Accounting Principles Second Canadian Edition Weygandt Kieso Kimmel

Accounting Principles Second Canadian Edition Weygandt · Kieso · Kimmel · Trenholm Prepared by: Carole Bowman, Sheridan College

CHAPTER 18 CASH FLOW STATEMENT

PURPOSE OF THE CASH FLOW STATEMENT • The primary purpose of the cash flow statement is to provide information about the cash receipts and cash payments of an entity during a period. • A secondary objective is to provide information about its – Operating activities – Investing activities – Financing activities

MEANING OF CASH FLOWS • The cash flow statement is usually prepared using cash and cash equivalents as its basis. • Cash equivalents are short-term, highly liquid investments that are both 1. readily convertible to known amounts of cash, and 2. so near to their maturity that their market value is relatively insensitive to changes in interest rates.

CLASSIFICATION OF CASH FLOWS • Operating activities • Investing activities • Financing activities

OPERATING ACTIVITIES • Include – Cash effects of transactions that create revenues and expenses and – Enter into determination of net income (loss) Balance Sheet: Noncash Current Assets and Current Liabilities; Income Statement Items

INVESTING ACTIVITIES • Include – Purchasing and disposing of investments and productive long-lived assets using cash and – Lending money and collecting the loans Balance Sheet: Investment and Long-Term Asset Items

FINANCING ACTIVITIES • Include – Obtaining cash from issuing debt and repaying the amounts borrowed and – Obtaining cash from owners/shareholders and paying them drawings/dividends Balance Sheet: Long-Term Liability and Equity Items

SIGNIFICANT NONCASH ACTIVITIES • If it does not affect cash, do NOT report in body of cash flow statement • Report in separate note to the financial statements

ILLUSTRATION 18 -2 FORMAT OF CASH FLOW STATEMENT Operating, investing, and financing plus the significant noncash investing and financing activities constitute the general format of the cash flow statement, an example of which is shown on the right. COMPANY NAME Cash Flow Statement Period Covered Cash flows from operating activities (List of individual items) XX Net cash provided (used) by operating activities Cash flows from investing activities (List of individual items) XX Net cash provided (used) by investing activities Cash flows from financing activities (List of individual items) XX Net cash provided (used) by financing activities Net increase (decrease) in cash Cash at beginning of period Cash at end of period Note x: Noncash investing and financing activities (List of significant noncash transactions) XXX XXX

PREPARING THE CASH FLOW STATEMENT The cash flow statement is prepared differently from the three other basic financial statements. 1. It is not prepared from the adjusted trial balance. 2. The cash flow statement deals with cash receipts and payments, so the accrual concept is not used in the preparation of this statement. The information to prepare this statement usually comes from three sources: 1. Comparative balance sheet 2. Current income statement 3. Additional information

ILLUSTRATION 18 -3 THREE MAJOR STEPS IN PREPARING THE CASH FLOW STATEMENT Step 1: Determine the net increase (decrease) in cash. The difference between the beginning and ending cash balances can be easily calculated from comparative balance sheets. + or - Step 2: Determine net cash provided (used) by operating activities. This step involves analysing not only the current year’s income statement but also comparative balance sheets and selected additional data. XYZ Goods Step 3: Determine net cash provided (used) by investing and financing activities. This step involves analysing comparative balance sheet data and selected additional information for their effects on cash. For Sale Investing Financing

STEP 1: DETERMINE NET INCOME (DECREASE) IN CASH

STEP 2: DETERMINE NET CASH PROVIDED (USED) BY OPERATING ACTIVITIES • Net income must be converted from an accrual basis to a cash basis in the operating activities section • Conversion may be done by two methods: – Indirect (used extensively in practice) – Direct

INDIRECT AND DIRECT METHODS • Both methods arrive at the same total amount of cash provided (used) by operating activities • Methods differ in disclosing the items that make up the total amount • Choice of methods affects only the operating activities section; the investing and financing activities sections are the same

OPERATING ACTIVITIES – INDIRECT METHOD Section 1

ILLUSTRATION 18 -6 NET INCOME VS. NET CASH PROVIDED BY OPERATING ACTIVITIES The indirect method starts with net income and converts it to net cash provided by operating activities. In other words, it adjusts net income for items that affect reported net income but do not affect cash, as shown below. Accrual Basis of Accounting Eliminate noncash revenues Earned Revenues Net Income Incurred Expenses Cash Basis of Accounting Net Cash Provided (Used) by Operating Activities Eliminate noncash expenses

NET INCOME TO NET CASH PROVIDED (USED) BY OPERATING ACTIVITIES (B/S: Noncash Current Assets and Current Liabilities) Adjustments to Convert Net Income to Net Cash Provided (Used) by Operating Activities Add* Deduct* Change in Current Asset Account Balance Accounts receivable Decrease Inventory Decrease Prepaid expenses Decrease Other current assets Decrease Increase Change in Current Liability Account Balance Accounts payable Increase Accrued expenses payable Increase Other current liabilities Increase Decrease * Add (deduct) change in account balance to net income

NET INCOME TO NET CASH PROVIDED (USED) BY OPERATING ACTIVITIES (I/S: Noncash Items) Adjustments to Convert Net Income to Net Cash Provided (Used) by Operating Activities Noncash Items on Income Statement Amortization (of capital assets) expense Amortization of bond discount to interest expense Amortization of bond premium to interest expense Loss on sale of asset Gain on sale of asset Income from long-term equity investment Add Deduct

NET CASH PROVIDED (USED) BY OPERATING ACTIVITIES Indirect Method – Sample Format

OPERATING ACTIVITIES – DIRECT METHOD Section 2

CASH RECEIPTS AND CASH PAYMENTS (Direct Method)

CASH RECEIPTS FROM CUSTOMERS • The relationships among cash receipts from customers, revenues from sales, and changes in accounts receivable is: Cash receipts from customers = { Revenues from sales + Decrease in accounts receivable or – Increase in accounts receivable

CASH PAYMENTS TO SUPPLIERS • The relationship among cash payments to suppliers, cost of goods sold, changes in inventory, and changes in accounts payable is: Cash payments to suppliers = Cost of goods sold { { + Increase in inventory or – Decrease in inventory + Decrease in accounts payable or – Increase in accounts payable

CASH PAYMENTS FOR OPERATING EXPENSES • The relationship among cash payments for operating expenses, changes in prepaid expenses, and changes in accrued expenses payable is: Cash payments for services = Operating dxpenses { { + Increase in prepaid expenses or – Decrease in prepaid expenses + Decrease in accrued expenses payable or – Increase in accrued expenses payable

CASH PAYMENTS FOR INCOME TAX • The relationships among cash payments for income tax, income tax expense, and changes in income tax payable is: Cash payments for income tax = Income tax expense { + Decrease in income tax payable or – Increase in income tax payable

NET CASH PROVIDED (USED) BY OPERATING ACTIVITIES Direct Method – Sample Format COMPUTER SERVICES CORPORATION Cash Flow Statement – Direct Method For the Year Ended December 31, 2002 Cash flows from operating activities Cash receipts from customers Cash payments: To suppliers For operating expenses For income tax Net cash used by operating activities $120, 000 ($75, 000) (36, 000) (10, 000)(121, 000) (1, 000)

STEP 3: DETERMINE NET CASH PROVIDED (USED) BY INVESTING AND FINANCING ACTIVITIES

NET CASH PROVIDED (USED) BY INVESTING ACTIVITIES • Study the balance sheet to determine changes in investments and long-term assets • Changes in each short-term investment (unless incorporated as part of cash definition) and long-term account are analysed using selected transaction data to determine the effect, if any, the changes had on cash

NET CASH PROVIDED (USED) BY FINANCING ACTIVITIES • Study the balance sheet to determine changes in noncurrent liabilities and owner’s/shareholders’ equity • Changes in each noncurrent account are analysed using selected transaction data to determine the effect, if any, the changes had on cash

ILLUSTRATION 18 -8 CASH FLOW STATEMENT INDIRECT METHOD COMPUTER SERVICES COMPANY Cash Flow Statement — Indirect Method For the Year Ended December 31, 2002 Operating activities used $1, 000 cash and investing activities used $10, 000 cash, while financing activities provided $45, 000 cash.

ILLUSTRATION 18 -23 CASH FLOW STATEMENT DIRECT METHOD COMPUTER SERVICES CORPORATION Cash Flow Statement For the Year Ended December 31, 2002 Cash flows from operating activities The cash flow Cash receipts from customers $120, 000 statement Cash payments: shows that To suppliers $(75, 000) For operating expenses (36, 000) operating For income tax activities used (10, 000) (121, 000) Net cash provided by operating activities$1, 000 cash (1, 000) Cash flows from investing activities and investing Purchase of equipment activities used $(10, 000) Net cash used by investing activities (10, 000) $10, 000 cash, Cash flows from financing activities while Issue of common shares $ 60, 000 financing Payment of cash dividends (15, 000) activities Net cash provided by financing activities 45, 000 provided Net increase in cash 34, 000 $45, 000 cash. Cash, January 1 0 Cash, December 31 $ 34, 000

USING CASH FLOWS TO EVALUATE COMPANY • Liquidity – Cash current debt coverage ratio • Profitability – Cash return on sales ratio – Cash flow per share • Solvency – Cash total debt coverage These ratios are cash-based instead of accrual-based

CASH CURRENT DEBT COVERAGE • Cash current debt coverage indicates the amount of cash to pay off current debt that is generated from operating activities. • The ratio provides a better picture of liquidity than using the current ratio because it uses cash provided by operating activities rather than the year-end asset balance. Cash Provided by Operating Activities Average Current Liabilities Cash Current Debt Coverage

CASH RETURN ON SALES • Cash return on sales indicates how quickly sales are turned into cash. • The company is efficient at turning sales into cash when its cash return on sales is greater than its accrual-based counterpart, the profit margin. Cash Provided by Operating Activities Net Sales Cash Return on Sales

CASH FLOW PER SHARE • Cash flow per share indicates the cash flow generated for each common share. Cash Flow from Operating, Investing, and Financing Activities Number of Common Shares Cash Flow per Share

CASH TOTAL DEBT COVERAGE • Cash total debt coverage indicates the amount of cash to pay off total debt that is generated from operating activities. • The ratio is the cash based counterpart to the debt to total assets ratio. Cash Provided by Operating Activities Average Total Liabilities Cash Total Debt Coverage

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