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Accounting for Managers 550Online Class Module 5 Introduction to Limited Companies and Measuring and Reporting Cash Flows (Ch 4 & 6)1Learning Objectives1. Explain why cash is important to the reporting entity2. Define cash and cash equivalents3. Discuss the three components of the statement of cash flows (operating activities, investing activities, financing activities)4. Identify non-cash transactions5. Recognise the alternative approaches for preparing a statement of cash flows6. Prepare and analyse a statement of cash flows

22The importance of cash and cash flow3Cash is important because organisations and people will not normally accept any other form of settlement of claim against the business

Businesses fail as a result of their inability to find sufficient cash to settle their responsibilities

The accrual nature of the statements of financial position, statement of comprehensive income are thought to obscure the question of how and where a company is generating the cash it needs to continue operating.3Differences between the four external financial reports4Statement of financial position Static report made at a given point in time and based on balances in assets, liabilities and owners equity Normally based on accrual transactions

Statement of comprehensive income (profit & loss) Measures the financial performance over a period of time Normally one year, related to revenues earned less expenses incurred

Differences between the four external financial reports5Statement of changes in equityIdentifies all changes in equity for the period related both to comprehensive income, owners contributions and withdrawals, and all other changes in equity

Statement of cash flows (SCF)Identifies all cash receipts and cash payments for the period All account types are included and is based on cash not accrual transactions

Statement of cash flows6Is an analysis of the business cash movements over the period concerned

All payments/receipts of a particular type are added together to give just one figure, which appears in the statement

The net total of the statement is the net increase or decrease in cash of the business over the period

Reference: AASB 107 Statement of Cash Flows

Structure and Format of statement of cash flows7Statement of Cash Flows

Cash flows from operating activitiesxxxCash flows from investing activitiesxxxCash flows from financing activitiesxxxNet increase (decrease) in cash & cash equivalentsxxxOpening cash and cash equivalents xxxClosing cash and cash equivalents xxx

Cash and cash equivalents8Cash represents cash on hand and demand deposits

Cash equivalents represent short-term, highly liquid investments that can be readily converted to a fixed amount of cash and are subject to an insignificant risk of changes in valueExamples include:Short-term (e.g. less than 3 months) depositsBank bills

Question: Can we classify short-term investment in stock market as cash equivalents?

No. (Risk of changes in value)Three Components91. Operating activities:the principal revenue-producing activitiesother activities that are not investing or financing activities.

Examples of cash flows from operating activitiesCash receipts from the sale of goods and the rendering of servicesCash receipts from fees, commissions and other revenueCash payments to suppliers and employeesCash payments for income taxes

Three Components102. Investing activities the acquisition and disposal of long-term assets and other investments

Examples of cash flows from investing activitiesCash payments to buy property, plant and equipment, and other long-term assets Cash receipts from the sale of property, plant and equipment, and other long-term assetsCash payments to buy shares or bonds of other companies (for investment purposes) Cash receipts from sales of shares or bonds of other companies Three Components113. Financing activities activities that result in changes in the size and composition of the contributed equity and borrowings

Examples of cash flows from financing activities Cash proceeds from issuing shares Cash payments to acquire or redeem the business's sharesCash proceeds from issuing bondsCash proceeds from bank borrowingsCash repayments of amounts borrowed

Interest and Dividend12Operating ActivitiesInvesting ActivitiesFinancing ActivitiesInterest receivedYesYesInterest paymentYesYesDividend receivedYesYesDividend paidYesYescash flows from interest and dividends received and paid shall each be:(i) disclosed separately; and (ii) classified in a consistent manner from period to period as either operating, investing, or financing activities.Non-cash transactions13= Transactions that do not directly involve cash

Most relate to the operating activity section and are linked to the difference between cash-based and accrual-based transactionsExamples depreciation, revaluations, doubtful debts, etc.

Some relate to the investing and financing activity section Examples direct exchanges such as shares for assets, non-current assets for reduction in debt, etc.Not included in SCF but should be disclosedRecap141. Explain why cash is important to the reporting entity2. Define cash and cash equivalents3. Discuss the three components of the statement of cash flows (operating activities, investing activities, financing activities)4. Identify non-cash transactions

15Before moving on to the next VDO clip, please attempt Quiz 5.11617Welcome back! Now we will continue with Clip 5.2: Cash flow from operating activities.Cash flows from operating activities Two approaches181. Direct methodreport major classes of gross cash receipts and gross cash payments

2. Indirect methodreconcile from profit or loss to net cash provided by operating activities more often used

The two methods have no effect on investing or financing activities.

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Derivation of cash flows21Note that we use the accrual basis to account for transactions during the period.

We need to make some adjustments to derive the amounts of cash receipts or cash payments.Cash received from customers22SalesxxxAdd Opn. Accounts Receivable (AR)xxxCash collectable from customersxxxLess Clo. AR (xxx)Cash receipts from customers xxx

Sales + Opn. AR Clo. AR = Cash receipts from salesSales AR = Cash receipts from sales AR = Change in AR = Clo. AR Opn. ARAR = Accounts Receivable

Cash received from customers23Cash receipts from sales = Sales AR

Cash receipts from sales = Sales if AR = 0

Cash receipts from sales = Sales Increase in AR Increase in AR => cash inflows from sales is less than the sales itself

Cash receipts from sales = Sales + Decrease in ARDecrease in AR => cash inflows from sales is greater than the sales itself

Cash paid to suppliers24Purchase of inventoryxxxAdd Opn. Accounts Payable (AP)xxxCash payable to suppliersxxxLess Clo. AP (xxx)Cash paid to suppliers xxx

Purchase (Clo. AP Opn. AP) = Cash paid to suppliers

Purchase AP = Cash paid to suppliersCOGS = Opn. Inventory + Purchase Clo. InventoryPurchase = COGS + Inventory

Cash paid to suppliers = COGS + Inven - AP

Cash paid to suppliers25Cash paid to suppliers = COGS + Inven - AP

An increase in inventory will increase the cash payment to suppliers => decrease cash flows from operating activities

An increase in accounts payable will decrease the cash payment to suppliers => increase cash flows from operating activities

Cash paid to employees26Salary ExpensexxxAdd Opn. SP (Salary Payable)xxxCash payable to employeesxxxLess Clo. SP (xxx)Cash paid to employeesxxx

Cash paid to employees = Salary Exp SPIf SP > 0 (an increase in SP), cash payment is less than the salary expense.If SP < 0 (a decrease in SP), cash payment is greater than the salary expense.

Cash payment related to prepaid expense27Clo. Prepaid Insurance (PI)xxxAdd Insurance ExpensexxxAmount payable related to prepaid insurancexxxLess Opn. PI (xxx)Cash paymentxxx

Cash Paid for Insurance = Insurance Expense + PI If PI > 0 (an increase in PI), cash payment is greater than the insurance expense.If PI < 0 (a decrease in PI), cash payment is less than the insurance expense.

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Summary29Net Income+/- Adjustment= Cash flows from operating activitiesSales revenue- Accounts Receivable Cash receipts from salesCosts of Goods Sold+ Inventory - Accounts PayableCash paid to suppliersSalary Expense- Salary Payable Cash paid to employeesInsurance Expense+ Prepaid InsuranceCash paid for insurance Depreciation ExpenseAdd back Non-cash itemProfit +/- adjustments for changes in working capital+/- adjustments for noncash items+/- adjustments for non-operating items = Cash flows from operating activitiesEx: Gains or losses on sales of non-current assets.30

When to add/deduct the increase/decrease?31See the previous slides for details.

Intuitive way to remember:Increase in current assets means you need to pay cash to buy them => we have less cash=> deduct increase/ add decrease

Decrease in current liabilities means you pay more cash to retire the debts => we have less cash=> deduct decrease/ add increase

Recap325. Recognise the alternative approaches to preparing a statement of cash flows

33Just one more clip to go. Before moving on to the next VDO clip, please attempt Quiz 5.2.3435Welcome back! Now we will continue with Clip 5.3: Preparation and use of statement of cash flows.Three Components361. Operating activitiesthe principal revenue-producing activitiesother activities that are not investing or financing activities.

2. Investing activities the acquisition and disposal of long-term assets and other investments

3. Financing activities activities that result in changes in the size and composition of the contributed equity and borrowings

Cash flows from investing activities37Opn. Asset xxxAdd Purchase xxxLess Disposal(xxx)Clo. Asset xxx

Asset purchase = Clo. Asset + Disposal Opn. Asset

Cash flows from investing activities38Opening balance of equipment = $300,000Closing balance of equipment = $550,000If machinery that originally cost $100,000 was sold during the year, what was the value of new equipment purchased?

Asset purchase = Clo. Asset + Disposal Opn. Asset = 550,000 + 100,000 300,000 = $350,000

Cash flows from financing activities - Long-Term Loan39Opening balance = $100,000.New debt amounting to $50,000 during the year.Closing balance = $120,000.

How much is the repayment?$100,000 + 50,000 120,000 = $30,000

39Cash flows from financing activities - Issues and Buy-backs of Shares40Opening balance of ordinary share capital = $200,000.New shares issued during the year = $100,000.Closing Balance = $280,000.

How much is the cash payment for buy-backs (share repurchase)?$200,000 +$100,000 $280,000 = $20,000

Cash flows from financing activities Dividend Payment41Opening balance of equity = $45,000Closing balance of equity = $35,000Profit = $10,000Calculate the amount of dividends paid.

In simple situation:Opn. Equity + Owners Investment + Profit Dividend = Clo. Equity$45,000 +$0 + 10,000 Dividend = $35,000Dividend = $20,000

Example of Statement of Cash Flows42

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What does the statement of cash flows tell us?47The statement of cash flows tells us how the business has generated cash during the period and where that cash has gone

Tracks the sources and uses of cash over time, which is indicative of trends and useful for predicting future opportunities and patterns of cash flow

Equity investors are interested in cash flows because Value of a firm = PV(Expected future cash flow)Future cash flows can be forecasted from history.

Creditors monitor cash flows because they wants to make sure they will receive interest and the repayment of the principal.

SCF helps you evaluate 48Liquidity: ability to meet financial obligations

Financial Flexibility: the ability to generate sufficient cash to meet unanticipated needs and opportunities.

Risk: Stability in cash flows.

Subjectivity involved in the determination of net income: earnings management generally does not affect cash.

Analysis of SCF49Cash flows from operating activities (CFO)High CFO is a good sign CFO should be the main source of cash since this is what the business is founded forRisk averse investors may prefer a business with steady CFOCFO should tell the same story as the net income

Cash flows from investing activities (CFI)High positive CFI can be a bad sign, especially when the firm has negative CFO and has lots of debt.

Analysis of SCF50Cash flows from financing activities (CFF)High CFF can be good or bad, depending on the situation and the capital structure of the firm

Note that positive CFF with negative CFO may not be a good sign, since the business cannot get cash from investors or creditors to pay for day to day operation forever. Manipulation of CF from Operation51Classification Classify interest and dividend revenues as CFO rather than CFIClassify dividend paid as CFF rather than CFO.

Capitalize operating costsEx: Classify as a long-term asset the R&D expenditure which should be classified as expense => The R&D expenditure becomes investing cash outflow rather than operating cash outflow. (This will also boost the net income.)

Real transactionsDelay the payment of short-term debt or accelerate the collection of AR (Accounts Receivable) (may not be good in a long run).

Recap526. Prepare and analyse a statement of cash flows

53Before you go, please work on DQ 4.5, 4.6, 6.3, 6.6, 6.7 and Application Exercise 6.1, 6.3, 6.6 and 6.8 Commonwealth of AustraliaCopyright Act 1968 Warning54The material included in this file has been copied and communicated to you by or on behalf of Curtin University under the Part VA or VB of the Copyright Act 1968 (the Act).

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Statement of cash flows Direct method

Cash flows from operating activities

Cash receipts from customersxxxx

Cash paid to suppliers and employees(xxx)

Cash generated from operationsxxx

Interest paid(xx)

Income taxes paid(xx)

Net cash from operating activitiesxxxx

Statement of cash flows Indirect methodCash flows from operating activities

Profit before taxxxxx

Adjustments for:

Depreciationxx

Increase in trade and other receivables(xx)

Decrease in inventoriesxx

Decrease in trade payables(xx)

Cash generated from operationsxxxx

Interest paid(xx)

Income taxes paid(xx)

Net cash from operating activities xxxx

Statement of cash flows Direct method

Cash flows from operating activities

Cash receipts from customersxxxx

Cash paid to suppliers and employees(xxx)

Cash generated from operationsxxx

Interest paid(xx)

Income taxes paid(xx)

Net cash from operating activitiesxxxx

Statement of cash flows Indirect methodCash flows from operating activities

Profit before taxxxxx

Adjustments for:

Depreciationxx

Increase in trade and other receivables(xx)

Decrease in inventoriesxx

Decrease in trade payables(xx)

Cash generated from operationsxxxx

Interest paid(xx)

Income taxes paid(xx)

Net cash from operating activities xxxx