Chapter 11 Financial 3 Ed

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  • In this section, we will look at how the statement of cash flows is formatted.
  • The three primary categories of cash flows are:Operating activities include cash receipts and cash payments for transactions relating to revenue and expense activities. These are essentially the very same activities reported on the income statement. In other words, cash flows from operating activities include the elements of net income, but reported on a cash basis. Common examples of operating activities include the collection of cash from customers or the payment of cash for inventory purchases, salaries, and rent.Investing activities include cash transactions involving the purchase and sale of long-term assets and current investments. Companies periodically invest cash to replace or expand productive facilities such as buildings, land, and equipment. They might also invest in other assets, such as stocks or bonds of other companies, with the expectation of a return on those investments. Eventually, many of these assets are sold. The purchase and sale of long-term assets and investments are common examples of investing activities.Financing activities are both inflows and outflows of cash resulting from the external financing of a business. A major portion of financing for many companies comes from external sources, specifically stockholders and lenders. Common financing activities are borrowing and repaying debt, issuing and repurchasing stock, and paying dividends.
  • This illustrationlists common cash receipts and cash payments for operating,investing, and financing activities. Review this illustration carefully (you mayeven want to bookmark it); it will come in handy in solving many of the homework problems at the end of the chapter.Let’s look at a few of the cash flows. For example, we report interest and dividends received from investments with operating activities rather than investingactivities. Similarly, we report interest paid on bonds or notes payable with operating activities rather than financing activities. They are included in operating activities because each is a cash flow from an activity reported in the income statement—interestrevenue, dividend revenue, and interest expense. As we discussed earlier, operating activities are those we report on the income statement. On the other hand, we record dividends paid as a financing activity. Recall that dividends are not an expense and, therefore, paying dividends has no effect on net income. The payment of dividends simply reduces assets (cash) and stockholders’ equity (retained earnings).
  • Income statement: The income statement provides important information in determining cash flows from operating activities.Balance sheet: We look at the change in asset, liability, and stockholders’ equity accounts from the end of the last period to the end of this period to find cash flows from operating, investing, and financing activities.Detailed accounting records: Sometimes we need additional information from the accounting records to determine specific cash inflows or cash outflows for the period.
  • This illustration summarizes the relationship of the income statement and balance sheet to the operating, investing, and financing sections in the statement of cash flows.
  • Suppose a company borrows $200,000 in cash from a bank, issuing a long-term note payable for that amount. The firm reports this transaction in a statement of cash flows as a financing activity. Now suppose the company uses that cash to purchase new equipment. It reports this second transaction as an investing activity. But if, instead of two separate transactions, the company acquired $200,000 of new equipment by issuing a $200,000 long-term note payable in a single transaction, we excluded the transaction from the statement of cash flows. This is because the transaction involved no cash. However, undertaking a significant investing activity and a significant financing activity as two parts of a single transaction does not lessen the value of reporting these activities. For that reason, transactions that do not increase or decrease cash, but that result in significant investing and financing activities, are reported as noncash activities either directly after the cash flow statement or in a note to the financial statements.
  • Using the indirect method, we begin with net income and then list adjustments to net income, in order to arrive at operating cash flows. The indirectmethod is more popular because it is generally easier and less costly to prepare. In fact, nearly all major companies in the United States (about 99%) prepare the statement of cash flows using the indirect method. For this reason, we emphasize the indirect method.Using the direct method, we adjust the items on the income statement to directly show the cash inflows and outflows from operations such as cash received from customers and cash paid for inventory, salaries, rent, interest, and taxes. If a company decides to use the direct method to report operating activities, it must also report the indirect method either along with the statement of cash flows or in a separate note to the financial statements.Companies choose between the indirect method and the direct method in reporting operating activities in the statement of cash flows. The indirect method is less costly to prepare and is used in practice by the majority of companies. The direct method more logically presents the cash inflows and outflows from operations. The investing and financing sections of the statement of cash flows are identical under both methods.
  • In this section, we first look at the steps involved in preparing the statement of cash flows, and its basic format. Then we work through the steps in preparing the operating, investing, and financing sections of the statement of cash flows.
  • Step 1. Calculate net cash flows from operating activities, using information from the income statement and changes in current assets (other than cash) and current liabilities from the balance sheet. Step 2. Determine the net cash flows from investing activities, by analyzing changes in long-term asset accounts from the balance sheet.Step 3. Determine the net cash flows from financing activities, by analyzing changes in long-term liabilities and stockholders’ equity accounts from the balance sheet.Step 4. Combine the operating, investing, and financing activities, and make sure the total change from these three activities agrees with the net increase (decrease) in cash shown at the bottom of the statement of cash flows.
  • In preparing the statement of cash flows, it’s helpful to first set up the basic format.This illustration shows, the last three lines of the statement of cash flows include amounts for the net increase (decrease) in cash, cash at the beginning of the period, and cash at the end of the period obtained from the E-Games balance sheet. Cash at the beginning of the period is $48,000 (the balance for cash in the 2014 balance sheet column), and cash at the end of the period is $62,000 (the balance for cash in the 2015 balance sheet column). The $14,000 change in the cash balance will be our “check figure,” which means the cash inflows and cash outflows we identify must net to this amount. After all, the purpose of the statement of cash flows is to explain why cash increased by $14,000.
  • The key to understanding the operating activities section of the statement of cash flows is to understand that both net income and cash flows from operating activities represent the same operating activities: The income statement reports net income on an accrual basis. That is, we report revenues when we earn them, regardless of when cash is received, and expenses when we incur them, regardless of when cash is paid. On the other hand, the statement of cash flows reports the very same activities on a cash basis —revenues when we receive cash, and expenses when we pay cash.Net income includes both cash and noncash components. In calculating net cash flows from operating activities, we remove some items from net income so that what’s left is cash flows only. We can classify these items as:Revenues and expenses that don’t affect cash at all (adjustments for noncash effects). Common examples include depreciation expense and amortization expense.Gains and losses that do not affect operating cash flows (adjustments for nonoperating effects). Common examples include gains and losses on the sale of long-term assets.Revenues and expenses that do affect cash, but not by the amount reported as the revenue or expense (changes in current assets and current liabilities).
  • Using the indirect method, we start with net income and adjust this number for (a) revenue and expense items that do not affect cash, (b) gains and losses that do not affect operating income, and (c) changes in current assets and current liabilities.
  • Adjustments for Noncash EffectsDepreciation Expense. Depreciation expense reduces net income. Remember, though, depreciation expense is not a cash outflow in the current period. But since we deducted this noncash expense in the determination of net income, we need to add it back in calculating operating cash flows. Amortization of intangible assets is treated the same way as depreciation of tangible assets. We add back both depreciation expense and amortization expense to net income in arriving at cash flows from operating activities.Gain or loss on sale of an asset. Gains on the sale of long-term assets increase net income, while losses on the sale of those assets decrease net income. The sale of assets is an investing activity, so the cash inflow is reported in the investing section of the statement of cash flows. Note that loss or gain is simply the difference between cash received in the sale of land (reported as an investing activity) and the cost of the land. It is not an operating cash inflow or cash outflow. And yet, we subtract or add it on the income statement in the determination of net income, so we need to adjust it in order to eliminate this nonoperating component of net income.
  • For components of net income that increase or decrease cash, but by an amount different from that reported on the income statement, we adjust net income for changes in the balances of related balance sheet accounts to convert the effects of those items to a cash basis.To convert other income statement components from accrual basis to cash basis, we adjust net income for changes in all current assets (other than cash) and current liabilities.
  • The second step in preparing the statement of cash flows is to determine the net cash flows from investing activities by analyzing changes in long-term asset accounts from the balance sheet.
  • The third step in preparing the statement of cash flows is to determine the net cash flows from financing activities. We can find a firm’s financing activities by examining changes in long-term liabilities and stockholders’ equity accounts from the balance sheet.
  • The fourth and final step in preparing the statement of cash flows is to combine the operating, investing, and financing activities and make sure the total of these three activities agrees with the net increase (decrease) in cash. This illustration shows the complete statement of cash flows for E-Games, with all three sections—operating, investing, and financing—included along with the note for noncash activities.
  • Cash return on assets indicates the amount of operating cash flow generated for each dollar invested in assets. We can separate cash return on assets into two components—cash flow to sales and asset turnover—to examine two important business strategies.Cash flow to sales measures the operating cash flows generated for each dollar of sales. Asset turnover, also covered in Chapter 7, measures the sales revenue generated per dollar of assets. Cash flow to sales and asset turnover represent two primary strategies that companies have for increasing their cash return on assets.
  • The presentation of operating activities in the main body of the chapter is referred to as the indirect method. By this method, we begin with reported net income and work backward to convert to a cash basis. An alternative is the direct method, by which we report the cash inflows and cash outflows directly on the statement of cash flows. For instance, we report cash received from customers as the cash effect of sales, and cash paid to suppliers as the cash effect of cost of goods sold. Income statement items that have no cash effect—such as depreciation expense or gains and losses on the sale of assets—are simply not reported under the direct method.The best way to apply the direct method is to convert each revenue and expense item to its cash-basis amount. We do this by considering how each income statement account is affected by related changes in current asset and current liability accounts.
  • Using the direct method, we examine each account in the income statement and convert it from an accrual amount to a cash amount. We directly report the cash inflows and cash outflows from operations as shown in this illustration.
  • Chapter 11 Financial 3 Ed

    1. 1. Financial Accounting Statement of Cash Flows Chapter 11 Spiceland | Thomas | Herrmann Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
    2. 2. 11-2 Learning Objectives • Classify cash transactions as operating, investing, or financing activities • Prepare the operating activities section of the statement of cash flows using the indirect method • Prepare the investing activities section and the financing activities section of the statement of cash flows • Perform financial analysis using the statement of cash flows Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
    3. 3. 11-3 Learning Objectives • Prepare the operating activities section of the statement of cash flows using the direct method Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
    4. 4. 11-4 Part A Formatting the Statement of Cash Flows Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
    5. 5. 11-5 Learning Objective 1 Classify cash transactions as operating, investing, or financing activities Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
    6. 6. 11-6 Cash Flow Activities • Operating activities: cash receipts and cash payments for transactions relating to revenue and expense activities • Investing activities: cash transactions involving the purchase and sale of long-term assets and current investments • Financing activities: inflows and outflows of cash resulting from the external financing of a business Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
    7. 7. 11-7 Illustration 11.2—Operating, Investing, and Financing Activities Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
    8. 8. 11-8 Information Sources for Preparing the Statement of Cash Flows • Income statement • Balance sheets • Detailed accounting records Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
    9. 9. Illustration 11.4—Relationship of the Income Statement and Balance Sheet to the Statement of Cash Flows Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 11-9
    10. 10. 11-10 Noncash Activities • Significant investing and financing activities that do not affect cash • Reported after the cash flow statement or in a note to the financial statements Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
    11. 11. 11-11 Operating Activities—Indirect and Direct Methods • Differ in presentation format for operating activities • Both methods report investing, financing, and noncash activities identically Indirect Method Direct Method • Begin with net income and then list adjustments to net income in order to arrive at operating cash flows • Most popular method • Easier and less costly • Adjust the items on the income statement to directly show the cash inflows and outflows from operations • Conceptually better method • More difficult and more costly Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
    12. 12. 11-12 Part B Preparing the Statement of Cash Flows Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
    13. 13. 11-13 Steps in Preparing the Statement of Cash Flows Step 1: Calculate net cash flows from operating activities Step 2: Calculate net cash flows from investing activities Step 3: Calculate net cash flows from financing activities Step 4: Combine operating, investing, and financing activities Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
    14. 14. 11-14 Illustration 11.7—Basic Format for the Statement of Cash Flows Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
    15. 15. 11-15 Learning Objective 2 Prepare the operating activities section of the statement of cash flows using the indirect method Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
    16. 16. 11-16 Operating Activities—Indirect Method • Both net income and cash flows from operating activities represent the same operating activities • Net income includes both cash and noncash components • Net cash flows from operating activities removes noncash components Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
    17. 17. 11-17 Illustration 11.16—Summary of Adjustments to Net Income Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
    18. 18. 11-18 Adjustments for Noncash Effects • Depreciation expense • Gain or loss on sale of an asset Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
    19. 19. 11-19 Changes in Current Assets and Current Liabilities • • • • – Increase in a current asset + Decrease in a current asset + Increase in a current liability – Decrease in a current liability Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
    20. 20. 11-20 Learning Objective 3 Prepare the investing activities section and the financing activities section of the statement of cash flows Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
    21. 21. 11-21 Investing Activities • Increase or decrease in investments • Increase or decrease in long-term assets Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
    22. 22. 11-22 Financing Activities • Examine changes in long-term liabilities and stockholders’ equity accounts from the balance sheet Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
    23. 23. 11-23 Illustration 11.19—Complete Statement of Cash Flows Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
    24. 24. 11-24 Learning Objective 4 Perform financial analysis using the statement of cash flows Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
    25. 25. 11-25 Components of Cash Return on Assets Cash return on assets = Operating cash flows Average total assets Cash flow to sales × Operating cash flows = Net sales Asset turnover Net sales × Average total assets • Cash return on assets measures the operating cash flow generated per dollar of assets • Cash flow to sales measures the operating cash flows generated for each dollar of sales • Asset turnover measures the sales revenue generated per dollar of assets Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
    26. 26. 11-26 Learning Objective 5 Prepare the operating activities section of the statement of cash flows using the direct method Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
    27. 27. 11-27 Operating Activities—Direct Method • Report the cash inflows and cash outflows directly • Converts each revenue and expense item to its cash-basis amount • Income statement items that have no cash effect are not reported Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
    28. 28. 11-28 Illustration 11.27—Operating Activities Using the Direct Method Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
    29. 29. 11-29 End of Chapter 11 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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