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Financial Statement Analysis

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  1. Financial Statement Analysis Study Session 7 & 8

  2. Financial Statement AnalysisBasic Concepts Study Session 7

  3. CONTENTS OF STOCKHOLDERS REPORT • Management’s Discussion and Analysis (MDA) • Balance Sheet • Income Statement • Statement of Stockholders’ Equity • Statement of Cash Flows • Statement of Comprehensive Income • Auditor’s Report • Explanatory Notes • Supplementary Information LOS 29 d discuss the additional sources of information accompanying the financial statements, including the financial footnotes, supplementary schedules, Management Discussion and Analysis (MD&A) and Proxy statements

  4. CONTENTS OF MANAGEMENT DISCUSSION AND ANALYSIS • Results of operations + discussion of trends • Capital resources and liquidity + trends in cashflows • General business overview based on known trends • Effects of known trends, events and uncertainties • Discontinued operations, extraordinary items,unusual items • Disclosures in interim financial statements • Segmental cash flow requirements and contributions LOS 29 d discuss the additional sources of information accompanying the financial statements, including the financial footnotes, supplementary schedules, Management Discussion and Analysis (MD&A) and Proxy statements

  5. Corporate Filings/Proxy Statements Detailed financial results reported to the SEC on annual basis. Audited and filed 90 days after the close of a fiscal year. Form 10-K Annual Report Proxy Publicly held companies report their financial results annually to shareholders in an annual report. Effectively the report is a condensed version of the 10-K. A proxy statement is sent to all shareholders in connection with company meetings. The proxy explains proposals that will be voted on by the shareholders. The proxy also contains information about management remuneration, stock options, special deals and related party transactions. The proxy will also detail any changes of auditor. LOS 29 d discuss the additional sources of information accompanying the financial statements, including the financial footnotes, supplementary schedules, Management Discussion and Analysis (MD&A) and Proxy statements

  6. Corporate Filings/Proxy Statements Public companies must file quarterly reports 45 days after the end of the period using form 10-Q. The form contains a balance sheet, statement of operations, cashflow and MDA but is not audited. Form 10-Q Form 8-K Form 144 Registration 8-K is used to inform the SEC of special events: changes in control, acquisitions, dispositions, auditor changes, director resignation and bankruptcy. (Normally due within 15 days – 5 for auditor) Insiders must register every time they buy or sell stock. When a publicly held company plans to issue securities, it must file a registration statement, including a prospectus and exhibits LOS 29 d discuss the additional sources of information accompanying the financial statements, including the financial footnotes, supplementary schedules, Management Discussion and Analysis (MD&A) and Proxy statements

  7. FINANCIAL ACCOUNTING STANDARD SETTING American Institute of Certified Public Accountants (AICPA) Securities and Exchange Commission (SEC) (Recognize) Pre-1973 APB Financial Accounting Standards Board (FASB) Statements of Financial Accounting Concepts (SFAC) Statements of Financial Accounting Standards (SFAS) LOS 29 a discuss the general principles of the financial reporting system and explain the objectives of financial reporting according to the Financial Accounting Standards Board (FASB) conceptual framework;

  8. INTERNATIONAL FINANCIAL ACCOUNTING STANDARD SETTING Different accounting standards make international comparisons difficult IOSCO IASB International Organization of Securities Commissions – 65 countries securities regulators investigate and set standards on multinational disclosure and financial statements. Implementation is left to the individual members. International Accounting Standards Board – attempting to provide a unified international framework of accounting standards. Has issued over 40 proclamations. Lacks a formal mechanism to ensure compliance with standards. Many governments now voluntarily adopting IAS. International Accounting standards were adopted by the EU in 2005. US and IAS are slowly converging. LOS 29c discuss the role of IOSCO and IASB in setting and enforcing global accounting standards

  9. General Principals ofFinancial Reporting System • Timing Economic events and accounting entries may take place in different periods, e.g., changes in market value of PP&E • Recognition Many economic events do not receive recognition, e.g., contingencies, off balance sheet finance • Measurement Certain items may be reported in different ways, e.g., FIFO vs. LIFO LOS 29a :  Discuss the general principals of the financial reporting system

  10. Objectives of Financial Reporting Interested in identifying firms with long term earning power, growth opportunities and ability to pay dividends Equity Investors Short Term Creditors Long Term Creditors Interested in liquidity of the business Long term asset position and earning power Investors – debt and equity Government – taxes/regulators Others – public, special interest groups, workforce etc Classes of user LOS 29a :  Discuss the general principals of the financial reporting system

  11. Foundations of Accrual Accounting Revenue is recognized when goods are delivered or services performed, not necessarily when the cash is received • Recognition Principle • Matching Principle • Historic Cost Principle Revenues and associated costs are recognized in the same accounting period Assets and liabilities are recorded at the transaction’s original value. The advantage is that historic cost is objective and verifiable. LOS 29a :  Discuss the general principals of the financial reporting system

  12. Statement of Financial Accounting Concepts (SFAC) 2 Information that could potentially affect a decision • Relevance • Timeliness • Reliability • Consistency • Comparability • Materiality Information looses value rapidly in the financial world. Helpful for forecasting. Verifiable and representational faithfulness Same accounting principles consistently applied over time Information should allow comparison between companies. Often difficult due to estimates and methods. Which data is important enough for inclusion in the financial statements. LOS 29 b identify the accounting qualities (e.g., relevance, reliability, predictive value, timeliness) set forth in Statement of Financial Accounting Concepts (SFAC) 2, and discuss how these qualities provide useful information to an analyst

  13. The Audit Report • Audit = independent review of the company’s financial statements • Financial statements are true and fair • Audit Report Responsibility of management to prepare accounts Independence of Auditor’s Properly prepared in accordance with relevant GAAP Free from material misstatement Accounting principles and estimates chosen are reasonable Unqualified opinion vs. qualified opinion Uncertainties LOS 29 e Discuss the role of the Auditor and the meaning of the audit opinion

  14. MONEY IN MONEY OUT Loan capital (ST & LT) Share capital Reserves Long-lived assets Current assets Investments probable current and future economic benefit obtained as a result of past transactions Assets Liabilities Equity probable sacrifices of economic benefit/transfers of wealth as a result of past transactions residual interest in Net Assets of an entity (Total Assets – Total Liabilities) LIABILITIES + STOCKHOLDER EQUITY ASSETS = Assets – In order of liquidity Liabilities – In order of due date LOS 29 d describe and distinguish between the principal financial statements: Balance Sheet, Income Statement, Statement of Comprehensive Income, Statement of Cash Flows and Statement of Stockholders’ Equity

  15. LOFTUS INC. BALANCE SHEET AS AT 31 DECEMBER 20X0 ASSETS Current assets $’000 $’000 $’000 Cash Short term investments Accounts receivable Less: Bad debt provision Inventory Prepayments 100 40 380 540 10 400 (20) Total current assets Investments Property plant & equipment 1,070 200 Land and Buildings Plant & Machinery Less: Accumulated depreciation 500 1800 (400) 1400 1,900 Intangible assets: Goodwill TOTAL ASSETS 2,000 5,170 LOS 29 d describe and distinguish between the principal financial statements: Balance Sheet LOS 30 a describe the factors that distinguish long-term assets from and identify common types of long-term assets and their carrying values on the balance sheet;

  16. Long Term Assets Long term asset = asset held for continuing use within the business, not resale Carrying Value Balance Sheet Profit on disposal – Income Statement $ $ X (X) X Proceeds NBV Profit/(loss) X (X) X/(X) Cost Accumulated Depn /Amort Net Book Value (NBV) Cost includes all expenditure to acquire the asset and ready it for usage (installation, broker, legal fees, etc.) For part exchange replace proceeds with trade in allowance LOS 30 a identify the common types of long-term assets and their carrying values on the balance sheet LOS 30 b determine the cost and record the purchase, of property, plant, and equipment LOS 30 d describe how to account for the sale, exchange, or disposal of depreciable assets

  17. LOFTUS INC BALANCE SHEET AS AT 31 DECEMBER 20X0 LIABILITIES Current liabilities $’000 $’000 $’000 Accounts payable Tax payable Current portion of long term debt 390 250 120 760 Total current liabilities Long term liabilities Bonds payable 2,340 STOCKHOLDERS EQUITY Contributed capital Common stock $1 par value 500,000 shares issued and outstanding Other paid in capital 500 200 Total contributed capital Retained earnings Total stockholders equity 700 1,370 2,070 TOTAL LIABILITIES AND STOCKHOLDERS EQUITY 5,170 LOS 29 d describe and distinguish between the principal financial statements: Balance Sheet LOS 31 f describe the components/format of the balance sheet

  18. Stockholders Equity Disclosure – dividends (fixed, floating, participating), call provisions, conversion privileges. If redeemable by holder reclassify after liabilities Preferred Stock Common Stock Additional Paid in Capital Other items Each class reported separately, recorded at par value, treasury stock contra for repurchases If common stock is issued above par value any excess is recorded in additional paid in capital - Minimum Liability Adjustment (Pensions) - Forex gains and losses under the all current method - Market Valuation Adjustment (Available for sale securities) - Unearned shares issued to employee stock ownership plans LOS 31 f describe the format and the components of the balance sheet and the format, classification, and use of each component of the statement of stockholders’ equity.

  19. STATEMENT OF STOCKHOLDERS’ EQUITY – LOFTUS INC. Year Ending December 31 20X0 $’000 Stockholders’ Equity at beginning 1,520 Additions: Sale of Common Stock at Par 200 Additional Paid-In Capital: 200 Net Income 200X 500 Dividends Paid: (350) Stockholders’ Equity at end 2,070 LOS 29 d describe and distinguish between the principal financial statements: Statement of Stockholders’ Equity LOS 31 f describe the format and the components of the balance sheet and the format, classification, and use of each component of the statement of stockholders’ equity.

  20. INCOME STATEMENT FOR THE YEAR ENDING 31 DECEMBER 20X0 LOFTUS INC $’000 Revenues Cost of goods sold Gross profit Operating expenses Depreciation Earnings before interest and taxes Interest expense Earnings before taxes Taxes Net income 6,350 2,400 3,950 2,500 200 1,250 500 750 250 500 LOS 29 d describe and distinguish between the principal financial statements: Balance Sheet, Income Statement, Statement of Comprehensive Income, Statement of Cash Flows and Statement of Stockholders’ Equity LOS 31 a describe the format on the Income Statement and the components of net income

  21. FINANCIAL STATEMENT FOOTNOTES • Information on accounting methods, assumptions and estimates • Additional information on items appearing in major statements • Disclosures relating to contingent losses • Depreciation methods • Inventory valuation methods • Leasing arrangements • Deferred tax calculations • Items not otherwise reported in the financial statements that are relevant and/or material (these are potential losses/payments potentially to be incurred by the firm, subject to the outcome of some future event/action e.g. litigation) Accrue a loss: - probable that loss has been incurred - amount can be reasonably estimated Footnote disclosure: - loss is reasonably possible - e.g., litigation, expropriation LOS 29 d discuss the additional sources of information accompanying the financial statements, including the financial footnotes, supplementary schedules, Management Discussion and Analysis (MD&A) and Proxy statements

  22. INCOME STATEMENT FORMAT SUGGESTED IN READING Revenues from the sales of goods and services: Other income and revenues Operating expenses Financing costs Unusual or infrequent items Pre-tax earnings from continuing operations Income tax expense Net income from continuing operations Income from discontinued operations Extraordinary items Cumulative effect of accounting changes Net income + – – +/– – +/– +/– +/– LOS 29 d describe and distinguish between the principal financial statements: Balance Sheet, Income Statement, Statement of Comprehensive Income, Statement of Cash Flows and Statement of Stockholders’ Equity LOS 31 a describe the format on the Income Statement and the components of net income

  23. CRITERIA FOR REVENUE RECOGNITION In order to recognize revenues (in the Income Statement) two conditions must be met: • Completion of the earnings process This amounts to the firm having provided all or virtually all of the services for which it is to be paid, knowing the total expected cost of providing those services and the associated revenues • Assurance of payment The seller must be able to reasonably estimate the probability of payment LOS 31 b Identify the requirements for revenue recognition to occur.

  24. METHODS OF REVENUE RECOGNITION Sales and corresponding costs recognized at the point of sale and/or when a service has been provided • Sales basis • Percentage-of-completion • Completed contract For long term contracts where a reliable estimate of revenues, costs and completion time exists. Revenues and costs recognized according to the proportion of work completed. For long term contracts where there is no contract or estimates of revenues and costs are unreliable. Revenues and costs are not recognized in the Income Statement until the entire project is completed. LOS 31 b explain the importance of the matching principle for revenue and expense recognition, identify the requirements for revenue recognition to occur, identify and describe the appropriate revenue recognition, given the status of completion of the earning process and the assurance of payment, and discuss different revenue recognition methods and their implications for financial analysis;

  25. METHODS OF REVENUE RECOGNITION For contracts where costs and revenues are known but the exact timing of the receipt of sales cash is unclear. Revenues and costs are recognized in the Income Statement in proportion to the cash collection. • Instalment sales • Cost recovery For contracts where revenues are known but the exact size of costs is not clear. Profits are not recognized in the Income Statement until all costs have been ‘recovered,’ i.e., through the recognition of sales just equal to costs incurred. LOS 31 b explain the importance of the matching principle for revenue and expense recognition, identify the requirements for revenue recognition to occur, identify and describe the appropriate revenue recognition, given the status of completion of the earning process and the assurance of payment, and discuss different revenue recognition methods and their implications for financial analysis;

  26. PERCENTAGE OF COMPLETION METHOD – EXAMPLE Bircham Properties Ltd. has a contract to build a hotel for $2,000,000 to be received in equal installments over 4 years. A reliable estimate of total cost of this contract is $1,600,000. During the first year, Bircham Properties incurred $400,000 in cost. During the second year, $500,000 of costs were incurred. The estimate of the projects total cost did not change in the second year. Calculate the revenue to be recognized in each of the first two years. LOS 31 c identify the appropriate income statement and balance sheet entries using the percentage-of-completion method and the completed contract method and describe and calculate the effects on cash flows and selected financial ratios that result from using the percentage-of-completion method versus the completed contract method;

  27. Amounts billed Cash received Costs incurred 20x1 800 600 500 20x2 700 900 700 20x3 500 500 300 Total 2,000 2,000 1,500 POC vs. CC METHODS – EXAMPLE (BALANCE SHEET) Cook Properties has a contract to build an office building for $2 million. An estimate of the contract’s total costs is $1.5 million. Billings and cost patterns are as follows: You are required to prepare the balance sheets using the percentage of completion and completed contract methods. LOS 31 c identify the appropriate income statement and balance sheet entries using the percentage-of-completion method and the completed contract method and describe and calculate the effects on cash flows and selected financial ratios that result from using the percentage-of-completion method versus the completed contract method;

  28. BALANCE SHEET – PERCENTAGE-OF-COMPLETION METHOD Total Assets Cash (Cash Rec’d – Cost Incurred) Accounts receivable (Amounts Billed – Cash Rec’d) Net CIP* Total Assets 20x1 20x2 20x3 * See working slide LOS 31 c identify the appropriate income statement and balance sheet entries using the percentage-of-completion method and the completed contract method and describe and calculate the effects on cash flows and selected financial ratios that result from using the percentage-of-completion method versus the completed contract method;

  29. BALANCE SHEET – PERCENTAGE-OF-COMPLETION METHOD Total Liabilities and Equity Net Advanced Billings* Retained Earnings Total Liabilities & Equity 20x1 20x2 20x3 * See working slide LOS 31 c identify the appropriate income statement and balance sheet entries using the percentage-of-completion method and the completed contract method and describe and calculate the effects on cash flows and selected financial ratios that result from using the percentage-of-completion method versus the completed contract method;

  30. MEMO CIP 20x1 20x2 20x3 Cost Profit Allocation Cost to Date Total Cost Contract Price – Total Cost X Amounts Billed Net CIP/(Net Advanced Billings)

  31. BALANCE SHEET – COMPLETED CONTRACT METHOD Total Assets 20x1 20x2 20x3 Cash Accounts receivable Net CIP Total Assets LOS 31 c identify the appropriate income statement and balance sheet entries using the percentage-of-completion method and the completed contract method and describe and calculate the effects on cash flows and selected financial ratios that result from using the percentage-of-completion method versus the completed contract method;

  32. BALANCE SHEET – COMPLETED CONTRACT METHOD Total Liabilities and Equity Net Advanced Billings Retained Earnings Total Liabilities & Equity 20x1 20x2 20x3 LOS 31 c identify the appropriate income statement and balance sheet entries using the percentage-of-completion method and the completed contract method and describe and calculate the effects on cash flows and selected financial ratios that result from using the percentage-of-completion method versus the completed contract method;

  33. MEMO CIP 20x1 20x2 20x3 Cost Amounts Billed Net CIP/(Net Advanced Billings)

  34. PERCENTAGE-OF-COMPLETION vs. COMPLETED CONTRACT During Project Life POC CC Net income Volatility ofincome Income Statement Total assets Liabilities R/E Balance Sheet Cash flow Importance of CFO Statement of Cash Flows LOS 31 c identify the appropriate income statement and balance sheet entries using the percentage-of-completion method and the completed contract method and describe and calculate the effects on cash flows and selected financial ratios that result from using the percentage-of-completion method versus the completed contract method;

  35. INSTALLMENT SALES METHOD – EXAMPLE During 20X0, Sturridge Inc. sold $20,000 of inventory, with a cost of $10,000. During 20X0 and 20X1, Sturridge collected $8,000 and $12,000 respectively, of its receivables. Under the Instalment Method, what are the sales and gross profit to be reported in each of the two years? LOS 31 b explain the importance of the matching principle for revenue and expense recognition, identify the requirements for revenue recognition to occur, identify and describe the appropriate revenue recognition, given the status of completion of the earning process and the assurance of payment, and discuss different revenue recognition methods and their implications for financial analysis;

  36. COST RECOVERY METHOD – EXAMPLE During 20X0, Sturridge Inc. sold $20,000 of services but the cost of providing this service was unclear at the outset of the contract. During 20X0 and 20X1, Sturridge Inc. collected $8,000 and $12,000, respectively of its receivables. The project was completed during 20X1 at which time the company had incurred total costs of $10,000. Under the Cost Recovery Method, what are the sales and gross profit to be reported in each of the two years? LOS 31 b explain the importance of the matching principle for revenue and expense recognition, identify the requirements for revenue recognition to occur, identify and describe the appropriate revenue recognition, given the status of completion of the earning process and the assurance of payment, and discuss different revenue recognition methods and their implications for financial analysis;

  37. CHOOSING THE APPROPRIATE REVENUE RECOGNITION METHOD Completion of Earning Process Complete Complete Complete with contingencies Complete with contingencies Incomplete and costs can be estimated Incomplete and costs can be estimated Incomplete and costs can’t be estimated Incomplete and costs can’t be estimated Assurance of Payment Assured Not assured Assured Not assured Assured Not assured Assured Not assured Revenue Recognition Method Sales basis Installment sales Cost recovery Cost recovery Percentage of completion Completed contract Completed contract Completed contract LOS 31 b explain the importance of the matching principle for revenue and expense recognition, identify the requirements for revenue recognition to occur, identify and describe the appropriate revenue recognition, given the status of completion of the earning process and the assurance of payment, and discuss different revenue recognition methods and their implications for financial analysis;

  38. INCOME STATEMENT FORMAT SUGGESTED IN READING Revenues from the sales of goods and services: Other income and revenues Operating expenses Financing costs Unusual or infrequent items Pre-tax earnings from continuing operations Income tax expense Net income from continuing operations Income from discontinued operations Extraordinary items Cumulative effect of accounting changes Net income + – – +/– Gross of tax – +/– +/– Net of tax +/– LOS 31 d describe the types and analysis of unusual or infrequent items, extraordinary items, discontinued operations, accounting changes, and prior period adjustments;

  39. INCOME STATEMENT: NON-RECURRING ITEMS • Gains of losses from disposal of a portion of a business segment • Gains or losses from sale of assets or investments • Impairments, write-offs and restructuring costs • Gains or losses from the early retirement of debt (note can be extraordinary if infrequent) • Provisions against environmental remediation • Unusual or infrequent items • Extraordinary items Unusual AND infrequent AND material: Losses due to a foreign governments expropriation of assets Uninsured losses from natural disasters LOS 31 d describe the types and analysis of unusual or infrequent items, extraordinary items, discontinued operations, accounting changes, and prior period adjustments;

  40. INCOME STATEMENT: NON-RECURRING ITEMS Operating income (e.g., revenue and expenses up to the date of disposal) and any gains or losses from their sale are reported separately since these activities will not contribute to future income and cash flows. • Discontinued operations • Changes in accounting principle The cumulative impact on prior period earnings is reported net of tax after extraordinary items and discontinued operations where, for example, the company changes the depreciation method. Not that this is not required for changes in accounting estimates. LOS 31 d describe the types and analysis of unusual or infrequent items, extraordinary items, discontinued operations, accounting changes, and prior period adjustments;

  41. Role of Nonrecurring Items inEstimating Earnings Power The analyst focus is often on net income from ‘continuing’ operations as this serves as a basis for forecasts. Companies therefore tend towards putting profitable one off transactions above this line in the income statement and loss producing one off items below this line • Classification of good/bad news • Income smoothing Companies attempt to reduce earnings in years of good performance and inflate earnings in years of bad performance through aggressive or conservative accounting policy selection. LOS 31 e discuss managerial discretion in areas such as classification of good news/bad news, income smoothing, big bath behaviour, and accounting changes, and explain how this discretion can affect the financial statements;

  42. Role of Nonrecurring Items inEstimating Earnings Power • Big bath techniques • Accounting changes When firms are experiencing a bad year they may attempt to recognize all of their ‘bad news’ at once. Going forward therefore, the subsequent improvement in performance will be magnified and this will show management in a better light. Firms can use accounting changes to smooth earnings, as noted above, and these can often have a material impact on earnings without effecting cash flow. LOS 31 e discuss managerial discretion in areas such as classification of good news/bad news, income smoothing, big bath behaviour, and accounting changes, and explain how this discretion can affect the financial statements;

  43. The Cashflow Statement Regular operations generate enough cash to sustain the business Enough cash is generated to pay off maturing debt Highlights the need for additional finance Ability to meet unexpected obligations The flexibility to take advantage of new business opportunities Benefits for the analyst How the firm obtains and spends cash Borrowing and debt repayment activities Issue and repurchase of equity Distributions to owners (dividends) Other factors affecting liquidity and solvency FASB requirements LOS 32 a identify the types of important information for investment decision making presented in the statement of cash flows;

  44. Cash flow from operations (CFO) Cash flow from investing (CFI) Cash flow from financing (CFF) + + = = Change in cash balance Ending cash + Beginning cash STATEMENT OF CASH FLOWS – SFAS 95 $ X X X X (X) (X) (X) (X) X/(X) Cash received from customers Cash dividends received Cash interest received Other cash income Payments to suppliers Cash expenses (wages etc) Cash interest paid Cash taxes paid CFO LOS 32 a identify the types of important information for investment decision making presented in the statement of cash flows; LOS 32 b compare and contrast the categories (i.e., cash provided or used by operating activities, investing activities, and financing activities) in a statement of cashflows, and describe how noncash investing and financing transactions are reported

  45. CASH FROM INVESTING • Purchase and sale proceeds of: • Property, plant & equipment • Subsidiaries, Joint Ventures and Affiliates • Investments CASH FROM FINANCING • Issue and redemption of: • Common stock • Debt • Dividend payments (divs rec’d = CFO) LOS 32 b compare and contrast the categories (i.e., cash provided or used by operating activities, investing activities, and financing activities) in a statement of cashflows, and describe how noncash investing and financing transactions are reported LOS 33 a classify a particular transaction or item as cash flow from 1) operations, 2) investing, or 3) financing;

  46. Non-Cash Investing and Financing Activities • Retirement of debt via conversion into equity • Conversion of preferred stock into common stock • Assets acquired under capital leases • Obtaining assets by issuing notes payable • Exchange of one non cash asset for another • Purchase of non cash assets by issuing equity or other securities All the above items will affect the Balance Sheet but not the Cashflow Statements as no cash is raised or paid LOS 32 b compare and contrast the categories (i.e., cash provided or used by operating activities, investing activities, and financing activities) in a statement of cashflows, and describe how noncash investing and financing transactions are reported

  47. CASH FROM OPERATIONS DIRECT METHOD INDIRECT METHOD Net income depreciation & amortisation gains on disposal of l/t assets losses on disposal of l/t assets other non-cash expenses non-cash revenues changes in non-cash working capital Cash inflows less cash outflows + – + + – +/– Cash from operations Cash from operations LOS 33 b compute and interpret a statement of cash flows, using the direct method and the indirect method; LOS 32 c calculate and interpret, using the indirect method, the net cash provided or used by operating activities;

  48. Direct Method CFO Steps • Start at the top of the Income Statement – e.g., Sales • Move to the balance sheet and identify any asset and liability that relate to that Income Statement item – e.g., Accounts Receivable • Look at the change in the Balance Sheet item during the period (ending balance – opening balance) • Apply the rule: • Adjust the Income Statement amount by the change in the Balance Sheet • Increases in an asset – deduct • Increase in a liability – add • Decrease in an asset – add • Decrease in a liability – deduct LOS 33 b compute and interpret a statement of cash flows, using the direct method and the indirect method; LOS 32 c calculate and interpret, using the indirect method, the net cash provided or used by operating activities;

  49. Direct Method cont. • Tick off the items dealt with in both the Income Statement and Balance sheet • Move to the next item on the Income Statement and repeat • Ignore depreciation/amortization and gains/losses on the disposal of assets as these are all non cash items • Keep moving down the Income Statement until all items included in Net Income have been addressed applying steps 1-8 • Total up the amounts and you have CFO LOS 33 b compute and interpret a statement of cash flows, using the direct method and the indirect method; LOS 32 c calculate and interpret, using the indirect method, the net cash provided or used by operating activities;

  50. EXAMPLE – HOLLOWAY INDUSTRIES Holloway Industries has the following Income Statement for 20X3 and Balance Sheets for 20X2 and 20X3. You are to construct the Statement of Cash Flows using the templates provided. Income Statement for Year to 31 December 20X3 200,000 105,000 95,000 20,000 115,000 40,000 75,000 Sales revenue Expenses: Cost of goods sold Salaries Goodwill amortization Depreciation Interest Gain from sale of PPE Pre-tax income Provision for taxes Net income 80,000 10,000 2,000 12,000 1,000 LOS 33 b compute and interpret a statement of cash flows, using the direct method and the indirect method; LOS 32 c calculate and interpret, using the indirect method, the net cash provided or used by operating activities;