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Chapter 12: Chapter 12: Statement of Cash FlowsStatement of Cash Flows

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General Information on SCFGeneral Information on SCF

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 year.

Serves to complement the other financial statements.

Focus is on cash flows, not income.Reconciles the balance sheet and the

income statement.

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Content of Statement of Cash FlowsContent of Statement of Cash FlowsExplains 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 commercial paper (short-term notes issued by corporations) and money market funds.

Format of SCF includes the following three sections:A. Cash flow from operating activities.B. Cash flow from investing activities.C. Cash flow from financing activities.

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A. Cash Flows from Operating ActivitiesA. Cash Flows from Operating ActivitiesCF from operating activities is based on

the income statement, and converts income activity to a cash basis in its presentation.

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.

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Cash Flows from Operating ActivitiesCash Flows from Operating ActivitiesIf 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.

Our coverage of Chapter 12 will focus only on the indirect method.

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B. Cash Flows from Investing ActivitiesB. 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, investments, intangible assets, and most other long term assets.

– cash received from sale of equipment, land, buildings, investments, intangible assets, and most other long term assets.

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C. Cash Flows from Financing ActivitiesC. 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.

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Cash Flows from Financing ActivitiesCash 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?

FASB chose to leave income related items (int. revenue, int. expense, div. income) in the operating section, rather than reclassify.

However, dividends declared has nothing to do with net income, and must be classified with financing.

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A. CF from Operations (indirect method):A. CF from Operations (indirect method):Specific CalculationsSpecific Calculations

To understand the adjustments to get from net income to CF from operations, we will classify the adjustments into 3 categories:(1) Noncash items.(2) Double counted gains and losses.(3) Change in related (accrual basis) assets and liabilities

Remember: net income includes many activities that are noncash, or only partly cash.

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(1) Indirect Method - Noncash Items(1) Indirect Method - Noncash ItemsNoncash activities include

-Depreciation expense. For example: Depreciation Expense xx

Accumulated Depreciation xx -Amortization expense on intangible assets such as

patents. Amortization Expense xx

Patent xx-Bad debt expense on the estimation of

uncollectibles: Bad Debt Expense xx

Allowance for Doubtful Accts. xxSince 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.

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(2)Indirect Method - Double Counted Items(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:

Cash 10,000

Land 9,000Gain on Sale of Land 1,000

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.

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(2)Indirect Method - Double Counted Items(2)Indirect Method - Double Counted Items

Therefore, any gains or losses from sale of investing (nonoperating) 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.

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(3) Indirect Method - (3) Indirect Method - Change in Related Assets and LiabilitiesChange 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.

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(3) Indirect Method -(3) Indirect Method - Change in Related Assets and Liabilities Change in Related Assets and Liabilities

Example: Sales = 100,000, and change in A/R from 2,000 to 3,000 or 1,000 increase .

A/RB + Sales - A/RE = Cash Collections2,000 + 100,000 - 3,000 = Cash Collections

99,000 = Cash CollectionsNote 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.

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(3) Indirect Method -(3) Indirect Method - Change in Related Assets and Liabilities Change in Related Assets and LiabilitiesThis 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.

Mnemonic to help you remember: AOLSAssets Opposite, Liabilities Same

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(3) Indirect Method -(3) Indirect Method - Change in Related Assets and Liabilities Change in Related Assets and 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.).

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(3) Indirect Method -(3) Indirect Method - Change in Related Assets and Liabilities Change in Related Assets and Liabilities

(primarily current assets and liabilities)(primarily current assets and liabilities)Examples of related assets are:

Accounts Receivable.Interest Receivable.Inventories. Prepaid Expenses.

Examples of related liabilities include:Accounts Payable.Interest Payable.Wages Payable.Income Tax Payable.Other Current Liabilities.Unearned Revenues.

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Additional Issues - SCFAdditional Issues - SCFThe FASB requires that significant noncash

investing and financing activities be disclosed in a note or supplementary schedule to the SCF.

Examples of significant noncash investing and financing activities include:– conversion of bonds or preferred stock to

common stock.– purchase of assets with issue of stock.– purchase of assets with debt.– declaration (but not payment) of cash

dividend.