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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Michael L. Hockenstein Commerce Department • Vanier College

Intermediate Accounting

Thomas H. BeechySchulich School of Business, York University

Joan E. D. ConrodFaculty of Management

Dalhousie University

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 5-2

Cash Flow Statement

Chapter 5


Introduction The cash flow statement

reveals the operating cash flow of the company enables the user to reconcile the cash flows

to net income The cash flows of an enterprise are of prime

importance to many users of the financial statements The AcSB has identified cash flow prediction

as a principal objective of financial reporting The starting point of cash flow prediction is

the analysis of historical cash flows


Evolution of the Cash Flow Statement The cash flow statement has evolved over the past twenty years

The title of cash flow statement is fairly recent In 1985, the AcSB substantially revised Section 1540 to eliminate the working

capital approach and focus instead on cash flows Previous historical analysis of long-term assets, long-term liabilities, and

owners’ equities shifted to that of analyzing cash flows, regardless of the nature of the flows


Cash Flow Reporting

Cash versus accrual Definition of cash Classification of cash flows


Cash vs. Accrual

Under the accrual basis, financial assets and liabilities (that is, receivables and payables) are recorded when the reporting enterprise has a right to receive cash or the obligation to pay cash, rather than later when the cash flows actually occur

On the cash flow statement, the effects of both accruals and interperiod allocations (such as depreciation and amortization) are eliminated, leaving only the cash flows

Cash flow is not affected by accounting policy choice


Cash vs. Accrual (cont.)

Receipts and disbursements are cash inflows and outflows

They can be for any purpose, whether to generate operating earnings, change the asset structure, or increase or decrease liabilities

Because of the accrual concept, a cash receipt or disbursement that gives rise to a revenue or expense may occur in a different period than that in which the revenue or expense is recognized


Definition of Cash For purposes of the cash flow

statement, “cash” includes: cash on handcash on depositcash equivalents---highly liquid short-term

investments Investments in shares are explicitly excluded In Canada, corporations often maintain lines of credit

with their banks that may be used as a cash account to run a negative balance, or overdraft


Definition of Cash (cont.)

“for an investment to qualify as a cash equivalent it must be readily convertible to a known amount of cash and be subject to an insignificant risk of changes in value” [CICA 1540.08]. “3 months maximum maturity period”


Classification of Cash Flows

Operating activities: the principal revenue producing activities of the enterprise and the related expenditures

The cash inflow from operations is measured as the cash received from customers or clients, plus activities such as finance revenue

The cash outflows are those disbursements that are incurred to earn the inflow, such as cash paid for inventories, wages and salaries, and overhead costs


Classification of Cash Flows (cont.) Investing activities: those activities that relate to

the asset structure of the company, including the acquisition and disposal of tangible and intangible capital assets and investments in other assets that are not included in cash equivalents

Financing activities: those that relate to the liabilities and owners’ equity. Cash flows that increase or decrease the size or composition of the accounts on the right side of the balance sheet are reported in this section


Exhibit 5-1


Exhibit 5-1 (cont.)


Exhibit 5-2


Exhibit 5-2 (cont.)


Preparing The Cash Flow Statement Basic Approach to Preparation Analyzing Cash Flow Presentation of Operations Offsetting Transactions Non-Cash Transactions Cash Flow per Share Quality of Earnings Effect of Accounting Policy Choices

on the Cash Flow Statement Summary of Disclosure Recommendations


Basic Approach to Preparation The Balance Sheet, Income Statement, and

Retained Earnings Statement are all prepared from the trial balance manually or, by computerized systems

The classification of the balance of each account is unambiguously pre-specified in the programming, and the statements (other than the cash flow statement) emerge more or less automatically from the system


Basic Approach to Preparation (cont.)

The cash flow statement is prepared by analyzing account balances and changes in balances

Standard computerized accounting systems normally cannot do that, therefore the cash flow statement is usually a hand-prepared statement


Exhibit 5-4


Presentation of Operations

Direct presentation: revenues and expenses are adjusted to a cash basis of reporting and shown directly in deriving cash provided by (or used by) operations on the cash flow section (Exhibit 5-5)

Indirect presentation: Operations begin with net income, and all interperiod allocations and accruals are reversed out of net income to derive the cash from operations (Exhibit 5-4)


Exhibit 5-5


Offsetting Transactions

In the investing and financing sections, gross cash flows (gross cash receipts and gross cash payments) are reported separately

Transactions relating to similar items of asset or equity structure should not be netted


Non-Cash Transactions

Common types of non-cash transactions include: retiring bonds through share issuance converting bonds to shares converting preferred shares to common

shares settling debt by transferring non-cash

assetsbond refinancing


Non-Cash Transactions (Cont.)

incurring capital lease obligations in exchange for leased assets

acquiring shares in another company in exchange for shares of the reporting enterprise

distributing assets other than cash as dividends (e.g., a spin-off of a subsidiary company)


Cash Flow Per Share

Financial analysts and other users often compute cash flow per share, which is defined in many different ways

One common measure of cash flow per share is net operating cash flow divided by common shares outstanding

The CICA Handbook is silent on the issue, which allows Canadian companies to use their judgement in this area.


Quality of Earnings

Earnings quality: relates the amount of net income to the amount of cash flow from operations

A company is said to have high quality earnings when there is a close correspondence between net income and cash flow from operations, especially if the close relationship between earnings and cash flow persists over several years and move in the same direction

A company that reports earnings that are not closely related to cash flows is said to have low quality earnings


Effect of Accounting Policy Choices on the

Cash Flow Statement

One of the reasons that users like to see the cash flow statement is that “cash doesn’t lie”

Accounting policy decisions and management’s measurement estimates can significantly affect net income, but they will have no impact on the underlying cash flow

The decision whether to capitalize or expense an expenditure does affect the cash flow statement


Summary of Disclosure Recommendations The CICA Handbook recommends the following

disclosures:statement should report the changes in cash and

cash equivalents, net of bank overdrafts, resulting from the activities of the enterprise during the period

the components of cash, cash overdrafts, and cash equivalents should be disclosed and should be reconciled with the balance sheet.


Summary of Disclosure Recommendations (cont.)

the statement should include only cash flows; non-cash transactions should not be reported on the cash flow statement, but should be disclosed elsewhere in the financial statements as appropriate

cash flows during the period should be classified by operating, investing, and financing activities

reporting enterprises are encouraged to report cash flows from operations by the direct method


Summary of Disclosure Recommendations (cont.)cash flows from investing and financing activities

should not be netted or offset; the gross amount of inflows and outflows should be reported

cash flows relating to extraordinary items should be classified according to their nature as operating, investing, or financing activities, and should be separately disclosed

the gross amounts of cash flows from interest and dividends (both received and paid) should be disclosed separately; interest and dividends that have been included in net income should be separately disclosed as part of operating cash flow


Analyzing More Complex Situations Using a Spreadsheet Worksheet Procedure Direct Presentation Method Indirect Method Summary of Reconciling

Adjustments


Using a Spreadsheet

The spreadsheet approach is useful because it:provides an organized format for documenting the

preparation process facilitates review and evaluation by othersprovides proofs of accuracy formally keeps track of the changes in balance

sheet accounts and ensures that all accounts are explained


Summary of Reconciling Adjustments To prepare the cash flow statement, it is necessary

to convert the accrual basis earnings to the cash basis and to trace other cash flows that caused changes in the asset and equity structure of the reporting enterprise

Basically, there are three types of adjustments that must be made to the accrual basis accounts:accruals must be “backed out” of the monetary

asset and liability accounts to determine the cash inflows and outflows for operations during the period


Summary of Reconciling Adjustments (cont.)

the effects of interperiod allocations of costs and revenues must be reversed

certain transactions, the net effects of which are included in net income, must be reclassified as investing or financing activities

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