FA2Module 3. Statement of Cash Flow

1. Definition and objectives

2. Classification of elements

3. Direct and indirect methods

4. Gains and losses

5. The T-account method

6. Accounts receivable

1. SCF: Definition and objectivesThe Statement of Cash Flow (formerly Statement of Changes in Financial Position) shows the changes in Cash and Cash Equivalents arising from the operating, financing and investing activities of the enterprise. This information is useful for:1. understanding effects of operating, financing and investing activities on cash;2. assessing liquidity and solvency; and3. assessing the firm=s ability to generate cash from internal sources.

Cash and cash equivalents

Cash and cash equivalents include cash, plus temporary investments that are highly liquid (e. g., maturities of three months or less, like treasury bills).

Investments in equities are excluded (no maturity date).

Bank overdraft can be considered “negative” cash equivalent if bank balance fluctuates regularly between positive and negative.

2. Classification of elementsa. Operating activities

Definition Cash flows related to central revenue-generating activities

InflowExamples

Cash collected from customers

Outflow examples

Cash paid to suppliers, salaries, etc., paid

2. Classification of elementsb. Investing activities

Definition Cash flows related to acquisition or disposal of long-term assets and non-cash investments

InflowExamples

Cash from sale of non-cash-equivalent investments and long-term assets

Outflow examples

Cash paid for non-cash-equivalent investments, fixed assets

2. Classification of elementsc. Financing activities

Definition Cash flows related to debt and shareholders’ equity

InflowExamples

Cash from issue of debt and shares

Outflow examples

Redemption of shares, repayment of debt

2. Classification of elements - Choices

Interest paid Operating or FinancingDividends paid Operating or FinancingInterest received

Operating or Investing

Dividends received

Operating or Investing

Income taxes paid

Operating, but should be in investing or financing if clearly associated with investing or financing transaction

Format of the SCFOperating activities

Net cash flows from operations $Investing activities

Acquisitions of non-current assets ($)Dispositions of non-current assets $Net cash from (used by) investing activities $

Financing activitiesIssues of shares/debt $Redemption of shares/debt repayment ($)Net cash from (used by) financing activities $

Net change in cash and cash equivalents $

3. SCF: Direct and indirect methodsThere are two methods of presentation of the SCF: the direct and indirect methods. The only difference is in the presentation of cash from operating activities.Direct method (preferred by IFRS)

Cash inflows from operations$

Cash outflows related to operations$

Net cash from operations$

Indirect methodNet income

$+/- diff. between accrual and cash acctg$Net cash from operations

$

Direct method

Cash flows from operations are identified and grouped by type (e. g., cash collected from customers, cash paid to suppliers)

Cash from customers

= Sales revenue (income stmt)+decrease/-increase in AR+inc./-dec. in customer advances

Cash paid for an expense

= Expense item (income stmt)+inc./-dec. in associated asset+dec./-inc. in associated liability

Example: A5-13

Indirect method

1. Starting point is net income.

2. Eliminate revenues and expenses that do not provide or use cash (e. g., amortization).

3. The resulting figure is adjusted for changes in balance sheet accounts that are associated with operating activities (e. g., accounts receivable, inventory, accounts payable, etc.):

Indirect method (two-step presentation)Net income $- Non-cash revenues ($)+ Non-cash expenses $

$Changes in non-cash working capital- increases in associated assets ($)+decreases in associated assets $+ increases in associated liabilities $- decreases in associated liabilities ($)Net cash from operations $Example: A5-13

4. Gains and lossesGains and losses arise from incidental and/or peripheral transactions that tend to be investing (e. g., sale of fixed asset) or financing (e. g., retirement of debt) activities. The gain or loss is generally the difference between any net cash flow related to the transaction and the book value of the asset or liability in question. The cash flow should be in the statement of cash flow; the gain or loss should not.

Gains, losses and the cash flow statementDirect method

Gains and losses are generally not included in operating activities; the related cash flow is presented in the appropriate SCF section.

Indirect method

Gains are deducted from, and losses added back to, net income in the operating activities section. The related cash flow is presented in the appropriate SCF section.

Gain example: Hogan LtdSales for the year were $70. Operating expenses for the year were $40. Aside from depreciation ($5), there were no non-cash sales or expenses. During the year, Hogan sold a piece of equipment (cost = $22; accumulated depreciation = $7) for $25. There were no other investing or financing activities during the year. The tax rate is 20% and all taxes were paid during the year.Required: Prepare the income statement.Prepare the cash flow statement using (1) the direct method; and (2) the indirect method.

5. The T-account methodThe T-account method is a quick, informal way to organize information to prepare a cash flow statement. It works best for indirect method SCF. The steps are:

1. Prepare t-accounts for each balance sheet account with the beginning and ending balance. There are 3 cash and cash-equivalent accounts, one for each of the cash flow statement sections.

5. The T-account method2. Go through the income statement and

additional information and “post” the implied transactions to the t-accounts. Non-cash income statement items are posted to Cash from operating activities.

3. Go through each of the balance sheet accounts and identify any unexplained variations. Using the most obvious explanation, assume and “post” the transaction.

5. The T-account method4. Using the numbers in the three cash

accounts, assemble the cash flow statement.

Often-used shortcut: Do not bother with t-accounts for the working capital accounts – usually, only the changes in these accounts matter. The non-working capital accounts are frequently affected by more than one cash transaction.

Example: A5-22

6. Accounts receivable

The usual cash flow statement treatment accorded accounts receivable and cash collections from customers is to add (subtract) the decrease (increase) in accounts receivable. The situation is usually more complicated than that because:

– Bad debt expense is a non-cash expense– Some accounts receivable are never collected

(write-offs)

Accounts receivable transactions

Dr. Accounts receivable Sales

Cr. Revenue

Dr. Cash Collections

Cr. Accounts receivable

Dr. Bad debt expense Est. bad debts

Cr. Allowance for doubtful accounts

Dr. Allowance for doubtful accounts write-offs

Cr. Accounts receivable

Gross accounts receivable method

Accounts receivable

Beginning balance(Credit) Sales

Write-offsCollections

Ending balance

Collections = Sales – write-offs + decrease in AR – increase in AR

SCF example: Gould Inc.

2011 2010Accounts receivableAllowance for doubtful accountantsAccounts receivable (net)

$70(8)62

$60(5)55

RevenueBad debt expenseOther expenses (all paid in cash)Net income

$2001240

$148In 2011, $9 in accounts receivable were written off as uncollectible. Prepare the operating activities section of the SCF.

Net accounts receivable method

Net accounts receivable (AR + AFDA)

Beg. Bal. (AR-AFDA)(Credit) SalesWrite-offs

Bad debt expenseCollectionsWrite-offs

Ending balance

Collections = Sales – bad debt expense + decrease in net AR – increase in net AR

Net cash from operating activities(Credit sales, cash expenses except bad debt)

Direct method Indirect method

AR (gross)

Collections (sales – write-offs +/- chg in gross AR)- Expenses paid

Net income+ Bad debt expense- Write-offs+/- chg in gross AR

AR (net)

Collections (sales – bad debt expense – chg in net AR)- Expenses paid

Net income+/- chg in net AR