The objective of financial reporting is to provide investors and creditors with useful information, primarily in the form of financial statements. The balance sheet and the income statement - the focus of your study in earlier chapters - do not provide all the information needed by these decision makers. Here you will learn how the statement of cash flows fills the information gap left by the other financial statements.
21 Chapter 21 THE STATEMENT OF CASH FLOWS REVISITED © 2013 The McGraw-Hill Companies, Inc CASH INFLOWS Operating Activities Cash received from revenues Investing Activities Financing Activities Sale of property, plant, and Issuance of shares equipment, and intangible assets Issuance of bonds Sale of investments and notes Collections of loans Business Cash paid for expenses Purchase of property, plant, and Payment of dividends equipment, and intangible assets Repurchase of shares Purchase of investments Repayment of debt Loans to others CASH OUTFLOWS 21 - Role of the Statement of Cash Flows Helps Helps users users assess assess aa firm’s firm’s ability ability to to generate generate cash cash aa firm’s firm’s ability ability to to meet meet its its obligations obligations the the reasons reasons for for differences differences between between income income and and associated associated cash cash flows flows the the effect effect of of cash cash and and noncash noncash investing investing and and financing financing activities activities on on aa firm’s firm’s financial financial position position 21 - Role of the Statement of Cash Flows Lists all cash inflows and all cash outflows by category: Operating, Investing, and Financing Explains the change in cash during the period Required by IFRS 21 - Cash is King! Especially during an economic downturn Cash and Cash Equivalents Resources immediately available to pay obligations 21 - • Short-term, highly liquid investments • Readily converted into cash, with little or no risk of loss • Examples: money market funds, Treasury bills • Maturity date must not be longer than months from date of purchase Primary Elements of the Statement of Cash Flows Operating Activities Investing Activities Financing Activities 21 - Reconciliation of the Net Increase or Decrease in Cash with the Change in the Balance of the Cash Accounts Significant Noncash Investing and Financing Activities are disclosed in the notes to the financial statements Primary Elements of the Statement of Cash Flows 21 - Operating Activities Reports the cash effects of the elements of net income Investing Activities Reports the cash effects of the acquisition and disposition of assets (other than inventory and cash equivalents) Financing Activities Reports the cash effects of the sale or repurchase of shares, and the issuance or repayment of debt securities Cash Flows from Operating Activities Inflows from: customers interest and dividends received from investments + Outflows to: 21 - suppliers of goods salaries and wages interest on debt income taxes dividends paid _ Cash Flows from Operating Activities Direct Method or Indirect Method of Reporting Cash Flows from Operating Activities Two Formats for Reporting Operating Activities Direct Method Indirect Method Reports the cash effects of each operating activity Starts with accrual net income and converts to cash basis Note that no matter which format is used, the same amount of net cash flows operating activities is generated 21 - Direct Method Under the direct method, the cash effect of each operating activity is reported directly in the statement 21 - 10 UNITED BRANDS CORPORATION Spreadsheet for the Statement of Cash Flows Changes Dec 31, Dec 31, 2012 Debits Credits 2013 Balance Sheet Assets: Cash Accounts receivable Short-term investments Inventory Prepaid insurance Land Buildings and equipment Less: Accumulated depreciation Liabilities: Accounts payable Salaries payable Income tax payable Notes payable Bonds payable Less: Discount on bonds payable 20 30 (1) (12) 50 60 75 (20) 221 12 20 50 (3) 29 32 12 46 80 81 (16) 267 26 20 35 (1) Shareholders' Equity: Ordinary share capital Short-term 100 Investments Beg bal 20 Share premium Purchases 12 Retained earnings End bal 12 25 221 21 - 25 130 29 19 267 The $12 million increase in the Short-term Investments account is due to the purchase of short-term investments during the year Note that in the textbook, entry number 12 illustrates the analysis of the Short-term Investments account Changes Dec 31, 2012 Statement of Cash Flows Operating Activities: Cash Inflows: From customers Dec 31, Credits 2013 Debits (1) 98 Investing Activities: Purchase of S-T investments Short-term Investments Beg bal Purchases 12 End bal 12 Financing Activities: 21 - 26 (12) 12 The final part of this entry is a $12 million entry on the Statement of Cash Flows under Investing Activities UNITED BRANDS CORPORATION Spreadsheet for the Statement of Cash Flows Changes Dec 31, Dec 31, 2012 Debits Credits 2013 Balance Sheet Assets: Cash Accounts receivable Short-term investments Inventory Prepaid insurance Land Buildings and equipment Less: Accumulated depreciation 20 30 (1) (12) 50 60 75 (14) (20) 221 Liabilities: Accounts payable Salaries payable Income tax payable Notes payable Bonds payable Less: Discount on bonds payable 20 50 (3) Shareholders' Equity: Ordinary share capital 100 29 32 12 46 80 81 (16) 267 12 20 x (14) 20x 26 20 35 (1) 130 Share premium 20 29 Retained earnings 25 221 21 - 27 19 267 In entry number 14, we find that a note payable was issued as payment for a building Investing in a new building is a significant investing activity and financing the acquisition with long-term debt is a significant financing activity UNITED BRANDS CORPORATION Spreadsheet for the Statement of Cash Flows Changes Dec 31, 2012 Debits Credits Balance Sheet Assets: Cash Accounts receivable Short-term investments Inventory Prepaid insurance Land Buildings and equipment Less: Accumulated depreciation 20 30 50 60 75 (20) 221 (19) (1) (12) 12 (13) (14) (9) (4) (8) 30 (3) 20x (9) (6) 10 14 (4) (5) (14) 20 x (7) (16) (17) (16) (17) 10 20 13 (11) 12 Liabilities: Accounts payable Salaries payable Income tax payable Notes payable Bonds payable Less: Discount on bonds payable 20 (10) 50 (15) (3) Shareholders' Equity: Ordinary share capital 100 Share premium Retained earnings 21 - 28 20 25 (16) (18) 221 15 Dec 31, 2013 29 32 12 46 80 81 (16) 267 26 20 35 (1) 130 29 19 267 After entering all the transactions, this is what the statement of financial position portion of the spreadsheet looks like Changes Dec 31, 2012 Debits Income Statement Revenues: Sales revenue Investment revenue Gain on sale of land Expenses: Cost of good sold Salaries expense Depreciation expense Bond interest expense Insurance expense Loss on sale of equipment Income tax expense Net income Dec 31, Credits 2013 (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) 100 60 13 12 After entering all the transactions, this is what the income statement portion of the spreadsheet looks like 21 - 29 100 (60) (13) (3) (5) (7) (2) (9) 12 Changes Dec 31, 2012 Statement of Cash Flows Operating Activities: Cash Inflows: From customers From investment revenue Cash Outflows: To suppliers of goods To employees To bondholders For insurance expense For income taxes Net cash flows Investing Activities: Sale of land Sale of equipment Purchase of S-T investments Purchase of land Net cash flows Financing Activities: Retirement of bonds payable Issuance of ordinary shares Payment of cash dividends Net cash flows Net increase in cash Totals 21 - 30 Dec 31, Credits 2013 Debits (1) (2) 98 (4) (5) (7) (8) (10) 50 11 11 22 (3) (9) 18 (12) (13) 12 30 (19) (17) (15) 15 (18) 26 (19) 376 376 After entering all the transactions, this is what the statement of cash flows portion of the spreadsheet looks like Here is the Statement of Cash Flows prepared using the direct method 21 - 31 UNITED BRANDS CORPORATION Statement of Cash Flows For the Year Ended December 31, 2013 ($ in millions) Cash Flows from Operating Activities: Cash Inflows: From customers $ 98 From investment revenue Cash Outflows: To suppliers of goods (50) To employees (11) To bondholders (3) For insurance expense (4) For income taxes (11) Net cash flows from operating activities $ Cash Flows from Investing Activities: Sale of land (30) Sale of equipment (12) Purchase of S-T investments 18 Purchase of land Net cash flows from investing activities Cash Flows from Financing Activities: Retirement of bonds payable 26 Issuance of ordinary shares (15) Payment of cash dividends (5) Net cash flows from financing activities Net increase in cash Cash balance, January Cash balance, December 31 $ 22 (19) 20 29 Preparing an SCF: The Indirect Method Getting There through the Back Door Net Income Adjustments for noncash effects: Gain on sale of land Depreciation expense Loss on sale of equipment Changes in operating assets and liabilities: Increase in accounts receivable Decrease in inventory Increase in accounts payable Increase in salaries payable Discount on bonds payable Decrease in prepaid insurance Decrease in income tax payable Net cash flows from operating activities 21 - 32 $ 12 (8) $ (2) 2 (2) 22 The indirect method derives the net cash increases or decreases from operating activities indirectly by starting with reported net income and “working backwards” to convert that amount to a cash basis Components of Net Income that Do Not Increase or Decrease Cash Depreciation Expense Loss on Sale of Equipment Gain on Sale of Land 21 - 33 Adding these items back to net income restores net income to what it would have been had depreciation and the loss not been subtracted at all Subtracting the gain reverses the effect of the gain having been added to net income Components of Net Income that Do Increase or Decrease Cash For components of net income that increase or decrease cash, but by an amount different from that reported on the income statement, net income is adjusted for changes in the balances of related statement of financial position accounts to convert the effects of those items to a cash basis Note: Cash and cash equivalents, short-term investments in securities available for sale, and short-term payables to financial institutions are excluded from this category 21 - 34 Comparison with the Direct Method 21 - 35 Appendix 21A: Spreadsheet for the Indirect Method A spreadsheet is equally useful in preparing a statement of cash flows whether we use the direct or the indirect method of determining cash flows from operating activities 21 - 36 Appendix 21B: The T-Account Method of Preparing the Statement of Cash Flows The T-Account method serves the same purpose as a spreadsheet in assisting in the preparation of a statement of Cash Flows 21 - 37 Appendix 21B: The T-Account Method of Preparing the Statement of Cash Flows 21 - 38 Draw a T-account for each income statement and statement of financial position account The T-account for cash should be drawn considerably larger Enter each account’s net change on the appropriate side (debit or credit) of the uppermost portion of each Taccount Reconstruct the transactions that caused changes in each account balance during the year and record the entries for those transactions directly in the T-accounts After all account balances have been explained by Taccount entries, prepare the statement of cash flows from the cash T-account, being careful also to report noncash investing and financing activities End of Chapter 21 ... entering all the transactions, this is what the statement of cash flows portion of the spreadsheet looks like Here is the Statement of Cash Flows prepared using the direct method 21 - 31 UNITED... position 21 - Role of the Statement of Cash Flows Lists all cash inflows and all cash outflows by category: Operating, Investing, and Financing Explains the change in cash during the period Required... 21 - 26 (12) 12 The final part of this entry is a $12 million entry on the Statement of Cash Flows under Investing Activities UNITED BRANDS CORPORATION Spreadsheet for the Statement of Cash Flows