Chapter 16: Reporting the Statement of Cash Flows Study Guide

Purpose and Importance of the Statement of Cash Flows

The Statement of Cash Flows provides critical information about a company's cash receipts and cash payments during a period. It answers several fundamental questions:

• How does a company receive its cash?

• What explains the change in the cash balance?

• Why do income and cash flows differ?

• Where does a company spend its cash?

Business Significance

• Creditors and Investors: Use the statement to decide if a company has enough cash to pay its debts and to evaluate its ability to pursue new opportunities.

• Managers: Use cash flow data to plan day-to-day operations and make long-term investment decisions.

Measurement and Classification of Cash Flows

Cash and Cash Equivalents

The statement measures the flow of both cash and cash equivalents. To be considered a cash equivalent, an item must meet two specific criteria:

1. Be readily convertible into cash.

2. Be sufficiently close to maturity so the market value is unaffected by interest rate changes.

The Three Classifications

1. Operating Activities: Activities that determine net income. These involve the production and delivery of goods and services.

2. Investing Activities: Activities related to the purchase and sale of long-term assets and other investments (excluding cash equivalents).

3. Financing Activities: Activities related to obtaining resources from owners and providing them with a return on their investment, as well as obtaining resources from creditors and repaying the amounts borrowed (long-term liabilities and equity).

Detailed Classification of Cash Inflows and Outflows

Operating Activities

• Cash Inflows:

  • From cash sales to customers.

  • From collections on credit sales.

  • From receipt of interest revenue.

  • From receipt of dividend revenue.

• Cash Outflows:

  • To pay operating expenses.

  • To pay salaries and wages.

  • To pay taxes.

  • To pay interest owed.

  • To pay suppliers for goods and services.

Investing Activities

• Cash Inflows:

  • From selling plant assets (Property, Plant, and Equipment).

  • From selling investments (in securities).

  • From selling intangible assets.

  • From collecting principal on notes receivable.

• Cash Outflows:

  • To buy plant assets.

  • To buy investments.

  • To buy intangible assets.

  • To loan money in return for notes receivable.

Financing Activities

• Cash Inflows:

  • From contributions by owners (shareholders).

  • From issuing common and preferred stock.

  • From issuing long-term debt (notes payable and bonds payable) or (borrowing funds).

  • From reissuing treasury stock.

• Cash Outflows:

  • To pay dividends to shareholders.

  • To pay off long-term debt (notes and bonds payable) or (loan).

  • To purchase treasury stock.

  • Withdrawals by owners.

Noncash Investing and Financing Activities

Companies must disclose significant activities that do not involve cash but affect the long-term asset, liability, or equity structure. These are reported in a separate schedule or note disclosure. Examples include:

• Retirement of debt by issuing equity stock.

• Conversion of preferred stock to common stock.

• Entering into a long-term lease of assets.

• Purchase of long-term assets by issuing a note or bond.

• Exchange of noncash assets for other noncash assets.

• Purchase of noncash assets by issuing equity or debt.

Preparing the Statement of Cash Flows: The Indirect Method

Information Sources

1. Comparative Balance Sheets: Used to calculate changes in assets, liabilities, and equity from the beginning to the end of the period.

2. Current Income Statement: Used to identify net income and items not affecting cash (like depreciation).

3. Additional Information: Details on specific transactions like asset sales or debt retirement.

Adjustment Logic for Operating Activities (Indirect Method)

The indirect method starts with Net Income and adjusts for items that did not affect cash.

1. Adjustments for Noncash Operating Items

• Add back to Net Income: Noncash expenses and losses (e.g., Depreciation, Depletion, Amortization; Losses on disposal of long-term assets; Losses on retirement of debt).

• Subtract from Net Income: Noncash revenues and gains (e.g., Gains on disposal of long-term assets; Gains on retirement of debt).

2. Adjustments for Changes in Current Assets and Liabilities

Genesis Case Study (Illustration)

Financial Data for 2027

• Net Income: $38,000$

• Depreciation Expense: $24,000$

• Loss on Sale of Equipment: $6,000$

• Gain on Retirement of Bonds: $16,000$

Changes in Current Accounts

• Increase in Accounts Receivable: $(20,000)$

• Increase in Inventory: $(14,000)$

• Increase in Prepaid Expenses: $(2,000)$

• Decrease in Accounts Payable: $(5,000)$

• Decrease in Interest Payable: $(1,000)$

• Increase in Income Taxes Payable: $10,000$

Operating Section Calculation

$\text{Net Income} = 38,000$ $\text{Depreciation} + 24,000$ $\text{Loss on Sale} + 6,000$ $\text{Gain on Retirement} - 16,000$ $\text{Increase in AR} - 20,000$ $\text{Increase in Inventory} - 14,000$ $\text{Increase in Prepaids} - 2,000$ $\text{Decrease in AP} - 5,000$ $\text{Decrease in Interest Payable} - 1,000$ $\text{Increase in Tax Payable} + 10,000$ Net Cash Provided by Operating Activities = $20,000$

Three-Step Analysis for Investing and Financing

For sections other than operating, a systematic three-step process is used:

1. Identify changes: Review comparative balance sheets for variations in long-term accounts.

2. Determine cash effects: Use T-accounts and reconstructed journal entries to isolate the cash component.

3. Report: Place the cash effect in the appropriate section of the statement.

Investing Analysis Examples

• Sale of Equipment: Equipment costing $20,000$ with $12,000$ accumulated depreciation (book value $8,000$) was sold for $2,000$.

  • Cash Effect: $2,000$ inflow from investing.

  • Operating Adjustment: The $6,000$ loss is added back to net income.

• Noncash Purchase: Land purchased for $60,000$ by issuing a note payable.

  • Reporting: Disclosed only in the noncash activities section.

Financing Analysis Examples

• Bond Retirement: Bonds with a book value of $34,000$ retired for $18,000$.

  • Cash Effect: $(18,000)$ outflow from financing.

  • Operating Adjustment: The $16,000$ gain is subtracted from net income.

• Stock Issuance: $3,000$ shares of $5$ par value stock issued for $15,000$ cash.

  • Cash Effect: $15,000$ inflow from financing.

• Dividends: $14,000$ cash dividends declared and paid.

  • Cash Effect: $(14,000)$ outflow from financing.

Final Proof of Cash Balance

Based on Genesis data:

• Net cash provided by Operating: $20,000$

• Net cash provided by Investing: $2,000$

• Net cash used in Financing: $(17,000)$

• Net increase in cash: $5,000$

• Cash balance at prior year-end: $12,000$

• Cash balance at current year-end: $17,000$

Analytical Ratio: Cash Flow on Total Assets

This ratio measures a company's ability to meet obligations, pay dividends, expand operations, and obtain financing using its assets to generate operating cash.

Formula

$\text{Cash Flow on Total Assets} = \frac{\text{Operating Cash Flows}}{\text{Average Total Assets}}$

Industry Comparison Data

Nike:

• Current Year Cash Flow on Total Assets: $15.0\%$

• 1 Year Ago: $13.3\%$

• 2 Years Ago: $19.3\%$

lululemon:

• Current Year Cash Flow on Total Assets: $36.2\%$

• 1 Year Ago: $18.3\%$

• 2 Years Ago: $30.4\%$

Appendix 16B: Direct Method of Reporting Operating Cash Flows

The direct method reports major classes of operating cash receipts and payments.

Adjustment Logic for Direct Method

• Receipts from Customers: $\text{Sales Revenue} + \text{Decrease in Accounts Receivable}$ (or $- \text{Increase}$)

• Payments to Suppliers: $\text{Cost of Goods Sold} + \text{Increase in Inventory}$ (or $- \text{Decrease}$) $+ \text{Decrease in Accounts Payable}$ (or $- \text{Increase}$)

• Payments for Operations: $\text{Operating Expense} + \text{Increase in Prepaids}$ (or $- \text{Decrease}$) $+ \text{Decrease in Accrued Liabilities}$ (or $- \text{Increase}$)

• Payments for Interest: $\text{Interest Expense} + \text{Decrease in Interest Payable}$ (or $- \text{Increase}$)

• Payments for Taxes: $\text{Income Tax Expense} + \text{Decrease in Income Tax Payable}$ (or $- \text{Increase}$)