FA2Module 3. Cash Flow Statement • Definition and objectives • Classification of elements • Direct and indirect methods • Gains and losses • The T-account method • Accounts receivable
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1. CFS: Definition and objectives The Cash Flow Statement (formerly Statement of Changes in Financial Position) shows the changes in Cash and Cash Equivalents arising from the operating, financing and investing activities of the enterprise. This information is useful for: 1. understanding effects of operating, financing and investing activities on cash; 2. assessing liquidity and solvency; and 3. assessing the firm=s ability to generate cash from internal sources.
Cash and cash equivalents Cash and cash equivalents include cash, plus temporary investments that are highly liquid (e. g., maturities of three months or less): • money market accounts • treasury bills Marketable Securities are often excluded. Liquid liabilities (e. g., line of credit) can be considered “negative” cash equivalents.
Format of the CFS Operating activities Net cash flows from operations $ Investing activities Acquisitions of non-current assets ($) Dispositions of non-current assets $ Net cash from (used by) investing activities $ Financing activities Issues of shares/debt $ Redemption of share/debt repayment ($) Net cash from (used by) financing activities $ Net change in cash and cash equivalents $
3. CFS: Direct and indirect methods There are two methods of presentation of the CFS: the direct and indirect methods. The only difference is in the presentation of cash from operating activities. Direct method (now preferred by the CICA) Cash inflows from operations $ Cash outflows related to operations $ Net cash from operations $ Indirect method Net income $ +/- diff. between accrual and cash acctg $ Net cash from operations $
Indirect method • Starting point is net income. • Eliminate revenues and expenses that do not provide or use cash (e. g., amortization). • The resulting figure is adjusted for changes in balance sheet accounts that are associated with operating activities (e. g., accounts receivable, inventory, accounts payable, etc.):
Indirect method (two-step presentation) Net income $ - Non-cash revenues ($) + Non-cash expenses $ $ Changes in non-cash working capital - increases in associated assets ($) +decreases in associated assets $ + increases in associated liabilities $ - decreases in associated liabilities ($) Net cash from operations $ Example: A5-29
4. Gains and losses Gains and losses arise from incidental and/or peripheral transactions that tend to be investing (e. g., sale of fixed asset) or financing (e. g., retirement of debt) activities. The gain or loss is generally the difference between any net cash flow related to the transaction and the book value of the asset or liability in question. The cash flow should be in the cash flow statement; the gain or loss should not.
Gains, losses and the cash flow statement Direct method Gains and losses are generally not included in operating activities; the related cash flow is presented in the appropriate CFS section. Indirect method Gains are deducted from, and losses added back to, net income in the operating activities section. The related cash flow is presented in the appropriate CFS section.
Gain example: Hogan Ltd Sales for the year were $70. Operating expenses for the year were $40. Aside from depreciation ($5), there were no non-cash sales or expenses. During the year, Hogan sold a piece of equipment (cost = $22; accumulated depreciation = $7) for $25. There were no other investing or financing activities during the year. The tax rate is 20% and all taxes were paid during the year. Required: Prepare the income statement. Prepare the cash flow statement using (1) the direct method; and (2) the indirect method.
5. The T-account method The T-account method is a quick, informal way to organize information to prepare a cash flow statement. It works best for indirect method CFS. The steps are: • Prepare t-accounts for each balance sheet account with the beginning and ending balance. There are 3 cash and cash-equivalent accounts, one for each of the cash flow statement sections.
5. The T-account method • Go through the income statement and additional information and “post” the implied transactions to the t-accounts. Non-cash income statement items are posted to Cash from operating activities. • Go through each of the balance sheet accounts and identify any unexplained variations. Using the most obvious explanation, assume and “post” the transaction.
5. The T-account method • Using the numbers in the three cash accounts, assemble the cash flow statement. Often-used shortcut: Do not bother with t-accounts for the working capital accounts – usually, only the changes in these accounts matter. The non-working capital accounts are frequently affected by more than one cash transaction. Example: Secada
6. Accounts receivable The usual cash flow statement treatment accorded accounts receivable and cash collections from customers is to add (subtract) the decrease (increase) in accounts receivable. The situation is usually more complicated than that because: • Bad debt expense is a non-cash expense • Some accounts receivable are never collected (write-offs)
Accounts receivable transactions Dr. Accounts receivable Sales Cr. Revenue Dr. Cash Collections Cr. Accounts receivable Dr. Bad debt expense Est. bad debts Cr. Allowance for doubtful accounts Dr. Allowance for doubtful accounts write-offs Cr. Accounts receivable
Net cash from operating activities(Credit sales, cash expenses except bad debt)