1. Classification of cash flows and non-cash activities.

This subject is for LOS 34.a.b.c.  

The cash flow statement provides important information about a company's cash
receipts and cash payments during an accounting period as well as information about a
company's operating, investing and financing activities. Although the income
statement provides a measure of a company's success, cash and cash flow are also
vital to a company's long-term success. Information on the sources and uses of cash
helps creditors, investors, and other statement users evaluate the company's liquidity,
solvency, and financial flexibility.

Cash receipts and cash payments during a period are classified in the statement of
cash flows into three different activities:

Operating Activities

These involve the cash effects of transactions that enter into the determination of net
income and changes in the working capital accounts (accounts receivable, inventory,
and accounts payable). Cash flows from operating activities (CFOs) reflect the
company's ability to generate sufficient cash from its continuing operations. In effect,
they are derived by converting the income statement from an accrual basis to a cash
basis. For most companies positive operating cash flows are essential for long-run
survival.

The major operating cash flows are (1) cash received from customers, (2) cash paid to
suppliers and employees, (3) interest and dividends received, (4) interest paid, and (5)
income taxes paid.

Special items to note:

 Interest and dividend revenue, and interest expenses are considered operating
activities, but dividends paid are considered financing activities. Note that
interest expense is reported on the income statement while dividends flow
through the retained earnings statement.

How do you remember? Remember that an interest/dividend item is an

operating activity if it appears on the income statement. For example, payments
of dividends do not appear on the income statement, and thus are not classified
as operating activities.

 All income taxes are considered operating activities, even if some arise from
financing or investing.
 Indirect borrowing using accounts payable is not considered a financing activity -
 such borrowing would be classified as an operating activity.

Investing Activities

These include making and collecting loans and acquiring and disposing of investments
(both debt and equity) and property, plant, and equipment. In general, these items
relate to the long-term asset items on the balance sheet. Investing cash flows reflect
how the company plans its expansions.

Examples are:

 Sale or purchase of property, plant and equipment.

 Investments in joint ventures and affiliates and long-term investments in
securities.
 Loans to other entities or collection of loans from other entities.

Financing Activities

These involve liability and owner's equity items, and include:

 Obtaining capital from owners and providing them with a return on (and a
return of) their investment.
 Borrowing money from creditors and repaying the amounts of borrowed.

In general, the items in this section relate to the debt and the equity items on the
balance sheet. Financing cash flows reflect how the company plans to finance its
expansion and reward its owners.

Examples:

 Dividends paid to stockholders (not interest paid to creditors!). Note that the
cash outflow caused by dividends is determined by dividends paid, not dividends
declared. Dividends paid are not reflected in the Retained Earnings account. The
amount is provided in the supplementary information.
 Issue or repurchase the company's stocks.
 Issue or retire long-term debt (including current portion of long-term debt).

Purchase of debt and equity securities of other entities (sale of debt or equity
securities of other entities), loans to other entities (collection of loans to other entities)
are considered investing activities. However, issuance of debt (bonds and notes) and
equity securities are financing cash inflows, and payment of dividend, redemption of
debt, and reacquisition of capital stock are financing cash outflows.

Non-cash Activities

Some investing and financing activities do not flow through the statement of cash
flows because they don't require the use of cash:

 Retiring debt securities by issuing equity securities to the lender.

 Converting preferred stock to common stock.
 Acquiring assets through a capital lease.
 Obtaining long-term assets by issuing notes payable to the seller.
 Exchanging one non-cash asset for another non-cash asset.
 The purchase of non-cash assets by issuing equity or debt securities.

For example, if a company purchases $200,000 of land by issuing a long-term bond,

this transaction is a non-cash one as it does not involve direct outlays of cash.
Therefore, it is excluded from the statement of cash flows. These types of transactions
should be disclosed in a separate schedule as part of the statement of cash flows, or in
the footnotes to the financial statements.

Differences between IFRS and U.S. GAAP

The above discussions are based on the U.S. GAAP. Under IFRS there is some flexibility
in reporting some items of cash flow, particularly interest and dividends.

 Interest and dividends received:

o Under U.S. GAAP, interest income and dividends received from
investment in other companies are classified as CFO.
o Under IFRS, interest and dividends received may be classified as either
CFO or CFI.
 Interest paid:
o Under U.S. GAAP, interest paid is classified as CFO.
o Under IFRS, interest paid may be classified as either CFO or CFF.
 Dividends paid:
o Under U.S. GAAP, dividends paid are classified as CFF.
o Under IFRS, dividends paid may be classified as either CFO or CFF.
2. Preparing the cash flow statement.
This subject is for LOS 34.d.e.f.  
The beginning and ending cash balances on the statement of cash flows tie directly to
the Cash and Cash Equivalents accounts listed on the balance sheets at the beginning
and end of the accounting period.

Net income differs from net operating cash flows for several reasons.

 One reason is non-cash expenses, such as depreciation and the amortization of

intangible assets. These expenses, which require no cash outlays, reduce net
income but do not affect net cash flows.
 Another reason is the many timing differences existing between the recognition
of revenue and expense and the occurrence of the underlying cash flows.
 Finally, non-operating gains and losses enter into the determination of net
income, but the related cash flows are classified as investing or financing
activities, not operating activities.

There are two methods of converting the income statement from an accrual basis to a
cash basis. Companies can use either the direct or the indirect method for reporting
their operating cash flow.

 The direct method discloses operating cash inflows by source (e.g. cash received
from customers, cash received from investment income) and operating cash
outflows by use (e.g. cash paid to suppliers, cash paid for interest) in the
operating activities section of the cash flow statement.
o Adjusts each item in the income statement to its cash equivalent.
o It shows operating cash receipts and payments. More cash flow
information can be obtained, and more easily understood by the average
reader.
 The indirect method reconciles net income to net cash flow from operating
activities by adjusting net income for all non-cash items and the net changes in
the operating working capital accounts.
o It shows why net income and operating cash flows differ.
o Used by most companies.
 The direct and indirect methods are alternative formats for reporting net cash
flows from operating activities. Both methods produce the same net figure
(dollar amount of operating cash flow).
 Under IFRS and U.S. GAAP, both the direct and indirect methods are acceptable
for financial reporting purposes. However, the direct method discloses more
 information about a company. Partly because companies want to limit
information disclosed, the indirect method is more commonly used.
 The reporting of investing and financing activities are the same for both direct
and indirect methods. Only the reporting of CFO is different.

Direct Method

Under the direct method, the statement of cash flows reports net cash flows from
operations as major classes of operating cash receipts and cash disbursements. This
method converts each item on the income statement to its cash equivalent. The net
cash flows from operations are determined by the difference between cash receipts
and cash disbursements.

Assume that Bismark Company has the following balance sheet and income statement
information:

Additional information:

 Receivables relate to sales and accounts payable relate to cost of goods sold.
 Depreciation of $5,000 and pre-paid expense both relate to selling and
administrative expenses.

Direct Method:

 Cash sales: sales on accrual basis are $242,000. Since the receivables have
decreased by $8,000, the cash collections are higher than accrual basis sales.

Sales $242,000
 Add decrease in receivables 8,000
Cash sales $250,000

 Cash purchases: since inventory decreased by $2,000, goods purchased in prior

years were used as cost of goods sold. Since accounts payable decreased by
$12,000, more cash was paid in 2000 for goods than is reported under accrual
accounting.

Costs of goods sold $105,000

Deduct decrease in inventories 2,000
Add decrease in accounts payable 12,000
Cash purchases $115,000

 Cash selling and administrative expense: the selling and administrative expenses
include a non-cash charge related to depreciation of $5,000. In addition, pre-
paid expenses (assets) increased by $1,000 and should be added to the selling
and administrative expenses.

Selling and administrative expenses $58,000

Deduct depreciation expense 5,000
Add increase in pre-paid expense 1,000
Cash selling and administrative expenses $54,000

 Cash income taxes: income tax on the accrual basis is $30,000. Tax payable,
however, has increased by $5,000. This means a portion of the taxes has not
been paid. As a result:

Income tax expense $30,000

Deduct increase in taxes payable 5,000
Income tax paid $25,000

The presentation of the direct method for reporting net cash flow from operating
activities:
Indirect Method

The indirect method uses net income (as reported in the income statement) as the
starting point in the computation of net cash flows from operating activities.
Adjustments to net income necessary to arrive at net cash flows from operating
activities fall into three categories: non-cash expenses, timing differences, and non-
operating gains and losses. Adjustments reconcile net income (accrual basis) to net
cash flows from operating activities. In other words, the indirect method adjusts net
income for items that affected reported net income but did not affect cash.

The four-step-process:

1. Start with net income.

2. Add back non-cash charges such as depreciation and amortization of intangibles.

Cash payments for long-lived assets such as plant and intangibles occur when they are
purchased. Purchase of these assets is reflected as an investing activity at that time.
When depreciation expense is recognized in the current period, it simply indicates the
paper allocation of original purchase cost to this period. As a result, expenses increase
without a corresponding cash outlay. Since depreciation does not affect cash flow, it
should be added back to net income to compute net CFO.

3. Add back losses and subtract gains from investing or financing activities. Examples
include gains/losses from sale of property, plant and equipment (investing activity), or
gains/losses from early retirement of debt (financing activity). Why? Disposal of fixed
assets will be used to illustrate this. The gains and losses from the disposal of fixed
assets appear on the income statement. However, disposal of fixed assets is an
investing activity, so the entire cash receipt is shown as an investing cash inflow.
Therefore, the gains or losses should be removed from net income so as to prevent
double counting cash flows. Note that it is the proceeds from disposal, not the gain or
loss, that constitute the cash flow.

4. Adjust for changes in operating related accounts (current assets and current
liabilities other than cash, short-term borrowings and short-term investments). For
example, an increase in current asset ties up cash, thereby reducing operating cash
flow. An increase in current liabilities postpones cash payments, thereby freeing up
cash and increasing operating cash flows in the current period. Increase in assets
reduces cash, and should be deducted from net income. Increase in liabilities increases
cash, and should be added to net income.

Note that short-term investments are considered an investing activity, and short-term
borrowing is considered a financing activity.

Example

Selton Co.'s balance sheet and income statement are presented below:

Additional information:
(a) Operating expenses include depreciation expense of $34,000 and amortization of
pre-paid expenses of $2,000
(b) Land was sold at its book value for cash.
(c) Cash dividend of $48,000 was paid in 2000.
(d) Interest expense of $8,000 was paid in cash.
(e) Equipment with a cost of $36,000 was purchased for cash. Equipment with a cost of
$24,000 and a book value of $18,000 was sold for $16,000 for cash.
(f) Bonds were redeemed at their book value for cash.
(g) Common stock ($1 par value) was issued for cash.

Explanations of the adjustments to net income of $57,000 are as follows:

a. Accounts receivable: The decrease of $2,000 should be added to net income to

convert from the accrual basis to the cash basis.
b. Inventories: The increase of $60,000 represents an operating use of cash for which
an expense was not incurred. This amount is therefore deducted from net income to
arrive at cash flow from operations.
c. Pre-paid expense: The decrease of $2,000 represents a charge to the income
statement for which there was no cash outflow in the current period. The decrease
should be added back to net income.
d. Accounts payable: When it increases, cost of goods sold and expense on a cash basis
are lower than they are on an accrual basis. The increase of $3,000 should be added
back to net income.
e. Depreciation expense: The depreciation expense for the building is $20,000. Due to
the sale of equipment the depreciation for equipment is (24,000 - 18,000) + 20,000 -
12,000 = $14,000. This amount plus $20,000 should be added back to net income to
determine net cash flow from operating activities.
f. Loss on sale of equipment: The loss of $2,000 on sale of equipment should be added
back to net income since the loss did not reduce cash but it did reduce net income.

Cash flows from investing and financing activities:

a. Land: The sale of land for $20,000 is an investing cash inflow.
b. Equipment: The purchase of equipment for $36,000 is an investing cash outflow,
and the sale for $16,000 is an investing cash inflow.
c. Bonds payable: This financing activity used cash of $40,000.
d. Common stock: Common stock of $80,000 was issued as a financing cash inflow.
e. Retained earnings: The increase of $9,000 is the result of net income of $57,000
from operations and the financing activity of paying cash dividends of $48,000.

The statement of cash flows is prepared as follows:

Conversion of Cash Flows from the Indirect to the Direct Method

Although the indirect method is most commonly used by companies, the analyst can
generally convert it to the direct format by following a simple three-step process.

1. Aggregate all revenue and all expenses.

2. Remove all non-cash items from aggregated revenues and expenses and break
out remaining items into relevant cash flow items.
3. Convert accrual amounts to cash flow amounts by adjusting for working capital
changes.