INTRODUCTORY FINANCIAL ACCOUNTING                                               SOMNATH
DAS


                            ...
Example:       IBM Corporation 1998.

See Statement of Cash Flows extracted from the 1998 Annual Report as shown on
page 5...
RECONCILING OPERATING RESULTS
                     FROM AN ACCRUAL BASIS TO CASH BASIS

EXAMPLE : XYZZ COMPANY




       ...
Classification of Cash Flows

      Three types of activities appear on the Statement of Cash Flows:


            Operat...
THE ACCOUNTING EQUATION AND THE STATEMENT OF CASH FLOWS


START with            Assets                    =Liabilities   +...
(Financing)   +[{Issue of new long term debt Less Redemption of long term debt}
                                        +{...
Stated in words,

      Under operating activities start with accrual NET INCOME and make adjustments to:

              ...
Implementing the Indirect Method:

             Instead of reporting cash receipts and disbursements, the purpose here is ...
EXAMPLE 1: E12-10

EXAMPLE 2: P 12-4

CASES      C12-1, C12-2, C12-3
EXAMPLE 3: TOPPS Company
       The following is a list of items involving the cash flow activities of the TOPPS Company
I...
TOPPS COMPANY
                                 Statement of Cash Flows
                            For Year Ending Decembe...
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Cash Flows and Accrual Accounting

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Cash Flows and Accrual Accounting

  1. 1. INTRODUCTORY FINANCIAL ACCOUNTING SOMNATH DAS STATEMENT OF CASH FLOWS Cash Flows and Accrual Accounting  A company with a profitable year does not necessarily increase its cash.  A company with a losing year does not necessarily experience a decrease in cash. Purpose of the Statement of Cash Flows Statement of cash flows reports the changes in cash over a period of time and explains these changes, i.e., information about cash receipts and disbursements (uses) during a period.  Complements accrual-based income statement by showing performance on a cash basis - Shows differences between net income on an accrual basis and on a cash basis  Summarizes operating, investing, and financing activities  Income statement focuses on operating activities BUT Statement of cash flows includes non operating sources and uses of cash  Permits users to assess entity's ability to generate net cash inflows to meet its obligations and pay dividends  Permits users to assess entity's need for external financing  Helps users to interpret how changes in balance sheet and income statement occurred  Answers the following:  where did cash come from  what was cash used for  what was the change in cash balance. The Definition of Cash: Cash and Cash Equivalents Certain items are recognized as being equivalent to cash: must be readily convertible to a known amount of cash, with a maturity of three months or less; e.g. commercial paper, money market funds, Treasury bills
  2. 2. Example: IBM Corporation 1998. See Statement of Cash Flows extracted from the 1998 Annual Report as shown on page 583 of your textbook. Note that IBM had a Net Income of $6,328 million BUT it had a net decrease in cash of $1,731 million during the same period. Presented below is the summary Income Statement of IBM for the period ending December 31, 1998: Total Revenue $81,667 COGS $50,795 Gross profit $30,872 Total operating expenses $21,708 Operating income 9,164 Other income, principally interest 589 Interest expense 713 Earnings before income and taxes 9,040 Provision for income taxes 2,712 Net earnings 6,328 1. Did IBM have a positive or negative Cash flow from operations? How about operating income or an operating loss? Should these be the same? WHY or WHY NOT? 2. Which non-operating items were the primary users of cash? Are these non- operating items likely to be repeated in future periods? WHY or WHY NOT? 3. Which TWO items were the principal contributors to the DIFFERENCE between Net Income and Net Cash Provided by Operating Activities? Are these items likely to be repeated in future periods. WHY or WHY NOT? 4. What was the PRIMARY source of cash from financing activities? From Investing activities? 5. How were Capital Investments paid for?
  3. 3. RECONCILING OPERATING RESULTS FROM AN ACCRUAL BASIS TO CASH BASIS EXAMPLE : XYZZ COMPANY Sales COS Deprectn Income Direct cash flows: Received from customers 4000 Paid to suppliers (6000) Net cash from operations (2000) From ACCRUAL Income Income Statement 6000 (2000)(1000)3000 Reconciling (Non-cash) Depreciation 1000 1000 (Change in current assets) Increase in receivables (2000) (2000) Increase in inventory (8000) (8000) (Change in current liabilities) Increase in payables 4000 4000 Cash from operations (2000)
  4. 4. Classification of Cash Flows Three types of activities appear on the Statement of Cash Flows:  Operating Activities include Acquiring and Selling Products and Services, Reported on Cash Basis - -principally relates to production and sale of goods and services and miscellaneous income and expense transactions - all activities other than those included in investing and financing  like an income statement, prepared on a cash basis  cash effects of items that enter into the determination of net income  usually relate to an increase or decrease in a current asset or liability  Investing Activities involve Acquiring and Disposing of Investments and Long-Term Assets  cash paid for plant and equipment referred to as capital expenditures  usually relate to long-term assets  Financing Activities are the issue of stock and various forms of debt, and their repurchase or repayment, along with the payment of dividends to stockholders  usually relate to long-term liabilities or stockholders’ equity  Reconciliation of cash and cash equivalents at beginning and end of year: The Change in Cash & Cash equivalents is equal to the net cash flow from operating, investing and financing activities.  How the Statement of Cash Flows is Put Together  emphasis is on why cash changed, not on the fact that it did change:  change can be found by comparing two balance sheets  requires analysis and classification.
  5. 5. THE ACCOUNTING EQUATION AND THE STATEMENT OF CASH FLOWS START with Assets =Liabilities + Owners’ Equity Let L= Change form one time period to next; i.e, from period T to T+1 Then, T Assets == Liabilities + + Owners’ Equity OR OCash + Non Cash Current Assets + NNoncurrent Assets = =Current Liabilities + CNoncurrent Liabilities + NOwners’ Equity Thus, isolating Cash on One Side; Increase (Decrease) in Cash, i.e., TCash ==Current Liabilities + CNoncurrent Liabilities + NOwners’ Equity LESS {LNon Cash Current Assets + NNoncurrent Assets} Now, NNoncurrent Assets = NET Capital expenditures Less Depreciation for the period Noncurrent Liabilities = Issue of new long term debt Less Redemption of long term debt Owners’ Equity = = Capital Stock + Retained Earnings where w Capital Stock = {Issue of New Shares Less Repurchase of Shares} Retained Earnings = {Net Income for the period Less Dividends declared} Thus, TCash ==Current Liabilities + {Issue of new long term debt Less Redemption of long term debt} + {Issue of New Shares Less Repurchase of Shares} ------ (Capital stock) + {Net Income for the period Less Dividends declared} ------ (Retained earnings) LESS {LNon Cash Current Assets + NET Capital expenditures Less Depreciation for the period} Rearranging gives us RCash (Operations) = [{Net Income + Depreciation for the period} + {{ Current Liabilities (Less) ( Non Cash Current Assets}] (The above is one of the most difficult and important aspect.) (Investments) Less NET Capital expenditures
  6. 6. (Financing) +[{Issue of new long term debt Less Redemption of long term debt} +{Issue of New Shares Less Repurchase of Shares} Less Dividends]
  7. 7. Stated in words,  Under operating activities start with accrual NET INCOME and make adjustments to:  Eliminate charges or credits to income not involving cash inflows or outflows  Include the net changes in current assets and liabilities (other than cash) involving cash inflows or outflows which were not included in determining accrual net income  RULES of THUMB: ADD: decrease in non-cash assets increase in liabilities SUBTRACT: increase in non-cash assets decrease in liabilities The above method of adjusting Net Income for its non-cash components is called the Indirect method of reporting Cash from Operating Activities. Two Methods to Report Cash Flow from Operating Activities  Direct method (not commonly used even though encouraged by SFAS 95)---  shows cash inflows and outflows on a gross basis ---  e.g. collections from customers, payments for materials - gross receipts and payments for all 3 major types of activities.  Essentially each individual income statement line items are converted from the accrual basis to the cash basis.  WILL IGNORE IN CLASS since use requires supplementary schedule. .  Indirect method (most commonly used can be derived from the Accounting Equation)  Cash inflows and outflows are shown separately for investing and financing activities.  Both DIRECT and INDIRECT methods should produce the same amount of cash from operating activities.
  8. 8. Implementing the Indirect Method: Instead of reporting cash receipts and disbursements, the purpose here is to reconcile net income to net cash flow from operating activities.  First Line Is Net Income The following are restatements of add back of Depreciation and other non-cash items affecting Net Income, AND changes in non-cash current assets and changes in current liabilities.  assume that all revenues increase cash flow and all expenses decrease it, then record adjustments to this assumption:  To the extent that accounts receivable increased, sales (reported as a part of net income) did not result in cash; thus, the increase in accounts receivable is deducted from net income  Decrease in inventory indicates that company sold (and thus deducted, when calculating income) more than it purchased; since cost of goods sold exceeds cash used, the difference is added back to net income  Decrease in prepaid insurance indicates that expenses were taken in excess of new payments made; thus not all the expenses required cash, so decrease is added back  Increase in accounts payable indicates that purchases for the period exceeded cash payments for purchases; the increase is added back to net income because cost of goods sold includes items for which company has not as yet expended cash  Increase in salaries and wages and taxes payable: added to from income to reflect the fact that payments made less than the period’s expense  Depreciation expense was deducted to arrive at net income, but required no cash, so it is added back  QUESTION: Will accelerated depreciation increase the CFO even more ?  Gain on sale of assets: it was the sale, not the gain on the sale, that generated cash; since the sale is reported as an investing activity, the gain is deducted, to remove it from the operating section  Gain on retirement of bonds: first, bonds are a financing activity, and the retirement is reported in that section; second, the actual cash paid to retire the debt, not the loss, is the cash effect of the transaction; thus this gain is subtracted to remove it from the net income. Comparison of two methods, direct and indirect  company using indirect must disclose payments for income taxes and interest separately  advocates of direct method cite user friendliness and ease of evaluating operating efficiency  advocates of indirect method believe indirect method focuses attention on differences between accrual income and cash generated
  9. 9. EXAMPLE 1: E12-10 EXAMPLE 2: P 12-4 CASES C12-1, C12-2, C12-3
  10. 10. EXAMPLE 3: TOPPS Company The following is a list of items involving the cash flow activities of the TOPPS Company Inc., for the year 2000. 1. Patent amortization expense , $3,500 2. Machinery was purchased for $44,500 3. At year end, bonds payable with a face value of $20,000 were issued for $17,000. 4. Net income, $51,200. 5. Dividends paid, $16,000. 6. Depreciation expense, $12,900. 7. Preferred stock was issued for $13,600. 8. Investments were acquired for $21,000. 9. Accounts receivable increased by $4,300. 10. Land was sold at cost, $11,000. 11. Inventories increased by $15,400. 12. Accounts payable increased by $2,700. 13. Beginning cash balance was $21,600. Prepare the statement of cash flows of TOPPS for the year 2000. (Leave as exercise). A Pro- forma statement is provided for your use. Verify Your Answer: Net increase in cash = $10,700.
  11. 11. TOPPS COMPANY Statement of Cash Flows For Year Ending December 31, 2000 Net Cash Flow From Operating Activities Net Income Adjustments for differences between income flows and cash flows from operating activities: ADD: Depreciation Expense Patent Amortization Expense Increase in accounts payable LESS: Increase in accounts receivable Increase in inventories Net cash provided by operating activities Cash Flows from Investing Activities Payment for purchase of machinery Payment for purchase of investments Proceeds from sale of land Net cash flows from investing activities Cash Flows Financing Activities Payment of dividends Proceeds from issuance of bonds Proceeds from Issuance of Preferred Stocks Net cash provided by financing activities Net Increase (Decrease) in cash ADD (Beginning Balance of Cash) Cash, December 31, 1999 (Balance Sheet at T) = (Ending Balance of Cash) Cash, December 31, 2000 (Balance Sheet at T+1)

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