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Chapters 4 B

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  1. Chapters 4 B Statement of Cash Flows

  2. Objectives of this Chapter • I. Identify business activities which can generate or use cash and differentiate between income flows (i.e., accrual basis) and cash flows from operating activities. • II. The Importance and the usefulness of the statement of cash flows. Statement of Cash Flows

  3. Objectives of this Chapter (contd.) • III. Learn how to prepare the statement of cash flows. • VI. The “cash burn rate” and the use of this rate in evaluating the financial viability of start-up companies. • V. Learn the two alternatives (direct and indirect methods) in preparing net cash flows from operating activities. Statement of Cash Flows

  4. I. Activities which can either generate cash or use cash for a business entity • A. Operating activities. • B. Investing activities. • C. Financing activities. Statement of Cash Flows

  5. A. Operating Activities (i.e., sales revenue, expenses) • All these activities are reported in the I/S (income statement). However, I/S only provides the accrual-basis net income (revenue –expense + gains – losses ) which very often is not the change in cash. • Therefore, we need to adjust from net income flows to cash flows in order to report the net cash provided by (or used in) operating activities. Statement of Cash Flows

  6. A. Operating Activities (contd.) • There are two approaches to reconcile net income to net cash provided by (or used in) operating activities: • 1. Indirect Method • ==> Lump-Sum Adjustment • 2. Direct Method • ==> Individual Account Adjustment Statement of Cash Flows

  7. 1. Indirect Method • Adjust net income (the lump sum amount of all revenues and expenses) for all differences between income flows and cash flows. Statement of Cash Flows

  8. 2. Direct Method • Adjust each revenue account to cash collection and adjust each expense account to cash payment. Subtract total cash payments from total cash collections to derive net cash flows of the operation activities. • SFAS No. 95 allows a choice between the direct and indirect approach for the cash flow statement Statement of Cash Flows

  9. Cash flows from operating activities • Cash Inflows: • 1. Collections from customers including cash received from sales (or services) and collections of A/R. • 2. Cash receipts of interests or dividends. • 3. Collections of other operating receipts (i.e., unearned revenue, rent revenue). Statement of Cash Flows

  10. Cash Flows from Operating Activities (contd.) • Cash Outflows: • 1. Payments to suppliers. • 2. Payments to employees. • 3. Payments for interest expense. • 4. Payments for income taxes. • 5. Payments for other expenses(i.e., Prepaid expenses; rent expenses). Statement of Cash Flows

  11. Activities which can either generate cash or use cash for a business entity • A. Operating activities. • B. Investing activities. • C. Financing activities. Statement of Cash Flows

  12. B. Investing Activities • In addition to generate cash from or use cash in the operating activities, companies can also generate cash from (or use cash in) investing activities. Statement of Cash Flows

  13. Cash Flows from Investing Activities • Transactions involving acquiring (Investing (Cash outflows)) and selling (Disinvesting (Cash inflows)): • a. Property, Plant and Equipment. • b. Investments (current and non-current). • c. Notes Receivable (current and non-current). Statement of Cash Flows

  14. Notes Receivable • Notes Receivable (current and non-current), including: • Lending money (N/R , cash outflow); • Collecting of loan (N/R , cash inflow); • Selling of N/R (N/R, discounting N/R, cash inflow) Statement of Cash Flows

  15. Activities which can either generate cash or use cash for a business entity • A. Operating activities. • B. Investing activities. • C. Financing activities. Statement of Cash Flows

  16. C. Financing Activities • Companies can also generate cash or use cash through financing activities: Statement of Cash Flows

  17. Cash Flows from Financing Activities • Obtaining resources from owners and creditors (cash inflows) and repaying the amount borrowed (cash outflows). • Cash inflows: • Cash received from issuance of common stock. • Cash received from issuance of bonds. • Cash received from issuance of N/P (short-term or long term). Statement of Cash Flows

  18. Cash Flows from Financing Activities (contd.) • Cash Outflows: • Retirement of bonds. • Retirement of stock. • Payments of N/P. • Payments of dividends. Statement of Cash Flows

  19. II. The Importance and Usefulness of the Statement of Cash Flows • Possible earnings managements may result in unreliable accrual earnings. • Accrual accounting relies on many subjective judgments that may introduce measurement error and uncertainty into reported earnings. • One-time write-offs and restructuring charges can reduce the quality of reported earnings. • For these reasons, analysts scrutinize a firm’s cash flows—not just its accrual earnings—to evaluate performance and creditworthiness.

  20. The Importance and Usefulness of the Statement of Cash Flows (cont.) • In order to show cash flows of a company, cash flows of all three activities should be reported. • In doing so, investors can also obtain all the information of operating, investing, and financing activities of a company. Moreover, the following questions can also be answered: Statement of Cash Flows

  21. The Importance and the Usefulness of the Statement of Cash Flows (contd.) • 1. What is the relationship between net income and cash provided by operations? • 2. Why did cash decreased when net income increased? • 3. What expansion (investment) activities took place and how were they financed? Statement of Cash Flows

  22. The Importance and the Usefulness of the Statement of Cash Flows (contd.) • 4. How much is the cash provided by operating activities? • 5. What happened to the proceeds received from issuance of bonds or common stock? • All of these cannot be answered from either the income statement or the balance sheet statement. Statement of Cash Flows

  23. SFAS No. 95 • To improve the comparability, SFAS No. 95, “Statement of Cash Flows,” requires companies present the statement of cash flows using a specific format. Statement of Cash Flows

  24. SFAS No. 95 (contd.) • Following SFAS No. 95, the statement of cash flows should have three sections: • 1. Cash flows from operating activities (using a direct or an indirect method). • 2. Cash flows from investing activities. • 3. Cash flows from financing activities. Statement of Cash Flows

  25. Cash flow statement:Wal-Mart example Adjustments to accrual earnings 4-25

  26. Cash flow statement:Wal-Mart example 4-26

  27. III. Procedures for Preparation of the Statement of Cash Flows • 1. Operating Cash Flows (indirect method). • 2. Investing Cash Flows. • 3. Financing Cash Flows. Statement of Cash Flows

  28. 1. Operating Cash Flows (Indirect Method; Reconciliation Method) • Net Income •  Adjustments • + Any increase in current Liabilities (except for N/P) • + Any decrease in current assets (except for cash and N/R) • - Any decrease in current liabilities (except for N/P) • - Any increase in current assets (except for cash and N/R) Statement of Cash Flows

  29. 2. Investing Cash Flows • Inflows: decrease in noncurrent assets (i.e., long-term investments, P.P.E.) and certain current assets (i.e., trading securities, N/R). • Outflows: increases in noncurrent assets and certain current assets Statement of Cash Flows

  30. 3. Financing Cash Flows • Inflows: increases in noncurrent liabilities (i.e., B/P, N/P), stockholders’ equity and certain current liability (i.e., N/P). • Outflows: decreases in noncurrent liabilities, stockholders’ equity, certain current liability and dividend payment. Statement of Cash Flows

  31. Net Income Adjustments Adjustments to Convert Net Income to Net Cash Flow from Operating Activities • + Depreciation, depletion and amortization expense, B/D expense • + Amortization of discount on B/P • + Amortization of premium on investment in bonds • + Increase in deferred income tax liability • + Loss on disposal of assets or liabilities • + Investment loss under the equity method Statement of Cash Flows

  32. Adjustments to Convert Net Income to Net Cash Flow from Operating Activities (contd.) • + Increases in current liabilities other than N/P (i.e., A/P, salaries payable, interest payable, I/T payable, deferred I/T, and any other current liabilities related to operations) • + Decreases in current assets other than cash and N/R (i.e., A/R, interest receivable, inventory, prepaids, and any other current assets related to operations) Statement of Cash Flows

  33. Adjustments Adjustments to Convert Net Income to Net Cash Flow from Operating Activities (contd.) • - Amortization of premium on B/P • - Amortization of discount on investment in bonds • - Gain on disposal of assets or liabilities • - Investment income under the equity method • - Decrease in deferred income tax liability • - Decreases in current liabilities • - Increases in current assets • | | • Net Cash Flows from Operating Activities Statement of Cash Flows

  34. Adjustments:+ Amortization of Discount on B/P • Example: Issue a 2-year bond, market int. rate = 12%, bond int. rate = 10% • P.V. of Bond = $10,000 x 0.797 + 1,000 x 1.690 = 9,600 • 1. 1/1/x1 • Cash 9,660 • Discount on B/P 340 • B/P 10,000 Statement of Cash Flows

  35. Adjustments:+ Amortization of Dis. on B/P (contd.) • 2. Payment of Interest on 12/31/x1 • Interest Expense • (12% x 9660)1159.2 • Cash 1,000.0 • Dis. On B/Pa 159.2 • a. Amortization of bond discount increase interest expense but does not use cash. Statement of Cash Flows

  36. Dis 340 159.2 174.4 Adjustments:+ Amortization of Dis. on B/P (contd.) • 3. Payable of Interest on 12/31/x2 • Interest Expense • (9660 +159.2)  0.12 1,174.4 • Cash 1,000.0 • Discount On B/P 174.4 Statement of Cash Flows

  37. Adjustments:+ Amortization of Premium on Investment in Bonds • Example: GEO Corp. purchased $100,000, 10% 5-year bonds on 1/1/x2, with interest payable on 7/1 and 1/1. The bonds sell for $108,111 which results in bond premium of $8,111 and an effective interest rate of 8%. Statement of Cash Flows

  38. + Amortization of Premium on Investment in Bonds (contd.) • Example (contd.) • Record the purchase on 1/1/x2: • Investments 108,111 • Cash 108,111 • Record the interest revenue on 7/1/x2: • Cash 5,000 • Interest Revenue 4,324a • Investments 676 • a. Interest revenue = $108,111 x 4% = $4,324 Statement of Cash Flows

  39. Adjustments:+ Loss on Disposal of PPE or Investments • Example: Sale a piece of land with a cost of $7,000 for $5,000 • Cash 5,000 • Loss on Sale of Landa 2,000 • Land 7,000 • a. This transaction results in a cash increase of $5,000 reported in the investing activity section, not the operating activity section. Statement of Cash Flows

  40. Adjustments: + Investment Loss under equity method • Equity method must be used to account for return on investment in stock when gaining ownership of 20% ~ 50% with significant influence. • Example: • Obtain 30% of ownership with significant influence on investment in stock of Green Corp. for $40,000 Statement of Cash Flows

  41. + Investment Loss under equity method (contd.) • 2/4/x2 • Investment in Stock 40,000 • Cash 40,000 • 12/31/x2 • Green’s Loss of Year x2 • = 100,000 • Loss in Investment 30,000 • Investment in Stock 30,000 Statement of Cash Flows

  42. Data needed to prepare statement of cash flows • 1. Comparative balance sheet statements. • 2. The income statement. • 3. The retained earnings statement. • 4. Other supplemental information concerning the reasons for the changes in the B/S accounts (other than cash). Statement of Cash Flows

  43. Example 1Layton Company Balance Sheet (12/31/x2) • a. Land was sold at cost for cash during the year. • b. A building was purchased for cash during the year and no building or equipment was sold during the year. Statement of Cash Flows

  44. Example 1 (contd.)Layton Company Balance Sheet (12/31/x2) • a. Bonds were issued at the end of year. Statement of Cash Flows

  45. Example 1 (contd.)Income Statement (for the year ended 12/31x2) Statement of Cash Flows

  46. Example 1 (contd.)Layton Company Retained Earnings (20x2) Statement of Cash Flows

  47. Layton CompanyStatement of Cash Flows For the Year Ended December 31, 20x2 • Net cash flow from operating activities: • Net Income $7,000 • Adjustments to reconcile net • income to net cash provided by • operating activities: • Add: Depreciation expense 2,300 • Increase in A/P 1,500 • Less: Increase in A/R (2,700) • Net cash provided by • operating activities $8,100 Statement of Cash Flows

  48. Layton CompanyStatement of Cash Flows (contd.) • Cash flows from investing activities: • Proceeds from sale of land $3,000 • Payments for • purchase of building (12,000) • Net cash used • by investing activities (9,000) • Cash flows from financing activities: • Proceeds from issuance of bonds 7,000 • Payments of dividends (3,500) • Net cash provided by • financing activities 3,500 Statement of Cash Flows

  49. Layton CompanyStatement of Cash Flows (contd.) • Net increase in cash $2,600 • Cash, Jan 1, 20x2 $4,000 • Cash, Dec 31, 20x2 $6,600 Statement of Cash Flows

  50. Example 2:Green Company Balance Sheet • Accounts 1/1/x2 12/31/x2 Difference • Cash $3,500 $5,500 • A/R 4,400 3,600 800  • Inventory 5,000 6,600 1,600  • Land 8,200 12,200 4,000c  • Building & Equip 35,700 48,700 13,000a,d • Acc. Depr. (6,000) (8,700) • Total Assets $50,800$67,900 Statement of Cash Flows