1. COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Statement of Cash Flows and Articulation Chapter 5 S t I c e | S t I c e | S k o u s e n Intermediate Accounting 16E Prepared by: Sarita Sheth | Santa Monica College

2. Learning Objectives 1.Describe the circumstances in which the cash flow statement is a particularly important companion of the income statement. 2.Outline the structure of and information reported in the three main categories of the cash flow statement: operating, investing, and financing.

3. Learning Objectives (cont.) 3.Compute cash flow from operations using either the direct or the indirect method. 4.Prepare a complete statement of cash flows and provide the required supplemental disclosures. 5.Assess a firm’s financial strength by analyzing the relationships among cash flows from operating, investing, and financing activities and by computing financial ratios.

4. Learning Objectives (cont.) 6.Demonstrate how the three primary financial statements tie together, or articulate, in a unified framework. 7.Use knowledge of how the three primary financial statements tie together to prepare a forecasted statement of cash flows.

5. Why Do We Need the Cash Flow Statement? It explains the change during the period on cash and cash equivalents. Sometimes earnings fail. Everything is on one page. It is used as a forecasting tool.

6. Cash Equivalents To qualify as a cash equivalent: 1.The item must be readily convertible to cash. 2.It must be so near to its maturity that there is insignificant risk of change in value due to changes in interest rate.

7. Cash Flow Activities Operating Activities -Transactions and events that enter into the determination of net income. Investing Activities -Transactions and events that involve the purchase and sale of securities, property, plant, equipment, and other assets not generally held for resale, and the making and collecting of loans. Financing Activities -Transactions and events whereby resources are obtained from or repaid to owners and creditors.

8. Cash Flow Pattern The normal pattern of positive inflows or negative outflows of cash reported are as follows: –Cash from operating activities, + –Cash from investing activities, − –Cash from financing activities, + or −

9. Noncash Transactions There are investing and financing activities that do not affect cash. Significant transactions should be disclosed separately. These transactions do not affect the statement of cash flows.

10. Operating Activities Section Simple concept: difference between cash received and cash disbursed. Two methods to report operating activities: – Direct Method- shows cash receipts and payments for a period of time. This method is more straight forward. – Indirect Method- involves reconciling net income to a cash basis. It shows how noncash flows affect net income.

11. Direct Method This method reports directly the major classes of operating cash receipts and payments of an entity during a period. Accrual basis revenues and expenses must be converted to equivalent cash receipts and payments. The amount of cash actually collected or paid is determined.

12. Indirect Method Adjustments for receivables and other current operating assets. Adjustments for payables and other current liabilities. Adjustments for depreciation and other noncash items. Adjustments for gains and losses. The indirect method makes the following adjustments:

13. Operating Activities Cash Inflow Cash receipt of sales Collection of receivables Interest revenue Dividend revenue Cash Inflow Cash receipt of sales Collection of receivables Interest revenue Dividend revenue Cash Outflow Inventory paymentsInventory payments Interest paymentsInterest payments WagesWages UtilitiesUtilities RentRent Cash Outflow Inventory paymentsInventory payments Interest paymentsInterest payments WagesWages UtilitiesUtilities RentRent

14. Investing Activities Cash Inflow Sale of plant assets Sale of securities, other than trading securities Collection of principal on loans Cash Inflow Sale of plant assets Sale of securities, other than trading securities Collection of principal on loans Cash Outflow Purchase of plant assets Purchase of securities, other than trading securities Making of loans with other entities Cash Outflow Purchase of plant assets Purchase of securities, other than trading securities Making of loans with other entities

15. Financing Activities Cash Inflow Issuance of own stock Borrowings Cash Inflow Issuance of own stock Borrowings Cash Outflow Dividend payments Repaying principal on borrowing Treasury Stock purchase Cash Outflow Dividend payments Repaying principal on borrowing Treasury Stock purchase

16. General Format of a Cash Flow Statement Cash Provided by (Used for): Operating Activities$XXX Investing Activities XXX Financing Activities XXX Net Increase (Decrease) in Cash $XXX Cash—Beginning of Year XXX Cash—End of Year $XXX

17. Six Step Process to Prepare a Cash Flow Statement 1.Compute how much the cash balance changed during the year. 2.Convert the income statement from an accrual-basis to a cash-basis summary of operations. a.Eliminate expenses that do not involve the outflow of cash, such as depreciation. b.Eliminate gains and losses associated with investing or financing activities. c.Adjust for changes in the balances of current assets and current liabilities.

18. Six Step Process to Prepare a Cash Flow Statement 3.Analyze the long-term assets to identify the cash flow effects of investing activities. 4.Analyze the long-term debt and stockholders’ equity account to determine the cash flow effects of any financing transactions. 5.Make sure that the total new cash flow from operating, investing, and financing activities is equal to the net increase or decrease in cash as computed in Step 1, then prepare a formal statement. 6.Prepare supplement disclosure of significant noncash transactions.

19. In 1987, the United States led the world concerning the statement of cash flows by issuing SFAS No. 95. International Cash Flow Statements

20. In 1991, the United Kingdom issued FRS 1. It specified eight categories for classifying cash flows. Operating activities Returns on investments and servicing of finance Taxation Capital expenditures and financial investment Acquisition and disposal Equity dividend paid Management of liquid resources Financing International Cash Flow Statements

21. Cash flow-to-net income Cash from operations Net income Measure of earnings quality Tends to be greater than 1 Should remain fairly stable for the years for a specific company Assessing Financial Strength

22. Cash flow adequacy Cash from operations Net income Measures relationship between investment spending and cash generated by operations Indicate a company’s attitude towards reinvestment in long-lived production assets When ratio is small it indicates that cash flows from operations fall short of funding growth Assessing Financial Strength

23. Cash times interest earned Cash from operations + Interest paid + Taxes paid Interest expense Measures ability to service debt Generally, a higher ratio indicates more solvency Assessing Financial Strength

24. Six Steps 1.Compute the change in cash. 2.Convert the income statement from an accrual to cash basis. 3.Analyze the long-term asset accounts. 4.Analyze the long-term debt and stockholders’ equity. 5.Prepare the forecasted statement of cash flows. 6.Disclose noncash activities. Forecasted Statement of Cash Flows