April 16, 2016

Statement of Cash Flows - Review Notes

The statement of cash flows reports cash flows—cash receipts and cash payments. It
● shows where cash came from (receipts) and how cash was spent (payments).
● reports why cash increased or decreased during the period.
● covers a span of time and is dated the same as the income statement

The statement of cash flows explains why net income as reported on the income statement does not equal the change in the cash balance. In essence, the cash flow statement is the communicating link between the accrual based income statement and the cash reported on the balance sheet.

The statement of cash flows helps
1. predict future cash flows. Past cash receipts and payments help predict future cash flows.
2. evaluate management decisions. Wise investment decisions help the business prosper, while unwise decisions cause the business to have problems. Investors and creditors use cash flow information to evaluate managers’ decisions.
3. predict ability to pay debts and dividends. Lenders want to know whether they will collect on their loans. Stockholders want dividends on their investments. The statement of cash flows helps make these predictions.

Cash Equivalents

On a statement of cash flows, Cash means cash on hand and cash in the bank, and  cash equivalents, which are highly liquid investments that can be converted into cash in three months or less. As the name implies, cash equivalents are so close to cash that they are treated as “equals.” Examples of cash equivalents are money-market accounts and investments in U.S. government securities.

Operating, Investing, and Financing Activities

There are three basic types of cash flow activities, and the statement of cash flows has a section for each:

● Operating activities
● Investing activities
● Financing activities

Each section reports cash flows coming into the company and cash flows going out of the company based on these three divisions.

Operating Activities
● Is the most important category of cash flows because it reflects the day-to-day operations that determine the future of an organization
● Generate revenues, expenses, gains, and losses
● Affect net income on the income statement
● Affect current assets and current liabilities on the balance sheet Investing Activities
● Increase and decrease long-term assets, such as computers, software, land, buildings, and equipment
● Include purchases and sales of these assets, plus long-term loans receivable from others (non-trade) and collections of those loans
● Include purchases and sales of long-term investments

Financing Activities
● Increase and decrease long-term liabilities and equity
● Include issuing stock, paying dividends, and buying and selling treasury stock
● Include borrowing money and paying off loans

Two Formats for Operating Activities

There are two ways to format operating activities on the statement of cash flows:
● The indirect method starts with net income and adjusts it to net cash provided by
operating activities.
● The direct method restates the income statement in terms of cash. The direct method shows all the cash receipts and all the cash payments from operating activities.

The indirect and direct methods
● use different computations but produce the same amount of cash flow from operations.
● present investing activities and financing activities in exactly the same format. Only the operating activities section is presented differently between the two methods.


Cash Flows from Operating Activities - Indirect Method

Operating cash flows begin with net income, taken from the income statement.

A. Net Income

The statement of cash flows—indirect method—begins with net income (or net loss) because revenues and expenses, which affect net income, produce cash receipts and cash payments. Revenues bring in cash receipts, and expenses must be paid. But net income as shown on the income statement is accrual based and the cash flows (cash basis net income) do not always equal the accrual basis revenues and expenses. For example, sales on account generate revenues that increase net income, but the company has not yet collected cash from those sales. Accrued expenses decrease net income, but the company has not paid cash if the expenses are accrued.

To go from net income to cash flow from operations, we must make some adjustments to net income on the statement of cash flows. These additions and subtractions follow net income and are labeled Adjustments to reconcile net income to net cash provided by operating activities.


B. Depreciation, Depletion, and Amortization Expenses

These expenses are added back to net income to reconcile from net income to cash flow from operations.

Depreciation does not affect cash because there is no Cash account in the journal entry. Depreciation is a noncash expense. However, depreciation, like all the other expenses, decreases net income. Therefore, to go from net income to cash flows, we must remove depreciation by adding it back to net income.

C. Gains and Losses on the Sale of Assets

Sales of long-term assets such as land and buildings are investing activities, and these sales usually create a gain or a loss. The gain or loss is included in net income, which is already in the operating section of the cash flow statement. The gain or loss must be removed from net income on the statement of cash flows so the total cash from the sale of the asset can be shown in the investing section.

A loss on the sale of plant assets would make net income smaller, so it would be added back to net income.

Changes in the Current Assets and the Current Liabilities

Most current assets and current liabilities result from operating activities. For example,
● accounts receivable result from sales,
● inventory relates to cost of goods sold, and so on.


Changes in the current accounts create adjustments to net income on the cash flow statement, as follows:
1. An increase in a current asset other than cash causes a decrease in cash. If Accounts receivable, Inventory, or Prepaid expenses increased, then cash decreased. Therefore, we subtract the increase in the current asset from net income to get cash flow from operations.



Cash Flows from Investing Activities

Investing activities affect long-term assets, such as Plant assets and Investments.

Cash Flows from Financing Activities

Financing activities affect the liability and owners’ equity accounts, such as Longterm
notes payable, Bonds payable, Common stock, and Retained earnings.

Computing Issuances and Payments of Long-Term Notes Payable

The beginning and ending balances of Notes payable or Bonds payable are taken
from the balance sheet. If either the amount of new issuances or payments is known,
the other amount can be computed.

Computing Issuances of Stock and Purchases of Treasury Stock

Cash flows for these financing activities can be determined by analyzing the stock
accounts. For example, the amount of a new issuance of common stock is determined
by analyzing the Common stock account.

Computing Dividend Payments

The amount of dividend payments can be computed by analyzing the Retained earnings
account.


Excerpts from
Financial and Management Accounting,
Horngren



Review Notes
http://seattlecentral.edu/faculty/moneil/A220/L18/Horngren16.htm


Presentation slides

http://wps.prenhall.com/wps/media/objects/1838/1883037/powerpoints/ch_05.ppt

Slides of the chapter from another source
http://wenku.baidu.com/view/149a6a7d5acfa1c7aa00ccd3.html

Financial, Cost and Management Accounting - Review Notes List

Updated  16 April 2016
8 Dec 2011

1 comment:

  1. THE RESOURCES-ALL RESOURCES,ARE LIMITED ,UNEQUALLY DISTRIBUTED IN A COUNTRY.
    THE FINANCIAL PHASING IS ESSENTIAL FOR THEIR PROPER MONITORING AND THEIR SURRENDERING AT THE END OF FINANCIAL YEAR-ASHOK

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