Chapter 12 Accounting

4.The cash investing and financing transactions during the period.

By examining a company's investing and financing transactions, a financial statement reader can better understand why assets and liabilities changed during the period.

1.The entity's ability to generate future cash flows.

By examining relationships between items in the statement of cash flows, investors make predictions of the amounts, timing, and uncertainty of future cash flows better than they can from accrual-basis data.

investing activities

include (a) cash transactions that involve the purchase or disposal of investments and property, plant, and equipment, and (b) lending money and collecting the loans.

financing activities

include (a) obtaining cash from issuing debt and repaying the amounts borrowed, and (b) obtaining cash from stockholders, repurchasing shares, and paying dividends.

operating activities

include the cash effects of transactions that create revenues and expenses. They thus enter into the determination of net income.

Product Life Cycle

All products go through a series of phases called the product life cycle. The phases (in order of their occurrence) are introductory phase, growth phase, maturity phase, and decline phase. The introductory phase occurs at the beginning of a company's life, when it purchases fixed assets and begins to produce and sell products. During the growth phase, the company strives to expand its production and sales. In the maturity phase, sales and production level off. During the decline phase, sales of the product decrease due to a weakening in consumer demand.

Do you include noncash investing and financing activities in the body of the statement of cash flows?

Do not include noncash investing and financing activities in the body of the statement of cash flows. Report this information in a separate schedule below the statement of cash flows.

3.Purchased two semi-trailer trucks for $170,000 cash.

.Investing activity

Not all of a company's significant activities involve cash. Examples of significant noncash activities are:

1.Direct issuance of common stock to purchase assets. 2.Conversion of bonds into common stock. 3.Direct issuance of debt to purchase assets. 4.Exchanges of plant assets.

General guidelines

1.Operating activities involve income statement items. 2.Investing activities involve cash flows resulting from changes in investments and long-term asset items. 3.Financing activities involve cash flows resulting from changes in long-term liability and stockholders' equity items.

KEEPING AN EYE ON CASH

Cash flow is closely monitored by analysts and investors for many reasons and in a variety of ways. One measure that is gaining increased attention is "price to cash flow." This is a variant of the price to earnings (P-E) ratio, which has been a staple of analysts for a long time. The difference is that rather than divide the company's stock price by its earnings per share (an accrual-accounting-based number), the price to cash flow ratio divides the company's stock price by its cash flow per share. A high measure suggests that the stock price is high relative to the company's ability to generate cash. A low measure indicates that the company's stock might be a bargain.

In the same way that products have life cycles, companies have life cycles as well.

Companies generally have more than one product, and not all of a company's products are in the same phase of the product life cycle at the same time. This sometimes makes it difficult to classify a company's phase. Still, we can characterize a company as being in one of the four phases because the majority of its products are in a particular phase.

Companies classify as operating activities some cash flows related to investing or financing activities.

For example, receipts of investment revenue (interest and dividends) are classified as operating activities. So are payments of interest to lenders. Why are these considered operating activities? Because companies report these items in the income statement, where results of operations are shown.

2.The entity's ability to pay dividends and meet obligations.

If a company does not have adequate cash, it cannot pay employees, settle debts, or pay dividends. Employees, creditors, and stockholders should be particularly interested in this statement because it alone shows the flows of cash in a business.

INDIRECT AND DIRECT METHODS

In order to perform Step 1, a company must convert net income from an accrual basis to a cash basis. This conversion may be done by either of two methods: (1) the indirect method or (2) the direct method. Both methods arrive at the same total amount for "Net cash provided by operating activities." They differ in how they arrive at the amount.

FREE CASH FLOW

In the statement of cash flows, net cash provided by operating activities is intended to indicate the cash-generating capability of the company. Analysts have noted, however, that cash provided by operating activities fails to take into account that a company must invest in new fixed assets just to maintain its current level of operations. Companies also must at least maintain dividends at current levels to satisfy investors. As we discussed in Chapter 2, the measurement of free cash flow provides additional insight regarding a company's cash-generating ability. Free cash flow describes the net cash provided by operating activities after adjustment for capital expenditures and dividends.

current income statement

Information in this statement helps determine the amount of net cash provided or used by operating activities during the period.

Companies do not report in the body of the statement of cash flows significant financing and investing activities that do not affect cash

Instead, they report these activities in either a separate schedule at the bottom of the statement of cash flows or in a separate note or supplementary schedule to the financial statements. The reporting of these noncash activities in a separate schedule satisfies the full disclosure principle.

3.The reasons for the difference between net income and net cash provided (used) by operating activities.

Net income provides information on the success or failure of a business enterprise. However, some financial statement users are critical of accrual-basis net income because it requires many estimates. As a result, users often challenge the reliability of the number. Such is not the case with cash. Many readers of the statement of cash flows want to know the reasons for the difference between net income and net cash provided by operating activities. Then they can assess for themselves the reliability of the income number.

Collected $20,000 cash for services performed.

Operating activity

Paid employees $12,000 for salaries and wages.

Operating activity

The indirect method

adjusts net income for items that do not affect cash to determine net cash provided by operating activities. A great majority of companies (98%) use this method. Companies favor the indirect method for two reasons: (1) it is easier and less costly to prepare, and (2) it focuses on the differences between net income and net cash flow from operating activities.

The information to prepare this statement usually comes from three sources:

comparative balance sheets, current income statement and additional information

2.Borrowed $200,000 from Castle Bank, signing a 5-year note bearing 8% interest.

financing activity

3.maturity phase

net cash provided by operating activities and net income are approximately the same. Cash generated from operations exceeds investing needs. Thus, in the maturity phase, the company starts to pay dividends, retire debt, or buy back stock.

4.decline phase

net cash provided by operating activities decreases. Cash from investing activities might actually become positive as the company sells off excess assets. Cash from financing activities may be negative as the company buys back stock and redeems debt.

The statement of cash flows classifies cash receipts and cash payments as operating, investing, and financing activities. Transactions and other events characteristic of each kind of activity are as follows.

operating activities, investing activities and financing activities

The statement of cash flows

reports the cash receipts and cash payments from operating, investing, and financing activities during a period, in a format that reconciles the beginning and ending cash balances. The information in a statement of cash flows helps investors, creditors, and others assess the following.

the direct method

shows operating cash receipts and payments. It is prepared by adjusting each item in the income statement from the accrual basis to the cash basis. The FASB has expressed a preference for the direct method but allows the use of either method.

The statement of cash flows is very similar under GAAP and IFRS. One difference is that,

under IFRS, noncash investing and financing activities are not reported in the statement of cash flows but instead are reported in the notes to the financial statements.

1. introductory phase

we expect that the company will not generate positive cash from operations. That is, cash used in operations will exceed cash generated by operations in the introductory phase. Also, the company spends considerable amounts to purchase productive assets such as buildings and equipment. To support its asset purchases, the company issues stock or debt. Thus, during the introductory phase, we expect negative cash from operations, negative cash from investing, and positive cash from financing.

2. growth phase

we expect to see the company start to generate small amounts of cash from operations. During this phase, net cash provided by operating activities on the statement of cash flows is less than net income. One reason net income exceeds cash flow from operations during this period is explained by the difference between the cash paid for inventory and the amount expensed as cost of goods sold. Since the company projects increasing sales, the size of inventory purchases increases. Thus, in the growth phase, the company expenses less inventory on an accrual basis than it purchases on a cash basis. Also, collections on accounts receivable lag behind sales, and accrual sales during a period exceed cash collections during that period. Cash needed for asset acquisitions will continue to exceed net cash provided by operating activities. The company makes up the deficiency by issuing new stock or debt. Thus, in the growth phase, the company continues to show negative cash from investing activities and positive cash from financing activities.

Net Income +/- Adjustments = Net Cash Provided/used by operating activities

•Add back noncash expenses, such as depreciation expense and amortization expense. •Deduct gains and add losses that resulted from investing and financing activities. •Analyze changes to noncash current asset and current liability accounts.

Companies prepare the statement of cash flows differently from the three other basic financial statements.

First, it is not prepared from an adjusted trial balance. It requires detailed information concerning the changes in account balances that occurred between two points in time. An adjusted trial balance will not provide the necessary data. Second, the statement of cash flows deals with cash receipts and payments. As a result, the company adjusts the effects of the use of accrual accounting to determine cash flows.

comparative balance sheets

Information in the comparative balance sheets indicates the amount of the changes in asset, liability, and stockholders' equity accounts from the beginning to the end of the period.

Additional information

Such information includes transaction data that are needed to determine how cash was provided or used during the period.

Which operating activities category is the most important and why?

The operating activities category because it shows the cash provided by company operations. This source of cash is generally considered to be the best measure of a company's ability to generate sufficient cash to continue as a going concern.

STEP 1: OPERATING ACTIVITIES DETERMINE NET CASH PROVIDED/USED BY OPERATING ACTIVITIES BY CONVERTING NET INCOME FROM AN ACCRUAL BASIS TO A CASH BASIS

To determine net cash provided by operating activities under the indirect method, companies adjust net income in numerous ways. A useful starting point is to understand why net income must be converted to net cash provided by operating activities. Under GAAP, most companies use the accrual basis of accounting which requires that a company record revenue when the performance obligation is satisfied and record expenses when incurred. Revenues include credit sales for which the company has not yet collected cash. Expenses incurred include some items that it has not yet paid in cash. Thus, under the accrual basis of accounting, net income is not the same as net cash provided by operating activities. Therefore, under the indirect method, companies must adjust net income to convert certain items to the cash basis. The indirect method (or reconciliation method) starts with net income and converts it to net cash provided by operating activities.

1.Issued 100,000 shares of $5 par value common stock for $800,000 cash

financing activity