CHAPTER 14 The Statement of Cash Flows

SYNOPSIS

In this chapter, the author provides a comprehensive discussion of the statement of cash flows. The author discusses (1) the rationale for the statement; (2) using the statement of cash flows to evaluate companies; (3) how the statement complements the income statement and balance sheet; (4) the incentives management has to manipulate cash flows; and (5) the mechanics of preparing the statement of cash flows. Preparing the statement of cash flows focuses on inferring the cash inflows and outflows of transactions from two balance sheets and an income statement. The ethics vignette considers a company in weak financial condition that manages the timing of its cash receipts and payments to manipulate its reported cash flows (especially from operations) in an effort to delay signalling that weakness to the public. The internet research exercise examines the 2008 cash flow statements of General Motors in the 10K financial statement and reviews the many drains on cash flow this company experiences as it spiralled down into bankruptcy. The following key points are emphasized in Chapter 14: 1. The structure and format of the statement of cash flows. 2. Cash flows from operating, investing, and financing activities. 3. How the statement of cash flows complements the other financial statements and how it

can be used by those interested in the financial condition of a company. 4. Important investing and financing transactions that do not appear on the statement of cash

flows and how they are reported. 5. Economic consequences associated with the statement of cash flows. 6. Preparing a statement of cash flows from the information contained in two balance sheets,

an income statement, and a statement of retained earnings.

TEXT/LECTURE OUTLINE

The statement of cash flows.

I. Purpose.

A. The definition of cash.

1. Cash only—coin, currency, money orders, certified checks, cashiers' checks, personal checks, bank drafts, and so forth.

2. Cash plus cash equivalents—usually defined as investments, such as

commercial paper, that have maturities of less than three months.

B. To provide information about the cash flows during the period associated with operating activities, investing activities, and financing activities.

II. A general description of the statement of cash flows.

A. The change in cash can be explained by summarizing the cash flows from operating and capital transactions.

1. Operating transactions are associated with acquiring and selling inventories

and services. That is, those activities that are part of the company's ongoing central activities. In general, items included on the income statement are considered to be operating activities.

2. Capital transactions.

a) Investing activities—associated with purchasing and selling nonoperating (i.e., noncurrent) assets. Investing activities include purchasing or selling long-lived assets, long-term investments, and intangible assets.

b) Financing activities—associated with cash flows from nonoperating debt

and shareholders' equity. Financing activities include issuing long-term debt or equity shares, retiring long-term debt, repurchasing equity shares, and paying cash dividends.

B. Methods to use in preparing the statement of cash flows.

1. Direct method.

a) Cash inflows and outflows from operating activities can be traced directly to the cash account in the general ledger. The actual cash inflow and outflow associated with each income statement item is disclosed on the face of the statement of cash flows.

b) Accrual income statement amounts are reported in the body of the

statement of cash flows at their cash amounts. That is, the actual cash inflows and cash outflows from individual operating activities are reported on the face of the statement of cash flows.

c) A schedule that reconciles net income to net cash flow from operating activities must accompany the statement of cash flows.

2. Indirect method.

a) Cash flows from operating activities are computed indirectly by adjusting net income.

b) Net income is adjusted from an accrual amount to net cash flow from operating activities on the face of the statement of cash flows. Accrual net income is adjusted for noncash charges to noncurrent accounts and changes in current accounts other than cash.

3. The choice of methods only affects the way that net cash flow from operating activities is disclosed.

a) The dollar amount reported for net cash flow from operating activities is

identical under the direct and indirect methods. b) The presentation of the investing activities and financing activities is

identical under the direct and indirect methods.

III. How the statement of cash flows can be used.

A. Assessing a company's ability to generate cash.

1. The strength of a company's operating activities. 2. Financial flexibility—a company's capacity to borrow, issue equity, and sell

nonoperating assets.

B. Analyzing the statement of cash flows.

C. The importance of cash from operating activities. D. The importance of significant noncash transactions.

IV. The statement of cash flows: economic consequences.

A. Importance of cash flow information in assessing potential investments. B. Incentives to window dress the statement of cash flows. C. Ease of manipulating cash flows. D. Reasons not to manipulate cash flows.

V. Deriving cash flows from accrual financial statements.

A. Cash provided (used) by operating activities.

B. Cash provided (used) by investing activities. C. Cash provided (used) by financing activities.

VI. The complete statement of cash flows

A. The direct method.

B. The indirect method. VII. Analyzing the statement of cash flows

A. Summarizing the cash effects of operating transactions.

B. Summarizing the cash effects of investing and financing transactions. C. Two additional observations.

1. Cash is king. 2. Inconsistency attributable to consolidated financial statements.

VII. International perspective. IX. Review problem. X. Ethics in the real world. XI. Internet research exercise.

LECTURE TIPS

1. Students have the greatest difficulty converting from accrual dollar amounts to cash flows,

particularly in deciding (1) which balance sheet accounts are related to specific income statement accounts and (2) how the accounts interrelate. End-of-chapter exercises 14–5, 14–12 through 14–16, and problems 14–8 through 14–11 are useful to demonstrate the process. Exercises 14–17 through 14–21 further emphasize determination of cash flow from operations under both the direct and indirect methods.

2. Some students have trouble classifying transactions as operating, investing, or financing

activities. Care should be taken in explaining the distinctions between the different types of transactions and several examples should be provided. End-of-chapter exercises 14–1 and 14–2 and problems 14–1, 14–2, 14–3, and 14–5 provide useful practice on the subject.

ANSWERS TO IN-TEXT DISCUSSION QUESTIONS

641. The differences between net income and cash flow from operations fall into two categories: (1) noncash charges to noncurrent accounts, and (2) changes in current accounts other than cash and securities. In the case of Starbucks for 2009, noncash charges to noncurrent accounts included (1) depreciation and amortization, (2) the provision for impairments and asset disposals, (3) deferred income taxes, and (4) other noncash items, most which were added back to net income in arriving at cash flow from operations. Changes in current asset and current liability accounts included decreases in inventories and operating assets and increases in current liabilities which are added back to net income in arriving at cash flow from operations. 641. Cash equivalents, such as commercial paper and other debt investments with original maturities of less than three months, can quickly and easily be converted into cash, and are so like cash, that they are combined with cash as a single number on the balance sheet and not carried as marketable securities. The cash flow statement explains changes in cash and cash equivalents.

643. If depreciation appears in the operating section of the statement of cash flows, Biomet is using the indirect method. The indirect method employs a reconciliation process, which begins with net income, and then adjusts net income for noncash items, such as depreciation, in arriving at cash flow from operations. Depreciation was deducted in arriving at net income, but did not require the use of cash, and therefore is added back to net income. The direct method, by contrast, does not reflect depreciation, because the direct method only includes those items that directly involve cash inflows and outflows. 644. An analyst would learn more about changes in the cash account from the direct method. Even when the direct method is used, the indirect or reconciliation approach must be disclosed. This is useful to analysts in evaluating the company’s components of net income that do not involve cash flows, and helps to evaluate the quality of reported earnings. 646. Google’s operating cash flows improved every year. This allowed management to make investments, evidenced by negative investing cash flows. Cash inflows from financing were also used to make investments. Google appears to have an aggressive plan for growth. 646. Cash and equivalents increased for 2007 and 2009 but decreased for 2008 Profitability has declined annually, with a positive net income for 2007 but a loss for 2008 and a bigger loss for 2009. Cash flows from operations were positive in all three years, increasing annually. Negative cash flows from financing activities show that debts are being paid faster than incurred. The positive cash flows from investing activities in 2007 is unusual and was attributable to proceeds from the sale of discontinued operations and from disposals of assets being greater than investments and capital expenditures. 647. In 2008 Nestlé's net income exceeded cash from operations. This is somewhat unusual. Because depreciation charges reduce net income but not cash flows from operations, it is more common for cash flows from operations to exceed net income. Most of the difference between Nestlé's net income and operating cash flows for 2008 is attributable to cash used in disposal of businesses. The prior year was more in line with what would be considered normal. 648. Reported net income over time means little unless it finds its way into the cash account. An analyst needs to assess the quality of earnings by understanding how the cash flows from operations relate to reported net income. This process helps the analyst identify possible misstatements and to identify negative trends in financial management. 649. Net income is more difficult to predict because it incorporates many variables, judgments, and estimates that can affect measurement of reported results. Cash flows on the other hand reflect what actually went through a company’s bank account. Even though cash flow reporting can be manipulated for a single period, cash flows viewed over time give a clearer picture of future trends. 663. The impairment charges and depreciation/amortization items were deductions (expenses) subtracted against revenues in arriving at net income. These items, however, but did not require the use of cash in the current period. Accordingly, using the indirect or reconciliation approach, the items were added back in arriving at cash flow from operations. The gains on sales of investments increased net income, but their effect on cash flow is not found in the operating section of the statement of cash flows and therefore has to be backed out (subtracted) in reconciling net income to operating cash flows 663. Safeguard Scientifics must have raised a substantial amount of cash through issuance of debt or equity capital, which would be reflected as a cash inflow from financing activities in the statement of cash flows, and would also appear as long term liabilities or shareholders’ equity in

the balance sheet. The infusion of capital probably came primarily from equity capital. A company that loses so much money is not a likely issuer of this much debt. 664. Based on the information given, it would appear that the overall operations of Motorola expanded in 2008. Accordingly, one would expect that the change in receivables would have been greater than for the previous year because of the increased level of business activity. 665. The adjustments for foreign currency exchange rate changes were positive and negative during this time frame. Over the three years the total was a net reduction in cash. The items reflect gains and losses from converting transactions conducted in foreign currencies into U.S. dollar amounts in order to prepare financial statements (in dollars) for a company that does business in multiple currencies.