Intermediate Accounting O ctober 21 st ,2010

1. Intermediate AccountingOctober 21st,2010 • General Course Questions • Questions on Balance Sheet Homework • Cash Flow Statement A. Reporting items as Operating, Investing & Financing B. Preparing an Indirect Statement of Cash Flows (pr. 5-6) • Review Quiz #3 Chapters 4, 17 & 22 • Assignments for Tuesday, October 26th: A. Chapter 5 Problem 7 B. Chapter 23 Exercise 15 6. Return and Review Quiz #3 Chapters 4, 17 & 22

2. Cash Flow Statement Learning Objectives Objectives: • Describe the purpose of the Cash Flow Statement (how it meets GAAP’s Objectives of Financial Reporting) • Prepare a Statement of Cash flows under both the Direct and Indirect Method. • Differentiate between Net Income and Cash from Operations (CFO) and use it to assess a company’s ability to generate future Cash Flows (CFO) • Evaluate the company’s quality of earnings by comparing and reconciling net income to cash • Determine whether a company is expanding or contracting using the “Investing” section of the Cash Flow Statement • Evaluate the company’s financing activity – are they relying on internal or external financing, and debt or equity financing? • Assess a company’s need for external financing and its ability to pay its debts and dividends

3. The Cash Flow Statement • What is included in “cash”? • The cash flow statement provides information for a period of time about: • cash receipts (cash inflows) • uses of cash (cash outflows) • Inflows and outflows are reported for: • operating • investing • financing activities • Summing to the net increase/decrease in cash over the period

4. Cash is King • Remember the 2nd Objective of Financial Reporting: to “Provide Information that is useful in assessing future ________ flows”. (see the House of GAAP from our first class, and repeated on the next slide) • A good place to start predicting future cash flows is the company’s historical cash flows. • The Statement of Cash Flows provides information about the cash receipts and cash disbursements during a specific time period, the same time period covered by the income statement. 4

5. HOUSE OF GAAP GAAP’s Objective is to provide Financial Information that is: • Useful in investment & credit decisions • Useful in assessing future ______ flows • About the enterprise resources (assets), claims (liabilities & owners’ equity) to resources, and _________ in them Qualitative Characteristics Relevance Predictive or Feedback Value Timeliness Reliability Comparability Consistency Elements Assets Liabilities Stockholders’ Equity Other Comprehensive Income Revenues Expenses Assumptions Economic Entity Going Concern Monetary Unit Periodicity Principles Historical Cost Revenue Recognition Matching Full Disclosure Constraints Cost/Benefit Materiality Industry Practice Conservatism

6. Highlighting Balance Sheet Changes • The 3rd Objective of Financial Reporting is to “Provide Information about the enterprise resources (assets), claims (liabilities & owners’ equity) to resources, and _________ in them” (see the House of GAAP Prior slide and first class) • The Cash Flow Statement also highlights how the Balance Sheet Accounts have changed. Changes in Balance Sheet Accounts: Located in Cash Flow Statement • Most Current Assets and Current Liabilities (working capital accts) Operating Section 2. Most Long-term Assets Investing Section • Most Non-operating Liabilities Stockholder’s Equity accounts Financing Section

7. Which Financial Statement should you use? • If you want to know the “Balance” of an Asset account, i.e. how much inventory a company has at the end of the period? • Income Statement • Balance Sheet • Statement of Stockholders’ Equity • Cash Flow Statement • If you want to know how much an asset account changed during the period, i.e. how much inventory increased or decreased? • Income Statement • Balance Sheet • Statement of Stockholders’ Equity • Cash Flow Statement

8. Which Financial Statement should you use? • If you want to know the “Balance” of an Liability account, i.e. how much a company owes its suppliers at the end of the period? • Income Statement • Balance Sheet • Statement of Stockholders’ Equity • Cash Flow Statement • If you want to know how much liability account has changed during the period, i.e. how much accounts payable has increased or decreased? • Income Statement • Balance Sheet • Statement of Stockholders’ Equity • Cash Flow Statement

9. Using the Statement of Cash Flows In addition to reporting the changes to each current operating asset & liability (accounts receivable, inventory, accounts payable) the Statement of Cash Flows also helps: • assess a company’s ability to generate positive future cash flows from operations, • reconcile differences between net income and the change in the cash balance. • monitor a company’s investment in property, plant and equipment – is it more or less than their depreciation expense? Is the company expanding or contracting? • assess a company’s need for external financing, source of external financing (debt or equity) and its ability to pay its debts and dividends.

10. The Cash Flow Statement Cash Inflows : Ending Cash Beginning Cash Operating Investing Financing Cash Outflows

11. The Three Sections of the Cash Flow Statement • Operating -cash inflows and outflows resulting form activities that are central to the day-to-day operation of the business. Cash flows from Revenue and Expenses. • Investing -cash inflows and outflows from the sale or purchase of property, plant & equipment, investment in other companies and loans to other companies. (Changes in non-current and/or non-operating assets) • Financing -cash inflows and outflows from the sale or re-purchase of the companies stock, borrowing or repaying interest bearing debt, and paying dividends to stockholders. (Changes in Non-operating liabilities and shareholders’ equity)

12. Changes to all Balance Sheet Accounts are on the Cash Flow Statement Decision Tree to determine where change will be: Operating – changes to all current & operating accounts Start with accrual accounting income and adjust it to get cash from operations Non-Operating – changes to all non-current and/or non-operating accounts Investing – non-current &/or non-operating ASSETS Financing – interest bearing debt and non-current &/or non-operating Liabilities & Stockholders’ Equity accts

13. For each item or event listed below, indicate whether the related it would be reported in the Operating, Investing or Financing section of the Cash Flow Statement: 1. Payment on long-term debt 2. Issuance of bonds at a premium 3. Collection (reduction) of accounts receivable 4. Cash dividends declared and paid 5. Collection (reduction) of notes receivable, affiliated company 6. Sale of (reduction) of trading securities (marketable securities) 7. Payment of wages (decrease in wages payable) 8. Issuance of common stock for cash, C.S increases 9. Payment of income taxes (decrease in income taxes payable) 10. Purchase of equipment (equipment increases) 11. Purchase of treasury stock (T.S. increases) 12. Sale of real estate held as a long-term investment 13. Purchase of inventory (inventory increases) Classification of Cash Flows

14. Preparing a Statement of Cash Flows The choice between methods of preparing the statement of cash flows only affects the “Cash from Operations” section. • Indirect method: derives cash flows from operations by starting with net income and adjusting it to get Cash from Operations • Used almost exclusively • Most be provided as a schedule if Direct Method is Used • Direct method: derives cash flows directly for each source or use of cash The Choice of Method has no effect on the other two sections of the Cash Flow Statement (the Cash Flows from “Investing” and “Financing”)

15. Operating Activities Operating activities consist of those activities that are central to the day-to-day operation of the business. The Cash Inflows and Outflows from the Revenues and Expenses that are reported on an accrual basis on the Income Statement will be reported in Operating section of the Cash Flows Statement. • Cash Inflows from Operating Activities include: 1. Cash from customers from the sale of products. 2. Interest and Dividends received on investments • Cash Outflows from Operating Activities include: 1. Cash paid to suppliers for purchases of inventory. 2. Cash paid to employees for wages and salaries 3. Cash paid to governments for taxes 4. Cash paid to creditors for interest on loans (but not for repayment of principal) • Operating Activities on the Cash Flow Statement include Normal Operating Activities + dividends received and both interest received and interest paid.

16. Decision Tree to determine Reporting on the Cash Flow Statement Operating – changes to all current & operating accounts Start with accrual accounting income and adjust it to get cash from operations Net Income (accrual basis) 1. Adjustments to go from Accrual to Cash a. Changes to all Current & Operating Assets b. Changes to all Current & Operating Liabilities c. Non Cash Expenses 2. Adjustments for non-operating gains and losses Net Cash Provided (Used) by Operations Non-Operating – changes to all non-current and/or non-operating accounts Investing – non-current &/or non-operating ASSETS Financing – interest bearing debt and non-current &/or non-operating Liabilities & Stockholders’ Equity accts

17. The changes to Current Operating Assets & Liabilities are needed to Convert Accrual Accounting Income to Cash from Operations Sales $98,000 Cost of Goods Sold 72,000 Gross Profit 26,000 Operating Expenses 14,000 Income before Taxes $12,000 Income Tax Expense 4,000 Net Income $ 8,000 Adjustments (to convert Accrual Net income) + - Cash From Operations Accounts Receivable End of Year Beg of the Year $20,000 $10,000 How did the increase in A/R affect Cash from Operations? Did you receive more or less cash than is reflected in Sales? Cash Flow Statement starts with Net Income & adjusts it to CFO

18. The changes to Current Operating Assets & Liabilities are needed to Convert Accrual Accounting Income to Cash from Operations Sales $98,000 Cost of Goods Sold 72,000 Gross Profit 26,000 Operating Expenses 14,000 Income before Taxes $12,000 Income Tax Expense 4,000 Net Income $ 8,000 Adjustments (to convert Accrual Net income) + - Cash From Operations Inventory End of Year Beg of the Year $8,000 $ 9,000 How did the decrease in Inventory affect Cash from Operations? Did you use more or less cash than is reflected in Cost G Sold? Cash Flow Statement starts with Net Income & adjusts it to CFO

19. The changes to Current Operating Assets & Liabilities are needed to Convert Accrual Accounting Income to Cash from Operations Sales $98,000 Cost of Goods Sold 72,000 Gross Profit 26,000 Operating Expenses 14,000 Income before Taxes $12,000 Income Tax Expense 4,000 Net Income $ 8,000 Adjustments (to convert Accrual Net income) + - Cash From Operations Accounts Payable End of Year Beg of the Year $7,000 $ 17,000 How did the decrease in Accounts Payable affect Cash from Operations? Did you spend more or less cash than is reflected in income tax expense? Cash Flow Statement starts with Net Income & adjusts it to CFO

20. The changes to Current Operating Assets & Liabilities are needed to Convert Accrual Accounting Income to Cash from Operations Sales $98,000 Cost of Goods Sold 72,000 Gross Profit 26,000 Operating Expenses 14,000 Income before Taxes $12,000 Income Tax Expense 4,000 Net Income $ 8,000 Adjustments (to convert Accrual Net income) + - Cash From Operations Taxes Payable End of Year Beg of the Year $5,000 $ 3,000 How did the increase in Taxes Payable affect Cash from Operations? Did you spend more or less cash than is reflected in income tax expense? Cash Flow Statement starts with Net Income & adjusts it to CFO

21. Changes in Current & Operating accounts & their affect on CFO Net Income 1. Adjustments to go from Accrual to Cash caused by changes to operating assets and liabilities: A. Subtract changes in current operating assets and current operating liabilities that USE up CASH: Deduct for cash spent to increase inventory & other current op. assets Deduct for cash used to Decrease Current Operating Liabilities B. Add changes in current operating assets and current operating liabilities that Provide CASH: Add cash collected from decrease in receivables or other current op. assets Add cash saved by not paying operating liabilities – accounts payable increased or more money was received as unearned revenue from customers making advance payments Net Cash Provided (Used) by Operations

22. Changes to all Balance Sheet Accounts are on the Cash Flow Statement Decision Tree to determine where change will be: Operating – changes to all current & operating accounts Start with accrual accounting income and adjust it to get cash from operations Net Income (accrual basis) 1. Adjustments to go from Accrual to Cash 2. Adjustments for non-operating gains and losses Net Cash Provided (Used) by Operations Non-Operating – changes to all non-current and/or non-operating accounts Investing – non-current &/or non-operating ASSETS Financing – interest bearing debt and non-current &/or non-operating Liabilities & Stockholders’ Equity accts

23. Accrual Based Statements Cash Flow Statement Income Statement: (Non Cash Exp. & Non-Op Gains &Losses) Balance Sheet: (changes in Current & Op .Assets and Current Operating Liabilities) Operating activities: Adjust net income to CFO Adjustment to go from accrual to cash & eliminate Non-Op items Investing activities: Inflows and Outflows from sales and purchases of Non-operating and Non-current assets Balance Sheet: Changes in Non-Current and Non-operating Assets Balance Sheet: Changes in Non-Current and Non-operating Liabilities And Equity Financing activities: Inflows and outflows from debt and equity Transactions excluding income Where do we find the Information for the the Statement of Cash Flows: Indirect Method

24. SCF: Indirect Preparation Guide • Calculate changes in balance sheet accounts (they will all need to be reflected on the Statement of Cash Flows to balance back to the change in cash, which is your reconciling number). • Use the Decision Tree to determine which section of the Cash Flow Statement should be used to reflect the change in each Balance Sheet account. • Calculate and Prepare the Cash from Operations by: A. Start with Net Income (which is based on accrual accounting) B. Adjust it to Cash from Operations by: 1. Adding back Non-cash Expenses (depreciation, amortization) 2. Eliminating non-operating gains and losses (excluding Dividend Income, Interest Income, and Interest Expense) 3. Adjust it for changes in Current & Operating Assets 4. Adjust if for changes in Current & Operating Liabilities Steps 4-6 continued on the next slide

25. SCF: Indirect Preparation Guide 4. Prepare the Investing Section: A. Allocate the change in PP&E between current year depreciation, purchases of PP&E and sales of PP&E, recording the cash received and paid for PP&E separately B. Account for the changes in all non-current and non-operating assets 5. Prepare the Financing Section A. Allocate change in RE between dividends and Net Income B. Allocate change in debt between new borrowings and repayments, recording cash received and paid separately C. Account for changes in all non-current & non operating (interest bearing) liabilities & equity 6. Reconcile the net change in cash from all three sections to the change in cash on the balance sheet

26. Prepare Statement of Cash Flows (Indirect using Ch 5 problem 6)

27. Prepare Statement of Cash Flows (Indirect using Ch 5 problem 6) Net Income for 2010 was $32,000, after depreciation of $11,000. Lansbury sold part of its investment portfolio for $15,000 resulting in a gain of $3,400. A tract of land was purchased for $18,000 cash. Land was purchased through the issuance of $30,000 bonds. Long-term notes payable in the amount of $16,000 were retired before maturity by paying $16,000 cash. An additional $20,000 in common stock was issued at par. Dividends totaling $8,200 were declared and paid to stockholders.

28. Computing Cash from Operations Start with Net Income and Adjust it to get Cash from Operations. Net Income(accrual basis) $_______ 1. Adjustments to go from Accrual to Cash: A. Add back non-cash expenses (Expenses that reduce net income but do not use up any cash) _____________________________ $______ _____________________________ $______ B. Changes in Operating Assets & Liabilities _____________________________ $______ _____________________________ $______ 2. Adjustments for non-operating gains and losses: We want only operating cash so add back non-operating losses which have reduced net income and subtract out gains from non-operating activities Loss on disposition of assets _____________________________ $______ ________ Net Cash Provided by Operations$ ______

29. Computing Cash from Operations Computing Cash from Operations Start with Net Income and Adjust it to get Cash from Operations. Net Income(accrual basis) $32,000 1. Adjustments to go from Accrual to Cash: A. Add back non-cash expenses (Expenses that reduce net income but do not use up any cash) Depreciation Expense $ 11,000 _____________________________ $______ B. Changes in Operating Assets & Liabilities Increase in Accounts Receivable (20,400) _____________________________ $______ 2. Adjustments for non-operating gains and losses: We want only operating cash so add back non-operating losses which have reduced net income and subtract out gains from non-operating activities Loss on disposition of assets Gain on sale of Investments ( 3,400) Net Cash Provided by Operations$ 12,800

30. Finding Investing Activity - Changes to what accounts? Decision Tree to determine where change will be: Operating – changes to all current & operating accounts Start with accrual accounting income and adjust it to get cash from operations Non-Operating – changes to all non-current and/or non-operating accounts Investing – non-current &/or non-operating ASSETS cash inflows and outflows from : 1) the sale or purchase of property, plant & equipment, 2) investment in other companies (marketable securities) 3) loans to other individuals or companies. Financing – non-current &/or non-operating Liabilities & Stockholders’ EquityAccounts

31. Investing Activities Investing activities come in two basic forms: 1) Investments in your own company, including the purchase of long-term productive assets such as property, plant and equipment 2) Investments in others by purchasing stocks and bonds of another corporation, or a partnership interest, or making loans to another entity • Cash Inflows result from the Sale of: 1. Property, Plant & Equipment 2. Investments in other companies 3. Collecting money loaned to other companies • Cash Outflows result from the Purchase of: 1. Property, Plant & Equipment 2. Investment in other companies 3. Loaning money to other companies

32. Computing Cash Investing & Financing Net Cash Provided by Operations $_______ Cash from Investing: (cash received or paid from changes in non-current & non-operating assets, including the affect of gains & losses) _____________________________ $______ _____________________________ $______ _____________________________ $______ $______ Cash from Financing: (cash received or paid from changes in non-current & non-operating Liabilities & Stockholders’ Equity, excluding income) _____________________________ $______ _____________________________ $______ _____________________________ $______ $______ Net Increase in Cash $ ______

33. Computing Cash Investing & Financing Net Cash Provided by Operations $ 19,200 Cash from Investing: (cash received or paid from changes in non-current & non-operating assets, including the affect of gains & losses) Sale of Investments $15,000 Purchase of Land (18,000) (3,000) Cash from Financing: (cash received or paid from changes in non-current & non-operating Liabilities & Stockholders’ Equity, excluding income) _____________________________ $______ _____________________________ $______ _____________________________ $______ $______ Net Increase in Cash $ ______

34. Finding Financing Activity - Changes to what accounts? Decision Tree to determine where change will be: Operating – changes to all current & operating accounts Start with accrual accounting income and adjust it to get cash from operations Non-Operating – changes to all non-current and/or non-operating accounts Investing – non-current &/or non-operating ASSETS cash inflows and outflows from : Financing – non-current &/or non-operating Liabilities & Stockholders’ Equity Accounts 1) the sale or re-purchase of the companies own stock, 2) borrowing or repaying interest bearing debt, and 3) paying dividends

35. Financing Activities This section focuses on the external financing activities of the company which come in two basic forms: 1) Equity financing includes the use of both Common & Preferred Stock. 2) Debt financing includes the use of notes (loans) and bonds. • Cash Inflows result from: 1. Selling shares of our own stock 2. Borrowing, bank loans, issuing bonds or other debt • Cash Outflows result from: 1. Dividend payments to stockholders 2. Reacquiring shares of the company’s own stock (Treasury stock) 3. Repaying principal on loans, bonds or other debt

36. Computing Cash Investing & Financing Net Cash Provided by Operations $ 19,200 Cash from Investing: (cash received or paid from changes in non-current & non-operating assets, including the affect of gains & losses) Sale of Investments $15,000 Purchase of Land (18,000) (3,000) Cash from Financing: (cash received or paid from changes in non-current & non-operating Liabilities & Stockholders’ Equity, excluding income) Issuance of Common Stock $ 20,000 Repayment of notes payable (16,000) Payment of cash dividends ( 8,200) (4,200) Net Increase in Cash $ 12,000

37. SCF Comments • Non-cash transactions are not shown on the face of the SCF – but material non-cash transactions must be disclosed (usually in the notes) • E.g. the firm trades $1M of common stock for a warehouse • Dividends are shown under financing activities, but these are dividends paid, not necessarily dividends declared • So if you see dividends on the R/E Statement, and dividends payable on the B/S, you must determine what was actually paid during the year

38. How to Read a SCFs • Know where a company is in lifecycle • Focus on subtotals • Dig into “larger items” • Consider if is healthy/unhealthy given lifecycle

39. Typical Company Cash Flow Life Cycle LO 2 Identify the major classifications of cash flows.

40. Using The Cash Flow Statement Objectives: • Use the Cash Flow Statement to assess the company’s ability to generate Cash from Operations • Evaluate the company’s quality of earnings by comparing net income to cash • Determine whether a company is expanding or contracting using the “Investing” section of the Cash Flow Statement. Investing internally or externally? • Evaluate the company’s financing activity – are they relying on internal or external financing, and debt or equity financing? • Assess a company’s need for external financing and its ability to pay its debts and dividends

41. Using the Statement of Cash Flows • Calculate each company’s cash balance at the end of the year. • Would you prefer to own company A, B or C? Why? • Which company would you least like to own? Why? • Which companies have net income and which have a net loss? • Explain what might cause company C’s net cash from financing activities to be negative. • Explain what might cause company A’s net cash from financing activities to be positive.

42. Using the Statement of Cash Flows • Would you prefer to own company X, Y or Z ? Why? • Which company would you least like to own? Why? • What could cause Co X’s net income to differ from its cash from operations? • What could cause Co Y’s net income to differ from its cash from operations? • What could cause Co Z’s net income to differ from its cash from operations?

43. Summary story from the Cash Flow Statement 201020092008 Cash provided by Operations 3,919 7,000 3,670 Cash (required) by Investing Activity (14,031) (4,600) (3,650) Net effect on Cash from issuing (retiring) debt (6,154) (2,339) 2,876 Net effect on Cash from issuing (retiring) stock 23,082 141 639 Effect of exchange rate changes on cash(4) 14 - Net increase (decrease) in Cash $6,812 $216 $3,535 What is Company’s major source of cash? Is the company relying upon internal or external financing? Is the Company generating enough cash to pay its debt obligations?

44. The Cash Flow Statement Objectives: • Use the Cash Flow Statement to assess the company’s ability to generate Cash from Operations • Evaluate the company’s quality of earnings by comparing net income to cash • Determine whether Cash From Operations (CFO) is positive and growing. • For Quality Earnings CFO should be greater than Net Income

45. The Cash Flow Statement Objectives: • Determine whether a company is expanding or contracting using the “Investing” section of the Cash Flow Statement • Compare the amount a company is spending on long-term assets to the amount they are expensing to determine whether they are growing.

46. The Cash Flow Statement Objectives: • Evaluate the company’s financing activity – are they relying on internal or external financing, and debt or equity financing? • Compare Cash From Operations to the amount of Cash received from new debt and/or from the sale of additional shares of stock. If CFO is greater the company is relying on internal financing.

47. The Cash Flow Statement Objectives: 5. Assess a company’s need for external financing and its ability to pay its debts and dividends. • Compute the amount of cash available to pay debts and dividends by deducting the cash needed for fixed asset purchases from the Cash from Operations. Is the remaining Cash From Operations sufficient to cover debt and dividend payments?

48. Interest Paid: US GAAP: operating activity (cash from the associated debt is financing activity) IFRS: operating or financing activities Interest Received: US GAAP: operating activity (cash from the related asset is investing activity) IFRS: operating or as investing activities Dividends Paid: US GAAP: financing activity, consistent with the placement of proceeds from selling stock. IFRS: financing or operating Dividends Received: US GAAP: operating activities (cash from related outflows was investing activity) IFRS: financing or operating Tax payments/refunds: US GAAP: operating activity, regardless of whether underlying taxable income relates to operations or not (e.g. if a firm has a taxable capital gain on the sale of equipment) IFRS: operating unless specifically associated with financing or investing activities SCF: Interest, Dividends and Taxes Classification

49. Format of the Statement of Cash Flows

50. Computing Cash from Operations Start with Net Income and Adjust it to get Cash from Operations. Net Income(accrual basis) $_______ 1. Adjustments to go from Accrual to Cash: A. Add back non-cash expenses (Expenses that reduce net income but do not use up any cash) _____________________________ $______ _____________________________ $______ B. Changes in Operating Assets & Liabilities _____________________________ $______ _____________________________ $______ 2. Adjustments for non-operating gains and losses: We want only operating cash so add back non-operating losses which have reduced net income and subtract out gains from non-operating activities Loss on disposition of assets _____________________________ $______ ________ Net Cash Provided by Operations$ ______