1. Classification of cash flows and non-cash activities. This subject is for LOS 34.a.b.c. The cash flow statement provides important information about a company's cash receipts and cash payments during an accounting period as well as information about a company's operating, investing and financing activities. Although the income statement provides a measure of a company's success, cash and cash flow are also vital to a company's long-term success. Information on the sources and uses of cash helps creditors, investors, and other statement users evaluate the company's liquidity, solvency, and financial flexibility.

Cash receipts and cash payments during a period are classified in the statement of cash flows into three different activities:

Operating Activities

These involve the cash effects of transactions that enter into the determination of net income and changes in the working capital accounts (accounts receivable, inventory, and accounts payable). Cash flows from operating activities (CFOs) reflect the company's ability to generate sufficient cash from its continuing operations. In effect, they are derived by converting the income statement from an accrual basis to a cash basis. For most companies positive operating cash flows are essential for long-run survival.

The major operating cash flows are (1) cash received from customers, (2) cash paid to suppliers and employees, (3) interest and dividends received, (4) interest paid, and (5) income taxes paid.

Special items to note:

Interest and dividend revenue, and interest expenses are considered operating activities, but dividends paid are considered financing activities. Note that interest expense is reported on the income statement while dividends flow through the retained earnings statement.

How do you remember? Remember that an interest/dividend item is an operating activity if it appears on the income statement. For example, payments of dividends do not appear on the income statement, and thus are not classified as operating activities.

All income taxes are considered operating activities, even if some arise from financing or investing.

Indirect borrowing using accounts payable is not considered a financing activity -

such borrowing would be classified as an operating activity.

Investing Activities

These include making and collecting loans and acquiring and disposing of investments (both debt and equity) and property, plant, and equipment. In general, these items relate to the long-term asset items on the balance sheet. Investing cash flows reflect how the company plans its expansions.

Examples are:

Sale or purchase of property, plant and equipment. Investments in joint ventures and affiliates and long-term investments in

securities. Loans to other entities or collection of loans from other entities.

Financing Activities

These involve liability and owner's equity items, and include:

Obtaining capital from owners and providing them with a return on (and a return of) their investment.

Borrowing money from creditors and repaying the amounts of borrowed.

In general, the items in this section relate to the debt and the equity items on the balance sheet. Financing cash flows reflect how the company plans to finance its expansion and reward its owners.

Examples:

Dividends paid to stockholders (not interest paid to creditors!). Note that the cash outflow caused by dividends is determined by dividends paid, not dividends declared. Dividends paid are not reflected in the Retained Earnings account. The amount is provided in the supplementary information.

Issue or repurchase the company's stocks. Issue or retire long-term debt (including current portion of long-term debt).

Purchase of debt and equity securities of other entities (sale of debt or equity securities of other entities), loans to other entities (collection of loans to other entities) are considered investing activities. However, issuance of debt (bonds and notes) and equity securities are financing cash inflows, and payment of dividend, redemption of

debt, and reacquisition of capital stock are financing cash outflows.

Non-cash Activities

Some investing and financing activities do not flow through the statement of cash flows because they don't require the use of cash:

Retiring debt securities by issuing equity securities to the lender. Converting preferred stock to common stock. Acquiring assets through a capital lease. Obtaining long-term assets by issuing notes payable to the seller. Exchanging one non-cash asset for another non-cash asset. The purchase of non-cash assets by issuing equity or debt securities.

For example, if a company purchases $200,000 of land by issuing a long-term bond, this transaction is a non-cash one as it does not involve direct outlays of cash. Therefore, it is excluded from the statement of cash flows. These types of transactions should be disclosed in a separate schedule as part of the statement of cash flows, or in the footnotes to the financial statements.

Differences between IFRS and U.S. GAAP

The above discussions are based on the U.S. GAAP. Under IFRS there is some flexibility in reporting some items of cash flow, particularly interest and dividends.

Interest and dividends received:o Under U.S. GAAP, interest income and dividends received from

investment in other companies are classified as CFO.o Under IFRS, interest and dividends received may be classified as either

CFO or CFI. Interest paid:

o Under U.S. GAAP, interest paid is classified as CFO.o Under IFRS, interest paid may be classified as either CFO or CFF.

Dividends paid:o Under U.S. GAAP, dividends paid are classified as CFF.o Under IFRS, dividends paid may be classified as either CFO or CFF.

2. Preparing the cash flow statement. This subject is for LOS 34.d.e.f. The beginning and ending cash balances on the statement of cash flows tie directly to the Cash and Cash Equivalents accounts listed on the balance sheets at the beginning and end of the accounting period.

Net income differs from net operating cash flows for several reasons.

One reason is non-cash expenses, such as depreciation and the amortization of intangible assets. These expenses, which require no cash outlays, reduce net income but do not affect net cash flows.

Another reason is the many timing differences existing between the recognition of revenue and expense and the occurrence of the underlying cash flows.

Finally, non-operating gains and losses enter into the determination of net income, but the related cash flows are classified as investing or financing activities, not operating activities.

There are two methods of converting the income statement from an accrual basis to a cash basis. Companies can use either the direct or the indirect method for reporting their operating cash flow.

The direct method discloses operating cash inflows by source (e.g. cash received from customers, cash received from investment income) and operating cash outflows by use (e.g. cash paid to suppliers, cash paid for interest) in the operating activities section of the cash flow statement.

o Adjusts each item in the income statement to its cash equivalent.o It shows operating cash receipts and payments. More cash flow

information can be obtained, and more easily understood by the average reader.

The indirect method reconciles net income to net cash flow from operating activities by adjusting net income for all non-cash items and the net changes in the operating working capital accounts.

o It shows why net income and operating cash flows differ.o Used by most companies.

The direct and indirect methods are alternative formats for reporting net cash flows from operating activities. Both methods produce the same net figure (dollar amount of operating cash flow).

Under IFRS and U.S. GAAP, both the direct and indirect methods are acceptable for financial reporting purposes. However, the direct method discloses more information about a company. Partly because companies want to limit

information disclosed, the indirect method is more commonly used. The reporting of investing and financing activities are the same for both direct

and indirect methods. Only the reporting of CFO is different.

Direct Method

Under the direct method, the statement of cash flows reports net cash flows from operations as major classes of operating cash receipts and cash disbursements. This method converts each item on the income statement to its cash equivalent. The net cash flows from operations are determined by the difference between cash receipts and cash disbursements.

Assume that Bismark Company has the following balance sheet and income statement information:

Additional information:

Receivables relate to sales and accounts payable relate to cost of goods sold. Depreciation of $5,000 and pre-paid expense both relate to selling and

administrative expenses.

Direct Method:

Cash sales: sales on accrual basis are $242,000. Since the receivables have decreased by $8,000, the cash collections are higher than accrual basis sales.

Sales $242,000Add decrease in receivables 8,000

Cash sales $250,000

Cash purchases: since inventory decreased by $2,000, goods purchased in prior years were used as cost of goods sold. Since accounts payable decreased by $12,000, more cash was paid in 2000 for goods than is reported under accrual accounting.

Costs of goods sold $105,000Deduct decrease in inventories 2,000Add decrease in accounts payable 12,000Cash purchases $115,000

Cash selling and administrative expense: the selling and administrative expenses include a non-cash charge related to depreciation of $5,000. In addition, pre-paid expenses (assets) increased by $1,000 and should be added to the selling and administrative expenses.

Selling and administrative expenses $58,000Deduct depreciation expense 5,000Add increase in pre-paid expense 1,000Cash selling and administrative expenses $54,000

Cash income taxes: income tax on the accrual basis is $30,000. Tax payable, however, has increased by $5,000. This means a portion of the taxes has not been paid. As a result:

Income tax expense $30,000Deduct increase in taxes payable 5,000Income tax paid $25,000

The presentation of the direct method for reporting net cash flow from operating activities:

Indirect Method

The indirect method uses net income (as reported in the income statement) as the starting point in the computation of net cash flows from operating activities. Adjustments to net income necessary to arrive at net cash flows from operating activities fall into three categories: non-cash expenses, timing differences, and non-operating gains and losses. Adjustments reconcile net income (accrual basis) to net cash flows from operating activities. In other words, the indirect method adjusts net income for items that affected reported net income but did not affect cash.

The four-step-process:

1. Start with net income.

2. Add back non-cash charges such as depreciation and amortization of intangibles. Cash payments for long-lived assets such as plant and intangibles occur when they are purchased. Purchase of these assets is reflected as an investing activity at that time. When depreciation expense is recognized in the current period, it simply indicates the paper allocation of original purchase cost to this period. As a result, expenses increase without a corresponding cash outlay. Since depreciation does not affect cash flow, it should be added back to net income to compute net CFO.

3. Add back losses and subtract gains from investing or financing activities. Examples include gains/losses from sale of property, plant and equipment (investing activity), or gains/losses from early retirement of debt (financing activity). Why? Disposal of fixed assets will be used to illustrate this. The gains and losses from the disposal of fixed assets appear on the income statement. However, disposal of fixed assets is an investing activity, so the entire cash receipt is shown as an investing cash inflow. Therefore, the gains or losses should be removed from net income so as to prevent double counting cash flows. Note that it is the proceeds from disposal, not the gain or loss, that constitute the cash flow.

4. Adjust for changes in operating related accounts (current assets and current liabilities other than cash, short-term borrowings and short-term investments). For example, an increase in current asset ties up cash, thereby reducing operating cash flow. An increase in current liabilities postpones cash payments, thereby freeing up cash and increasing operating cash flows in the current period. Increase in assets reduces cash, and should be deducted from net income. Increase in liabilities increases cash, and should be added to net income.

Note that short-term investments are considered an investing activity, and short-term

borrowing is considered a financing activity.

Example

Selton Co.'s balance sheet and income statement are presented below:

Additional information:(a) Operating expenses include depreciation expense of $34,000 and amortization of pre-paid expenses of $2,000(b) Land was sold at its book value for cash.(c) Cash dividend of $48,000 was paid in 2000.(d) Interest expense of $8,000 was paid in cash.(e) Equipment with a cost of $36,000 was purchased for cash. Equipment with a cost of $24,000 and a book value of $18,000 was sold for $16,000 for cash.(f) Bonds were redeemed at their book value for cash.(g) Common stock ($1 par value) was issued for cash.

Explanations of the adjustments to net income of $57,000 are as follows:

a. Accounts receivable: The decrease of $2,000 should be added to net income to

convert from the accrual basis to the cash basis.b. Inventories: The increase of $60,000 represents an operating use of cash for which an expense was not incurred. This amount is therefore deducted from net income to arrive at cash flow from operations.c. Pre-paid expense: The decrease of $2,000 represents a charge to the income statement for which there was no cash outflow in the current period. The decrease should be added back to net income.d. Accounts payable: When it increases, cost of goods sold and expense on a cash basis are lower than they are on an accrual basis. The increase of $3,000 should be added back to net income.e. Depreciation expense: The depreciation expense for the building is $20,000. Due to the sale of equipment the depreciation for equipment is (24,000 - 18,000) + 20,000 - 12,000 = $14,000. This amount plus $20,000 should be added back to net income to determine net cash flow from operating activities.f. Loss on sale of equipment: The loss of $2,000 on sale of equipment should be added back to net income since the loss did not reduce cash but it did reduce net income.

Cash flows from investing and financing activities:a. Land: The sale of land for $20,000 is an investing cash inflow.b. Equipment: The purchase of equipment for $36,000 is an investing cash outflow, and the sale for $16,000 is an investing cash inflow.c. Bonds payable: This financing activity used cash of $40,000.d. Common stock: Common stock of $80,000 was issued as a financing cash inflow.e. Retained earnings: The increase of $9,000 is the result of net income of $57,000 from operations and the financing activity of paying cash dividends of $48,000.

The statement of cash flows is prepared as follows:

Conversion of Cash Flows from the Indirect to the Direct Method

Although the indirect method is most commonly used by companies, the analyst can generally convert it to the direct format by following a simple three-step process.

1. Aggregate all revenue and all expenses.2. Remove all non-cash items from aggregated revenues and expenses and break

out remaining items into relevant cash flow items.3. Convert accrual amounts to cash flow amounts by adjusting for working capital

changes.