1. VII.1 Chapter 4 – Learning objectives 1. Understand why the use of the accrued accounts creates a need for a statement of cash flows. 2. Understand the various types of activities resulting in cash flows. 3. Prepare a statement of cash flows from the balances, income statement, and notes. 4. (Analysis a statement of cash flows). Copyright  2000 by Harcourt Inc. All rights reserved.

2. VII.2 Overview of the statement of cash flows Statement of cash flows:  Is a supplement for the financial accounting, explaining the “causes” of the changes in “funds” from opening to ending balance, typically the changes in liquid funds.  Classifies the “causes” of changes into operations, investment and financing activities.  Balances the accounting result of the year with cash flows from the operations. Copyright  2000 by Harcourt Inc. All rights reserved.

3. VII.3 1. Overview of the statement of cash flows  The rules for companies having shares quoted on the Københavns Fondsbørs require a ”financing analysis”  Accounting guidance No. 11 requires and deals with the statement of cash flows  Please note that we have many names for the things we love: Statement of cash flows=payment accounts =financial analyses= cash flow statement!  The term statement cash flows is (most often) used below:

4. VII.4 1.Overview of the statement of cash flows  Definitions according to the Accounting Standard No. 11:  Cash: Cash and deposits in banks at free disposal.  Cash (possible usage in statements of cash flows): Cash and short-term marketable securities with insignificant risk of changes market price.  Cash flows: payments of cash to and from the company.  Working capital (frequent usage when the subject is financial accounting): current assets minus short-term debt.

5. VII.5 2. Classification of statement of cash flows  1. Operations – payments derived from the company’s main activity and other activities which cannot be related to investment or financing activities ~ technically a residual (neither investment or financing activity) E.g.:  Payments received from sales of goods and services.  Payments received from royalties, fees, commissions and other revenues.  Payments made for suppliers of goods and services.  Payments made for staff. Copyright  2000 by Harcourt Inc. All rights reserved.

6. VII.6 2. Classification of statement of cash flows  2. Investment activity – payments derived from purchase and sale of all types of fixed assets: intangible, tangible, or financial fixed assets E. g.:  Payments made for purchase of tangible and intangible fixed assets.  Payments received from sale of tangible and intangible fixed assets.  Payments made for purchase or payments made from sale of shares or other securities, that are fixed financial assets

7. VII.7 2. Classification of statements of cash flows  3. Financing activity – payments derived from changes of amount of the composition of share capital or interest bearing loans in financial institutions E.g.:  Payments received on issue of shares.  Payments of dividends and capital repayments to shareholders or  Payments made when raising loans or issuing bonds.  Payments made for repayments of loans.

8. VII.8 Components in the cash flow accounts Cash received from sale of goods and services Cash received from sale of goods and services Cash paid for operating goods and services Cash paid for operating goods and services cash flow from operations cash flow from operations Operations -= Cash received from sales of investments and P,P,&E Cash received from sales of investments and P,P,&E Cash paid for ac- quisition of invest- ments and P,P,&E Cash paid for ac- quisition of invest- ments and P,P,&E cash flow from investing cash flow from investing Investing -= Cash received from issue of debt or capital stock Cash received from issue of debt or capital stock Cash paid for dividends and reacquisition of debt or capital stock Cash paid for dividends and reacquisition of debt or capital stock cash flow from financing cash flow from financing Financing -= Net change in cash for the period Net change in cash for the period = + - Figure 4.1 page 170 Copyright  2000 by Harcourt Inc. All rights reserved.

9. VII.9 4. Examples of the condition between the cash flows from operations, investing and financing A. New fast-growing company. No income yet, prepares for the future by investing in assets. B. Older than end A, but still a young company, profitable operations, still invests in assets and needs financing for it. C. Profitable operations, lower level of investment, repayments of the debt. D. Mature company with profitable operations, low level of investment, repayments of the debt. Copyright  2000 by Harcourt Inc. All rights reserved.

10. VII.10 3. Elaboration of statement of cash flows  Starting point:  A cash flow statement is derived from the the changes from the opening balance to the closing balance(=the changes in balance) and information about the income statement and notes. The changes are divided into gross movements in order to elucidate the changes which have a payment effect.  Of course, the cash flow statement can also be elaborated directly from the bookkeeping. Normally it will be much easier to use the change in balance as a starting point

11. VII.11 3. Elaboration of a statement of cash flows  A distinction is made between two methods of layout in relation to cash generated from operations (=the effect of operations):  1. Indirect presentation: Is based on the income statement, usually on the the net income for the year. The net income is corrected for items in the income statement, which have not resulted in payments received and made (e.g. depreciations, provisions etc.) and for for the changes in the net working capital of the accounting year, which have reduced/augmented the payments from operations relative to the net income  2. Direct presentation: Payments received and made for the operating activity are stated directly ~ Each item in the income statement is corrected one by one on the basis of cash movements  The indirect method is the must applied method in practice.

12. VII.12 3. Elaboration of a statement of cash flows  The well-known balance equation forms the basis of the statement of cash flows, cf.: Assets = liabilities + shareholders’ equity or A = L + SE Assets or either liquid funds (C) or non-liquid funds (N$A) C + N$A = L + SE  C +  N$A =  L +  SE (  = the change in the balance). On the basis of the basic balance equation the equation for statements of cash flows appears as follows:  C =  L +  SE -  N$A

13. VII.13 3. Elaboration of a statement of cash flows  The change in liquid funds is explained by movements in the other items.  It is the essence in a statement of cash flows: We can identify the reasons why the liquid funds have changed by examining the changes of the non-cash-account.  The basic equation for the statement of cash flows can be applied on the basis of two different points of view (cf. text book):  1. The columnar work sheet  2. T-drafts

14. VII.14 3.1 The columnar work sheet  Cf. exhibit 4.4 page 176 in the textbook. The starting point is the changes in the balance. These changes are categorized into operational, financial or investment causes for the changes. As far as corrections are needed, these are made (e.g. sales of fixed assets) Then the figures are booked in the final statement of cash flows, cf. exhibit 4.5/4.7 on page 180 and 182.  Good method in relatively simple situations with few transactions.  Gives an understanding of the idea behind statements of cash flows.  In situations with many and complex transactions the T-drafts are better. Copyright  2000 by Harcourt Inc. All rights reserved.

15. VII.15 Changes in the balance If assets increased, then cash was spent, so cash is an outflow. If assets increased, then cash was spent, so cash is an outflow. If assets decreased, then they provided cash so cash is an inflow. If assets decreased, then they provided cash so cash is an inflow. If liab. or O.E. increased, then cash was obtained, so cash is an inflow. If liab. or O.E. increased, then cash was obtained, so cash is an inflow. If liab. or O.E. decreased, then cash was spent, so cash is an outflow. If liab. or O.E. decreased, then cash was spent, so cash is an outflow. Assets: Liabilities and Shareholders’ equity IncreaseDecrease Copyright  2000 by Harcourt Inc. All rights reserved.

16. VII.16 3. Elaboration of a statement of cash flows  The changes in balance items that are not accompanied by cash flows (e.g. depreciations, provision for deferred tax, allowances for uncollectible accounts) are reversed in order to isolate the cash flow parts of changes in the items  Remember: Items are included in the income statement by using the accrual accounting, where no attention is paid to cash flows. (Accrual: Revenues and costs are included in the income statement in the period in question, not in the period where they are paid). Copyright  2000 by Harcourt Inc. All rights reserved.

17. VII.17 3. Elaboration of a statement of cash flows  2. T-drafts: Cf. exhibit 4.9 page 184 in the textbook. The changes of the balance are shown as T-drafts. A general account is made, liquid funds, which are divided into operations, investment and financing. Here the changes in cash are extracted from all accounts and sorted in reasons for those cash flows.  An useful method when having many and complex transactions, if e.g. a transaction can be referred to more than one of the 3 activities.

18. VII.18 T-drafts Cash beginning balance Operations Investing Financing ending balance Various Balance Sheet Accounts beginning balance ending balance nnnnnn 1. adjustments are made to all balance sheet accounts to bring the beginning balance to the ending balance. 2. these are offset by an opposite entry in the cash account. 3. this part of the cash account becomes the cash flow statement. Copyright  2000 by Harcourt Inc. All rights reserved.

19. VII.19 3. Sale of fixed assets  Sale of fixed assets complicates the elaboration of a statement of cash flows on the basis of the change of balance.  The following entries are made in connection with the sale of an asset. Payment nnnn Accumulated depreciations nnnn The asset nnnn Profit/loss nnnn Copyright  2000 by Harcourt Inc. All rights reserved.

20. VII.20 3. Sale of fixed assets  Every single entry of the four entries requires a correction in relation to the statement of cash flows.  Payments received for the asset sold is the only cash generated by the transaction and it shall be included in cash flows from the investment/disinvestment activity.  Neither the debit on accumulated depreciations account nor the credit on the asset account reflect any cash flow, but the difference between the credit and the debit reflect the net book value of the asset sold. AND this net book value plus the profit/loss from the sale reflects the sales price and thus the cash flow to be included as cash flow from disinvestment.  Profit/loss is eliminated from the net result from operations – since it neither by itself a cash flow or caused by operations. Copyright  2000 by Harcourt Inc. All rights reserved.

21. VII.21 Chosen procedure - statement of cash flows The procedure, which is chosen for the layout of the statement of cash flows in the note on cash flow statement is a hybrid between the columnar list method and the T-draft method: A columnar list is applied for the changes in the balance sheet, and all net changes are expanded into the underlying types of gross changes and sorted into two columns, i.e.+assets/-liabilities and - assets/+liabilities. All the movements are then marked ”D”, ”I”, ”F” or ”0”. These marks are used when making the statement of cash flows.

22. VII.22 Review of examples, cf. the note concerning statements of cash flows  Starting point -> The change in each balance sheet item  The net change in each items is expanded into the types of gross changes behind the net change. This is done in order to to identify that part of the net change which is related to cash flows.  The expanding into the gross changes will typically be especially relevant for the following accounting items:  Fixed assets: Purchase, sales depreciation, write-downs and revaluations.  Debt: New loans raised, repayments of debts  Owners´ equity: Net result, share capital issued, dividends paid out, revaluations

23. VII.23 Review of examples, cf. the note concerning statements of cash flows  Cf. the example on page 3 in the note.  Please note, that the change from beginning to end is divided into two columns:  +asset/-liability -> a payment reflects a cash outflow  -asset/+liability -> a payment reflects a cash inflow For every change it is indicated if the change is related to a cash flow and and the underlying cause  Operations: D  investment: I  financing: F  It is not connected to cash flow: O

24. VII.24 Review of examples, cf. the note concerning statements of cash flows  In enclosure 1 of the note the changes in the balance sheet for the numerical example are accounted for. Please note the column used for stepwise controlling in order to make current control for errors.  The Danish tradition has been to make the “statement of cash flows” for either “the cash” or “the net current assets” (current assets less short-term debt) – in recent years only statements of cash flows are published.

25. VII.25 Sale of machinery and equipment Line 7 in exhibit 13.3, page 734. The company sells machinery and equipment at the price of DKK 180. The machinery and equipment has originally been purchased at the price of DKK 600. Totally DKK 450 has been depreciated, and the book value of the time of sale is therefore DKK 150.

26. VII.26 Deferred tax Line 5 in exhibit 13.3, page 734. The amount DKK 300 has been charged to income the income statement as tax of the result for the year. DKK 200 of this is tax payable (which is paid in the year), whereas DKK 100 is not paid, but increases deferred tax.

27. VII.27 Profit shares - the equity method Line 8 in exhibit 13.3, page 734. The company owns 40% of the capital in company A, which has obtained a result of DKK 1,200, of which only DKK 400 is distributed/paid in cash to the owners (including our company)

28. VII.28 Inventories Line 13 in exhibit 13.3, page 734. The inventories of the company have increased by DKK 850. Furthermore the accounts payable have increased by DKK 780. The cost of goods sold in the income statement is DKK 6.000.

29. VII.29 Spending of provisions for guarantees Line 14 in exhibit 13.3, page 734. The amount of DKK 920 has been charged to income in the income statement for the expected guarantee costs (for those products that have sold in the year). Guarantee works made on products sold in previous yearsi have entailed DKK 1,120 in cost, which is DKK 200 more than those guarantee expenses that is matched with sales for the year.