1. b a c kn e x t h o m e Thomas H. Beechy Schulich School of Business, York University Joan E. D. Conrod Faculty of Management, Dalhousie University PowerPoint slides by: Bruce W. MacLean, Faculty of Management, Dalhousie University Copyright  1998 McGraw-Hill Ryerson Limited, Canada Intermediate Accounting

2. b a c kn e x t h o m e Thomas H. Beechy Schulich School of Business, York University Joan E. D. Conrod Faculty of Management, Dalhousie University PowerPoint slides by: Bruce W. MacLean, Faculty of Management, Dalhousie University Copyright  1998 McGraw-Hill Ryerson Limited, Canada Cash Flow Statement CHAPTER 5

3. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Introduction n The cash flow statement –reveals the operating cash flow of the company, –enables the user to reconcile the cash flows to net income. n The cash flows of an enterprise are of prime importance to many users of the financial statements. n The AcSB has identified cash flow prediction as a principal objective of financial reporting. n The starting point of cash flow prediction is the analysis of historical cash flows. Income Statement Cash Flow Statement Predict Future Reconcile User Prediction Decisions

4. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Evolution of The Cash Flow Statement n The cash flow statement has evolved over the past twenty years. The title of cash flow statement is fairly recent. Section 1540 of the CICA Handbook. Present changes in long-term assets and equities, while emphasizing changes in the residual, net working capital. which was affected by accounting policies chosen for all of the current assets, including inventories leading to anomalous situations In 1985, the AcSB substantially revised Section 1540 to eliminate the working capital approach and focus instead on cash flows. The AcSC further modifed section 1540 to bring it in line with International Accounting Standard (IAS) 7 which was endorsed: in 1993 by the International Organization of Securities Commissions and, in 1994, by the U.S. Securities and Exchange Commission as an alternative to existing FASB standards. CICA Handbook in 1998, effective on 1 January 2000.

5. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Cash Flow Reporting n Cash versus Accrual n Definition of Cash n Classification of Cash Flows n Statement Title

6. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Start of Entity Life of Entity Time Periods Deferrals Accruals Cash versus Accrual n Under the accrual basis, financial assets and liabilities (that is, receivables and payables) are recorded when the reporting enterprise has a right to receive cash or the obligation to pay cash, rather than later when the cash flows actually occur. It is due to the accrual basis that balance sheets show accounts receivable and payable and accrued revenues and expenses. n On the cash flow statement, the effects of both accruals and inter-period allocations (such as depreciation and amortization) are eliminated, leaving only the cash flows. n Cash flow is not affected by accounting policy choices. ? Inter-period allocations refer to the revenue and expense recognition policies that a company uses to measure net income. ? Receipts and disbursements are cash inflows and outflows. They can be for any purpose, whether to generate operating earnings, change the asset structure, or increase or decrease liabilities. ? Because of the accrual concept, a cash receipt or disbursement that gives rise to a Revenue or Expense may occur in a different period than that in which the revenue or expense is recognized.

7. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Definition of Cash n For purposes of the cash flow statement, “cash” includes: < cash on hand, < cash on deposit, and < Cash equivalents - highly liquid short-term investments n Investments in shares are explicitly excluded. n In Canada, corporations often maintain lines of credit with their banks which may be used as a cash account that can run a negative balance, or overdraft. The components of cash and cash equivalents (including overdrafts) should be disclosed, and the net change that is reported in the cash flow statement should be reconciled to the equivalent items in the balance sheet [CICA 1540.48]. “for an investment to qualify as a cash equivalent it must be readily convertible to a known amount of cash and be subject to an insignificant risk of changes in value” [CICA 1540.08]. 3 months maximum maturity period.

8. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Classification of Cash Flows  Operating activities are the principle revenue producing activities of the enterprise and the related expenditures. The cash inflow from operations is measured as the cash received from customers or clients, plus activities such as finance revenue. The cash outflows are those disbursements that are incurred to earn the inflow, such as cash paid for inventories, wages and salaries, and overhead costs.  Investing activities are those activities that relate to the asset structure of the company, including the acquisition and disposal of tangible and intangible capital assets and investments in other assets that are not included in cash equivalents.  Financing activities are those that relate to the liabilities and owners’ equity. Cash flows that increase or decrease the size or composition of the accounts on the right side of the balance sheet are reported in this section.

9. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Dividends received from controlled or significantly- influenced affiliates are not included in net income and therefore should be reported in the investing activities section. Dividends received and reported in net income should be reported as an operating cash flow. Dividends paid are not included in net income and therefore should not be included in operating cash flow. Instead, dividend payments are separately disclosed as a financing activity (that is, as a payment to providers of capital). Classification of Cash Flows - Interest and Dividends Operating activities Investing activities Financing activities Interest income and interest expense that have been included in determining net income should remain as part of operating cash flow, but separately disclosed [CICA 1540.34]. Interest payments that are not included in net income would be classified “according to their nature” [CICA 1540.35].

10. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Classification of Cash Flows n The income statement reports revenues and expenses. n The purpose of the cash flow statement is to report cash inflows and outflows within the three categories of activities. n The classification is not determined by the treatment of a transaction on the income statement. For example, a gain on the sale of a capital asset will be reported in the income statement. For the cash flow statement, however, the transaction will be reported in the investing section because it relates to a capital asset. Operating activities Investing activities Financing activities - Negative+ Positive

11. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Statement Title n Historically, the most common name for the cash flow statement was: Statement of Changes in Financial Position. –About two-thirds of Canadian public companies used this title. Financial Reporting in Canada 1995, p. 234. n The intent of the new section 1540 is to encourage companies to use the simpler and more understandable title of: Cash Flow Statement, –especially since all non-cash transactions have been banished from the statement.

12. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Preparing The Cash Flow Statement n Basic Approach to Preparation n Indirect Preparation Approach: A Simple Example n Presentation of Operations n Offsetting Transactions n Non-Cash Transactions n Cash Flow per Share n Quality of Earnings n Effect of Accounting Policy Choices on the Cash Flow Statement n Interim Statements n Summary of Disclosure Recommendations

13. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Basic Approach to Preparation n The Balance Sheet, Income Statement, and Retained Earnings Statement are all prepared from the trial balance manually or, by computerized systems. n The classification of the balance of each account is unambiguously pre-specified in the programming, and the statements (other than the cash flow statement) emerge more-or-less automatically from the system. n However, the cash flow statement is prepared by analyzing account balances and changes in balances. Standard computerized accounting systems normally cannot do that, and therefore the cash flow statement is usually a hand-prepared statement. FS Trial Balance Cash Flow

14. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Preparation Approach n The process of describing cash flows by analyzing the cash account(s) is the direct preparation approach. –Some large-scale and/or customized computerized accounting systems are capable of the direct preparation approach. n An alternative approach is to describe the cash activities by analyzing the changes in all of the non-cash accounts, the indirect preparation approach. –Since the basic, indisputable, characteristic of the balance sheet is that it balances, we can determine cash flows by looking at the causes of the changes in all of the other accounts except cash and cash equivalents. –The indirect preparation approach is the more commonly used, and is virtually the only method used when the preparation is manual or when cash flow statement is prepared from the other financial statements as produced by an off- the-shelf accounting software package such as NuViews® or AccPac®.

15. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Indirect Preparation Approach: A Simple Example n The data for preparing the cash flow statement for Simple Limited by the indirect preparation approach is shown in Exhibit 5-2. Click to Open

16. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Indirect Preparation Approach: A Simple Example n The cash flow statement that can be derived from the information in Exhibit 5-2 is shown in Exhibit 5-3. (The letters in the “key” column refer to the explanations just below.) n Click below to open the Exhibit In Excel

17. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Presentation of Operations Direct presentation: The revenues and expenses are adjusted to a cash basis of reporting and shown directly in deriving cash provided by (or used by) operations on the cash flow section. Indirect presentation: Operations begins with net income, and all interperiod allocations and accruals are reversed out of net income to derive the cash from operations. –In Exhibit 5-3, the indirect method of presentation was used. In Exhibit 4 –Exhibit 5-4 presents the Operations section of Simple Limited’s cash flow statement, but by using the direct approach of presentation

18. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Offsetting Transactions n A basic objective of the cash flow statement is to explain the investing and financing activities of the enterprise. n Within each of those two categories, there often are transactions that, overall, have the effect of offsetting each other. n For example, if a company refinances its debt by retiring an outstanding bond issue and issuing new bonds, the net impact on the balance sheet may be relatively minor. However, these activities do demonstrate the company’s ability to renew its capital structure. The flows associated with the refinancing should be disclosed separately and not offset, or netted. In essence, offsetting (or netting) is permitted for: cash receipts and payments that are on behalf of customers rather than for the reporting enterprise itself [CICA 1540.25(a)] cash receipts and payments for items where the volume of activity is high and the holding period is short (i.e., the turnover is quick) [CICA 1540.25(b)].

19. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Non-Cash Transactions n Common types of non-cash transactions include:  Bond retirement through share issuance  Conversion of bonds to shares  Conversion of preferred shares to common shares  Settlement of debt by transferring non-cash assets  Bond refunding  Incurrence of capitalized lease obligations in exchange for leased assets  Acquisition of shares in another company in exchange for shares of the reporting enterprise  Distribution of assets other than cash as dividends (e.g., a spin-off of a subsidiary company)

20. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Cash Flow per Share n Financial analysts and other users often compute cash flow per share, which is defined in many different ways. n One common measure of cash flow per share is net operating cash flow divided by common shares outstanding. SFAS No. 95 n In the United States, SFAS No. 95 prohibits disclosure of statistics so labeled in financial statements, except for contractually determined cash flow per share values. CICA Handbook n The CICA Handbook is silent on the issue, which allows Canadian companies to use their judgment in this area.

21. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Quality of Earnings n Investment analysts sometimes refer to the earnings quality of a company that they are analyzing. This concept relates the amount of net income to the amount of cash flow from operations. n A company is said to have high quality earnings when there is a close correspondence between net income and cash flow from operations, especially if the close relationship between earnings and cash flow persists over several years and move in the same direction. n In contrast, a company that reports earnings that are not closely related to cash flows is said to have low quality earnings.

22. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Effect of Accounting Policy Choices on the Cash Flow Statement “cash doesn’t lie”.. n One of the reasons that users like to see the cash flow statement is that “cash doesn’t lie”.. no impact on the underlying cash flow n Accounting policy decisions and management’s measurement estimates can significantly affect net income, but they will have no impact on the underlying cash flow The accounting policy decision to Expense or Capitalize The accounting policy decision to Expense or Capitalize one or more types of cost affects the cash flow statement by affecting the classification of items on the statement. charged to expense If expenditures of a certain category (i.e., start-up costs) are charged to expense, they will be included as a deduction in net income and be included in operating cash flow. capitalized On the other hand, if those expenditures are capitalized, they will appear on the cash flow statement as an investing activity cash flow from operations In subsequent years, amortization of capitalized costs is deducted in determining net income, but is then added back to net income to derive cash flow from operations. neveroperating cash flowinvesting activity The result is that capitalized costs never enter into operating cash flow but will appear only as an investing activity. For example, a retail chain that capitalizes and amortizes its store start-up costs will show a consistently higher cash flow from operations than one that charges start-up costs to expense, all other things being equal.

23. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Interim Statements n The securities acts require public companies to issue interim financial statements at least quarterly. n The importance of the cash flow statement to users is illustrated by the fact that the securities acts require a condensed income statement and statement of change in financial position (i.e., a cash flow statement) as interim financial statements. n A balance sheet is not required, although many companies do provide one. n The securities acts presume that the flow activities, both earnings and cash, are most important to continuing evaluation of the company.

24. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Summary of Disclosure Recommendations n The CICA Handbook recommends the following disclosures : changes in cash and cash equivalents  The cash flow statement should report the changes in cash and cash equivalents, net of bank overdrafts, resulting from the activities of the enterprise during the period. components  The components of cash, cash overdrafts, and cash equivalents should be disclosed and should be reconciled with the balance sheet. include only cash flows  The statement should include only cash flows; non-cash transactions should not be reported on the cash flow statement, but should be disclosed elsewhere in the financial statements as appropriate. operatinginvestingfinancing  Cash flows during the period should be classified by operating, investing and financing activities.

25. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Summary of Disclosure Recommendations n The CICA Handbook recommends the following disclosures relating to the cash flow statement:  Reporting enterprises are encouraged to report cash flows from operations by the direct method.  Cash flows from investing and financing activities should not be netted or offset; the gross amount of inflows and outflows should be reported.  Cash flows relating to extraordinary items should be classified according to their nature as operating, investing or financing activities, and should be separately disclosed.  The gross amounts of cash flows from interest and dividends (both received and paid) should be disclosed separately; interest and dividends that have been included in net income should be separately disclosed as part of operating cash flow.

26. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Summary of Disclosure Recommendations n The CICA Handbook recommends the following disclosures relating to the cash flow statement:  Cash flows arising from income tax on operating income should be separately disclosed as an operating activity. If income tax cash flows can be specifically identified with investing or financing activities, they should be classified as investing or financing activities.  The cash flows arising from acquisitions and disposals of subsidiaries or other business units should be presented separately and classified as investing activities. Non-cash exchanges involving such acquisitions or disposals would not be reported on the cash flow statement (but would be disclosed in a note). Disposals are not netted against acquisitions.  This aspect of cash flow reporting is discussed in Chapter 12.

27. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Analyzing More Complex Situations n Using a Spreadsheet n Worksheet Procedure n Direct Presentation Method n Summary of Reconciling Adjustments

28. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Using a Spreadsheet n It is common to use some form of worksheet or spreadsheet to force some discipline on the process and to help assure that we don’t overlook any relevant transactions. The spreadsheet approach is useful because it:  provides an organized format for documenting the preparation process,  facilitates review and evaluation by others,  provides proofs of accuracy, and  formally keeps track of the changes in balance sheet accounts and ensures that all accounts are explained. n The comparative balance sheet and the income statement for Accrue Corporation are shown in Exhibit 5-7, along with some important supplementary information.

29. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Using a Spreadsheet n To set up the worksheet, it is necessary to transfer the accounts and account balances from the balance sheet to a four-column worksheet. Exhibit 5-8 demonstrates the set-up for Accrue Corporation, based on the information in Exhibit 5-7. –The intent is to identify the cash flows. But instead of debiting and crediting all of the cash flows directly to the cash account, we will classify the ‘cash’ part of the transactions in another section of the worksheet. Below the balance sheet accounts, we create a section of the worksheet in which to record the cash flow effects. Within this lower section, a sub- section is labeled for each of the three types of cash activity: operating, investing and financing.

30. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Worksheet Procedure n The beginning and ending account balances have been entered into the worksheet or spreadsheet, we can begin to make the necessary adjustments. –Generally speaking, the place to start is with the reconciliation of retained earnings, simply because it is where the net income for the year has been transferred. –Starting with net income also focuses our attention on the income statement and on the adjustments that are necessary to remove the effects of interperiod allocations. n The cash flow statement, using the indirect preparation method, is illustrated in Exhibit 5-9.

31. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Direct Presentation Method n The requirement to separately disclose all interest, dividends and income tax receipts and payments does complicate the operations section if the indirect presentation method is used. The alternative (which is ‘encouraged’ by the ED) is to use the direct method. The cash flow amounts in the final column of the lower part of Exhibit 5-8 are used in the operations section of the cash flow statement. The direct presentation approach is illustrated in Exhibit 5-10. Note that the presentation is much simpler than the indirect approach of Exhibit 5-9 because it is not necessary to remove interest, dividends and taxes from the net income, only to put them back in again later.

32. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Summary of Reconciling Adjustments n To prepare the cash flow statement, it is necessary to convert the accrual basis earnings to the cash basis and to trace other cash flows that caused changes in the asset and equity structure of the reporting enterprise. Basically, there are three types of adjustments that must be made to the accrual basis accounts: –Accruals must be ‘backed out’ of the monetary asset and liability accounts to determine the cash inflows and outflows for operations during the period. –The effects of interperiod allocations of costs and revenues must be reversed. n Certain transactions, the net effects of which are included in net income, must be reclassified as investing or financing activities

33. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada International Perspective n Internationally, a trend toward cash flow reporting has developed, similar to the experience of Canada over the 1980s and 1990s. n The revisions to section 1540 brought Canada’s recommended approach into line with that recommended by the International Accounting Standards Committee in IAS 7. n The AcSB’s change to section 1540 was a move toward international harmonization, but it also was the final step toward a true cash flow statement instead of a broader and less focused reporting on balance sheet changes.

34. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Summary Of Key Points n The cash flow statement is one of the three major financial statements. It is structured to report cash flows in meaningful categories. n The basic objective of the cash flow statement is to reveal the cash inflows and outflows of the reporting period, segregated between cash flows from operating activities, cash flows related to investing activities, and cash flows relating to financing activities. In each category, cash flows includes both inflow and outflows. n Cash flow information is used to predict future cash flows and to assess liquidity, the ability of a firm to pay dividends and obligations, the ability of a firm to adapt to changes in the business environment, the quality of earnings, and for other purposes.

35. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Summary Of Key Points n The reporting basis for the cash flow statement is the net cash position. The net cash position includes cash and cash equivalents, and also includes overdraft accounts. n Cash equivalents includes all short-term liquid investments that are readily convertible into cash and that bear little risk of change in value. n The components of cash and cash equivalents should be disclosed and should be reconciled to the balance sheet.

36. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Summary Of Key Points n Operating flows are related to the main activities of the business and are connected to the earnings process. n Investing flows describe long-term asset acquisitions and the proceeds from sale of long-term assets. Interest and dividend income from investments must be disclosed separately. They may be reported either as a component of operations or as an investing activity. n Financing flows describe the sources of debt and equity financing and repayments of liabilities and equities, excluding liabilities directly relating to operations such as accounts payable. Interest paid on debt can be reported as a component of operations or as a financing activity, but separate disclosure is required.

37. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Summary Of Key Points n Dividend payments to shareholders may be reported either as a financing outflow or as a deduction from cash flow from operations, but must be disclosed. n Cash paid for income taxes should be disclosed as part of the operations section. n The direct method reports the cash inflows from the main classifications of revenues and cash outflows from the main classifications of expenses. In contrast, the indirect method reports operating activities by showing a reconciliation of net income before extraordinary items and discontinued operations with net cash flow from operating activities. Companies are ‘encouraged’ to use the direct method.

38. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Summary Of Key Points n The operating activity sections of both the direct and indirect cash flow statements convert accrual income to cash-basis income, the net cash flow from operations. The indirect method uses a series of add-backs to negate the effects of accruals and inter-period allocations, which can result in a confusing presentation. n In the investing and financing sections, gross cash flows are reported. Transactions are not netted against other flows in the same category. n Significant non-cash transactions (e.g., acquiring plant assets by issuing a long-term note) are not shown as outflows and inflows on the cash flow statement. However, they should be disclosed elsewhere in the financial statements, normally in a note.

39. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Summary Of Key Points n There are many approaches to preparing the cash flow statement. The same objectives apply to all – analyze transactions to identify all cash flows, reconciling items, and non-cash transactions. n The format-free approach to preparing the cash flow statement emphasizes transaction analysis and uses no particular format. Search for transactions in the following order: income statement, additional information, and comparative balance sheets. n The spreadsheet is an organized format allowing substantiation of the preparation process and provides many accuracy checks. Both the direct and indirect method cash flow statement may be developed with the same spreadsheet.

40. b a c kn e x t h o m e 5 Copyright  1998 McGraw-Hill Ryerson Limited, Canada Summary Of Key Points n The net cash flow is not affected by accounting policy choices or by management’s accounting estimates. However, the reported cash flow from operations can be increased by capitalizing certain types of costs (i.e., development costs or start-up costs), because the costs are reclassified as investing activities and amortization has no effect on operating cash flows in future periods. n Securities legislation requires that a cash flow statement be included as one of public companies’ quarterly reports to shareholders, along with interim income statements.