lecture 6 ifa1 2011(1)

Chapter 14 1Use with Financial Accounting and Reporting: A Global Perspective, 3rd Edition, ISBN 1-4080-2113-2

© 2010 H. Stolowy, M. J. Lebas and Y. Ding 1

IFA1 lecture 6

Chapter 14

Statement of cash flow construction

Use with Financial Accounting and Reporting: A Global Perspective, 3rd Edition, ISBN 1-4080-2113-2 © 2010 H. Stolowy, M. J. Lebas and Y. Ding




Chapter 14 Statement of cash flows construction

Financial Accounting and Reporting - A Global Perspective (third edition)




List of topics1 Limit of traditional financial statements

2 Usefulness of the statement of cash flows

3 Contents of the activities

4 Calculating cash flows from operating activities

5 Cash and cash equivalents

6 Example of a statement of cash flows

7 Operating cash flow – indirect method

8 Operating cash flow – direct method

9 Cash flow from investing activities



10 Cash flows from financing activities

11 Non-cash investing and financing transactions





1 Limit of the traditional financial statements

• Statement of financial position (Balance sheet) = static view of the financial structure/position

• Income statement = a dynamic view of the business activity

• No dynamic view of the financial structure, (changes in the structure in general, and changes in cash in particular)




Statement of cash flows

• To meet these information needs: the statement of cash flows

• See chapter 3




Table 14.1 Statement of cash flows structure

The statement of cash flows classifies cash flows in three categories of activities: operating, investing and financing

Net cash provided by/used in operating activities A Net cash provided by/used in investing activities B Net cash provided by/used in financing activities C Net increase/decrease in cash and cash equivalents D = A + B + C Cash and cash equivalents at beginning of year E Cash and cash equivalents at end of year F = D + E




2 Usefulness of the statement of cash flows

• The importance of cash

• Cash is objective

• A valuable forecasting tool

• Developments in international practice (see Appendix 14.1)




3 Contents of the activities (1/2)

• Clear partitioning of the statement of cash flows between the various ‘activities’ is vital

• The classification of certain operations is sometimes difficult




Contents of the activities (2/2)

• Operating activities: derived from the main or core revenue-producing activities of the enterprise.

• Investing activities

• Financing activities

• See Table 14.2 and Appendix 14.2




Table 14.2 Classification of cash flows

Activities Cash inflows (receipts) Cash outflows (payments) Operating activities Sale of goods and rendering of

services to customers Royalties, fees, commissions and

other revenues Interests on loans and investments

Purchase of goods and services Salaries, fringe benefits and social

expenses Taxes Interests on borrowings

Investing activities Sale of fixed assets (intangible, tangible, financial – securities which are not cash equivalents)

Receipt of repayment of loans and advances

Purchase of long-lived assets (intangible, tangible, financial – i.e., long-term securities which are not cash equivalents)

Loans and advances made

Financing activities Proceeds from issuing new shares Proceeds from selling own shares Proceeds from issuing new debt

Repurchase of own shares Repayment of debts Payment of dividends




Table 14.3 Differences in classification of five flows of cash

Interests paid Interests received

Dividends paid

Dividends received

Taxes paid

IASB OPE or FIN OPE or INV OPE or FIN OPE or INV OPE or INV or FIN

USA OPE OPE FIN OPE OPE




4 Calculating cash flows from operating activities

• ‘Cash flows from operating activities’ (= ‘Operating cash flows’ = ‘Cash flows from operations’)

• Two methods:– direct– indirect

• Most standards recommend the direct method while allowing the indirect method

• The vast majority of businesses report cash flows from operating activities using the indirect method, which is much simpler




Figure 14.1 Reporting cash flows from operating activities




5 Cash and cash equivalents

• Definitions: – Cash comprises cash on hand and demand deposits. – Cash equivalents are short-term, highly liquid

investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value (IAS 7)




6 Example of a statement of cash flows (1/4)

Source of the information

Cash flow from operating activities (indirect method) (gross amounts)

Net income/loss ± IS X2 Adjustments to reconcile net income/loss to net cash provided by/used in operating activities

Depreciation and amortization + IS X2 Gain/loss on sale of fixed assets ± IS X2 Potential cash flow =

Changes in operating assets and liabilities Change in accounts receivable (gross amount) ± BS X1/X2 Change in inventories (gross amount) ± BS X1/X2 Change in prepaid expenses ± BS X1/X2 Change in accounts payable and accrued expenses ± BS X1/X2 Net cash provided by/used in operating activities = (A) = IS: Income Statement - BS: Balance Sheet - AI: Additional Information




Table 14.4 Example of a statement of cash flows (2/4)


Cash flow from operating activities (indirect method) (net amounts) Net income/loss ± IS X2 Adjustments to reconcile net income/loss to net cash provided by/used in operating activities

Depreciation and amortization (excluding those applying to current assets [inventories and accounts receivable])

+ IS X2

Gain/loss on sale of fixed assets ± IS X2 Potential cash flow =

Changes in operating assets and liabilities Change in accounts receivable (net amount) ± BS X1/X2 Change in inventories (net amount) ± BS X1/X2 Change in prepaid expenses ± BS X1/X2 Change in accounts payable and accrued expenses ± BS X1/X2 Net cash provided by/used in operating activities = (A) =

IS: Income Statement - BS: Balance Sheet - AI: Additional Information.






Cash flow from operating activities (direct method) Cash received from customers + IS X2 & BS X1/X2 Cash paid to suppliers* - IS X2 & BS X1/X2 Cash paid to employees* - IS X2 & BS X1/X2 Cash dividend received + IS X2 & BS X1/X2 Other operating cash receipts + IS X2 & BS X1/X2 Other operating cash payments - IS X2 & BS X1/X2 Interest paid in cash - IS X2 & BS X1/X2 Income taxes paid in cash - IS X2 & BS X1/X2 Net cash provided by/used in operating activities = (A) =

IS: Income Statement - BS: Balance Sheet - AI: Additional Information * These two lines are often merged.






Cash flows from investing activities Purchases of long-lived assets - BS X1/X2 & AI X2 Proceeds from sale of long-lived assets + IS X2 & AI X2 Loans granted - BS X1/X2 & AI X2 Repayment of loans + BS X1/X2 & AI X2 Net cash provided by/used in investing activities = (B) = Cash flows from financing activities Proceeds from issuance of long-term debt + BS X1/X2 & AI X2 Proceeds from issuance of shares + BS X1/X2 & AI X2 Dividends paid - BS X1/X2 & AI X2 Payment on long-term debt - BS X1/X2 & AI X2 Payment on reduction of share capital (repayment of shares) - BS X1/X2 & AI X2 Net cash provided by/used in financing activities = (C) = Net increase in cash and cash equivalents = (A) + (B) + (C) = (D) = Cash and cash equivalents at beginning of year = (E) Cash and cash equivalents at end of year = (F) = (E) + (D)

IS: Income Statement - BS: Balance Sheet - AI: Additional Information.




Table 14.5 Liszt

company Comparative

balance sheets

000 CU X2 X1 Changes (X2 – X1)

Assets Fixed assets Tangible assets Equipment (gross) 615 460 155 Accumulated depreciation -116 -70 -46 Equipment (net) 499 390 109 Financial assets (loans granted) 115 174 -59 Total fixed assets 614 564 50 Current assets Inventory 144 100 44 Accounts receivable 44 63 -19 Cash and marketable securities 25 15 10 Prepaid expenses* 4 7 -3 Total current assets 217 185 32 Total assets 831 749 82 Shareholders’ equity and liabilities Shareholders’ equity Share capital 282 200 82 Share premium 198 115 83 Retained earnings/Reserves 124 122 2 Net income of the period (before appropriation)

9 10 -1

Total shareholders’ equity 613 447 166 Liabilities Long-term liabilities (loans received and bonds)

155 245 -90

Current liabilities Accounts payable 62 54 8 Income taxes payable 1 3 -2 Total current liabilities 63 57 6 Total liabilities 218 302 -84 Total shareholders’ equity and liabilities 831 749 82 * Related to ‘Other operating expenses’




Table 14.6 Liszt company - Income statement

000 CU Sales 800 Cost of merchandise sold -570 Gross profit 230 Depreciation expense -60 Other operating expenses -162 Operating profit 8 Interest expense -15 Investment income 18 Gain on sale of equipment 3 Profit before taxes 14 Income taxes -5 Net profit 9




Additional information (1/2)

- Equipment was purchased for 175

- Equipment with an original cost of 20 and accumulated depreciation of 14 was sold for 9

- No new loan were either granted or obtained

- 135 was raised from the issue of shares in cash (share capital of 66 plus share premium of 69)




Additional information (2/2)

- Bonds were converted into capital for 30 (share capital for 16 and share premium for 14)

- Bonds were repaid at face (nominal) value at maturity for 60

- Dividends (relating to net income of X1) were paid in cash for 8




7 Operating cash flow – Indirect method

• Commonly used method

• Important concepts: – non-cash items– potential cash flow




Figure 14.2 Cash and non-cash items in the income statement




Potential cash flow

• Potential cash flow = Cash revenues - Cash expenses

or

• Potential cash flow = Net income + Non-cash expenses - Non-cash revenues




Gain on sale of equipmentSales price 9Original cost 20Accumulated depreciation - 14Book value 6 -6Gain on sale 3

Operating activities . Net income (including Gain on sale) 3 (…)

Investing activities . Proceeds from sale of equipment 9 (…)

To avoid double counting of the gain on sale of fixed assets




Changes in inventories, receivables and payables

• Potential cash flow: adjusted by the amount of changes in inventories, receivables and payables

• For inventories, same principle as for receivables: an increase has a negative impact on cash and a decrease has a positive impact on cash




Table 14.7 Sign of changes in assets and liabilities

Important table for changes in inventories, receivables and payables

Change (ending minus beginning balances)

Impact on cash

Assets Increase - Decrease + Liabilities Increase + Decrease -




Figure 14.3 From ‘potential’ cash flow to ‘real’ cash flow from operations




Figure 14.4 Indirect method




Table 14.8 Cash flows from operating activities (indirect method)

Net income 9 Adjustments to reconcile net income/loss to net cash provided by/used in operating activities

Depreciation expense 60 Gain on sale of fixed assets -3 Potential cash flow 66 Adjustments to acknowledge changes in operating assets and liabilities

Change in accounts receivable 19 Change in inventories -44 Change in prepaid expenses 3 Change in accounts payable 8 Change in income taxes payable -2 Total adjustments 41 41 Net cash provided by/used in operating activities 50




8 Operating cash flow (direct method)

• Direct method

• In reality: ‘semi-direct’ method

• Income statement items are adjusted for changes in inventories and operating receivables and payables to give cash flows




Figure 14.5 Determination of cash flows using the semi-direct method




Figure 14.6 From income statement to ‘real cash flow’ (to be extended to each cash item on the

income statement)




Cash received from customers

- ‘Sales revenue’ is obtained from the income statement and flows through the ‘accounts receivable’

- The change in accounts receivable is taken from the ‘changes’ column of the comparative balance sheet

Income statement item ± Change in related balance sheet item

= Cash flow from customers

Sales revenue Change in accounts receivable Cash received from customers

800 + 19 (decrease) = 819




Cash paid-out in relation to cost of merchandise sold (cash paid to suppliers of goods for resale)

Purchases = Change in inventory + Cost of merchandise sold614 = 44 + 570

Income statement item

± Change in related balance sheet item

= Cash flow related to the acquisition of

merchandise Purchases Change in accounts payable Cash paid out for

purchases -614 + 8 (increase) = -606

Two steps




Cash paid for other operating expenses (cash paid to suppliers of

other operating expenses)

Income statement item ± Change in related balance sheet item

= Cash flow related to other operating expenses

Other potentially cash impacting operating

expenses

Change in prepaid expenses Cash paid out for other operating expenses

-162 + 3 (decrease) = -159




Cash paid for interest

• In our example: no accrued interest payable on the balance sheet

• Cash outflow = interest expense: - 15

• In general, cash paid for interest = interest expense adjusted for the change in accrued interest payable




Cash received from investment income

• No accrued interest receivable on the balance sheet

• Cash inflow = the investment income (dividends received): 18




Cash paid for income taxes

Income statement item ± Change in related balance sheet items

= Cash flow related to taxes

Income taxes expense Change in income taxes payable Income taxes paid -5 - 2 (decrease) = -7




Gain on sale of equipment

• The gain on sale of equipment is not included in the direct method

• See the explanation of the indirect method




Table 14.9 Income statement items and related balance sheet items

Income statement items Related current assets Related current liabilities Sales Accounts receivable Advances received from

customers Revenues recorded in advance (unearned revenues)

Financial revenues Interests receivable Accrued interests receivable

Unearned interests

Cost of merchandise sold Inventory Advances paid to suppliers

Accounts payable

Rent expense Prepaid rent (Expenses recorded in advance)

Rent payable Accrued rent payable

Compensation and social expenses Prepaid compensation and social expenses (Expenses recorded in advance)

Compensation and social expenses payable Accrued salaries and social expenses payable

Other operating expenses Prepaid other operating expenses (Expenses recorded in advance)

Other expenses payable Accrued other expenses payable

Taxes including income taxes Prepaid taxes – prepaid income taxes (Expenses recorded in advance)

(Income) Taxes payable Accrued (income) taxes payable

Financial expenses Prepaid interests Interests payable Accrued interests payable




Table 14.10 Cash flows from operating activities (direct method)

Cash received from customers 819Cash paid in relation to cost of merchandise sold -606Cash paid in relation to other operating expenses -159Cash paid on interest -15Cash received from investment income 18Cash paid on income taxes -7Net cash provided by/used in operating activities 50




9 Cash flows from investing activities

Beginning balance

+ Increases - Decreases = Ending balance

A + B - C = D

This A + B – C = D formula is a valuable tool for:• Checking the changes between the beginning and

ending balance sheet• Identifying one of the components, when the other

three are known




Purchase of equipment

Beginning balance + Increases - Decreases = Ending balance Equipment (gross

value) + New equipment

purchased (at cost) - Value of equipment

sold at its original cost = Equipment (gross

value) 460 + 175 - 20 = 615




Sale of equipment

Sales price (9) included in the statement of cash flows

Beginning balance


Accumulated depreciation

+ Depreciation expense

- Accumulated depreciation of fixed

assets sold

= Accumulated depreciation

70 + 60 - 14 = 116




Repayment of loan

Beginning balance + Increases - Decreases = Ending balanceLoan + New loan granted - Repayment of loan = Loan174 + 0 - ? = 115

• 174 + 0 – X = 115 X = 174 – 115 = 59

• Loans were repaid for a total amount of 59




Table 14.11 Cash flows from investing activities

Purchase of equipment -175 Proceeds from sale of equipment 9 Repayment of loan by borrowers 59 Net cash provided by/used in investing activities -107




10 Cash flows from financing activities

• 135 was raised from the issue of shares in cash (66 of share capital and 69 of share premium)

• Bonds were converted into capital for 30 (share capital of 16 plus share premium of 14)

• Bonds were repaid at face value at maturity for 60

• Dividends (relating to net income of X1) were paid in cash for 8




Issuance of share capital

Beginning balance + Increases - Decreases = Ending balance Share capital + Issued - Repayment = Share capital

200 + 66 + 16 = 82 - 0 = 282 Share premium + Issued - Repayment = Share premium

115 + 69 + 14 = 83 - 0 = 198




Table 14.12 Share issues

Share capital Issue in cash 66Issue by conversion of debts 16 135Total 82

Share premium Issue in cash 69 30Issue by conversion of debts 14Total 83




Bonds movements

The above decrease comprise the following components:• Repayment: 60 (see additional information)• Conversion into capital: 30 (see additional

information)

Beginning balance


Bonds + New issue - Repayment Conversion = Bonds 245 + 0 - (60 + 30) = 155




Dividends

• Balance sheet presented before appropriation• Changes in retained earnings/reserves:

Beginning balance 31/12/X1

+ Increases (Added on 31/12/X1)

- Decreases during X2 = Ending balance 31/12/X2

Retained earnings/Reserves before income of

X1

+ Net income of year X1 - Dividends paid in year X2 or capitalization to Retained

earnings/Reserves

= Retained earnings/Reserves before income of

X2 122 + 10 - 8 = 124




Table 14.13 Cash flows from financing activities

Proceeds from issuance of shares 135Payments on long-term debt -60Dividends paid -8Net cash provided by/used in financing activities 67




Table 14.14 Statement of cash flows of Liszt Company Year 2 (indirect method)

Cash flows from operating activities (indirect method) Net income 9 Adjustments to reconcile net income to net cash provided by operating activities Depreciation expense 60 Gain on sale of fixed assets -3 Potential cash flow 66 Changes in operating assets and liabilities Change in accounts receivable 19 Change in inventories -44 Change in prepaid expenses 3 Change in accounts payable 8 Change in income taxes payable -2 Total adjustments 41 Net cash provided by/used in operating activities 50 Cash flows from investing activities Purchase of equipment -175 Proceeds from sale of equipment 9 Repayment of loan 59 Net cash used in investing activities -107 Cash flows from financing activities Proceeds from issuance of shares 135 Payments on long-term debt -60 Dividends paid -8 Net cash provided by financing activities 67 Net increase in cash and cash equivalents 10 Cash and cash equivalents at beginning of year 15 Cash and cash equivalents at end of year 25

Schedule of non-cash investing and financing transactions (see section 9) Conversion of bonds into capital 30




11 Non-cash investing and financing transactions

• Acquisition of assets either by assuming directly related liabilities or by means of a finance lease (see Chapter 12)

• Acquisition of an enterprise exclusively by means of an equity issue

• Conversion of debt to equity (see Chapter 11)

• Issuance of shares by capitalization of reserves (see Chapter 11)

lecture 6 ifa1 2011(1)

Documents

reporting cash flows

importance of cash cash

operating cash flows

classification of cash

cash investing

calculating cash flows

amounts of cash

global perspective