Accounting Chp 6

US GAAP vs IFRS: Classifying cash flows

US GAAP: --Requires firms to classify cash receipts from interest and dividends as an operating activity and to classify cash flows related to the purchase and sale of investments in securities as an investing activity. Cash payments for interest expense are also classified as an operating activity. IFRS: Permits firms to classify cash received from interest and dividends as operating, investing, or financing activities provided the classification is consistently applied across periods. Under both US GAAP and IFRS, issuing or repaying debt is a financing activity, as is paying cash dividends.

t account work sheet

We use the t-account worksheet to show the effects of transactions on the cash account. -->The t account worksheet does not show accounts as they appear in the firms general ledger. -->The t account worksheet is like scratch paper, used for computations that are no a part of the formal record keeping system.

Adjustments to net income required under the indirect method to account for changes to working capital items:

Working Capital Account --> adjustment to NIU required to derive CFO under the indirect method: Change in current asset: >Increase --> subtraction in the amount of the increase >decrease--> addition in the amount of the decrease Change in current liability: >Increase--> addition in the amount of the increase >decrease--> subtraction in the amount of the decrease

cash flow from financing activities (CFF)

A category in a company's cash flow statement that accounts for external activities that allow a firm to raise capital and repay investors, such as issuing cash dividends, adding or changing loans or issuing more stock. -->Cash flow from financing activities shows investors the company's financial strength. -->A company that frequently turns to new debt or equity for cash, for example, could have problems if the capital markets become less liquid. The formula for cash flow from financing activities is as follows: Cash Received from Issuing Stock or Debt - Cash Paid as Dividends and Re-Acquisition of Debt/Stock

cash flow from investing activities (CFI)

An item on the cash flow statement belongs in the investing activities section if it results from any gains (or losses) from investments in financial markets and operating subsidiaries. -->An investing activity refers to cash spent on investments in capital assets such as plant and equipment, which is collectively referred to as capital expenditure, or capex. -->The acquisition of non current assets, particularly PPE usually represents a major on going use of cash -->firms not experiencing rapid growth can often finance the acquisition of non current assets with CFO. -->Rapidly growing firms must often borrow funds or issue common shares to finance these acquisitions

Other Equations:

Beginning RE + NI - Dividends = Ending RE Dividends = Beginning RE + NI - Ending RE

US GAAP vs IFRS: Presentation of Statement of Cash Flows:

Both allow certain flexibility but the following are required: 1: Firms must reports cash flows from operations, investing, and financing for the current and prior two years 2: Must report beginning and ending cash balances as well as the change in the cash balance. -->change in cash must reconcile to the sum of the cash inflows and outflows. 3: For investing and financing cash flows, firm must show the gross cash inflows and outflows. 4: Firms must disclose non monetary transactions in the body of the statement of cash flows, or in a separate schedule or note.

cash equivalents

Cash equivalents represent short term, highly liquid investments in which a firm has temporarily placed excess cash. -->Under US GAAP and IFRS the statement of cash flows explains the changes in cash and cash equivalents

Analytic Entries:

In constructing the T-account worksheet, we make analytic entries that resemble journal entries. Remember: -->debits on the t-account worksheet must equal credits. -->Debits increase asset accounts and decrease liability and equity accounts -->credits decrease asset accounts and increase both liability and equity accounts -->Expenses = debits -->Revenues = credits

free cash flow

The excess of cash flow from operations over cash flow used for investing = free cash flow. --> (Positive OCF) - (cash flow used in investing ) = free cash flow -->used for various purposes: Repay borrowing, pay a dividend, repurchase common shares, or add to cash on the balance sheet.

Analytic Entries and the Indirect Method:

The indirect method of presenting cash flows from operations reconciles net income to operating cash flows: -->both the t-account worksheet and the cash flow from operations section of the actual statement of cash flows, for the indirect method, start with the provisional assumption that all earnings produce cash from operations. --> subsequent additions and subtractions adjust for transactions where that assumption is invalid. Not all expenses decrease cash and not all sales/revenues produce cash. -->To calculate cash from operations, we must add back to net income the amounts of expenses that do not use cash in this period but instead use non-cash net assets in this period and visa versa for profits. Examples: 1: depreciation expense -->analytic entry for depreciation expense adds back depreciation expense to Net income in calculating cash flow from operations. 2: Dividends: -->Dividends reduce retained earnings and cash. -->paying cash dividends is a financing activity on the statement of cash flows Once the t-account worksheet reflects the supplementary information, we must make inferences about the reasons for the remaining changes in the non cash balance sheet accounts. 3: Accounts Receivable: -->The amount of the increase (decrease) n AR is the amount that must be subtracted from (added to) net income to calculate cash from operations. -->inventory -->PP&E -->Long term investments -->Accounts Payable -->Accrued liabilities -->Bonds Payable Analytic entries explain all changes in the non-cash t-accounts and show annotations in the components of change in the cash account.

indirect method

The indirect method of presenting the cash from operations section of the statement of cash flows begins with net income for a period and presents adjustments to net income for revenues and expenses not matched with cash receipts from customers or disbursements to suppliers of goods and services in the current period. -->Most firms report cash flow from operations using the indirect method.

Preparing the Statement of Cash Flows from the balance sheet and income statement:

Step 1: -->Obtain balance sheets for the beginning and end of the period covered by the statement of cash flows and an income statement for that period. Step 2: -->Prepare a T-account worksheet -->the top of the worksheet shows a master t account titled CASH, subdivided into 3 sections labeled operations, investing, and financing. --> The master t-account, cash, represents the left hand side of the cash change equation (the change in cash) -->Below the mast cash t-account, Complete the worksheet by preparing t-accounts for each liability, shareholders equity, and non cash asset account. -->the sum of the changes in these individual t accounts expresses the right hand side of the cash change equation. Step 3: -->Explain the change in the master cash t-account between the beginning and end of the period by accounting for the cash effect of the change in each non-cash account during the period: -->First, reconstruct the entries originally recorded in the accounts during the period. -->second, classify the entries in the master account for cash as operating, investing, or financing activities. -->the net change in all non-cash accounts provides the information needed to account for the change in cash, the left hand side of the cash change equation. Step 4: -->In the final step, use the information in the master T-account for cash flows to prepare a statement of cash flows

cash flow from operations (CFO)

The amount of cash flow from operations indicates the extent to which operating activities generate more cash than they use. -->A financially healthy company generates sustained cash inflows from selling goods and providing services --> a firm can use cash flow from operations to acquire buildings and equipment, pay dividends, retire long term debt, and pay for other investing and financing activities. Investopedia: In accounting, cash flow from operations a measure of the amount of cash generated by a company's normal business operations. Operating cash flow is important because it indicates whether a company is able to generate sufficient positive cash flow to maintain and grow its operations, or whether it may require external financing. OCF is calculated by adjusting net income for items such as depreciation, changes to accounts receivable and changes in inventory.

direct method

The direct method of presenting the cash from operations section of the statement of cash flows reports the amounts of cash received from customers less cash disbursed to suppliers, employers, lenders, and taxing authorities. 3 Steps: -->1: Copy income statement and cash flow from operations -->2: Copy information from t account worksheet next to related income statement item (uses cash flow from operations derived with the indirect method, just uses a different order--net income is at the bottom) 3: Sum across rows to derive direct receipts and expenditures

Relations among Cash Flows:

The relations among cash flows from each of the three principal business activities differ depending on the characteristics of the firm's products and its maturity: Rapidly Growing not Yet Profitable Firms: -->often has negative cash flow from operations -->To sustain growth, invests in PP&E and relies on external sources of cash to finance operating and investing activities More Seasoned but Still Growing Firms: -->Generates positive CFO but not enough to finance acquisitions of PP&E -->Requires external financing Mature, Stable Firms: -->Generates sufficient CFO to acquire new PP&E, repay financing from earlier periods, and, perhaps, to pay dividends. Declining Firms: -->CFO may be positive because of decreases in AR and inventories. In later stages of decline, CFO may turn negative. -->Declining firms reduce capital expenditures and uses some CFO to retire outstanding debt/shares -->May also use cash to invest in developing new products / to explore new industries.

statement of cash flows

The statement of cash flows shows the sources and uses of cash during a period. -->statement of cash flows reports the impact of a firms operating, investing, and financing activities on cash flows during the period. -->net income from a particular period DOES NOT equal cash flow from operations When analyzing a company's cash flow statement, it is important to consider each of the various sections that contribute to the overall change in cash position. In many cases, a firm may have negative overall cash flow for a given quarter, but if the company can generate positive cash flow from its business operations, the negative overall cash flow is not necessarily a bad thing.

Direct vs indirect method

The two methods differ with respect to their derivation of cash flow from operations, but they end up calculating the same amount for cash flows from operations. -->They are identical with respect to their derivations of cash flow from investing and cash flow from financing. The indirect and direct methods calculate the same amount of cash from operations: 1: Indirect: -->the indirect method starts with net income, equal to revenue - expenses. Then it adjusts net income for revenues or expenses that produce or use cash in amounts different from the revenue or expense item. 2: Direct: -->the direct method lists each revenue amount that increases cash and each expense amount that reduces cash.

types of cash flows

There are three types of cash flows: 1: operations: -->(Cash received from sales of goods and services) - (cash paid for operating goods and services) = OCF 2: Investing -->(Cash received from sales of investments and PP&E) - (cash paid for acquisition of investments and PP&E) = Cash flow from investing 3: Financing -->(Cash recieved from issue of debt or capital stock) - (Cash paid for dividends and reacquisition of debt or capital stock) = cash flow from financing The sum of all three types of cash flows = Net change in cash for the period.

cash change equation

To understand the preparation of a statement of cash flows, you must understand how changes in cash relate to changes in non-cash accounts. Balance Sheet Equation (Eq.1) -->Assets = liabilities + Shareholder's Equity -->Cash +Non Cash Assets = Liabilities + Shareholders Equity (Eq.2) -->Change in Cash + Change in non cash assets = change in liabilities + change in shareholders' equity Cash Change Equation (Eq.3) -->Change in cash = change in liabilities + change in shareholders' equity - change in non cash assets We identify the causes of the change in cash by studying the changes in non-cash accounts and classifying each change as operating or investing or financing activities.