MGAB02H3 Lecture Notes - Lecture 8: Common Rule, Capital Structure, Longrun

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MGAB02 - Reporting and Interpreting Cash Flows
Chapter 5
Classification of Cash Flows
The statement of cash flows explains how the cash balance at the beginning of the period
changed to another cash balance at the end of the period
oThe definition of cash includes cash and cash equivalents
Cash Equivalents are short-term, highly liquid investments with an original
maturity of less than 3 months, and subject to an insignificant risk of changes
in value
I.e. treasury bills, money market funds, and commercial paper
The statement of cash flows reports cash inflows and outflows based on 3 broad categories
1. Operating activities
2. Investing activities
3. Financing activities
Cash Flows from Operating Activities
Cash Flows from Operating Activities are cash inflows and outflows directly related to
earnings from normal operations
There are 2 alternative approaches for presenting the operating activities section of the
statement
1. The Direct Method
The Direct Method of presenting the operating activities section of the
statement of cash flows reports components of cash flows from operating
activities as gross receipts and gross payments
The difference between these cash inflows and outflows is called net cash
inflow (outflow) from operating activities
This method is rarely used in Canada because it is more expensive to
implement than the indirect method
2. The Indirect Method
The Indirect Method of presenting the operating activities section of the
statement of cash flows adjusts net earnings to compute cash flows from
operating activities
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Cash Flows from Investing Activities
Cash Flows from Investing Activities are cash inflows and outflows related to the
acquisition or sale of productive facilities and investments in the securities of other
companies
The difference between these cash inflows and outflows is called net cash inflow (outflow)
from investing activities
Cash Flows from Financing Activities
Cash Flows from Financing Activities are cash inflows and outflows related to external
sources of financing (owners and creditors) for the enterprise
The difference between these cash inflows and outflows is called net cash inflow (outflow)
from financing activities
Net Increase (Decrease) in Cash
The combination of the net cash flows from operating activities, investing activities, and
financing activities must equal the net increase (decrease) in cash for the reporting period
Relationships to the Statement of Financial Position and the Statement of Earnings
Companies cannot prepare the statement of cash flows by using amounts recorded in the
specific accounts because these amounts are based on accrual accounting
oInstead, accountants must analyze the amounts recorded under the accrual basis and
adjust them to a cash basis
To prepare statement of cash flows, you need the following data
1. Comparative Statements of Financial Position
Used to compute the cash flows from all activities
2. A Complete statement of earnings
Used primarily to identify cash flows from operating activities
3. Additional details
Concerning selected accounts that reflect different types of transactions and
events
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Analysis of individual accounts is necessary because often the net change in
an account balance during the year does not reveal the underlying nature of the
cash flows
Our approach to preparing and understanding the statement of cash flows focuses on changes
in the accounts that are reported on the statement of financial position
oIt relies on a simple algebraic manipulation of the accounting equation
oFirst, assets can be split into cash and non-cash assets
oTherefore
Thus, any transaction that changes cash must be accompanied by a change in
liabilities, shareholders’ equity, or non-cash assets
In general, increased in cash are associated with decreases in non-cash asset accounts and
increases in liability and shareholders’ equity accounts
The financial position accounts related to generating earnings (operating activities) should be
marked with an O, these accounts include the following
oMost current assets (other than short-term investments that relate to investing
activities)
oMost current liabilities (other than amounts owed to investors and financial
institutions, all of which relate to financing activities)
oRetained earnings because it increases by the amount of net earnings, which is the
starting point of the operating sections
Retained earnings also decreases by the amount of dividends declared, which
is a financing outflow noted by an F
The financial position accounts related to investing activities should be marked with an I
oThese include all of the remaining assets on the statement of financial position
The financial position accounts related to financing activities should be marked with an F
oThese include all of the remaining liability and shareholders’ equity accounts on the
statement of financial position
Reporting and Interpreting Cash Flows from Operating Activities
A Simplified Illustration
The indirect method begins with the computation of net earnings, which is the difference
between revenues (including gains) and expenses (including losses)
oRevenues earned do not necessarily result in an equal amount of cash collections from
customers during the year
oThe amount of expenses incurred during the year may not equal the amount of cash
payments for these expenses
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