Financial Accounting

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Chapter 19Reporting and Analyzing Cash Flow
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In this chapter
Balance Sheet Balance Sheet Balance Sheet Balance Sheet Balance Sheet Balance Sheet Balance Sheet Balance Sheet Balance Sheet Balance Sheet Balance Sheet
Current Assets Cash Chapter 19 Chapter 19 Chapter 19 10000 Current Liabilities Accounts Payable 5000 5000
Accounts Receivable Accounts Receivable 20000 20000 Wages Payable 25000 25000 25000 25000
Notes Receivable Notes Receivable 15000 15000 Utilities Payable 2000 2000 2000 2000
Marketable Securities Marketable Securities 25000 25000 Long-Term Debt
Inventory Inventory 120000 120000 Notes Payable 20000 20000 20000 20000
Capital Assets Capital Assets Bonds Payable 600000 600000 600000 600000
Equipment Equipment 250000 250000 Owners Equity
Buildings Buildings 500000 500000 Common Stock 300000 300000 300000
Goodwill Goodwill 60000 60000 Retained Earnings 48000 48000 48000 48000
Total Assets Total Assets 1000000 1000000 Total Liabilities OE 1000000 1000000 1000000 1000000 1000000
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Purpose of the Cash Flow Statement

• Purpose is to report detailed info about the
  major cash receipts and cash payments during the
  period
• Generally there are 3 types of activities that
  generate or consume cash
• Operating
• Investing
• Financing
• Although one of the more complex statements, this
  Cash Flow Statement or the Statement of Changes
  in Financial Position (SCFP) is one of the most
  important statements

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Why is cash important?

• Cash is the grease that allows the company to
  move and articulate its resources to achieve
  goals
• Cash is needed to
• Pay debts
• Meet unexpected obligations
• Pursue unexpected opportunities
• Plan day-to-day operating activities
• Make long-term investment decisions
• The Statement of Changes in Financial Position
  (SCFP) can help answer
• How does the company obtain cash
• How does it spend cash
• What is the change in the cash balance

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Cash and Cash Equivalents

• Lets also remember that this statement needs to
  cover both cash and cash equivalents
• Cash Equivalents
• Assets that are readily convertible to a known
  amount of cash
• Significantly close to maturity (within roughly 3
  months) that its eventual cash value is
  determinable

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3 Types of Activities Operating

• Operating the principal revenue generating
  activities of the business
• Examples
• Production of goods and services for sale
• Purchase of raw materials and labour
• Admin expenses, taxes
• Collection of loan principal
• The above activities generate or consume cash as
  shown in Exhibit 19.1

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3 Types of Activities Operating
Balance Sheet Balance Sheet Balance Sheet Balance Sheet Balance Sheet Balance Sheet Balance Sheet Balance Sheet Balance Sheet Balance Sheet Balance Sheet
Current Assets Cash 10000 Current Liabilities Accounts Payable 5000 5000
Accounts Receivable Accounts Receivable 20000 20000 Wages Payable 25000 25000 25000 25000
Notes Receivable Notes Receivable 15000 15000 Utilities Payable 2000 2000 2000 2000
Marketable Securities Marketable Securities 25000 25000 Long-Term Debt
Inventory Inventory 120000 120000 Notes Payable 20000 20000 20000 20000
Capital Assets Capital Assets Bonds Payable 600000 600000 600000 600000
Equipment Equipment 250000 250000 Owners Equity
Buildings Buildings 500000 500000 Common Stock 300000 300000 300000
Goodwill Goodwill 60000 60000 Retained Earnings 48000 48000 48000 48000
Total Assets Total Assets 1000000 1000000 Total Liabilities OE 1000000 1000000 1000000 1000000 1000000
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3 Types of Activities Investing

• Investing these are activities that generally
  affect long-term assets
• As shown in Exhibit 19.2, investing activities
  typically involve
• Purchase or sale of capital assets
• Purchase or sale of investments, other than cash
  equivalents
• Lending and collecting on loans (long-term notes
  receivables that were created for activities
  other than operating activities)

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3 Types of Activities Investing
Balance Sheet Balance Sheet Balance Sheet Balance Sheet Balance Sheet Balance Sheet Balance Sheet Balance Sheet Balance Sheet Balance Sheet Balance Sheet
Current Assets Cash 10000 Current Liabilities Accounts Payable 5000 5000
Accounts Receivable Accounts Receivable 20000 20000 Wages Payable 25000 25000 25000 25000
Notes Receivable Notes Receivable 15000 15000 Utilities Payable 2000 2000 2000 2000
Marketable Securities Marketable Securities 25000 25000 Long-Term Debt
Inventory Inventory 120000 120000 Notes Payable 20000 20000 20000 20000
Capital Assets Capital Assets Bonds Payable 600000 600000 600000 600000
Equipment Equipment 250000 250000 Owners Equity
Buildings Buildings 500000 500000 Common Stock 300000 300000 300000
Goodwill Goodwill 60000 60000 Retained Earnings 48000 48000 48000 48000
Total Assets Total Assets 1000000 1000000 Total Liabilities OE 1000000 1000000 1000000 1000000 1000000
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3 Types of Activities Financing

• Financing these are activities that affect a
  company's owners and creditors
• Financing activities include
• Obtaining or disbursing cash as a result of debt
  incurred or debt paid off
• Obtaining cash from or distributing cash to
  owners
• Note
• Interest expense usually incurred to support the
  companys ability to generate revenue.
• Therefore it is deducted from revenue to get Net
  Income on the Income Statement. This is
  considered an Operating activity
• Accounts payable are also incurred to purchase
  raw materials
• Therefore, paying AP is considered Operating
  activities

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3 Types of Activities Financing
Balance Sheet Balance Sheet Balance Sheet Balance Sheet Balance Sheet Balance Sheet Balance Sheet Balance Sheet Balance Sheet Balance Sheet Balance Sheet
Current Assets Cash 10000 Current Liabilities Accounts Payable 5000 5000
Accounts Receivable Accounts Receivable 20000 20000 Wages Payable 25000 25000 25000 25000
Notes Receivable Notes Receivable 15000 15000 Utilities Payable 2000 2000 2000 2000
Marketable Securities Marketable Securities 25000 25000 Long-Term Debt
Inventory Inventory 120000 120000 Notes Payable 20000 20000 20000 20000
Capital Assets Capital Assets Bonds Payable 600000 600000 600000 600000
Equipment Equipment 250000 250000 Owners Equity
Buildings Buildings 500000 500000 Common Stock 300000 300000 300000
Goodwill Goodwill 60000 60000 Retained Earnings 48000 48000 48000 48000
Total Assets Total Assets 1000000 1000000 Total Liabilities OE 1000000 1000000 1000000 1000000 1000000
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Format of the SCFP

• Page 960 shows you a typical SCFP
• The SCFP is a cash flow statement that
  illustrates the activities that occurred during a
  period,
• such that it explains how transactions affect the
  beginning period cash balance to produce the end
  of period cash balance
• Operating Activities are listed first with a Net
  Cash Inflow (Outflow) for the period
• Investing Activities are listed second with a Net
  Cash Inflow (Outflow) for the period
• Financial Activities are listed last with a Net
  Cash Inflow (Outflow) for the period

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5 Easy Steps to create a SCFP

• Calculate the net increase or decrease in cash
  and cash equivalents from current year and prior
  year BS
• Calculate the net cash inflows (outflows) from
  operating activities using the Direct Method
• Note See next slide The book uses the Indirect
  Method to calculate the cash from Ops activities.
  On the exam, we will use the Direct Method
• Calculate the net cash inflows/outflows from
  investing activities
• Calculate the net cash inflows/outflows from
  financing activities
• Sum up the net cash inflows (outflows) from each
  of the above, then add this amount to the
  beginning period cash balance to show the end of
  period cash balance

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About the 2 Methods for Ops Activities

• Both the indirect method and the direct method
  are used by companies,
• although most companies seem to prefer the
  indirect method
• Its easier to do
• The direct method is encouraged (but not
  required) by IFRS
• And will likely be the requirement in the future
• For the purposes of this course,
• we will use the Direct method
• The final exam will require you to use the Direct
  method
• The indirect method will be given no points
• The book covers the indirect method in the main
  body of the chapter and the direct method in the
  Appendix to the chapter

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Lets try it out

• Lets see how we can generate the SCFP for Genesis
  Corp on page 932.
• Step 1 Look at the 2011 and 2010 Balance Sheet
  and calculate the change in cash
• 17000-12000 5000 increase
• Step 2 This step is about restating Net Income
  from the Income Statement from accrual basis to
  cash basis
• Well use the Direct Method only. Using the
  Indirect method will be marked wrong!!!
• In using the Direct Method, we use the difference
  shown between the Year 1 balance and Year 2
  balance of balance sheet accounts and apply that
  difference to the related Income Statement
  account to get an idea of cash paid or generated
  from that activity

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Lets try it out

• Faithfully follow the process
• Only in the leap from the lion's head will he
  prove his worth."
• http//www.youtube.com/watch?vxFntFdEGgws

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Direct Method

• A good way to start thinking about the Direct
  Method is simply to look a your Cash T-account
  once you have journalized and posted transactions
  affecting cash to its T-account
• Again, note using the Indirect method will be
  marked wrong
• Then, you can generally take these postings and
  break them into these categories
• Cash received from customers
• Cash paid for merchandise
• Cash paid for wages
• Cash paid for operating expenses
• Cash paid for interest
• Cash paid for taxes

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Cash received from customers

• If all sales are paid by cash, then
• Cash received from customers (cash sales) Sales
• But most times, companies permit customers to pay
  on credit (AR). Therefore,
• Cash received from customers (credit sales)
• Credit Sales AR in Yr 1 AR in Yr 2
• Therefore Cash received from Customers
• Cash received from cash sales cash received
  from credit sales
• If you like T-accounts, look at T-account
  versions throughout the chapter
• You can also receive cash for other reasons
  (rent, interest, etc)
• You can use a similar formula as above to
  calculate the affect on cash
• Cash received from customers Rent Income Rent
  Receivable in Year 1 Rent Receivable in Year 2

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Operating Cash Payments

• There are many areas that could cause a cash
  outflow from operating activities. Well cover
  some common ones
• Note that these will all show as a negative
  number in the SCFP
• Cash paid for merchandise is usually cash paid
  for raw materials that form the basis for the
  final product
• We can use a similar analysis to our previous
  Cash received from customers to produce Cash paid
  for merchandise
• Cash paid for merchandise uses a 2 step approach.
  
• First, it examines changes to the inventory asset
  account to see how they affect COGS
• Second, it examines changes to AP to determine
  Cash paid for merchandise

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Cash paid for merchandise

• First, looking at the Inventory account
• Cost of purchases COGS Inv in Year 2 Inv in
  Year 1
• Then, using AP and purchases calculated above
• Cash paid for merchandise Cost of Purchases
  AP in Year 1 AP in Year 2
• Of course, Cash paid for merchandise represents
  an outflow of cash, so it is shown as a negative
  number

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Cash paid for wages, interest, taxes

• In the example of Genesis, they have combined
  wages with other operating expenses. Generally,
  the following analysis is applied to any expense
  affecting cash
• Cash paid for Wages Wages Expense Wages
  Payable in Year 1 Wages Payable in Year 2
• Cash paid for Interest Interest Expense
  Interest Payable in Year 1 Interest Payable in
  Year 2
• Cash paid for Taxes Taxes Expense Taxes
  Payable in Year 1 Taxes Payable in Year 2

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Other Operating Expenses

• Amortization Expenses These are non-cash
  expenses which represent the allocation of
  capital assets to revenue generated over time.
  Since the cash affects of capital assets are
  covered in the Investing activities we ignore
  Amortization in the Operating section
• Gain/Loss on Sale of Assets regardless of a
  loss or gain, the actual cash received from a
  sale or purchase is recorded in the Investing
  activities section
• Bond Retirements Shown under Financing
  activities

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Cash Flows from Investing Activities

• Step 3 Calculate net cash inflows (outflows)
  from Investing activities
• Youll recall that these are activities that
  generally affect long-term assets
• As shown in Exhibit 19.2, investing activities
  typically involve
• Purchase or sale of capital assets
• Purchase or sale of investments, other than cash
  equivalents
• Lending and collecting on loans (long-term notes
  receivables that were created for activities
  other than operating activities)

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Cash Flows from Investing Activities

• We use a 3 step process to determine cash inflows
  (outflows) from investing activities
• Identify changes in investing activities accounts
• Explain these changes using reconstruction
  analysis
• Report the cash flow effects
• Investing activities accounts are
• Any long-term asset account, like capital assets,
  property, plant and equipment, trucks, cars,
  buildings, etc
• Reconstruction analysis is the artists
  impression of what the journal entry might have
  been to cause the change

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Cash Flows from Investing Activities

• Example, cash from sale of a fixed asset

Date Account Titles and explanation PR Debit Credit
July 25 Cash 120000
Accum Amort - Building 40000
Gain on sale of Building 30000
Building 130000
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Cash Flows from Investing Activities

• So, in the Investing Section of the SCFP, you
  would see something like the top example on page
  960

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Cash Flows from Financing Activities

• Step 4 Calculate net cash inflows (outflows)
  from Financing activities
• These are activities that affect a company's
  owners and creditors
• We can get a good idea of where to start by
  examining the activity in the following accounts
• Long-Term Debt, Bonds Payable
• Notes Payable
• Owners Equity
• Common Shares
• Preferred Shares
• Retained Earnings

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Cash Flows from Financing Activities

• Again,we use a 3 step process to determine cash
  inflows (outflows) from financing activities
• Identify changes in financing activities accounts
• Explain these changes using reconstruction
  analysis
• Report the cash flow effects
• Here are some typical financing activities
  changes
• Cash generated by issuing bonds

Date Account Titles and explanation PR Debit Credit
Jun 31 Cash 100000
Bonds Payable 100000
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Cash Flows from Financing Activities

• Cash paid out by retiring bonds
• Cash generated by selling common shares

Date Account Titles and explanation PR Debit Credit
July 25 Bonds Payable 34000
Gain on Bonds Retirement 16000
Cash 18000
Date Account Titles and explanation PR Debit Credit
Jun 31 Cash 100000
Common Shares 100000
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Cash Flows from Financing Activities

• Dividends paid to owners
• Note, for the above example, we would need to
  examine the Net Income that went into Retained
  Earnings to help determine the cash for dividends
  that came out (see page 993)
• Cash paid for Dividends Net Income (Retained
  Earnings Yr 1- Retained Earnings Yr 2)
  Dividends Payable Year 1 Dividends Payable Year
  2

Date Account Titles and explanation PR Debit Credit
Jun 31 Retained Earnings 10000
Cash 10000
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Final Step Proving the change in Cash

• We have now examined all the changes that could
  affect cash
• Now we simply sum up the inflows (outflows) in
  each of the 3 activities individually, then we
  sum the 3 up to get an overall increase or
  decrease in cash
• Then we find the beginning period cash balance,
  add the above increase or decrease and see if it
  results in the ending cash balance

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Demonstration Problem

• Lets go through the Demonstration Problem