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Book 2: FSA
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What signals a high quality of earnings?
When CFO > net income
A firm’s earnings is being backed up by the cash being collected
What does each section of the cash flow statement relate to with respect to the balance sheet?
CFO ==> current assets and current liabilities
CFI ==> noncurrent assets
CFF ==> noncurrent liabilities and equity
Which section of the CFS is different in the two ways of recording the CFS?
the CFO
CFI and CFF are the same for both methods
Direct Method
shows only cash payments and cash receipts over the period
Steps for Direct Method
1.) Start with revenue
2.) Examine the balance sheet for any assets or liabilities relating to the income statement
3.) Compute the change in the balance sheet asset or liability
4.) Adjust the income statement for the change in the balance sheet
subtract an increase in an asset (use of cash) or add a decrease in an asset (source of cash)
add an increase in a liability (source of cash) or subtract a decrease in a liability (use of cash)
5.) Move to the next applicable item
6.) Ignore noncash charges
7.) Sum the amount to get CFO
In the example on the wall for Direct Method, what balance sheet adjustments needed to be made?
Cash collected from customers
Cash paid to suppliers
Wages paid
Interest paid
Cash paid to tax authorities
Cash collected from customers
Sales - increase in AR + increase in deferred rev = cash collected
Cash paid to suppliers
COGS + decrease in inv - increase in AP = cash paid to suppliers
Wages paid
wage expense - decrease in wages payable = cash paid to employees
Interest paid
interest expense + increase in interest payable = cash interest paid
Cash paid to tax authorities
tax expense + increase in taxes payable + increase in DTLs
Indirect Method Steps
1.) Begin with net income
2.) Adjustments
Add back all noncash charges
Subtract noncash components of revenue
Subtract gains and losses that resulted from financing or investing cash flows
3.) Adjust WC by adding or subtract changes to balance sheet operating accounts
Add back
Decreases in current operating assets
Increases in current operating liabilities
Subtract
Increases in current operating assets
Decreases in current operating liabilities
How do GAAP and IFRS differ in their preference toward Direct Method or Indirect Method?
US GAAP: prefers Direct Method but accepts Indirect Method. If using Indirect Method, there is a required disclosure of net income must be stated
IFRS: prefers Direct Method but accepts Indirect Method
CFI def
consists of CFs that result from acquiring or disposing of long-term assets and certain investments
CFF def
consists of CFs resulting from transactions affecting a firm’s capital structure
US GAAP Operating Activity Inflows
Cash collected from customers
Interest and dividend received from acquisition of debt and equity investments and loans made to others
Sale proceeds from trading securities
US GAAP Operating Activity Outflows
Cash paid to employees
Cash paid for other expenses
Acquisition of trading securities
Interest paid on debt or leases
Taxes paid
US GAAP Investing Activity Inflows
Sale proceeds from PP&E and intangibles
Sale proceeds from debt and equity investments
Principal received from loans made to others
US GAAP Investing Activity Outflows
Acquisition of PP&E and other intangibles
Acquisition of debt and equity investments
Loans made to others
US GAAP Financing Activity Inflows
Principal amounts of debt issued
Proceeds from issuing stock
US GAAP Financing Activity Outflows
Principal paid on debt or leases
Payments to reacquire stock
Dividends paid to shareholders
Counterintuitive classification examples from the US GAAP CFS classification standards
1.) Debt and equity investments (other than trading securities) and loans made to others are reported as Investing Cash Outflows whereas the income from these investments (interest and dividends received) are reported under Operating Inflows
2.) Principal amounts borrowed are reported as Financing Inflows whereas interest paid is an Operating Outflow
3.) Trading securities are the exception to all equity and debt investments that are bought and sold and are considered to be Operating Cash Flows, not Investing Cash Flows
Differences Between US GAAP and IFRS CFS Reporting: Interest Received
US GAAP: CFO
IFRS: CFO or CFI
Differences Between US GAAP and IFRS CFS Reporting: Interest Paid
US GAAP: CFO
IFRS: CFO or CFF
Differences Between US GAAP and IFRS CFS Reporting: Dividends Received
US GAAP: CFO
IFRS: CFO or CFI
Differences Between US GAAP and IFRS CFS Reporting: Dividends Paid
US GAAP: CFF
IFRS: CFO or CFF
Differences Between US GAAP and IFRS CFS Reporting: Bank overdrafts
US GAAP: treated as a balance sheet debt
IFRS: treated as balance sheet cash
Differences Between US GAAP and IFRS CFS Reporting: Taxes
US GAAP: CFO
IFRS: Either CFO, CFI, or CFF; depends on what it is being soldDifferences Between US GAAP and IFRS CFS Reporting: Interest Received
Steps to go from Indirect Method to Direct Method
1.) Aggregate all revenues and gains and all expenses and losses
2.) Remove all noncash charges and disaggregate the remaining items
3.) Convert from accruals to cash flows by adjusting for the change in working capital