You Will Learn
Chapter 5
| You Will Learn...
1.To describe the circumstances in which the cash flow statement is a particularly important companion of the income statement. They include:
CWhen noncash expenses are high, earnings gives an overly pessimistic view of a company’s performance; cash flow from operations may give a better picture.
CThe operations of rapidly growing companies can consume cash even when reported net income is positive.
CThe cash flow statement provides a reality check in situations where companies have an incentive to bias the accrual accounting assumptions.
CThe cash flow statement offers a one-page summary of the results of a company’s operating, investing, and financing activities for the period.
2.To outline the structure of and information reported in the three main categories of the cash flow statement: operating, investing, and financing. Use this base:
COperating activities—those activities that enter into the calculation of net income.
CInvesting activities—the purchase and sale of land, buildings, equipment, and nontrading financial instruments.
CFinancing activities—involve the receipt of cash from and the repayment of cash to owners and creditors.
CNoncash investing and financing transactions include the purchase of long-term assets in exchange for the issuance of debt or stock.
3.To appreciate the historical process involved in the development of the modern statement of cash flows. Keep in mind:
CThe current structure was mandated by the FASB in 1987.
CPrior to that, companies presented a statement of changes in financial position that did not focus strictly on cash flow.
4.To compute cash flow from operations using either the direct or the indirect method. Remember:
CThe direct method is a recap of the income statement with the objective of reporting how much cash was received or disbursed in association with each income statement item.
CThe indirect method starts with net income and then reports adjustments for operating items not involving cash.
CNet cash from operations is the same whether it is computed using the direct method or the indirect method.
5.To prepare a complete statement of cash flows and provide the required supplemental disclosures.
CBasic information comes from these parts of the financial statements.
Operating—income statement and current assets and liabilities.
Investing—long-term assets.
Financing—long-term liabilities and equities.
CPreparation of a cash flow statement is not done until each income statement item has been considered, all changes in balance sheet items have been explained, and the net change in cash has been exactly reconciled.
6.To understand the difference among cash flow statements prepared according to U.S. GAAP, U.K. GAAP, and International Accounting Standards. Keep in mind:
CPrimary differences relate to alternative classifications.
CIAS 7 closely matches U.S. GAAP, but grants greater flexibility in classifying cash transactions such as interest, dividends, income taxes paid, and interest and dividends received.
CU.K. GAAP—eight different categories for classifying cash flow transactions.
7.To assess a firm’s financial strength by analyzing the relationships among cash flows from operating, investing, and financing activities and by computing financial ratios based on cash flow data.
CPatterns of positive and negative cash flow in operating, investing, and financing activities yield insights into the health and current strategy of a company.
CData from the cash flow statement can be used in conjunction with balance sheet and income statement data to compute financial ratios.
8.To use knowledge of how the three primary financial statements tie together in order to prepare a forecasted statement of cash flows.
CConstructed using information from projected balance sheet and income statement.
CAllows a company to plan for new loans, long-term asset acquisitions, etc.
CAllows potential lenders to evaluate the likelihood of repayment, and potential investors to evaluate the likelihood of receiving dividends in the future.
9.To use a T-account or work sheet approach to prepare a statement of cash flows.
CIn the preparation of more complicated cash flow statements, the use of T-accounts or a work sheet provides a systematic, structured approach.
| Important Points
Gains and Losses as Noncash Income Statement Items
You may be confused by the treatment of gains and losses in the reconciliation of net income and cash flow from operations. Remember that the related disposition of the asset is an investing activity. The adjustment for the noncash gains and losses merely removes their effect from net income to obtain cash flow. The total proceeds from asset disposition is presented in the investing activities section, while the gain or loss is the difference in the asset’s carrying value and the cash received in the disposition.
Cash Equivalency
Securities that are short-term and highly liquid may qualify for cash equivalency status. Generally, only those investments with original maturities of three months or less qualify as cash equivalents. Cash equivalency is thus determined only once—at the acquisition date. A security originally determined not to be cash equivalent cannot become a cash equivalent when its maturity date is within three months.
You should recognize that the total of cash and cash equivalents is treated as one single amount. When preparing the cash flow statement any cash equivalent items are added to cash and the total is the target amount of cash flow to be reconciled on the cash flow statement.