20.10 Chapter Summary

LO 1: Describe the statement of cash flows (SCF) in accounting and business.

The SCF reports on how a company obtains and utilizes its cash flows and how it reconciles with the opening and ending cash and cash equivalent balances of the statement of financial position. It is separated into operating, investing, and financing activities, and the combination of positive and negative cash flows from within each activity can provide important information about how a company is managing its cash flows. Large differences between reporting net income and the net cash flows from operations reduce the quality of earnings and the reliability of the financial statements, creating the need for further evaluation into the reasons for the differences.

LO 2: Explain the purpose of the statement of cash flows and the two methods used.

The statement of cash flows provides the means to assess a business’s capacity to generate cash and to determine the source of their cash flows. The statement combines with the SFP/BS to evaluate a company’s liquidity and solvency, which represents its financial flexibility. This information, based on past events, can be used to predict the future financial position and cash flows of the company. It can also shed light on a company’s quality of earnings and whether there may be a disconnect between report earnings and net cash flows from operating activities.

The SCF can be prepared using either the indirect or direct method. With the indirect method, the statement is presented in three distinct sections: operating activities (net income, current assets and liabilities), investing activities (non-current assets), and financing activities (long-term debt and equity), which follows the basic structure of the SFP/BS classifications. The changes between the opening and closing balances of the SFP/BS items are reported in the SCF as either cash inflows or cash outflows. The three sections net to a single net cash inflow or outflow, when combined with the cash and cash equivalent opening balance results in the same amount as the ending balance reported on the SFP/BS. The only difference between the methods is the categorization of cash flows by nature in operating activities, as occurs with the direct method. The investing and financing sections are identical for both methods.

There are some reporting differences between IFRS and ASPE regarding interest received and paid, dividends received and paid, and income taxes paid. For simplicity’s sake, the chapter focuses on reporting interest received and paid, dividends received in operating activities, and dividends paid in financing activities. Income taxes paid can be separately reported for ASPE but it is only mandatory for IFRS. Whereas, both accounting standards require that non-cash transactions be reported in the notes to the financial statements. Where transactions involve some cash flows, this portion of the transaction is included in the SCF with supplementary disclosures of the transactions in the notes.

When preparing a statement of cash flows using the indirect method, the operating activities section begins with the net income/loss amount from the income statement. Entries for non-cash items such as depreciation, depletion, amortization, and gains/losses from sale/disposal of non-current assets are shown as adjustments to net income in order to remove the effects of non-cash items. The remainder of the operating activities section lists each non-cash working capital account change from opening to closing balances and reports as either cash flow in or out (cash flow out is prefixed by a minus sign). The investing activities are the change amounts between the opening and closing balances for any non-current assets such as long-term investments, property, plant, equipment, and intangible assets. Each line item from the non-current assets section of the SFP/BS is analyzed to determine if any non-current assets were purchased or sold during the year, and to report the cash paid or received. These amounts are reported as cash flows in or out. The financing section uses the same method as the investing for non-current liabilities and equities, such as any long-term debt, issuance or repurchase of shares for cash and dividends paid. These amounts are reported as cash flows in or out. Finally, the three sections are netted to a single amount and added to the cash and cash equivalent opening balance. The resulting sum should match the ending cash and cash equivalent balance reported in the SFP/BS, and the required disclosures (as described above) need to be prepared.

LO 3: Describe the statement of cash flows using the direct method and explain the difference in format from the indirect method.

With the direct method, the operating activities section is composed of major categories of cash flows in and out (determined by nature). Categories can include cash received from sales, cash paid for goods and services, cash paid to or on behalf of employees, as well as separate categories for interest received and paid and dividends received.

To prepare a statement of cash flows using the direct method, the operating activities section begins with the income statement where each line item is assigned to the most appropriate category as either a positive cash flow in or a negative cash flow out. Non-cash items are recorded as a memo item only. Next, each non-cash working capital account change between its opening and closing balance is then assigned to the most appropriate category as either a positive or negative cash flow. The net cash flow from each category, and for operating activities, is calculated. The methods used to prepare the investing and financing activities are the same as with the indirect method.

LO 4: Describe how the results from the statement of cash flows are interpreted.

The SCF, using the indirect method, is the most commonly used format in business, and the most important section within it is the operating activities. This is because it shows the cash flows in or out that result from the company’s daily operations, which allows us to determine if the company is solvent. If cash flows in this section are negative, then management must determine if this is due to a temporary condition or if fundamental changes are needed to better manage the collections of accounts receivables or levels of unsold inventory. In any case, if a company is in a negative cash flow position from operating activities, it will usually either increase its debt through borrowing, increase its equity by issuing more shares, or sell off some of its assets. If any of these steps are taken, they will be reported as cash inflows from either the investing or financing sections. While none of these options are ideal, they can be used for the short-term, but they are unsustainable in the long-run. Positive cash flows from operating activities must also be evaluated to determine if they are sustainable and to ensure that they will be consistent going forward.

LO 5: Describe the required disclosures for the statement of cash flows.

The main disclosures identified in this chapter included an explanation of the changes in the opening and closing cash balance (including cash equivalents) as well as the components and policy used to determine them. Cash flows in and out are classified as operating, investing, and financing–using either the indirect or direct method. The major classes of cash flows in and out are also to be separately reported within each of the three sections. Cash flows from interest, dividends, and income taxes are separately disclosed as explained above, while non-cash transactions require supplementary disclosure.

LO 6: Describe the types of analysis techniques used for the statement of cash flows.

While the statement of cash flows may report a positive net income, this does not guarantee a positive cash flow for that period. Also, determining which activity the positive cash flows originate from is critical analytical information for the stakeholders. At the end of the day, operating activities must be able to sustain a positive cash flow for the company to survive. There are ratios that assess the operating activities cash flow, but trends or industry standards are also needed in order for the results to be informative. Two of the common ratios used are the current cash debt coverage ratio and the cash debt coverage ratio. Free cash flow analysis is another technique used, and it calculates the remaining cash flow from the operating activities section after deducting cash spent on capital expenditures, such as purchasing property, plant and equipment. Some companies also deduct cash paid dividends. The cash flow remaining is available to the company for strategies such as expansion, repayment of long-term debt, or down-sizing share holdings to improve the share price, reduce the amount of dividends to pay, and to attract future investors.

LO 7: Review and understand a comprehensive example of an indirect and direct statement of cash flows that includes complex transactions from intermediate accounting courses.

Examples of how to prepare a SCF using the indirect and direct method are explained previously in the chapter. The examples include complex transactions including investments classified as available for sale, accrued pension liabilities, deferred income taxes, bonds issued as a discount with amortization, bonds converted to shares, stock options, and re-acquisition of shares.

LO 8: Discuss specific items that affect the statement of cash flows.

Several issues are identified, and discussed, in this section in terms of their effect on the SCF. These include what makes up cash equivalents, restricted cash or cash equivalents, bank overdrafts, discontinued operations, impairments of assets, investments in associates, comprehensive income, netting of old and new liabilities, leases, complex financial instruments, and stock splits and dividends.

LO 9: Summarize the differences between ASPE and IFRS regarding reporting and disclosure requirements of the statement of cash flows.

The differences are identified throughout the chapter.