W11 - Statement of Cash Flows (Theory)

Acquire Cash Flow Information through Non-Cash Accounts

- Another way to prepare the statement of cash flows is to acquire the cash flow information through non-cash accounts. + We can determine a company's cash inflows and outflows by looking at balance sheets and a statement of comprehensive income because each journal entry has two parts—a debit and a credit. In the case of the cash account, every time Cash is debited, some other account is credited; every time Cash is credited, some other account is debited. + We can use our knowledge of double-entry accounting to infer those details.

Cash and Cash equivalents

- Cash comprises cash on hand and demand deposits + Cash equivalents are short-term, highly liquid investments that are readily convertible to know amounts of cash and which are subject to an insignificant risk of changes in value + No need to include investments in quoted shares as cash equivalent because they are not subject to an significant risk of changes of value - Fixed deposits pledged to banks for banking facilities granted are excluded from cash and cash equivalent - Bank over drafts are borrowing and deducted from cash and cash equivalent

Organization of Cash Flows Statement

- Cash flow statement is presented in three major categories: + Operating activities + Investing activities + Financing activities - It provides information that allows users to assess the impact of these activities on the financial position of the enterprise and the amount of cash and cash equivalents - It may also be used to evaluate the relationship among these activities.

The Direct Method of Cash Flows from Operating Activities

- Cash flows from operations relate to preparing the operating activity section of the statement of cash flows. + We have two approaches to preparing cash flows from operating activities—the direct method and the indirect method. - The direct method is a method of reporting net cash flows from operations that shows the major classes of cash receipts and payments for a period of time. + Using the direct method, the operating activities section of a statement of cash flows is, in effect, a cash-basis statement of comprehensive income. - Using the direct method, the operating activities section of a statement of cash flows is, in effect, a cash-basis statement of comprehensive income. + Unlike the indirect method, the direct method does not start with Income before Income Tax. + Instead, this method directly reports the major classes of operating cash receipts and payments of an entity during a period. - No matter which method you use to prepare a statement of cash flows, there is no difference in the presentation of investing and financing activities. + So we focus on only operating activities. - Although the presentation of operating activities is different between the two methods, the "final" amount of cash flows from operating activities is the same.

Relationship between Cash Flows Statement and Balance Sheet

- Changes in current liabilities and assets affect operating cash flows - Investing cash flows comes from non-current asset - Financing cash flows come from movement in non-current liabilities and owner's equity

Financing Activities

- Financing activities include transactions and events whereby resources are obtained from or paid to owners (equity financing) and creditors (debt financing). - Dividends paid may be classified as a component of cash flows from operating activities in order to assist users to determine the ability of an entity to pay dividends out of operating cash flows. + But, once a classification is adopted, it should be applied consistently. - Useful in predicting claims on future cash flows by providers of capital to the enterprise + Provides information on how investing activities are being financed

Some Rules of Thumb

- For increase in current asset, subtract adjustment from pretax income - For decrease in current asset, add adjustment to pretax income - For increase in current liabilities, add adjustment to pretax income - For decrease in current liabilities, subtract adjustment from pretax income

Statement of Cash Flows

- Income statement and balance sheet are prepared under the accrual basis of accounting + Under this basis, the effects of transactions and other events are recognized in the accounting records when they occur and not as cash or its equivalent is received or paid - Cash flow statements enable us to: + Reports how a company generates and uses its cash + Presents cash inflows and outflows from operating, investing and financing activities of the business + Enables us to access how much of the company's reported net income (as recorded under accrual basis of accounting) is cash

Any Significant Investing or Financing Transactions That Does Not Involve Cash

- Investing and financing transactions that do not require the use of cash or cash equivalents shall be excluded from a statement of cash flows as these items do not involve cash flows in the current period. + Such transactions shall be disclosed elsewhere in the financial statements in a way that provides all the relevant information about these investing and financing activities.

Operating Activities

- Operating activities are primarily the principal revenue-producing activities of the entity. + They generally include the transactions and other events that enter into the determination of profit or loss. - The focus in analyzing operating activities is to determine cash flows from operations. + An analysis is required to convert income from an accrual-basis to a cash-basis number. + To do this, begin with the net income (or income before income tax), remove all items relating to investing activities (like depreciation and gains/losses on the sale of equipment) and financing activities (like gains/losses on retirement of debt), and then adjust for changes in those current assets and current liabilities that involve cash and relate to operations (which are most of the current assets and current liabilities). - Cash flows from operating activities is an important indicator of a company's ability to generate sustainable cash flows through operations and its management of working capital + For a company to survive in the long-run, it must have positive net cash flows from operating activities. - Operating cash flows (OCF) is an important indicator of liquidity of the company + Both creditors and shareholders are interested in operating cash flows as it is an indicator of the ability of the company to pay maturing liabilities, interest and dividends - A higher number is preferred

Cash Flows from Operating Activities: Direct Method

- The basic idea of the direct method is to adjust all the items in the statement of comprehensive income from accrual basis to cash basis. + Our objective at this point is to convert the statement of comprehensive income to cash flows from operations. - Recall that this involves three steps: + Eliminate expenses not involving cash. + Eliminate the effects of non-operating activities. + Adjust the remaining figures from an accrual basis to a cash basis. - The first two adjustments involve removing depreciation expense (because it does not involve an outflow of cash) and eliminating the gain on the sale of the equipment (because the sale of equipment is an investing activity, the effect of which will be disclosed in the investing activities section of the statement). + Note that because depreciation expense was initially subtracted to arrive at net income, our adjustment involves adding back because no cash actually flowed out of the company relating to depreciation. + The adjustments now involve converting the remaining revenue and expense items from an accrual basis to a cash basis. + To put it simply, we want to know how much the company has received in "cash" from its customers, and how much it has paid in "cash" 1/ Cash Received from Customers - Recall that the amount of cash collected from customers differed from sales for the period. + An adjustment must be made to increase the accrual-basis sales figure to its cash-basis counterpart 2/ Cash Payment to Vendors - Next, we turn our attention to Cost of Goods Sold. + The statement of cash flows should reflect the amount of cash paid for inventory during the period. + We can compute that amount by adjusting Cost of Goods Sold to reflect the inventory used this period but purchased last period, as well as inventory that was purchased last period and paid for this period. 3/ Cash Paid for Operating Expense: Rent Expense and Wage Expense - Because expenditure could either be prepaid or paid after the company has received the product or service, we analyze two balance sheet accounts related to operating expenses, prepaid expense, and accrued liabilities. + As for wage expense, neither a miscellaneous expenses payable account nor a prepaid expenses account exists. + We can safely assume that all the miscellaneous expenses were paid for in cash. + Therefore, there would be no adjustment. 4/ Cash Paid for Interest and Income Tax - Since it requires interest and income tax payments to be disclosed separately, there is no difference between the indirect method and the direct method in terms of either computation logic or representation in the statement of cash flows.

Summary of Three Accrual Adjustments

- The direct or indirect method may be used to show the net cash flows provided by (used in) operating activities. - The indirect method starts with income before income tax, as reported on the statement of comprehensive income, and adds or subtracts adjustments to convert accrual net income to net cash flows from operations. + When using the indirect method, adjustments to net income (or income before income tax) are made for increases and decreases in operating account balances, non-cash items such as depreciation, and gains and losses from the sale of assets. + Payments for income tax, interest, and receipts of interest are to be separately presented. 1/ Add back non-cash expense (+) Depreciation expense (+) Amortization expense (+) Depletion expense 2/ Deduct gains and losses that resulted from investing and financing activities (-) Disposal gains of PP&E (+) Disposal losses of PPE 3/ Analyze changes to non-cash current asset and liability accounts (+) Decrease/ (-) Increase in accounts receivable (+) Decrease/ (-) Increase in prepaid expense (-) Decrease/ (+) Increase in accounts payable (-) Decrease/ (+) Increase in accrued liabilities

The Indirect Method of Cash Flows from Operating Activities

- The indirect method is a method of reporting cash flows from operations that involves converting accrual-basis net income to a cash basis. + The indirect method begins with net income (or income before income tax) as reported on the statement of comprehensive income and then details the adjustment made to arrive at cash flows from operations. - (1) Interest received, (2) Dividends received, (3 Interest paid (4) Dividends paid have the same requirement as tax paid + Financial reporting standard requires that cash flows from interest and dividends received and paid to be disclosed separately. + All 4 items can be classified under operating cash flows, but 1. and 2. can also be classified under investing cash flows and 3. and 4. can also be classified under financing cash flows

Quality of Income

- There are 2 aspects of quality of income + Ability of current income to forecast future income + Proportion of current income in cash - QOI Ratio + Measures the portion of net income that was generated in cash + Higher ratio implies the company is able to meet its operating and other cash needs for operations + If ratio decrease it implies earnings is growing faster than operating cash flows. May be suggestive of creative accounting practices to boost earnings

Investing Activities

- Transactions and events that involve the purchase and sale of securities (other than FVTPL securities), property, buildings, equipment, and other assets not generally held for resale, and the making and collecting of loans are classified as investing activities. - Cash flows from investing activities represent the extent to which expenditures have been made for resources intended to generate future income and cash flows + Indicate how much of the cash flows is non-recurring (that is, one-off, e.g. cash receipts from sale of PPE, investments etc) - The analysis of investing activities involves identifying those accounts on the balance sheet relating to investments (typically long-term asset accounts) and then explaining how those accounts changed and how those changes affected the cash flows for the period.

Converting from an Accrual Basis to a Cash Basis

- While the indirect method generally does not report individual items of cash inflows and cash outflows from operating activities, companies are still required to list operating cash flows for income tax, interests, and dividends separately, even though companies choose to use the indirect method to convert net income in the statement of comprehensive income to the cash basis. (1) Start with the Item "Income before Income Tax" - Intuitively, we should start from net income to convert all items related to net income to a cash basis because other comprehensive incomes are primarily non-cash accounts. - However, the application of the indirect method should start with income before income tax. - It is required that operating cash flows for income tax payments to be presented separately. (2) Calculate and Report Separately Operating Cash Flows for Income Tax Payments - To determine the amount, we need to consider the change in income tax payable from the comparative balance sheets. + When income tax payable increases during the year, income tax expenses on an accrual basis are higher than cash payments arising from income tax. + This means that not all of the income tax expense results in cash payments. · Thus, we deduct from income tax expense the increases in income tax payable. + On the contrary, a decrease in income tax payable means that the amount that companies pay for income tax exceeds the income tax expense in the year. + Companies should add back the decrease in income tax payable to income tax expense. (3) Add Back Interest Expense and Deduct Interest Revenue. Calculate and Report Operating Cash Flows (Separately) for the Payments of Interests, and the Receipts of Interests - Interest Payments + We replace the amount of interest expense with the amount of cash payments for interests. - Interest Receipts + Silmaril, Inc. reported on the statement of comprehensive income interest revenue of $120. + However, interest receivable decreased by $80. This decrease means that the amount of interest receipts is more than the amount of interest revenues reported in the statement of comprehensive income. (4) Add Back Operating Expenses Not Involved with Cash Outflows: Depreciation Expense - Procedures (4)-(6) are three main adjustments that can convert the rest of net income items to net cash provided by operating activities. + The first adjustment in procedure (4) requires companies to add back depreciation expense because depreciation is a non-cash charge. + Other non-cash operating expenses include amortization of intangible assets, depletion expenses, and expected credit loss. (5) Deduct All the Gains and Add Back All the Losses Resulting from Investing or Financing Activities - investing or financing activities because they should not be included in cash flows from operating activities. + In a disposal transaction of a building, a company should recognize the cash receipts for the building and remove the carrying amount of the building, with the difference being accounted for as gains or losses. + Since the cash receipts are considered as cash inflows of investing activities, but not cash inflows of operating activities, we should not include the related gains/losses from the disposal in the operating activities. (6) Adjust Changes in Non-Cash Current Assets and Current Liability Accounts - The last adjustment for cash flows from operating activities relates to the changes in non-cash current asset and current liability accounts. - We start with the first non-cash current asset account—the accounts receivable account. + A debit to Accounts Receivable is most frequently associated with a sale on account. + A credit to Accounts Receivable most likely means cash was collected. + If we have the beginning and ending balances for the accounts receivable account (from comparative balance sheets) and sales for the period (from the statement of comprehensive income), we can infer the cash collected for the period. - We then move to the second non-cash current asset account—the inventory account. + A debit to Inventory is most frequently associated with the cash purchase of merchandise inventory. + A credit to Inventory most likely relates to the use of consumption or the use of inventory. + Because Inventory declined for the period, this means that Cost of Goods Sold includes the consumption of inventory that was purchased last period and the consumption of inventory purchased in this period. - Decrease in Prepaid Rent + This means that rent expense on an accrual basis exceeds its cash payments of rents in the year by the amount equivalent to the decrease in prepaid rents. - Decrease in Accounts Payable + The net effect of this adjustment along with the adjustment to the decrease in inventory is to convert the accrual-basis Cost of Goods Sold figure to the amount of inventory paid for during the year.

Acquire Cash Flow Information through the Cash Account

- With information from the cash T-account, we can prepare a statement of cash flows. + Here, we need to categorize each cash inflow and outflow as an operating, investing, or financing activity.

Accounting for Investing Activites

1/ Land - Be mindful with information indicates that land was purchased by both cash and notes payable 2/ Equipment - To make the T-account balance, equipment must have been sold. + Entries on the debit side of that account track the accumulated depreciation associated with equipment that has been sold. + Entries to the credit side are associated with depreciation expense for the period. + Because we know depreciation expense for the period (from the statement of comprehensive income), and we know the beginning and ending balances in the account (from the balance sheet), we can infer the accumulated depreciation associated with the equipment that was sold.

Analysis of Cash Flows

1/ Liquidity - Red flags that indicate the increasing cash balance could be deceiving + Decreasing equity (company making losses) + Increasing total liabilities and debt ratio - If company has been making losses, cash is unlikely to be from operations. 2/ Quality of Income - Assess how much of a company's reported net income is cash (quality of income) - Difference between accrual income and cash flows is in the "timing" - Red Flag: Increasing gap between profit and operating cash flows 3/ Evaluating cash flows - Report how a company generates and uses its cash - Do not interpret the adjustments as cash flows because negative adjustment does not mean that the item had caused operating cash flows to decrease

Accounting for Financing Activities

1/ Long-term Debt - Therefore, for the financing activities of the cash flow statement, the company should record repayment of long-term debts, and proceeds from new debts. 2/ Common Stock - In the case of equity accounts, we examine both the common stock and retained earnings accounts for increases and decreases. + The common stock account will increase as a result of the issuance of stock and decrease if any stock is repurchased and retired. + Again, if an unusual transaction had occurred, information relating to the transaction would be available in the notes. 3/ Retained Earnings - Retained Earnings increases from the recognition of net income (an operating activity) and through the payment of dividends (a financing activity).

Summarize the Cash Flows and Check the Balance

After we have finished analyzing all the changes in the balance sheet and adjusted for some specific accounts in the statement of comprehensive income, we could summarize the cash flow effects from the three activities and check if the bottom figure in the statement of cash flows is equal to the ending cash balance shown in the balance sheet.