivable (short and long term). Inventories. Prepaid Expenses. Deferred Tax Assets (because this relates to income tax expense). Trading Investments (because they relate to unrealized gains and losses on the income statement as well as gains and losses on sale). Equity Investments (because this relates to “Income from Investment”).

23 (3) Indirect Method - Change in Related Assets and Liabilities Examples of related liabilities include: Accounts Payable. Interest Payable. Income Tax Payable. Other Current Liabilities. Trade Notes Payable (short and long term). Unearned Revenues (short and long term). Deferred Tax Liabilities (because this relates to income tax expense).

24 Direct Method

25 Indirect Method