Chapter 13

1. Chapter 13 Statement of Cash Flows

2. Lecture • Statement of Changes in Financial Position. • Motivation for a Statement of Cash Flows. • The cash flow statement and the nonarticulation problem that arises when the indirect method is used. • Classification problems that exist in the FASB’s trichotomy of operating, investing, and financing activities. • Analytical usefulness of the cash flow statement for different users. • Free cash flows, what are they?

3. Statement of Changes in Financial Position (SCFP) • SCFP is the successor to a prior financial statement, the funds flow statement. • SCFP reported changes in assets, liabilities, and owners’ equities account balances. • It was recommended, but not required for inclusion in the annual report until 1971. • Objectives of SCFP per APB Opinion No. 19 • Disclosure of changes in financial position • Summarize financing and investing activity • Report funds flow from operations

4. Two Balancing Sections in the SCFP • Sources of resources • Transaction credits • Arise from increases in liabilities and owners’ equity and decreases in assets • Uses of resources • Transaction debits • Arise from decreases in liabilities and owners’ equity and increases in assets

5. Increases to fund balance accounts From net income From other sources Other sources of resources Decrease, if any, in the fund balance for the period Decreases to the fund balance accounts From net losses From other sources Other uses of resources Increase, if any, in the fund balance for the period Standard Format of the Statement of Changes in Financial Position Sources of Resources Uses of Resources

6. Motivation for a Statement of Cash Flows. • Net working capital came to be viewed as a poor measure of liquidity for three reasons. • Deferred charges and credits are included in net working capital, but have no cash flow consequences. • The conversion of current assets into cash can take a year or longer for firms with a long operating cycle. • Items such as inventory are carried on a cost basis and thus do not explicitly measure the cash flow potential of the inventory. • In light of these ambiguities, cash flow reporting appeals because of its literal interpretation—cash is cash is cash.

7. An Early FASB Discussion Memo suggested that cash flow data are a useful supplemental disclosure because they • Provide feedback on actual cash flows • Help to identify the relationship between accounting income and cash flows • Provide information about the quality of income • Improve comparability of information in financial reports • Aid in assessing flexibility and liquidity • Assist in predicting future cash flows

8. Cash Flows from Operating Activities Cash Flows from Investing Activities Cash Flows from Financing Activities Net Change in Cash & Cash Equivalents Cash & Cash Equivalents at Beginning of Year Cash & Cash Equivalents at End of Year Statement of Cash Flows

9. Definition: Cash • Literal cash on hand or on demand deposit plus cash equivalents • Cash equivalents are highly liquid assets that are convertible to known amounts of cash and have short-term maturities

10. Cash Flows from Operating Activities Cash Flows from Investing Activities Cash Flows from Financing Activities Net Change in Cash & Cash Equivalents Cash & Cash Equivalents at Beginning of Year Cash & Cash Equivalents at End of Year Statement of Cash Flows

11. Operating Activities Section • Direct method reports literal cash flows related to income statement classifications • FASB appears to favor • Cost to prepare > than with indirect method • Indirect or reconciliation method starts with accrual income and adjusts it for the noncash items in it • In 1996, 98% of American firms use • Nonarticulation problems

12. Direct vs. Indirect Method • Operating activities section is the only section that differs • The investing and financing activities sections are the same under both methods

13. Indirect Method: Nonarticulation • Working capital account changes on balance sheet do not equal working capital adjustments in the operating activities section of SCF (75% of the time in sample) • Potential causes • Acquisitions of subsidiaries during the year • Transactions involving working capital accounts that do not affect cash • Write-up/down of working capital items • Depreciation allocations within inventories • Reclassifications of accounts between current and non current categories • occur when one accounts payable account is used for the purchase of both working capital assets (e.g., inventories), as well as for the purchase of non-working capital assets

14. Cash Flows from Operating Activities Cash Flows from Investing Activities Cash Flows from Financing Activities Net Change in Cash & Cash Equivalents Cash & Cash Equivalents at Beginning of Year Cash & Cash Equivalents at End of Year Statement of Cash Flows

15. Investing Activities Section: Examples • Proceeds from sale of facility • Payment received on note for sale of plant • Capital expenditures • Payment for purchase of company X

16. Cash Flows from Operating Activities Cash Flows from Investing Activities Cash Flows from Financing Activities Net Change in Cash & Cash Equivalents Cash & Cash Equivalents at Beginning of Year Cash & Cash Equivalents at End of Year Statement of Cash Flows

17. Financing Activities Section: Examples • Net borrowings under line-of-credit agreement • Principal payments under capital lease obligation • Proceeds from issuance of long-term debt • Proceeds from issuance of common stock • Dividends paid

18. SFAS No. 95 Classification Issues • Appearing in operating activities section • Interest expense • Interest revenue • Dividend revenue • Related balance sheet items (bonds payable, stock investments, and long-term notes receivable) are either financing or investing elements

19. Ingram and Lee (1997) • 1,000 firms over the period 1974-1992 • Use the income statement and the cash flow statement together • Over time growing firms will have higher income and lower cash flows • Reverse occurs for shrinking firms

20. SCF is less manipulable than income, it is not exempt from the problem. • Increase cash flows from operations by shifting cash outflows from operating activities to investing activities, or • Move cash inflows from investing activities to cash inflows from operating activities

21. Free Cash Flows • There are several definitions of free cash flow used by companies and in the financial press. • Free Cash Flows (FCF) cannot be determined directly from the Statement of Cash Flows. • FCF = NOPLAT – investment in operating invested capital

22. Improving Accounting Standards • Require the direct method for the Statement of Cash Flows • Require the associated reconciliation of net income to operating cash flow for the operating activities section. • Require a firm to explain the source of any nonarticulation that occurs in the operating section of the SCF.

23. Summary • Statement of Changes in Financial Position. • Motivation for a Statement of Cash Flows. • The cash flow statement and the nonarticulation problem that arises when the indirect method is used. • Classification problems that exist in the FASB’s trichotomy of operating, investing, and financing activities. • Analytical usefulness of the cash flow statement for different users. • Free cash flows, what are they?