1. Powerpoint slides by: Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Michael L. Hockenstein  Commerce Department Vanier College Intermediate Accounting Thomas H. Beechy Schulich School of Business, York University Joan E. D. Conrod Faculty of Management Dalhousie University

2. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-2 Cash Flow Statement Chapter 5

3. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-3 Introduction  The cash flow statement reveals the operating cash flow of the company enables the user to reconcile the cash flows to net income  The cash flows of an enterprise are of prime importance to many users of the financial statements  The AcSB has identified cash flow prediction as a principal objective of financial reporting  The starting point of cash flow prediction is the analysis of historical cash flows

4. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-4 Evolution of the Cash Flow Statement  The cash flow statement has evolved over the past twenty years  The title of cash flow statement is fairly recent  In 1985, the AcSB substantially revised Section 1540 to eliminate the working capital approach and focus instead on cash flows  Previous historical analysis of long-term assets, long- term liabilities, and owners’ equities shifted to that of analyzing cash flows, regardless of the nature of the flows

5. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-5 Cash Flow Reporting  Cash versus accrual  Definition of cash  Classification of cash flows

6. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-6 Cash vs. Accrual  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  On the cash flow statement, the effects of both accruals and interperiod allocations (such as depreciation and amortization) are eliminated, leaving only the cash flows  Cash flow is not affected by accounting policy choice

7. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-7 Cash vs. Accrual (cont.)  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

8. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-8 Definition of Cash  For purposes of the cash flow statement, “cash” includes: cash on hand cash on deposit cash equivalents---highly liquid short-term investments  Investments in shares are explicitly excluded  In Canada, corporations often maintain lines of credit with their banks that may be used as a cash account to run a negative balance, or overdraft

9. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-9 Definition of Cash (cont.) “ 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”

10. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-10 Classification of Cash Flows  Operating activities: the principal 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

11. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-11 Classification of Cash Flows (cont.)  Investing activities: 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: 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

12. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-12 Exhibit 5-1

13. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-13 Exhibit 5-1 (cont.)

14. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-14 Exhibit 5-1 (cont.)

15. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-15 Exhibit 5-2

16. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-16 Exhibit 5-2 (cont.)

17. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-17 Preparing The Cash Flow Statement  Basic Approach to Preparation  Analyzing Cash Flow  Presentation of Operations  Offsetting Transactions  Non-Cash Transactions  Cash Flow per Share  Quality of Earnings  Effect of Accounting Policy Choices on the Cash Flow Statement  Summary of Disclosure Recommendations

18. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-18 Basic Approach to Preparation  The Balance Sheet, Income Statement, and Retained Earnings Statement are all prepared from the trial balance manually or, by computerized systems  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

19. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-19 Basic Approach to Preparation (cont.)  The cash flow statement is prepared by analyzing account balances and changes in balances  Standard computerized accounting systems normally cannot do that, therefore the cash flow statement is usually a hand-prepared statement

20. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-20 Exhibit 5-4

21. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-21 Presentation of Operations  Direct presentation: 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 (Exhibit 5-5)  Indirect presentation: Operations begin with net income, and all interperiod allocations and accruals are reversed out of net income to derive the cash from operations (Exhibit 5-4)

22. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-22 Exhibit 5-5

23. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-23 Offsetting Transactions  In the investing and financing sections, gross cash flows (gross cash receipts and gross cash payments) are reported separately  Transactions relating to similar items of asset or equity structure should not be netted

24. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-24 Non-Cash Transactions  Common types of non-cash transactions include: retiring bonds through share issuance converting bonds to shares converting preferred shares to common shares settling debt by transferring non-cash assets bond refinancing

25. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-25 Non-Cash Transactions (Cont.) incurring capital lease obligations in exchange for leased assets acquiring shares in another company in exchange for shares of the reporting enterprise distributing assets other than cash as dividends (e.g., a spin-off of a subsidiary company)

26. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-26 Cash Flow Per Share  Financial analysts and other users often compute cash flow per share, which is defined in many different ways  One common measure of cash flow per share is net operating cash flow divided by common shares outstanding  The CICA Handbook is silent on the issue, which allows Canadian companies to use their judgement in this area.

27. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-27 Quality of Earnings  Earnings quality: relates the amount of net income to the amount of cash flow from operations  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  A company that reports earnings that are not closely related to cash flows is said to have low quality earnings

28. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-28 Effect of Accounting Policy Choices on the Cash Flow Statement  One of the reasons that users like to see the cash flow statement is that “cash doesn’t lie”  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 decision whether to capitalize or expense an expenditure does affect the cash flow statement

29. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-29 Summary of Disclosure Recommendations  The CICA Handbook recommends the following disclosures: statement should report the changes in cash and cash equivalents, net of bank overdrafts, resulting from the activities of the enterprise during the period the components of cash, cash overdrafts, and cash equivalents should be disclosed and should be reconciled with the balance sheet.

30. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-30 Summary of Disclosure Recommendations (cont.) 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 cash flows during the period should be classified by operating, investing, and financing activities reporting enterprises are encouraged to report cash flows from operations by the direct method

31. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-31 Summary of Disclosure Recommendations (cont.) 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

32. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-32 Analyzing More Complex Situations  Using a Spreadsheet  Worksheet Procedure  Direct Presentation Method  Indirect Method  Summary of Reconciling Adjustments

33. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-33 Using a Spreadsheet  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 formally keeps track of the changes in balance sheet accounts and ensures that all accounts are explained

34. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-34 Summary of Reconciling Adjustments  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

35. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   5-35 Summary of Reconciling Adjustments (cont.) the effects of interperiod allocations of costs and revenues must be reversed certain transactions, the net effects of which are included in net income, must be reclassified as investing or financing activities