Class Notes (811,169)
Canada (494,539)
Commerce (1,859)


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McMaster University
Teal Mc Ateer

T HE STATEMENT OF C ASH FLOWS P RIMARY PURPOSE AND FORMAT OF THE STATEMENT OF CASH FLOWS The main purpose of the statement of cash flows is to provide information about cash receipts, cash payments, and the net change in cash rng from the operating, investing, and financing activities of a company during a specific period. In addition to information about the firm’s ability to generate accrual income, investors and are equally interested in the firm’s ability to generate cash flows. The statement of cash flows provides feedbafirm’s ability to generate cash from the key areas of activity: Operations, Financing and Investing Statement of Cash Flows answers key cash-related questions: • Can the company meet short-term obligations? Operating • How is the company managing key areas of working capital? Operating • Is the company making adequate investments in new productive capacity? Operating • Has the company generated sufficient cash intern ally (either from operation or the sale of long-term assets) or is there reliance on exte rnal sources of funding (such as borrowing or issuing capital)? • Is the company changing the proportion of debt and equity in its capital structure? To recognize the type of business activitry useful to be able to recognize the affected accounts. For example, financing activities are mainly related to long-term debt and shareholders’ equity; investing activitie s are related to long-term assets; a nd operating activitie s are related to income statement items, current assets, and current liabilities. The following is the general format of the statement of cash flows ABC Inc. Statement of Cash flows For the year ended December 31, 2006 Cash Flows from Operating Activities ƒ Cash inflows: • From sale of goods or services • From interest received and dividends received ƒ Cash outflows: • To suppliers for inventory • To employees for services • To government for taxes • To lenders for interest • To others for expenses Net cash provided (used) by Operating Activities Cash Flows from Investing Activities ƒ Cash inflows: • From sale of long-term assets • From sale of investments • From collection of loans to other entities ƒ Cash outflows: • To purchase long-term assets • To purchase investments in securities • To make loans to other entities Net cash provided (used) by Investing Activities Cash Flows from Financing Activities ƒ Cash inflows: • From issuance of shares (Capital) • From issuance of long-term debt ƒ Cash outflows: • To shareholders as dividends • To redeem long-term debt • To reacquire capital shares Net cash provided (used) by Financing Activities Net Change in cash during the period . Add: Beginning Cash Balance Ending Cash Balance In addition, footnotes to the stat ement of cash flows must disclose significant non-cash investing and financing transactions. Examples include issuance of common shares or debt in exchange for long-term assets, conversion of debt to equity, and exchanges of long-term assets. PREPARING THE STATEMENT OF C ASH FLOWS The statement of cash flows covers the same peri od as the income statement and the statement of retained earnings. For the purposes of the statemen t of cash flows, cash includes cash equivalents, which include short-term, liquid investments that ar e readily convertible into cash and they present little risk of loss in value upon conversion to cash. The income statement, the balance sheet, and the statement of retained earnings are prepared from the adjusted trial balance for the current period. The statement of cash flows, however, is prepared from information in the income statement and the balance sheet. More over, two years of the balance sheet are required. Cash flows from investing and financing activities can be easil y prepared by identifying cash activities related to long-term assets and investment (investing activities) and to long-term debt and equity (financing activities). Cash flows from operating activities, however, are more challenging. C ASH FLOWS FROM OPERATING ACTIVITIES : Cash flows from operating activities are measured by converting accrual basis net income to cash basis income. The measurement of cash flow from operating activities can be determined by either the direct method (reports the gross receipts and gross payments) or the indirect method (starts with net income and eliminates non-cash transaction that impact net income). Both methods produce the same amount of cash provided (used) by operating activities. INDIRECT METHOD The indirect method begins with the accrual-basis income and adju sts it to derive the cash flows from operating activities. The cash flows from operat ing activities is simply net income calculated under the cash basis. Therefore, cash flows from operating activities equal net income after purging non-cash elements from accrual income. Operationally, the calculation of cash flows frooperating activities begins with net income as reported in the income statement and then makes few adjustments to purge non-cash elements of net income. Blow is an illustration: Net Income Adjustments to reconcile accrual income to cash flows from operating activities: Add: Depreciation and amortization expense Losses on the disposal of long-term assets Decreases in current assets Increases in current liabilities Subtract: Gains on the disposal of long-term assets Increases in current assets Decreases in current liabilities The purpose of the above adjustments is to remove the non-cash elements of accrual income. Below is the rationale of how the above adjustments are non-cash elements of accrual income. Depreciation and amortization expense : the depreciation and amor tization expense is an allocation of the long-term asset’s cost over its useful life. A lthough depreciation and amortization expense reduce net income, it is not a cash outf low; that is, companies do not pay cash when recording depreciation and amortization expense. Therefore, to adjust accrual basis income to cash basis we must add back amortization and depreciation expense. Consider the following example: In 2008, Nova Scotia Ltd. provided services to customers for $50,000 cash, and paid $15,000 for all operating expenses, except for depreciation and amortization expens e. Depreciation and amortization expense for 2008 was $5,000. Accrual income = Revenues – operating expenses – depreciation and amortization expense Accrual income = 50,000 – 15,000 – 5,000 = $30,000 Cash income = Cash collections – cash payments Cash income = 50,000 – 15,000 = $35,000 Since companies disclose the accrual income in the income statement, we can convert that income to cash income by adding back depreciation and amortization expense: Cash income = accrual income + depreciation and amortization expense Cash income = 30,000 + 5,000 = $35,000 Gains or losses on the disposal of long-term assets: Long-term assets are reported on the balance sheet at cost minus accumulated depreciation as follows: Property, Plant, and Equipment 70,000 Accumu daptreciation (22,000) Property, Plant, and Equipment, net 48,000 The term “book value” of an asset refers to the cost of the asset minus the related accumulated depreciation: Book value = cost – accumulated depreciation When a company sells an asset, the gain or loss on the sale is: Gain (loss) = proceeds from sale – book value For example, if the above asset is sold for $45,000, then Gain (loss) = 45,000 – 48,000 = ($3,000) a loss! The cash received from the sale of the asset will be reported in the investing activities section of the statement of cash flows. Keep in mind that the loss is a “paper” loss. The only reason we have this loss is that there is a 1ifference between book value (i.e., the value of the asset on “paper”) and the proceeds from the sale. 1 Recall that depreciation expense is based on estimates of useful life and salvage values. That means that the annual depreciation expense can change when these estimates change. Some companies can be aggressive by estimating higher useful life or salvage va lues, thus reducing the annual depreciation expense, and others can be conservative by estimating lower u seful life or salvage value, thus reporting higher depreciation expense. Assume in the above exampl e that the company was more conservative in its estimates of the useful life and the salvage value, an d as a result, the accumulated depreciation of the asset was $30,000 instead of $22,000. In this case, the book value of the asset would be $40,000 ($70,000 - The following example illustrates how gains or losse s on the sale of long-term assets are non-cash elements of accrual income: In 2008, Newfoundland Inc. provided services for $80,000 cash, and paid $56,000 for all operating expenses. In addition, the company sold an asset with a cost of $60,000 and accumulated depreciation of $28,000 for $25,000. Book value of the asset = cost – accumulated depreciation Book value of the asset = 60,000 – 28,000 = $32,000 Gain (loss) on sale of the asset = sales price – book value Gain (loss) on sale of the asset = 25,000 – 32,000 = ($7,000)* Accrual income = revenues – expenses – loss on sale of assets Accrual inc
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