cash flow notes

7/29/2019 Cash Flow Notes

1/14

CASH FLOW STATEMENT

INTRODUCTION

The cash flow statement is the fourth financial statement that businesses prepare. Theobjective of the cash flow statement is to identify the change in cash during the year,including both the ending cash position of the firm and the sources and uses of cash inthe business over the last year. The format and content of the cash flow statementhave evolved over time, as a result of an increased emphasis on the cash position of abusiness.

Net income, measured using accrual accounting, is considered to be the best indicatorof current and future earnings of the business. Both creditors and investors want toinvest in businesses that will be profitable, as a business that is not profitable over thelong term will not be able to pay interest and principal to its creditors, nor will it be ableto pay dividends to investors. The share price of a business that continually incurslosses will plummet, not increase.

It is possible, however, that a profitable business will be unable to meet its obligationsas they fall due as a result of inadequate cash on hand. A growing company may beacquiring more capital assets and inventory, and accounts receivable may be growingin proportion to the growth in sales, leaving the firm with very little cash on hand.

Accordingly, presenting an income statement alone does not provide users of thefinancial statements with adequate information to assess the future prospects of thebusiness. While a quick glance at the balance sheet can inform the users of thechange in cash from the beginning to the end of the year, and the amount of cash onhand at year end, it is much more difficult to assess why the available cash on handhas changed. The cash flow statement provides this information.

FORMAT OF THE CASH FLOW STATEMENT

The cash flow statement reports cash flows under three categories: operating activities,investing activities, and financing activities. All sources and uses of cash must fallunder one of these three categories.

Operating activities

Operating activities are the income generating activities of the business and arereported on the income statement. The operating activities section of the cash flowstatement report the cash provided or used by the business when generating revenueand incurring expenses. Another way of looking at the operating activities section ofthe cash flow statement is as the income statement on a cash basis instead of anaccrual basis. The operating activities should be the primary source of cash for abusiness over the long term, although in periods of growth operating activities mayactually use funds.Use of the accrual basis for preparation of the income statement means that there arerevenues and expenses recorded in period, even though the cash will be received orpaid in a different period. To convert accrual income to cash basis income, it is


2/14

necessary to adjust for changes in accounts receivable, unearned revenue, accountspayable, inventory, prepaid expenses and other payables that affect the calculation ofnet income, such as salaries payable, income tax payable, interest payable, andemployee deductions payable. The change in dividends payable is not included in theoperating activities section of the cash flow statement, as dividends do not appear onthe income statement.

Other adjustments required to accrual net income are for non-cash revenue andexpense items. The income statement includes amortization expense for theamortization of capital and intangible assets. Amortization expense is always a non-cash item, as amortization is the matching of the cost of an asset to the revenuesgenerated in the periods in which the asset is used. Recall that amortization of anasset is recorded as a debit to amortization expense and a credit to accumulatedamortization, there is never an entry to cash. The cash outflow occurs when the assetis acquired or when the loan taken out to acquire the asset is paid.

Other non-cash items are gains and losses reported on the income statement as part of

non-operating items. These can occur when capital or intangible assets are sold, wheninvestments are sold, or when bonds payable are reacquired by the corporation. Ineach of these situations, the cash is compared to the book value of the item beingremoved from the balance sheet and the difference is reported on the incomestatement as a gain or loss. A gain or loss is therefore not a cash item, but thedifference between cash and book value. In addition, the proceeds from the sale of acapital or intangible asset or an investment are properly recorded as an investingactivity on the cash flow statement. Cash used to reacquire bonds payable should beclassified as a financing activity on the cash flow statement.

When preparing the operating activities section of the cash flow statement, the income

statement must be examined for non-cash revenues and expenses, and the currentassets and liabilities section of the balance sheet should be examined. The changes inall current asset and liability accounts affecting the calculation of income should berecorded in the operating activities section. The change in the cash balances is notlisted, as the cash flow statement reports the details of the change in the year. Theoperating activities section of the cash flow statement can usually be prepared byexamining the balance sheet and income statement; supplementary information isusually not necessary.

There are two different ways in which the information about operating activities can bepresented. One is the indirect method, the other is the direct method. At theintroductory accounting level, the direct method is presented only so that students willbe familiar with the presentation when examining financial statements later in their livesand careers. When examining how to prepare a cash flow statement, the indirectmethod will be used. The details of these two methods will be reviewed later in thismaterial. Regardless of whether the direct or indirect method is used, the operatingactivities section of the cash flow statement is always presented first. Either theinvesting activities section or the financing activities section may be presented as thesecond section of the cash flow statement.


3/14

Investing activities

There are really two types of investments that a business makes. The first is theinvestment in productive assets that are used in the business to generate profits.

Acquisition of land, building, equipment, furniture, fixtures, vehicles, patents, franchises,licences, and goodwill can all be considered productive assets. If the business doesnot have sufficient investment in these types of assets, the ability of the firm to operatein the short term and long term may be significantly impaired.

The second type of investment is the investment of surplus funds of the business inshares and bonds of other corporations. The objective of this type of investment is togenerate a higher return on the surplus cash than would be obtained by allowing thecash to remain in the operating bank accounts of the business.

The distinction between these two types of investments is not important for thepreparation of the cash flow statement, as they are reported in the same way. Thedistinction is very important, however, when interpreting the information presented in

the cash flow statement. If a business obtains cash by selling its investment in sharesand bonds of other companies, the ability of the business to continue to operateprofitably in the future is not impaired. If the business obtains cash by selling itsproductive assets, the situation is different. In most situations, selling productive assetswill result in fewer assets used to generate income and therefore lower net income inthe future. Occasionally, a firm will discontinue operations or downsize and no longerneed all of its assets for future operations. In this situation, future operations are not

jeopardized. A point worth noting, however, is that investing activities cannot be lookedupon as an ongoing source of funds. At some point the sale of investments will have adetrimental effect on the operations of the firm.

When preparing the investing activities section of the cash flow statement, the longterm assets section is evaluated. Supplementary information is normally required here,as it is common for a business to both buy and sell assets in the same period. Thedifference between the asset balances at the beginning and end of the year may bedue to several different transactions. When preparing the cash flow statement, GAAPrequires that cash used to acquire assets be shown separately from proceeds on thesale of assets, and it is necessary to separate tangible capital assets from intangiblesand investments in shares/bonds. If a business borrows money to acquire an asset,there is no effect on cash flow and both the investment in assets and the debt incurredare excluded from the cash flow statement.

Financing activities

Financing activities can be broken down into transactions affecting three types ofaccounts: incurring or repaying long term debt; issuing or reacquiring shares; andpayment of dividends. Dividends are the distribution of profits to the shareholders, orthe return on their investment in the shares of the company. Accordingly, cashdividends paid are classified as a financing activity. Interest provides the return tocreditors for their investment in the form of a loan to the business. However, interest isdeducted as an expense in calculating net income, and is therefore classified as an


4/14

operating expense. Recently, some firms have begun classifying interest as afinancing activity instead of an operating activity, but this is beyond the scope ofintroductory accounting.

The financing activities section of the cash flow statement is normally prepared byexamining the long term debt section of the balance sheet (and the current portion oflong term debt in current liabilities, if any), the share capital section of the balancesheet, and the statement of retained earnings (for dividends declared) and the currentportion of the balance sheet (for changes in dividends payable). As with investingactivities, several transactions may affect one account, such as long term loanspayable, within one year. As a result, supplementary information is usually necessaryin order to properly prepare the cash flow statement. It is necessary to show both thecash provided by the issuance of long term debt, and the cash used to repay theprincipal portion of long term debt.

Proof

After the sources and uses of cash are reported as operating, investing and financingactivities, the net increase or decrease in cash during the year is reported. The nextstep is normally a proof to show that this increase/decrease reflects the actual changein cash during the year. The difference between ending and beginning cash iscalculated, and should agree to the net increase/decrease reported on the cash flowstatement.

CASH AND CASH EQUIVALENTS

When trying to determine the increase or decrease in cash during the year, it is

necessary to determine the accounts that comprise cash. The current assets Acash@is always included, but two other accounts may be included as well. If a business hasshort term deposits such as treasury bills that may be cashed at any time, these shortterm deposits may be classified as cash. (If not classified as cash, any change in thisaccount would be classified as an investing activity). Secondly, if the business has ademand loan, the demand loan is treated as a reduction in cash on hand. If thedemand loan exceeds the cash and short term deposits, the surplus is treated as anoverdraft or negative cash position.INDIRECT METHOD

When using the indirect method, cash provided or used by operating activities iscalculated indirectly, by starting with net income on an accrual basis from the incomestatement and adjusting to income on a cash basis, hence the name Indirect Method.The format varies in practice from business to business, but the following format will beused as the template for this course.

Company NameCash Flow Statement

for the year ended ????


5/14

CASH PROVIDED (USED) BY:OPERATING ACTIVITIES

Net income (loss)Adjust for non-cash items on income statement

Amortization expenseGain on sale of equipment ( )

Adjust for changes in non-cash working capital balances

Accounts receivableInventoryPrepaid expensesAccounts payableUnearned revenueInterest payableIncome tax payable

Cash provided (used ) by operating activities

INVESTING ACTIVITIESProceeds from the sale of investmentsPurchase of capital assets ( )

Cash provided (used) by investing activities

FINANCING ACTIVITIESProceeds from the issuance of sharesReacquisition of long term debt ( )Dividends paid ( )

Cash provided (used) by financing activitiesIncrease (decrease) in cash and equivalents $

Proof:Cash and equivalents, end of year $Cash and equivalents, beginning of year

Increase (decrease) in cash and equivalents $Several things are worth noting at this point.1) Net income is a source of cash; if a loss is incurred on the income statement it istreated as a use of cash.2) Whether the changes in current assets and liabilities should be added or deductedfrom net income depends on whether an increase or a decrease has occurred in eachspecific account. These adjustments will be examined in detail through the use of anexample.3) Gains recorded on the income statement have increased net income (remember again is recorded as a credit entry). To remove a gain from the calculation of netincome, it must be deducted. Similarly, losses decrease net income and must beadded back to net income to remove the non-cash item from the income statement.4) Amortization expense is a non-cash item that has been deducted in calculating netincome. Amortization expense must be added back. Please remember that you arestarting with net income. To identify the correct adjustment you must determinewhether the amount increased or decreased net income on the income statement, and


6/14

then reverse it. If it increased net income, it must be deducted. If it decreased netincome, it must be added back.5) In the investing activities section, purchase of an asset is a use of cash and shouldbe in parentheses.6) Sale of an asset is a source of cash equal to the proceeds on sale and shouldalways appear without parentheses. The book value and gain or loss on the saleaffects the income statement, but has no impact on the cash flow statement. The gainor loss is eliminated in the operating activities section of the cash flow statement, andthe actual cash proceeds recorded as a source of funds in the investing activitiessection.7) In the financing activities section, payment of cash dividends is always a use offunds, recorded with parentheses and therefore deducted.8) Issuance of debt or shares, whether preferred or common, is a source of cash andshould be recorded without parentheses in the financing activities section of the cashflow statement.9) Repayment of debt is a use of cash and the amount paid is always in parenthesesand deducted as a financing activity.

10) Reacquisition of shares is a use of cash and the amount paid is always inparentheses and deducted as a financing activity.

Preparation of the proof of the change in the cash position from the beginning to theend of the year shows that the preparer is aware of what the increase or decreaseshould be. Always complete the proof on an exam, even if the increase(decrease)does not agree to the amount shown on the cash flow statement.

EXAMPLE: Yoko Ono Enterprises Ltd.Balance Sheet

as at March 31, 2001

ASSETS2001 2000

CURRENTCash $ 18,325 $ 7,925Accounts receivable 18,300 23,400Inventory 32,650 29,850Prepaid expenses 1,900 1,700

71,175 62,875CAPITAL

Land 50,000 60,000Building 225,000 225,000Accumulated amortization - building ( 101,250) ( 90,000)Equipment 477,000 370,000Accumulated amortization - equipment ( 135,300)


7/14

( 110,700)515,450 454,300

GOODWILL, net 14,100 16,450$600,725 $533,625

LIABILITIESCURRENT

Demand loan payable $ 5,000 $ 1,000Accounts payable 31,420 24,720

Income tax payable 2,100 5,100Interest payable 1,300 -Unearned revenue 2,910 3,810Dividends payable 6,000 5,000

48,730 39,630LONG TERM

Bonds payable 235,000 335,000

SHAREHOLDERS= EQUITY

SHARE CAPITALPreferred shares 85,000 34,000Common shares 70,000 80,000

155,000 114,000RETAINED EARNINGS 161,995 44,995

316,995 158,995$600,725 $533,625

Yoko Ono Enterprises Ltd.Statement of Income and Retained Earningsfor the year ended March 31, 2001

Sales revenue $1,876,425Cost of goods sold 864,000Gross profit 1,012,425

Operating expensesAdvertising 120,000Amortization - capital assets 35,850Amortization - goodwill 2,350Computer software and support 11,625Office 9,466Property taxes 18,943Repairs and maintenance 37,598Salaries and employee benefits 461,056Telephone and internet 17,806Utilities 69,441

784,135


8/14

Operating income 228,290

Other itemsInterest expense ( 32,500)Gain on the sale of land 40,000

7,500

Income before income taxes 235,790Income tax expense 68,790

Net income $ 167,000

Supplementary information:1) Yoko sold a strip of land that was not in use for $50,000 cash. The original cost ofthe land was $10,000 in 1975.2) Equipment with a cost of $107,000 was acquired for cash during the year.3) Yoko had been unable to borrow additional funds to acquire the equipment, as the

existing level of borrowings was considered too high. Yoko issued $51,000 in preferredshares to improve its cash position.4) Yoko reacquired $100,000 in its own bonds payable on the bond market at bookvalue.5) $10,000 in common shares were reacquired at book value when there was atemporary drop in the market price of the shares.6) Dividends of $50,000 were declared during the year; dividends of $49,000 were paid

REQUIRED: Prepare the cash flow statement for Yoko Ono Enterprises Ltd.

Yoko Ono Enterprises Ltd.

Cash Flow Statementfor the year ended March 31, 2001

CASH PROVIDED (USED) BY:

OPERATING ACTIVITIESNet income $167,000Adjust for non-cash items on income statement

Amortization expense 38,200Gain on sale of land ( 40,000)

165,200Adjust for changes in non-cash working capital balances

Accounts receivable 5,100Inventory ( 2,800)Prepaid expenses ( 200)Accounts payable 6,700Unearned revenue ( 900)Interest payable 1,300Income tax payable ( 3,000)

Cash provided by operating activities 171,400


9/14

INVESTING ACTIVITIESProceeds on the sale of land 50,000Purchase of equipment ( 107,000)

Cash provided (used) by investing activities ( 57,000)FINANCING ACTIVITIES

Proceeds on the issuance of preferred shares 51,000Dividends paid ( 49,000)Repurchase of common shares ( 10,000)Repayment of bonds payable ( 100,000)

Cash provided (used) by financing activities ( 108,000)

Increase in cash and equivalents $ 6,400

Proof:Cash and equivalents, end of year $ 13,325Cash and equivalents, beginning of year 6,925


Things to note:1) Cash and equivalents: end start

Cash $18,325 $ 7,925Demand loan ( 5,000) ( 1,000)

13,325 6,925

2) Change in the accrual accounts:

Accounts receivable, opening 23,400closing (18,300)

Decrease 5,100

The receivables outstanding at the start of the year are presumed to have beencollected in full during the current year, however they were recorded on the incomestatement last year, not this year. As the cash was received, it is necessary to add theopening accounts receivable to the net income reported for the current year.

The receivables outstanding at the end of the year are included in the current year=sincome statement, but the cash has not yet been received. The ending receivablesmust be deducted from net income to adjust to the actual cash amount received duringthe year.

The amount to be added, opening receivables is greater than the amount to bededucted, so the net difference is added to net income in the operating activitiessection of the cash flow statement.


10/14

GENERAL RULE: An increase in current assets is a use of funds, while a decrease is asource of funds. If the difference is calculated by subtracting the ending from theopening balance, a result is in parentheses and deducted on the cash flow statement.

A number without parentheses is added on the cash flow statement.

Inventory, opening 29,850closing (32,650)

Increase ( 2,800)

Opening inventory was paid for last year when acquired, but is recorded on the currentyear income statement as cost of goods sold. Closing inventory has been paid for, butas it has not yet been sold it does not appear as an expense on the income statement.It will be included in cost of goods sold next year when sold. To convert accrual netincome to cash flow, the opening inventory must be added back to net income toremove it from the expense, cost of goods sold. The closing inventory should bededucted from net income as the cash has been paid in the current year. As the

deduction exceeds the add back, the difference between opening and closing inventoryis deducted from net income.

Prepaid expenses, opening $ 1,700closing ( 1,900)

Increase ( 200)

For prepaid expenses, opening balance represents the amount paid last year for anexpense recorded on the income statement in the current period. The opening amountmust therefore be added back to net income as the cash was not reduced in this year.The ending amount represents the amount paid in the current year, but to be expensed

in future years. As the cash has been paid in the current year, but not deducted on theincome statement, the closing amount must be deducted from net income. As thededuction exceeds the add back, the net increase is deducted from net income on thecash flow statement.

Accounts payable, closing 31,420opening (24,720)

Increase 6,700

The closing accounts payable have been deducted as expenses on the incomestatement, but have not been paid in the current year. Accordingly, it is necessary toadd the closing payable amount back to net income. The opening payables werededucted in calculating the net income for the previous year, but the cash was paid tothe suppliers during the current year. It is necessary to deduct the opening payablesfrom net income to reflect the cash paid in the current year. In this example, the addback exceeds the deduction and the difference between opening and closing payablesis added to net income on the cash flow statement.

GENERAL RULE: An increase in current liabilities is a source of funds, while adecrease is a use of funds. If the difference is calculated by subtracting the opening


11/14

from the ending balance, a result in parentheses is deducted on the cash flowstatement. A number without parentheses is added on the cash flow statement.

The rationale for changes in all the payables accounts (salaries, interest, income tax,property tax, employee benefits) is the same EXCEPT FOR DIVIDENDS PAYABLE.Please remember dividend payments are classified as financing activities and shouldnever appear in the operating activities section of the cash flow statement.

Income tax payable, ending 2,100opening ( 5,100)

Decrease ( 3,000) deducted from net income

Interest payable, ending 1,300opening -

Increase 1,300 added to net income

Unearned revenue, ending 2,910opening ( 3,810)

Decrease ( 900) deducted from net income

The ending unearned revenue represents cash received but not yet earned by thebusiness. It has not been included in net income in the current year, so must be addedto net income to reflect cash flow. The opening unearned revenue reflects the cashreceived in the previous year, but earned and included in net income in the currentyear. As the cash has not been received in the current year, the opening unearnedrevenue must be removed from net income. As the amount to be deducted exceedsthe amount to be added to net income, the difference between opening and closing

unearned revenue is deducted from net income.

FINANCING AND INVESTING ACTIVITIES

If a business has offsetting transactions within an account, both must be reported onthe cash flow statement. If Yoko Ono had sold equipment with a cost of $100,000 forcash of $100,000 and purchased new equipment for $100,000 cash, the cash flowstatement would show $100,000 proceeds as a source of cash and $100,000 use ofcash to acquire equipment. The same is true if the business repays a loan and takesout a new loan in the year, or issues and reacquires shares.

INTERPRETING THE CASH FLOW STATEMENT

Preparation of a cash flow statement is a mechanical process, however interpreting acash flow statement must take into consideration all the information available about thebusiness.

As stated earlier, operating activities must be the primary source of cash for a businessover the long term. It is possible, however, that a successful company may report ause of cash from operating activities. This is quite common in the first year or two of


12/14

operations, when accounts receivable and inventory levels may be increasingdramatically. It also may occur when an established company is entering a growthstage and is significantly increasing revenues, which will again affect receivables andinventory.

This growth in accounts receivable and inventory is inevitable when sales volumeincreases. For example, if a business allows customers 30 days to pay, and salesdouble in amount, the amount outstanding at any point in time should double. If abusiness wants to significantly increase its sales, it must have more inventory to sell. Ifthe business was doing a good job of inventory management before, and sales double,it is logical that inventory would double as well. Sales cannot increase unless themerchandise is there to sell. Accordingly, growth in accounts receivable and inventory,usually accompanied by a proportionate increase in accounts payable as well, isexpected and not a cause for concern if sales are increasing proportionately. If,however, receivables and inventory are increasing when sales have not changed, thereis the possibility of high bad debts and obsolete or damaged inventory. Increasedreceivables could be the result of a failure to properly carry out credit checks on new

customers or to respond to poor performance of existing customers that can no longerpay their debts as they become due. Increased inventory could occur because there isno longer sufficient demand for the product, or that inventory contains significantunsaleable items. It is important, then, to examine the balance sheet and incomestatement in addition to the cash flow statement when evaluating the cash flow positionof a business. If changes in receivables and inventory are not consistent with changesin sales revenue, the user should be concerned.

Investing activities must be carried on over the entire life of a business. A successfulbusiness must continue to replace its worn and obsolete equipment, even if salesvolume is stable. In any year, then, a business may report investing activities as either

a source or use of cash. Sometimes new assets will be acquired in one year, usingcash, and the assets being replaced are sold the following year, providing cash.Investing activities cannot be the primary source of cash for a business, however.Eventually the firm=s productive capacity will be reduced if assets needed to operatethe business must be sold to provide cash. Certainly during the start up phase of abusiness or during a period of expansion, investing activities may be a very significantuse of cash.

Financing activities also occur throughout the life of a business, and in any particularyear a business may report that financing activities have been a source or use of cash.During the start up phase, expansion of the business, or when significant replacementof capital assets is necessary, financing activities are normally a source of cash. Inother circumstances it is more common for financing activities to be a use of funds asdebt is repaid and dividends paid. Share capital is considered permanent capital for abusiness, so share transactions are less common than issuing and repaying debt.

Yoko Ono Enterprises Ltd.>s cash flow statement is fairly typical of an established firm.Operating activities provide a significant cash inflow, although the increase in accountspayable seems high, considering inventory has increased much less. Investing andfinancing activities have both used funds during the period, indicating Yoko Ono is


13/14

continuing to pay off debt even when assets are being replaced, a sign that cash flowsare good. Even if Yoko had shown financing activities as a source of funds, it would notbe a concern here. It would be a concern, however, if operating activities were a use offunds and the cash flow from financing activities was necessary in order for Yoko Onoto pay its liabilities as they come due. The cash on hand is low, in comparison to thetotal assets. With operating activities providing a healthy cash flow, this suggests thatthe cash flow is relatively stable so it is not necessary to keep large quantities of cashon hand.

DIRECT METHODYoko Ono Enterprises Ltd.

Cash Flow Statementfor the year ended March 31, 2001

CASH PROVIDED (USED) BY:

OPERATING ACTIVITIESCash from customers 1,880,625Cash paid to employees ( 461,056)Cash paid to suppliers (1,145,179)Cash paid for interest ( 31,200)Cash paid for income taxes ( 71,790)

Cash provided by operating activities 171,400

INVESTING ACTIVITIESProceeds on the sale of land 50,000Purchase of equipment ( 107,000)

Cash provided (used) by investing activities ( 57,000)FINANCING ACTIVITIESProceeds on the issuance of preferred shares 51,000Dividends paid ( 49,000)Repurchase of common shares ( 10,000)Repayment of bonds payable ( 100,000)

Cash provided (used) by financing activities ( 108,000)


Cash and equivalents, end of year $ 13,325Cash and equivalents, beginning of year 6,925Increase in cash and equivalents $ 6,400

When the direct method is used to prepare a cash flow statement, the only difference isin the presentation of the operating activities. Instead of reconciling from net incomereported on the income statement to cash flow from operations, the direct methodprepares a highly summarized income statement on a cash basis, identifying cashreceived from customers and investments, and cash paid to suppliers, employees, andfor interest and income taxes. The same accrual accounts must be adjusted for, but


14/14

these are allocated to the relevant line. For example, accounts receivable andunearned revenues are both received from customers and changes in these accountsare used to adjust sales revenue to obtain cash received from customers. Thecalculations are not shown here as they are beyond the scope of an introductoryaccounting course. The cash flow statement for Yoko Ono Enterprises Ltd. ispresented so that students are aware of the existence and appearance of a directmethod cash flow statement.

cash flow notes

Documents