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Chapter 10

COMMERCE 1AA3 Chapter Notes - Chapter 10: Cash Flow, Net Income, Accrual


Department
Commerce
Course Code
COMMERCE 1AA3
Professor
Aadil Merali Juma
Chapter
10

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Chapter 10 Accounting
Explain the Uses of the Statement of Cash Flows
Balance Sheet
reports its cash position at a specific date
balance sheets from consecutive financial periods show whether its cash balance
increased or decreased over the interim period
DOES NOT show what caused the cash balance to change
Income Statement
Reports a company’s revenues, expenses, and net income but because it is prepared on
an accrual basis, it provides limited information about how cash flows were affected by
the company’s business activities during the reporting period
Statement of Cash Flows
How a company’s cash flows affected its cash position during a reporting period
The information disclosed by a company about its cash flows provides decision-relevant
information to users of the company’s financial statements
Details about a company’s cash receipts and cash disbursement from operating,
investing and financing activities and permits a user to determine exactly what caused
the company’s cash balance to increase or decrease during the period
It is dated the same way as the income statement
Helps managers, investors and creditors perform the following functions:
o Predict future cash flows
Past cash receipts and payments are reasonably good predictors of future
cash flows
o Evaluate management decisions
Businesses that make wise investment decisions prosper, and those that
make unwise decisions suffer loses
Reports how managers got cash and how they used cash to run the
business
o Determine ability to pay dividends and interest
Shareholders want dividends on their investments
Creditors collect interest and principal on their loans
Statement of cash flows reports on the ability to make these payments
o Assess the relationship of net income to cash flows
Usually, cash and net income move together
High levels of income tend to lead to increases in cash, and low levels of
income tend to lead to decreases in cash
Company’s cash flow can suffer even when net income is high or improve
with it suffers a net loss

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Cash means more than just cash in the bank
o It includes cash equivalents
Short-term investments that are easily convertible to known amount of
cash which are very unlikely to change in value
Only investments with maturities of three months or less meet these
criteria
o Bank overdraft balances should also be netted against the cash and cash
equivalents total
o Companies want to earn net income because profit measures success
o Without net income, a business sinks
There will be no dividends and share price will likely suffer
High net income helps attract investors but companies can’t pay bills with
net income that requires cash
o Companies need both net income and strong cash flow
o Income and cash flow usually move together because net income generates cash
Sometimes they show different patterns
Explain and Classify Cash Flows from Operating, Investing and Financing Activities
A business engages in three types of business activities
o Operating activities
Comprise the main revenue-producing activities of a company and
generally result from the transactions and other events that determine
net income
Other activities that are not investing or financing activities are classified
as operating activities
Activities include cash receipts from a company’s sales of its primary
goods and services and cash payments to suppliers and employees for
the goods and services they provide to generate these sales
If a business is in the business of buying and selling long-lived assets or
trading investments, the cash flows from these transactions are classified
as investing activities
A company that does not regularly generate sufficient cash flows from
operating activities will eventually suffer liquidity and solvency problems
o Investing activities
Include the purchase and sale of long-term assets and other investments
that do not qualify as cash equivalents
Consist of transactions that result in cash inflows or outflows related to
resources used for generating future income and cash flows
IFRS and ASPE state that only expenditures related to assets that are
recognized on the balance sheet qualify as investing activities

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Activities include cash payments to acquire tangible and intangible long-
lived assets, and the cash received on the sale of these assets, are
common investing activities
Any short term investments that qualify as cash equivalents are excluded
from investing activities
o Financing activities
Result in changes in the size and composition of a company’s contributed
equity and borrowings
Activities include the issuance and acquisition of the company’s shares;
the payment of cash dividends
With the exception of bank overdrafts, both short-term and long-term
borrowings are included in financing activities
Classifying Interest and Dividends
IFRS and ASPE offer different guidance on classifying cash flows related to interest and
dividends
o IFRS note that there is no consensus on the classification of interest paid or
interest and dividends received
o Under IFRS, interest paid and interest and dividends received may be classified
as operating cash flows because they enter into the determination of net income
Interest paid may be classified as a financing cash flow because it is a cost of obtaining
financial resources, while interest and dividends received may be classified as investing
cash flows because they represent returns on investments
Companies are free to choose either classification scheme but must use it consistently
from then onward under IFRS
ASPE require that all interest paid and all interest and dividends received and included
in the determination of net income be classified as operating activities
IFRS says when classifying dividends paid, they may either be classified as a financing
cash flow because they are a cost of obtaining financial resources or they may be
classified as cash flows from operating activities so that users may determine the
company’s ability to pay dividends out of operating cash flows
ASPE requires that any dividends paid and charged against retained earnings be
classified as a financing activity
Two Methods of Determining Cash Flows from Operating Activities
Indirect method
o Net income is adjusted for non-cash transactions for any deferrals or accruals of
past or future operating cash receipts or payments or future operating cash
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