Chapter three

Cash flow statement

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 Chapter outline
3.1 Distinguish the three components of the
statement of cash flows

3.1.1 Operating activities

3.1.2 Investing activities
3.1.3 Financing activities
3.2 Preparation of Cash flow Statement
3.2.1 Direct method
3.2.2 Indirect method
3.3 The Importance and the usefulness of the statement of
cash flows
( Individual assignment 3)
3.4 The “cash burn rate” and the use of this rate in
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 INTRODUCTION
Cash
 Cash are defined to include both cash and cash equivalents
Cash include:
 Coins
 Currency
 Cash in checking accounts
 Cash in savings accounts
 Bank drafts
 Money orders
 Petty cash
 Cash equivalents include:
 Money market funds
 Highly-liquid investments with original maturities of less
than 3 months: bank certificates of deposit and U.S.
Treasury bills.
• Foreign currency on hand
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 Statement of Cash Flows
Statement of Cash Flows (SCF)
 Its primary purpose is to provide information about a
company’s cash receipts and cash payments during a
period.
 Its secondary objective is to provide cash-basis information
about the company’s operating, investing, and financing
activities.
 The statement of cash flows therefore reports cash
receipts, cash payments, and net change in cash resulting
from a company’s operating, investing, and financing
activities during a period.
 Its format reconciles the beginning and ending cash balances
for the period.
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 Source of information to prepare SCF
 The information to prepare this statement usually comes from three sources:

1. Comparative balance sheets provide the amount of the changes in assets, liabilities, and

equities from the beginning to the end of the period.

2. Current income statement data help to determine the amount of cash provided by or used by

operations during the period.

3. Selected transaction data from the general ledger provide additional detailed information

needed to determine how the company provided or used cash during the period.

 For one thing, it is not prepared from an adjusted trial balance.

 The cash flow statement requires detailed information concerning the changes in account

balances that occurred between two points in time.

 But an adjusted trial balance will not provide the necessary data

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 Internal Uses of CFS
Along side with cash budget CFS is used:
 To assess liquidity

• Determine if short-term financing is necessary

 To determine dividend policy

• Decide to distribute; or increase or decrease

 To evaluate the investment and financing decisions

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 External Uses of CFS
• To assess the ability of a firm to manage cash flows

• To assess the ability of a firm to generate cash through its

operations

• To assess the company’s ability to meet its obligations and its

dividend policy

• To provide information about the effectiveness of the firm to

convert its revenues to cash

• To provide information to anticipate the company’s need for

additional financing
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3.1 Distinguish the three components of the statement of cash flows

The Statement of Cash Flows shows cash inflows and cash outflows, organized into

three different business activities: operating, investing, and financing activities.

3.1.1 Operating activities
 Are the main revenue-generating activities of an entity, result from the
transactions and other events that enter in to the determination of profit or loss
 IAS 7 states that “the amount of cash flows arising from operating activities is a
key indicator of the extent to which the operations of
the entity have generated sufficient cash flows to
 Repay loans
 Maintain the operating capability and continue as a going concern.
 Pay dividends and
 Make new investments without recourse to external sources of financing

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 Operating activity …(Cont’d)

 According to IAS 7 Operating activities involve

 Cash receipts from
o Sale of goods and rendering services to customers
o Non-operating activities such as dividends from investments, interest
revenue, commissions, and fees
o Insurance policy benefit
o Contracts held for dealing or trading purpose
 Cash payments for
o Suppliers for acquisitions of goods and services
o Employees and on behalf of employees
o An insurance policy premiums and others
o Income taxes unless they can be specifically identified with financing
and investing activities; and
o Contracts held for dealing or trading purposes
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 INDIVIDUAL ASSIGNMENT 5:

Interest on loans extended to others and

return on equity securities (Dividend) are
reported as cash inflow from operating activities.
WHY?
Such inflows are reported as other income during
income statement preparation

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 Components …(Cont’d)

3.1.2 Investment activities

Investing activities include cash inflows from

 Sales of PPE, intangibles and other long-term assets
 Sales of equity or debt instruments of other entities and interests in joint

ventures (other than receipts for those instruments considered to be cash

equivalents and those held for dealing or trading purposes)

 The repayment of advances and loans made to other parties (other than

advances and loans of a financial institution)

 Futures, forward, option and swap contracts except when the contracts are held

for dealing or trading purposes, or the receipts are classified as financing11

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 Investment activities …(Cont’d)
Investing activities include cash outflows to:
 Acquire PPE, intangibles and other long-term assets.
o Like capitalized development costs and self-constructed
PPE
 Equity or debt instruments of other entities and interests in
joint ventures (other than payments for those instruments
considered to be cash equivalents or those held for dealing
or trading )
 Cash advances and loans made to other parties other than
advances and loans made by a financial institution
 Futures, forward, option and swap contracts except when
the contracts are held for dealing or trading purposes, or the
payments are classified as financing activities
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 Components …(Cont’d)

3.1.3 Financing activities

 Financing activities involve short term and long term
cash flows related to liability and stockholders’ equity
items
 Includes
Obtaining capital from owners and creditors
Repaying creditors and a return to owners .

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Transaction IFRS U.S. GAAP

Taxes paid Mainly operating activities, but a portion operating activities

of tax expense can be allocated to
investing or financing activities if it can
be directly assigned

Interest received Operating or investing activities Operating activities

Interest paid Operating or financing activities Operating activities

Dividends received Operating or investing activities Operating activities

Dividends paid Operating or financing activities Financing activities

Statement of Cash Flows

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 Statement of Cash Flows
FORMAT OF THE STATEMENT OF CASH FLOWS

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 Format of the Cash Flow Statement

Name of the Company

Cash Flow Statement
For the period …………..
Cash from operating activities A
Cash from investing activities B
Cash from financing activities C
Net Change in Cash D = (A+B+C) increase or (decrease)
+ Beginning Cash balance CB, from the beginning balance sheet
Ending Cash balance =CB + D should equal to ending
cash
balance in the ending balance sheet
Non-cash Investing and Financing Activities
 Steps in preparation
Preparing the statement of cash flows from the data sources above involves three
major steps:

Step 1. Determine the change in cash. This procedure is straight forward. A

company can easily compute the difference between the beginning and the ending
cash balance from examining its comparative balance sheets.
Step 2. Determine the net cash flow from operating activities. This procedure is
complex. It involves analyzing not only the current year’s income statement but also
comparative balance sheets as well as selected transaction data.
Step 3. Determine net cash flows from investing and financing activities. A
company must analyze all other changes in the balance sheet accounts to determine
their effects on cash.

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 RELEVANT FACTS - Similarities

* Both GAAP and IFRS require that companies prepare a statement of cash flows

* Both IFRS and GAAP require that the statement of cash flows should have three
major sections—operating, investing, and financing—along with changes in cash
and cash equivalents

* Similar to GAAP, the cash flow statement can be prepared using either the indirect
or direct method under IFRS

* For both IFRS and GAAP, most companies use the indirect method for reporting
net cash flow from operating activities

*The definition of cash equivalents used in IFRS is similar to that used in GAAP
 RELEVANT FACTS - Differences

* A major difference in the definition of cash and cash equivalents is that in certain
situations, bank overdrafts are considered part of cash and cash equivalents
under IFRS(which is not the case in GAAP).
- Under GAAP, bank overdrafts are classified as financing activities.

*IFRS requires that non-cash investing and financing activities be excluded from
the statement of cash flows. Instead, these non-cash activities should be reported
elsewhere. This requirement is interpreted to mean that non-cash investing and
financing activities should be disclosed in the notes to the financial statements
instead of in the financial statements.
- Under GAAP, companies may present this information in the cash flow
Statement.

* One area where there can be substantive differences between IFRS and GAAP
relates to the classification of interest, dividends, and taxes.
- IFRS provides more alternatives for disclosing these items,
- While GAAP requires that except for dividends paid (which are classified as a
financing activity), these items are all reported as operating activities.
 Illustration 1
Suppose the first year’s operation for Tax
Consultants Inc. was as given bellow. The
company started on January 1, 2011, when it
issued 60,000 shares of $1 par value
common stock for $60,000 cash. The
company rented its office space, furniture,
and equipment,& performed tax consulting
services throughout the first year. The
comparative balance sheets at the beginning
& end of the year 2011 was as follow:
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Illustration 1…(cont’d)

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 Illustration 1…(cont’d)

The income statement and additional information for Tax

Consultants for 2011 were as follow

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 Solution

Step 1: Determine the Change in Cash

To prepare a statement of cash flows, the first step is to

determine the change in cash. This is a simple computation.
Tax Consultants had no cash on hand at the beginning of
the year 2011. It had $49,000 on hand at the end of 2011.
Thus, cash changed (increased) in 2011 by $49,000.

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 Solution…(cont’d)
Step 2: Determine Net Cash Flow from Operating Activities
 To determine net cash flow from operating activities, net
income must be converted to net cash provided by operating
activities.
 In accrual basis of accounting, companies record revenue when
earned and record expenses when incurred.
 Earned revenues may include credit sales for which the
company has not yet collected cash.
 Expenses incurred may include some items that the company
has not yet paid in cash.
 Thus, under the accrual basis of accounting, net income is not the
same as net cash flow from operating activities.

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 Solution…(cont’d)
To arrive at net cash flow from operating

activities, a company must determine revenues

and expenses on a cash basis.
It does this by eliminating the effects of income

statement transactions that do not result in an

increase or decrease in cash.
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Solution…(cont’d)

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 Solution…(Cont’d)
A company may convert net income to net cash flow from operating
activities through either a direct method or an indirect method.

Direct Method
 The direct method also called the income statement method
reports cash receipts and cash disbursements from operating
activities.
 The difference between these two amounts is the net cash flow
from operating activities.
 It deducts operating cash disbursements from operating cash
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receipts.
 Solution…(cont’d)
As indicated from the accrual-based income statement, Tax Consultants reported
revenues of $125,000.

However, because the company’s accounts receivable increased

during 2011 by $36,000, the company collected only $89,000 ($125,000 -
$36,000) in cash from these revenues.

Similarly, Tax Consultants reported operating expenses of $85,000.

However, accounts payable increased during the period by $5,000.

Assuming that these payables relate to operating expenses, cash operating

expenses were $80,000 ($85,000 -$5,000).

Because no taxes payable exist at the end of the year, the company must have
paid $6,000 income tax expense for 2011 in cash during the year.
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 Solution…(cont’d)
Tax Consultants computes net cash flow from operating activities as shown bellow

“Net cash provided by operating activities” is the equivalent of cash basis net income. (“Net cash used by operating activities” is equivalent to cash

basis net loss.)

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 Solution…(cont’d)

 Indirect Method

The indirect method (or reconciliation method) starts with net

income and converts it to net cash flow from operating activities.

 To compute net cash flow from operating activities, a company adds

back noncash charges in the income statement to net income and

deducts noncash credits.

 This is explained with the two accounts used for

adjustments to net income for Tax Consultants, namely, the increases

in accounts receivable and accounts payable, as follows:

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 Solution…(cont’d)

 Increase in Accounts Receivable—Indirect Method. Tax Consultant’s

accounts receivable increased by $36,000 (from $0 to $36,000) during the
year. For Tax Consultants, this means that cash receipts were $36,000 lower
than revenues.

 The Accounts Receivable account in Illustration 1 shows that Tax

Consultants had $125,000 in revenues (as reported on the income statement),
but it collected only $89,000 in cash
Account receivable
Jan1, 2011 0 89000 Receipt from customer
Revenue 125000 -
125000 89000
31/12/ 11 36 000
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 Solution…(cont’d)

 As shown in Illustration 1, to adjust net income to net cash

provided by operating activities, Tax Consultants must deduct the

increase of $36,000 in accounts receivable from net income.

 When Accounts Receivable balance decreases, cash receipts

are higher than revenue earned under the accrual basis.

 Therefore, the company adds to net income the amount of

the decrease in accounts receivable to arrive at net cash

provided by operating activities.

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 Solution…(cont’d)

 Increase in Accounts Payable - Indirect Method. When accounts

payable increase during the year, expenses on an accrual basis
exceed those on a cash basis. Why?
 Because Tax Consultants incurred expenses, but some of the
expenses are not yet paid. To convert net income to net cash flow
from operating activities, Tax Consultants must add
back the increase of $5,000 in accounts payable to net income.
 For computation of net income in accrual basis, expenses were
deducted excessively ( unpaid expenses were deducted . That is why
we are adding increase in accounts payables back)
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 Solution…(cont’d)

 As a result of the accounts receivable and accounts payable adjustments, Tax

Consultants determines net cash provided by operating activities is $3,000 for the

year 2011. Illustration 1 shows this computation.

Net income……………………………………………….34000
Adjustment to reconcile net income to
net cash provided by operating activity:
Increase in account receivable ……(36000)
Increase in account payable ………… 5000 (31000)
Net cash provided by operating activity ………………… 3000

 Note that net cash provided by operating activities is the same whether using direct

or indirect method. 12/8/20 35

 Solution…(cont’d)
Step 3: Determine Net Cash Flows from Investing and Financing Activities

 After net cash flow from operating activities has been computed ,

the next step is to determine whether any other changes in balance

sheet accounts caused an increase or decrease in cash.

 An examination of the remaining balance sheet accounts for Tax

Consultants shows increases in both common stock and retained

earnings.

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 Solution…(cont’d)
 The common stock increase of $60,000 resulted from the issuance of
common stock for cash.
 The issuance of common stock is reported in the statement of cash
flows as a receipt of cash from a financing activity.
 Two items caused the retained earnings increase of $20,000:
1. Net income of $34,000 increased retained earnings.
2. Declaration and payment of $14,000 of dividends decreased
retained earnings.
 Tax Consultants has converted net income into net cash flow from
operating activities, as explained in previous slides. The additional
data indicate that it paid the dividend. Thus, the company reports the
dividend payment as a cash outflow, classified as a financing
activity.
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 Solution…(cont’d)
Tax consults INC
Statement of Cash flow
For the month ended December 31, 2011
Cash flow from operating activities
Net income………………………………………………………….34000
Adjustment to reconcile net income to
net cash provided by operating activity:
Increase in account receivable ……………….(36000)
Increase in account payable ……………………. 5000 (31000)
Net cash provided by operating activity ………….…………… 3000
Cash flow from financing activities
Issuance of common stock…………………………60000

Payment of dividend declared …………………..(14000) (why?)

Net cash provided by financing activity……………………….46000
Net increase in cash…………………………………………….49000
Cash on Jan 1, 2011……………………………………..………..0
Cash on December 31,2011………………………………….....49000
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 Illustration 2:

Tax Consultants Inc. continued to grow and prosper in its

second year of operations. The company purchased land,

building, and equipment, and revenues and net income

increased substantially over the first year. Illustrations

23.10 and 23.11 present information related to the

second year of operations for Tax Consultants Inc.

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Statement of Cash Flows

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Illustration …(cont’d)

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 Illustration …(cont’d)
Step 1: Determine the Change in Cash
 To prepare a statement of cash flows from the available
information, the first step is to determine the change in
cash. As indicated from the information presented,
cash decreased $12,000 ($49,000 - $37,000)
Step 2: Determine Net Cash Flow from Operating
Activities—Indirect Method
 Using the indirect method, we adjust net income of
$134,000 on an accrual basis to arrive at net cash flow
from operating activities.

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 Illustration …(cont’d)
 Decrease in Accounts Receivable. Accounts receivable
decreased during the period, because cash receipts (cash-basis
revenues) are higher than revenues reported on an
accrual basis.
 To convert net income to net cash flow from operating activities,
the decrease of $10,000 in accounts receivable must be added to
net income .

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 Illustration …(cont’d)
Increase in Prepaid Expenses:
 Tax Consultants has made cash payments in the current
period, but expenses (as charges to the income statement) have
been deferred to future periods.
 To convert net income to net cash flow from operating activities,
the company must deduct from net income the increase of
$6,000 in prepaid expenses.
 An increase in prepaid expenses results in a decrease in cash
during the period.
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 Illustration …(cont’d)
Increase in Accounts Payable

 Tax Consultants must add the 2012 increase of $35,000 in

accounts payable to net income, to convert to net cash flow

from operating activities.

 The company incurred a greater amount of expense than the

amount of cash it disbursed.

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 Illustration …(cont’d)
Depreciation Expense (Increase in Accumulated Depreciation).
 The purchase of depreciable assets is a use of cash, shown in the
investing section in the year of acquisition.
Tax Consultant’s depreciation expense of $21,000 (also represented
by the increase in accumulated depreciation) is a noncash charge;
the company adds it back to net income,
to arrive at net cash flow from operating activities.
 The $21,000 is the sum of the $11,000 depreciation on the building
plus the $10,000 depreciation on the equipment.
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 Illustration …(cont’d)
As a result of the foregoing items, net cash provided by operating
activities is $194,000 as shown in Illustration 23-12.

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 Illustration …(cont’d)
Step 3: Determine Net Cash Flows from Investing
and Financing Activities

After you have determined the items affecting net cash provided
by operating activities, the next step involves analyzing the
remaining changes in balance sheet accounts. Tax Consultants Inc.
analyzed the following accounts.

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 Illustration …(cont’d)

Increase in Land

 As indicated from the change in the Land account, the company

purchased land of $70,000 during the period.

 This transaction is an investing activity, reported as a use of cash.

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 Illustration …(cont’d)
Increase in Buildings and Related Accumulated Depreciation.
 As indicated in the additional data, and from the change in the
Buildings account, Tax Consultants acquired an office building
using $200,000 cash.
 This transaction is a cash outflow, reported in the
investing section.
 The $11,000 increase in accumulated depreciation results from
recording depreciation expense on the building. As indicated
earlier, the reported depreciation expense has no effect on the
amount of 12/8/20
cash. 50
 Illustration …(cont’d)
Increase in Equipment and Related Accumulated Depreciation.
 An increase in equipment of $68,000 resulted because the
company used cash to purchase equipment.
 This transaction is an outflow of cash from an investing
activity.
 The depreciation expense entry for the period explains the
increase in Accumulated Depreciation—Equipment

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 Illustration …(cont’d)
Increase in Bonds Payable.

 The Bonds Payable account increased $150,000.

 Cash received from the issuance of these bonds represents an

inflow of cash from a financing activity.

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 Illustration …(cont’d)
Increase in Retained Earnings.

 Retained earnings increased $116,000 during the year.

Two factors explain this increase:

1) Net income of $134,000 increased retained earnings, and

2) dividends of $18,000 decreased retained earnings.

 As indicated earlier in the previous slides, the company adjusts net income
to net cash provided by operating activities in the operating activities
section.

 Payment of the dividends is a financing activity that involves a

cash outflow.
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Illustration …(cont’d)

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End of Chapter 3

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