READING 30 ANALYZING STATEMENTS OF CASH FLOWS I MODULE 30.1: CASH FLOW INTRODUCTION AND DIRECT METHOD sy, CFO thiseontnt is available online. LOS 30.a: Describe how the cash flow statement is linked to the income statement and the balance sheet. The cash flow statement provides information for a reporting period beyond that available from the income statement, which is based on accrual, rather than cash, accounting, Analysts use cash flow statements to understand = A company’s cash receipts and cash payments during an accounting period = Acompany’s operating, investing, and financing activities = The impact of accrual accounting events on cash flows = Acompany’s quality of earnings An analyst can use the statement of cash flows to assess a firm's liquidity, solvency, and financial flexibility, including: = Whether regular operations generate enough cash to sustain the business = Whether the firm generates enough cash to pay off existing debts as they mature = Whether the firm is likely to need additional financing = Whether the firm can meet unexpected obligations = Whether the firm can take advantage of new business opportunities as they arise The cash flow statement reconciles the beginning and ending balances of cash in the balance sheet over an accounting period, The change in cash is a result of the firm's operating, investing, and financing activities, as follows:Operating cash flow +/— Investing cash flow +/— Financing cash flow = Change ia cash balance + Beginning cash balance Ending cash balance Earnings are considered to be of high quality when operating cash flows, which can also be called cash flow from operations (CFO), are close to or higher than reported carnings, If earnings are consistently higher than CFO, their quality is lower because the accruals-based earnings are not backed by cash creation from operating activities. Like the statement of cash flows, the income statement is a “flow” statement (sometimes referred to as a dynamic statement), as it shows the company’s performance between two balance sheet dates. However, due to the accruals concept, net income is not the same as cash generated by the company. In addition, many financing and investing cash flows do not affect the income statement at the time of the transactions, With respect to the balance sheet, operating activities relate (with a few exceptions) to the firm's current assets and current liabilities. Investing activities typically relate to the firm's noncurrent assets, and financing activities typically relate to the firm's noncurrent liabilities and equity. Transactions for which the timing of revenue or expense recognition differs from the receipt or payment of cash are reflected in changes in balance sheet accounts. For example, when revenues (sales) exceed cash collections, the firm has sold items on credit, and accounts receivable (an asset) increase. The opposite occurs if customers repay more on their outstanding accounts than the firm extends in new credit: cash collections exceed revenues, and accounts receivable decrease. Similarly, when purchases from suppliers exceed cash payments, accounts payable (a liability) increase. When cash payments exceed purchases, accounts payable decrease. It is helpful to understand how transactions affect each balance sheet account. For example, accounts receivable are increased by sales on credit and decreased by cash collections. We can summarize this relationship as follows: Beginning accounts receivable Opening balance sheet + Sales Income statement — Cash collections Cash flow statement Ending accounts receivable Closing balance sheet Knowing three of the four variables, we can solve for the fourth. For example, if beginning accounts receivable are €10,000, ending accounts receivable are €15,000, and sales are €68,000, then cash collections must equal €63,000. By rearranging this relationship, we can say that cash = sales - ending accounts receivable + beginning accounts receivable, or cash = sales - change in accounts receivable. Cash = €68,000 - (€15,000 — £63,000.Revenue recognition standards affect when a sale is recorded in the income statement, but not the timing of cash flows from the customer. Ifa firm receives cash from a customer in advance of the sale being recorded in the income statement (unearned revenue), the cash received will appear in the cash flow statement at the time of payment, not when the sale is recorded, For example, if a company provided a service agreement to a customer, the cash received is reflected in the cash flow statement when the customer pays for the contract (normally in advance), but revenue recognized in the income statement is spread over the life of the contract. EXAMPLE: Balance sheet and income statement impacts on cash flow Loftus Communications Limited provides equipment sales and installation of telecommunication equipment. Loftus also provides maintenance for systems installed under service contracts. Revenue from maintenance contracts is deferred and recognized over the life of the contract. Selected Financial Statement Data: Loftus Communications Limited ‘Financial year 20X2«20X1 £m fm Income statement extract Revenues 2,000,000 1,800,000 Balance sheet extract Accounts receivable 900,000 500,000 ‘Unearned revenue (deferred) 1,000,000 300,000 Calculate the cash received from customers in 20X2. Answer: 20% ém ‘Revenue 2,000,000 Increase in accounts receivable (400,000) Increase in uneamed revenue 700,000 Cash received from customers 2,300,000 The increase in accounts receivable represents credit extended to customers, which is a use of cash from the firm's perspective. The increase in unearned revenue represents services that customers have paid for in advance, a source of cash. Understanding these interrelationships is not only useful in preparing the cash flow statement, but is also helpful in uncovering accounting shenanigans, as we will see in our reading on Financial Reporting Quality. LOS 30.b: Describe the steps in the preparation of direct and indirect cash flow statements, including how cash flows can be computed using income statementand balance sheet data. PROFESSOR’S NOTE Throughout the discussion of the direct and indirect methods, remember the following points: = The terms cash flow from operations (CFO), cash flow from operating activities, and operating cash flows (OCE) are used interchangeably in the Level I CFA curriculum. = Two methods can be used in the accounts to present CFO, CFO is presented differently under the direct and indirect methods, but the result is the same under both methods. = Cash flow from investing (CFI) and cash flow from financing (CFF) are each presented the same way regardless of which method a firm chooses to present CFO. = An increase in an asset account is a use of cash, and a decrease in an asset account isa source of cash. = An increase in a liability account is a source of cash, and a decrease in a liability is a use of cash. = Sources of cash are positive numbers (cash inflows), and uses of cash are negative numbers (cash outflows). The Direct Method for Cash Flow From Operating Activities The direct method of presenting a firm's statement of cash flows shows only cash payments and cash receipts over the period. The sum of these inflows and outflows is CFO, The direct method gives an analyst more information than the indirect method (which we will explain later in this reading). The analyst can see the actual amounts that went to each use of cash and that were received from each source of cash. This information can help the analyst to better understand the firm's performance over time and to forecast future cash flows. The following are common components that appear on a statement of cash flows presented using the direct method: = Cash collected from customers (typically the main component of CFO) = Cash used in the production of goods and services (cash inputs) = Cash operating expenses, such as salaries = Cash paid for interest = Cash paid for taxes These are steps for the direct method: Step 1: Start at the top of the income statement with revenue. Step 2: mine the balance sheet for any a relating to the income statement item. s or liabilities (typically current)Step 3: Compute the change in the balance sheet asset or liability. Step 4: Adjust the income statement for the change in the balance sheet amount using the following rules: = Subtract an increase in an asset (a use of cash), or add a decrease in an asset (a source of cash). = Add an increase in a liability (a source of cash), or subtract a decrease in a liability (a use of cash). For these rules to work consistently, we must treat expense items as negative numbers (e.g, cost of goods sold, wages and salaries) before we adjust them. Step 5: After adjusting the income statement item for the change in the balance sheet asset or liability, move to the next item in the income statement. Step 6: Ignore any noncash charges (eg, depreciation, gains and losses on asset disposal). A noncash charge is any amount in the income statement that is due to accounting treatment rather than actual cash flows. Step 7: Once all income statement items have been adjusted for accruals, total the amount to get CFO. EXAMPLE: CFO using the direct method Use the following balance sheet and income statement to prepare operating cash flows using the direct method. The company produces its financial statements under US, GAAP. Income Statement for 20X7 s Sales 104,000 Expenses Cost of goods sold 40,000 Wages 5,000 Depreciation 7,000 Interest 1,000 Total expenses 53,000 Income from continuing operations 51,000 Gain from sale of land 10,000 Loss on disposals of PP&E 2,000 Pretax income 59,000 Provision for income taxes 20,000 Net income 39,000 Common dividends declared 8,500 Balance Sheets for 20X7 and 20X620X7 «0X6 Assets s s Current assets Cash 53,000 11,500 Accounts zeceivable 10,000 9,000 Inventory 5,000 7,000 Total current assets 68,000 27,500 ‘Noncurrent assets Land 35,000 40,000 Gross plant and equipment 69,000 60,000 Less: accumulated depreciation (1,000) (9,000 Net plant and equipment 97,000 51,000 Goodwill 10,000 10,000 Total assets 170,000 128,500 Liabilities Current liabilities Accounts payable 9,000 5,000 ‘Wages payable 4,500 8,000 Interest payable 3,500 3,000 Unearned revene 6000 2,000 Taxes payable 5,000 4,000 Dividends payable 6,000 1,000 ‘Total current liabilities 34,000 23,000 ‘Noncurrent liabilities Bonds payable 15,000 10,000 Deferred tax liability 20,000 15,000 Total Liabilities 69,000 48,000 Stockholders’ equity ‘Common stock. 15,000 20,000 Additional paid in capital 30,000 Contributed capital 50,000 Retained earnings 30,500 Total equity 80,500 ‘Total liabilities and stockholders’ equity Answer: Start at the top of the income statement and adjust each line for the change in balance sheet asset and liabilities that arise due to the accruals process. Cash collected from customers s Sales 104,000 Increase in accounts receivable (1,000) Increase in unearned revenue liability 4,000 Cash collected 107,000To calculate cash paid to suppliers, adjust cost of goods sold for the change in inventory (the result is purchases for the period) and for the change in accounts payable. Cash paid to suppliers $ Cost of goods sold (40,000) Decrease in inventory 2,000 Purchases (38,000) Increase in accounts payable 4,000 Cash paid to suppliers (34,000) All expenses, including cost of goods sold, must be treated as negative values if we wish to apply the rules for sources and uses of cash. Expenses in the income statement may be shown as either negative or positive values in the financial statements at the company’s discretion. Users of the accounts are expected to know that revenue and gains increase net income, and that expenses and losses decrease it. s (6,000) Decrease in wages payable (3,500) Cash paid toemployees (8,500) The next line in the income statement is depreciation. When using the direct method we ignore depreciation because it is not a cash flow. Interest paid s Interest expense (2,000) Increase in interest payable 500 Cash interest paid (500) We also ignore the gain from sale of land and the loss on disposal of P&E because these items relate to investing activities (CFI) and not operating activities (CFO), Later in this reading we will explain how to determine the related cash flows when we calculate CFI. The last item in the income statement before net income is the tax expense, Here we must adjust not only for changes in the current liability for taxes payable, but also for any changes in deferred tax assets and deferred tax liabilities, which are typically noncurrent items, We will explain these further in our reading on Analysis of Income Taxes. Cash paid to tax authorities $ Tax expense (provision for (20,000) income taxes) Increase in taxes payable liability 1,000 Increase in deferred tax liability 5,000 Cash paid for taxes (14,000)Having arrived at the bottom of the income statement, we can sum the cash flows to compute CFO: 20X7 CFO $ s Cash collected from customers 107,000 Cash paid to suppliers 34,000 ‘Wages paid to employees 8,500 Cash interest paid 500 Cash paid to tax authorities 14,000 Total cash operating expenses (57,000) Operating cash flows 50,000 MODULE 30.2: INDIRECT METHOD CFO w Using the indirect method of presenting CFO, we begin with net income v4.5 covering and adjust it for differences between accounting items and actual cash this content is inflows and outflows. available online. Non-cash-based items in the income statement can be described as either noncash charges or working capital investment. For example, depreciation is a noncash charge as it is deducted in calculating net income, but it requires no cash outlay. Therefore, we must add depreciation (and amortization) back to net income for the period. Another adjustment to net income on an indirect statement of cash flows is to subtract gains and add back losses on the disposal of assets. Proceeds from the sale of fixed assets are an investing cash flow. Because gains and losses relate to CFI activities, we need to remove them from net income to calculate CFO under the indirect method. PROFESSOR’S NOTE Candidates are often confused by why noneash charges and gains and losses are ignored when using the direct method, but adjusted for under the indirect method. The key to understanding this is to realize that these items have been included in arriving at net income, which is the starting point of our computation when we use the indirect method. That is, net income includes some non-cash and non-operating items that we have to unwind to arrive at CFO. Under the indirect method, we also need to adjust net income for any change in balance sheet accounts, just as we do with the direct method. If, for example, accounts receivable went up during the period, we know that sales during the period were greater than the cash collected from customers. We need to reduce net income to reflect the fact that sales, rather than cash collected, were used in calculating net income, The net change in a company's total operating assets and liabilities is known as its investment in working capital. We can think of CFO as net income adjusted for noncash charges and the investment in working capital:CFO =NI} NCC - WCyy Noncash charges are gains and losses that have passed through the income statement but are not cash flows. While we call them “charges.” in practice they can either increase or decrease net income, Gains and losses on asset disposals are classic examples. Figure 30.1 lists some of the typical noncash charges in company income statements. Figure 30.1: Typical Noneash Charges, Gains, and Losses Add Back Depreciation, depletion, and amortization Loss on asset disposal Asset impairments and write-downs Losses on early retirement of debt Amortization of bond discounts (under the amortized cost method) Increases in deferred tax liabilities, decreases of deferred tax assets Losses of equity accounted associates Subtract Gains on asset disposals, Gains on early retirement of debt Reversals of impairment and write downs Amortization of bond premiums (under the amortized cost method) Decreases in deferred tax liabilities, increases in deferred tax assets Working capital investment represents the investment in noncash working capital. This means we need to look at the change in current assets and liabilities that relate to the operating revenues and expenses and ignore any assets or liabilities that do not relate to operating items. PROFESSOR’S NOTE The definition of working capital is not the same in all parts of the Level | CFA. curriculum. In our module covering ratios, we will see it defined as total current assets minus total current liabilities. Here and in Corporate Issuers, it is defined as operating assets minus operating liabilities; this is often referred to as noncash working capital. In practice, when looking at the current assets, we ignore cash and any short-term investments (except trading securities, for which cash flows are treated as CFO). Dividends payable and any short-term interest-bearing debt instruments are also excluded, as they affect cash flow from financing (CFF), not CFO. Adjust for changes in working capital accounts as follows: Add back Decreases in current operating assets Increases in custent operating liabilities Subtract Increases in current operating assets Decreases in current operating liabilities The steps in calculating CFO under the indirect method can be summarized as follows:Step 1: Begin with net income. Step 2: Add back all noncash charges to income (such as depreciation and amortization) and subtract all noncash components of revenue. Subtract gains or add losses that resulted from financing or investing cash flows (such as gains from sale of land). Step 3: Adjust for working capital by adding or subtracting changes to balance sheet operating accounts as follows = Subtract increases in operating asset accounts (uses of cash), and add decreases (sources of cash). = Add increases in operating liability accounts (sources of cash), and subtract decreases (uses of cash). EXAMPLE: Statement of cash flows using the indirect method Use the balance sheet and income statement presented in the previous direct method example to prepare operating cash flows under the indirect method, Answer: ‘Step 1: Start with net income of $39,000. ‘Step 2: Add back noncash charges: Depreciation = $7,000 (Change in deferred tax liability — $5,000 Loss on disposal of PP&E = $2,000 Deduct noncash gains: Gain from sale of land = $10,000 ‘Step 3: Subtract increases in receivables and inventories and add increases in payables.Net income 39,000 ‘Noncash charges Depreciation 7,000 Increase in deferred tax liability 5,000 Loss on disposal of P&E 2,000 Gain from sale of land 20,000) Subtotal 43,000 Investment in working capital Increase in receivables (2,000) ‘Decrease in inventories 2,000 Increase in accounts payable 4,000 Decrease in wages payable (3,500) Increase in interest payable 500 Increase in unearned revenue liability 4,000 Increase in taxes payable 1,000 Operating cash flows 50,000 Alternatively, we can look at noncash working capital in aggregate rather than line by line. 20X7_—-20X s s ‘Total current assets 68,000 27,500 Less cash 3,000) (11,500) Operating assets 15,000 16,000 Total current liabilities 34,000 23,000 Less dividends payable (6,000) (1,000) Operating liabilities 28,000 22,000 Non-cash working capital (13,000) (6,000) Tovestment in working capital __(S7,000)_ We can then calculate CFO as NI + NCC - WC)yy: CFO = 39,000 + 4,000 — (~7,000) = $50,000 Our examples demonstrate that whether CFO is calculated using the direct or indirect method, we arrive at the same figure. Both IFRS and U.S. GAAP encourage the use of a statement of cash flows in the direct format. Under U.S. GAAP, a statement of cash flows under the direct method must include footnote disclosure of the indirect method, Most companies, however, report cash flows using the indirect method, which requires no additional disclosure. Later in this reading we will illustrate the method an analyst can use to create a statement ofcash flows in the direct method format when the company reports using the indirect method. MODULE QUIZ 30.1, 30.2 1. The Continental Corporation reported sales revenue of $150,000 for the current year. If accounts receivable decreased $10,000 during the year and accounts payable increased $4,000 during the year, cash collections were; A. $154,000. B. $160,000. C. $164,000. Use the following data, prepared under U.S. GAAP, to answer Questions 2 through 4. Income statement selected data: 20x7 $ Cost of goods sold 1,490,000 Tax expense 200,000 Balance sheet selected data: 20X7 20X6 s s Longrlived assets Deferred tax 30,000 20,000 Current assets Accounts receivable 200,000 150,000 Inventory 260,000 280,000 Current liabilities Accounts payable 120,000 150,000, Unearned revenue 220,000 150,000 Tax payable 150,000 240,000 Long-term liabilities Deferred tax 1 100 100,000 2, What was cash collected from customers in 20X7? A, $1,950,000. B. $1,930,000, . $2,020,000. 3. What was cash tax paid in 20X7? A, $160,000, B. $250,000. ©. $290,000, 4, What was cash paid to suppliers in 20X7? A. $1,350,000, B. $1,410,000, ©. $1,450,000. 5. Using the following information, what is the firm’s cash flow from operations?Net income $120 Decrease in accounts receivable 20 Depreciation 25 Increase in inventory 10 Increase in accounts payable 7 Decrease in wages payable 3 Increase in deferred tax liabilities 6 Profit from the sale of land 2 A. S158, B. $170. $174. 6. Net income for Monique, Inc., for the year ended December 31, 20X7 was $78,000. Its accounts receivable balance at December 31, 20X7, was $121,000, and this balance was $69,000 at December 31, 20X6. The accounts payable balance at December 31, 20X7, was $72,000, and it was $43,000 at December 31, 20X6. Depreciation for 20X7 was $12,000, and there was an unrealized gain of $15,000 included in 20X7 income from the change in value of trading securities. Which of the following amounts represents Monique's cash flow from operations for 20X7? A. $52,000. B. $67,000. C. $82,000. 7. From an analyst's perspective, an advantage of the indirect method for presenting operating cash flow is that the indirect method: ‘A. shows operating cash received and paid. B. provides more information than the direct method. C. shows the difference between net income and operating cash flow. MODULE 30.3: INVESTING AND FINANCING (>) CASH FLOWS AND IFRS/U.S. GAAP Vileo covering DIFFERENCES svat ole Cash flow from investing activities (CFI) consists of the cash inflows and outflows that result from acquiring or disposing of long-term assets and certain investments, Cash flow from financing activities (CFF) consists of the cash inflows and outflows that result from transactions affecting a firm's capital structure, such as borrowing, repaying debt, and issuing or redeeming equity securities. Sxamples of each cash flow classification, in accordance with US. GAAP, are presented in Figure 30.2.Figure 30.2: U.S. GAAP Cash Flow Classifications Operating Activities Inflow Outhions Cash collected from customers ‘Cash paid to employees and suppliers Interest and dividends received Cash paid for other expenses Sale proceeds from trading securities Acquisition of trading securities Interest paid on debt or leases ‘Taxes paid Tnvesting Activities Inflows Outtiows Sale proceeds from PP&E and intangibles Acquisition of PP&E and intangibles Sale proceeds from debt and equity Acquisition of debt and equity investments investments Principal received from loans made to ‘Loans made to others others Financing Activities Inflows Outflow Péincipal amounts of debt issued Principal paid on debt or leases Proceeds from issuing stock Payments to reacquire stock Dividends paid to shareholders Debt and equity investments (other than trading securities) and loans made to others are reported as investing cash outflows. However, under US. GAAP the income from these investments (interest and dividends received) is reported as operating cash inflows. Principal amounts borrowed are reported as financing cash inflows, but interest paid is reported as an operating cash outflow. Finally, dividends paid to the firm's shareholders are financing cash outflows. Later in this reading we will see that IFRS offers companies more discretion than US. GAAP with regard to how they may classify these cash flows. PROFESSOR’S NOTE Don't confuse dividends received and dividends paid. Under U.S. GAAP, dividends received are operating cash flows, and dividends paid are financing cash flows, EXAMPLE: Computing CFI Returning to the financial statements we used in our CFO examples, we will use the following information to compute CFI:20X7 —-20X6 Balance sheet extract s s Land 35,000 40,000 Gross PP&E 69,000 60,000 Accumulated depreciation (12,000) (9,000) Net PP&E 57,000 51,000 Income statement extract Depreciation 7,000 Gain on sale of land 10,000 Loss on disposal of PP&E 2,000 A footnote disclosure reveals that the company purchased PP&E for $25,000 during 20X7. Answer: CFI will comprise additions to PP&E and the disposal proceeds from the sale of PP&E and land. The footnote disclosure shows acquisitions of PP&E were $25,000; however, gross PPE has only increased by $9,000, This, coupled with the disposal loss in the income statement, indicates that the company must have disposed of PP&E during 20X7. ‘Step 1: Compute cost of disposed P&E $ Beginning gross PP&E. 60,000 Acquisitions gross cost 25,000 Disposals gross cost oo Ending gross PP&E 69,000 The value (X) we need to calculate is the cost of the assets that have been disposed of; that is, the gross book value the company recorded when it first acquired these assets. By rearranging the reconciliation, the gross cost of the disposed asset is computed as follows: beginning PP&E + acquisitions — ending gross PP&E — disposals gross cost disposals gross cost = $60,000 + $25,000 — $69,000 = $16,000 Next, we can see that accumulated depreciation has increased by $3,000 when the 20X7 depreciation expense is $7,000. The difference is also due to the asset disposal, because when a company disposes of an asset, it removes the accumulated depreciation on that asset from the total.‘Compute accumulated $ depreciation on disposed PP&E ‘Beginning accumulated depreciation 9,000 Depreciation expense 7,000 Accumulated depreciation on disposed PP&E (X) Ending accumulated depreciation 12,000 Accumulated depreciation on disposed PP&E = beginning accumulated depreciation + depreciation expense - ending accumulated depreciation $9,000 + $7,000 — $12,000 — $4,000. Step 3: Compute carrying value of PP&E disposal Gross cost 16,000 Accumulated depreciation (4,000) Carrying value before disposal 12,000 PROFESSOR’S NOTE Steps 1-3 can be combined for a quicker result: ‘Shortcut approach $ Beginning carrying value 51,000 Depreciation expense (7,000) Additions to PP&E 25,000 Carrying value of assets disposed (X) Ending carrying value 57,000 Carrying value of assets disposed = beginning carrying value - depreciation expense + additions to PP&E - ending carrying value = $51,000 - $7,000 + $25,000 - $57,000 = $12,000 When an asset is disposed of, the carrying value is removed from the balance sheet and netted against proceeds received from the sale, and any difference is reported as an accounting gain or loss in the income statement. A gain results if the proceeds from the sale exceed the carrying value, and a loss results if the proceeds are less than the carrying value. The only elements of the disposal that are cash flows are the disposal proceeds ‘Step 4: Compute disposal proceeds $ Disposal proceeds x Carrying value removed from balance sheet (12,000) Disposal gain/(loss) in income statement (2,000) The disposal proceeds on the sale of PP&E must have been $10,000. We carry out similar calculations for the disposal of land. This will be simpler because land is not depreciated, so the carrying value is its gross cost. Because thefootnotes do not mention any acquisitions of land, the carrying value of the land disposed of is the change in carrying value reported on the balance sheet. Carrying value of disposed land = $40,000 - $35,000 = $5,000. ‘Compute disposal proceeds $ Disposal proceeds x Carrying value removed from balance sheet (5,000) Disposal gain/(loss) in income statement 10,000 ‘The disposal proceeds on the sale of land must have been $15,000. Finally we can combine these results to determine cash flow from investing: cash paid for PP&E acquisitions + disposal proceeds CFI = ~$25,000 + $10,000 + $15,000 = $0 CEI= The cost of new assets acquired was, by coincidence, perfectly matched by the proceeds from asset disposals. EXAMPLE: Computing cash flow from financing (CFF) Returning to the financial statements from our CFO examples, we will need the following information to compute CFF: 20X7 20X6 Balance sheet extract s s Current liabilities Dividends payable 6,000 1,000 Noncurrent liabilities ‘Bonds payable 15,000 10,000 Stockholders’ equity Common stock 15,000 20,000 Additional paid-in capital 25,000 30,000 Contributed capital 40,000 50,000 Retained earnings 61,000 30,500 Other financial statement data Net income 39,000 Dividend declared 8,500 A footnote disclosure reveals that the bonds outstanding had been issued at face value (par). Answer: We can begin by determining cash flows from issuing or repaying bonds:$ Beginning bonds payable 10,000 ‘Net principal flows x/) Ending bonds payable 15,000 net principal flow — ending bonds payable — beginning bonds payable — $15,000 — $10,000 — $5,000 (inflow) Next we can determine cash flows from issuing or redeeming equity shares. Contributed capital is the sum of common stock at par and additional paid-in capital, and reflects the price at which the company issued shares. Reconciliation of equity s contributed capital ‘Beginning contributed capital 50,000 Net proceeds from repurchases and issuance X/(X) Ending contributed capital 40,000 net proceeds from buyback and issuance — ending contributed capital — beginning contributed capital — $50,000 — $40,000 = ~$10,000 (use of cash, or a net share repurchase of $10,000) Next we determine cash dividends paid, which can be a two-step process: Step 1: Calculate dividend declared if it is not given. In this example, the dividend declared of $8,500 was given. If it had not been, we could compute it based on the change in retained earnings: Reconciliation of retained earnings $ ‘Beginning retained earnings 30,500 Net income 39,000 Dividend declared aw Ending retained earnings 61,000 dividends declared — beginning retained earnings + net income — ending retained earnings $30,500 + $39,000 — $61,000 = $8,500 Step 2: Adjust the dividend declared for changes in the dividends payable liability. Simply because it is declared does not mean it has been paid. While the dividend declared does not pass through the income statement, it does reduce retained earnings; therefore, we treat it as a negative value. We then apply the increase/decrease rules for balance sheet liabilities: ividends paid s Dividend declared (8,500) Increase in dividend payable liability 5,000 Cash dividend paid (3,500)Computation of CFF s ‘Net principal on bonds 5,000 ‘Net proceeds from share repurchase and issuance (10,000) Cash dividends 500) Cash flow from financing (8,500) Having computed CFO, CFI, and CFE, we can complete the cash flow statement. Total cash flow s Cash flow from operations 50,000 Cash flow from investing 0 Cash flow from financing (8,500) Total cash flow 41,500 20X6 balance sheet cash 11,500 20X7 balance sheet cash 53,000 The total cash flow of $41,500 is equal to the increase in cash. The difference between beginning cash and ending cash should be used as a check figure to ensure that the total cash flow calculation is correct. PROFESSOR’S NOTE ‘The Level | CFA curriculum makes a few simplifications in the calculation of CFF For bonds issued at a premiums or discounts, the difference relative to par is amortized over the life of the bond, Amortization of premiums and discounts are not cash flows: coupon + amortized discount - amortized premium = interest expense With amortization of a discount bond, amortization will increase the interest expense and carrying value. With amortization of a premium bond, amortization will decrease the interest expense and carrying value. ‘The curriculum mentions the noncash element affecting interest expense (see Figure 30.1), but does not mention the impact on the balance sheet carrying value. The Level I curriculum sidesteps such complications by assuming that bonds are issued at par value in computations of CFF, which means there are no premiums or discounts to amortize. A second simplification in the Level | curriculum is to assume that stock buybacks are transacted at the same price that the shares were initiallyissued for: In practice, this is unlikely, and if the buyback price differs from issue price, adjustments to retained earnings are made. LOS 30.c: Demonstrate the conversion of cash flows from the indirect to direct method. The only difference between the indirect and direct methods of presentation is in the cash flow from operations (CFO) section. CFO under the direct method can be computed using a combination of the income statement and a statement of cash flows prepared under the indirect method. PROFESSOR’S NOTE The Level I CFA curriculum describes a three-step method for converting from indirect cash flow statements to direct cash flow statements, Provided that you understood the direct and indirect methods presented earlier, you will find little that you do not already know (although it is presented slightly differently) Here is the three-step process: Step 1: Aggregate all revenues and gains and all expenses and losses. Step 2: Remove all noncash charges and disaggregate the remaining items Step 3: Convert from accruals to cash flows by adjusting for the change in working capital. EXAMPLE: Conversion from indirect to direct CFO Using the same data as the direct and indirect examples, the three stages are as follows: s ‘Step I; Total revenues and gains 114,000 Total expenses and losses 75,000 Net income 39,000Step 2: Revenues less noncash charges 104,000 ($114,000 — $10,000) $10,000 — gain on asset disposal Expenses less noncash charges 61,000 ($75,000 — $7,000 — $2,000 — $5,000) $7,000 = depreciation $2,000 = loss on disposal of PP&E $5,000 = change in deferred tax liability Cost of goods sold 40,000 Wages 5,000 Interest 1,000 Tax payable 15,000 (Tax provision — increase in DTL) Total 61,000 Step 3: Cash collected from customers 107,000 $104,000 — $1,000 + $4,000 Cash paid to suppliers (34,000) $40,000 + $2,000 + $4,000 Cash paid to employees (8,500) $5,000 — $3,500 Cash interest paid (500) —$1,000 + $500 Cash paid to tax authorities* (24,000) $15,000 + $1,000 ‘Net cash flow from operating activities 50,000 * Note that the computation of cash paid looks slightly different from the direct method example. This is because the change in deferred tax is treated as a noncash charge and adjusted for in Step 2. LOS 30.d: Contrast cash flow statements prepared under International Financial Reporting Standards (IFRS) and US generally accepted accounting principles (US GAAP). Recall that under US. GAAP, dividends paid to the firm's shareholders are reported as, financing activities, while interest paid is reported in operating activities. Interest received and dividends received from investments are also reported as operating activities. International Financial Reporting Standards (IFRS) allow more flexibility in the classification of cash flows. Under IFRS, interest and dividends received may be classified as either operating or investing cash inflows. Dividends paid to the company’sshareholders and interest paid on the company's debt may be classified as either operating or financing cash outflows Another important difference relates to income taxes paid. Under U.S. GAAP, all taxes paid are reported as operating cash outflows—even taxes related to investing and financing transactions. Under IFRS, income taxes are reported as operating cash outflows unless they are associated with an investing or financing transaction. For example, consider a company that sells land that was held for investment for $1 million, Income taxes on the sale total $160,000. Under U.S. GAAP, the firm reports an inflow of cash from investing activities of $1 million and an outflow of cash from operating activities of $160,000. Under IFRS, the firm can report a net inflow of $840,000 from investing activities. The differences between US. GAAP and IFRS are summarized in Figure 30.3. Figure 30.3: Differences Between U.S. GAAP and IFRS U.S. GAAP JERS Interest received CFO. (CEO o: CET Interest paid CFO CEO o: CFF Dividends received CFO CEO or CEI Dividends paid CIF CEO o: CFF Bank overdraft Treated as balance sheet debt Treated as balance sheet cash Taxes CFO May be split between CFO, CFT, and CFF according to the nature of the transaction that caused tax to become payable Presentation of Disect preferred, but indicect Direct prefersed, but indisect CFO allowed; a reconciliation of allowed net income to CFO must be disclosed if using direct methodMODULE QUIZ 30.3 Assuming U.S. GAAP, use the following data to answer Questions 1 and 2. Net income 45 Depreciation 5 Taxes paid 25 Interest paid 5 Dividends paid 10 Cash received from sale of company building 40 Issuance of preferred stock 35 Repurchase of common stock 30 Purchase of machinery 20 Issuance of bonds 50 Debt retired through issuance of common stock 4s Paid off long-term bank borrowings 13 Profit on sale of building 20 1. Cash flow from investing activities is: A.-$30, B. $20. ©. $50. 2, Cash flow from financing activities is: A. $30. B. $56, C.875. 8, Which of the following items is least likely considered a cash flow from financing activity under U.S, GAAP? A. Receipt of cash from the sale of bonds. B, Payment of cash for dividends. C. Payment of interest on debt. 4, Which of the following would be least likely to cause a change in investing cash flow? A. The sale of a division of the company B. The purchase of new machinery. C. An increase in depreciation expense. Issuing bonds is classified as: A. an investing activity. B. a financing activity. C. having no cash flow impact. 6, The sale of land is classified as a(n): A. operating activity. B. investing activity. C. financing activity. 7. Which balance sheet items are most likely to be linked to cash flows from financing? A. Long-lived assets. B, Current assets and liabilities, C. Long-term liabilities and equity. 8. Under IFRS, interest expense may be classified as:A either operating cash flow or financing cash flow. B. operating cash flow only. C. financing cash flow only. 9. Under U.S. GAAP, dividends received from investments are classified as A. operating cash flow. B. investing cash flow. C. financing cash flow. LOS 30.2 Cash flow from operations is not the same as earnings because of the accruals process, To calculate CFO, balance sheet operating assets and liabilities are used to adjust income statement revenues and expenses to cash flows. Cash flows can be computed as the income statement figure — increase in related operating assets + decreases in related operating assets + increases in related operating liabilities - decrease in related operating liabilities. Operating activities typically relate to the firm's current assets and current liabilities. Investing activities typically relate to noncurrent assets. Financing activities typically relate to noncurrent liabilities and equity. LOS 30.b Under the direct method of presenting CFO, each line item of the accruals-based income statement is adjusted to get cash receipts or cash payments. The main advantage of the direct method is that it presents clearly the firm's operating cash receipts and payments. Under the indirect method of presenting CFO, net income is adjusted for transactions that affect net income but do not affect operating cash flow, such as depreciation and gains or losses on asset sales, and for changes in balance sheet items. The main advantage of the indirect method is that it focuses on the differences between net income and operating cash flow and gives the user of the accounts an indication of earnings quality. CFI is calculated by determining the changes in asset accounts that result from investing activities. The cash flow from selling an asset is its book value plus any gain on the sale (or minus any loss on the sale). CFF is the sum of net cash flows from creditors (new borrowings minus principal repaid) and net cash flows from shareholders (new equity issued minus share repurchases minus cash dividends paid). LOS 30.c An indirect cash flow statement can be converted to a direct cash flow statement by adjusting each income statement account for changes in associated balance sheet accounts and by eliminating noncash and nonoperating items (i.e, applying the direct. method)LOS 30.4 Differences in cash flow classifications between U.S. GAAP and IFR: U.S. GAAP IFRS Taterest received CFO (CEO or CFT Interest paid cFo CFO or CFF Dividends received CFO CEO or CFI Dividends paid CEF CFO or CFF Bank overdraft ‘Treated as Treated as balance sheet cash balance sheet debt Taxes CFO May be split between CFO, CFI, and CFF according to the nature of the transaction that caused tax to become payable Presentation of CFO Direct Direct preferred but indirect allowed; a preferred reconciliation of net income to CFO must but indirect be disclosed if using the direct method allowed MODULE QUIZZE: Module Quiz 30.1, 30.2 1.B $150,000 sales + $10,000 decrease in accounts receivable = $160,000 cash collections. The change in accounts payable does not affect cash collections. Accounts payable result from a firm's purchases from its suppliers. (Module 30.1, LOS 30.a, LOS 30.b) 2.C Revenue must be adjusted for the change in accounts receivable asset and unearned revenue liability: s Revenue 2,000,000 Increase in accounts receivable (50,000) Increase in unearned revenue 70,000 Cash from customers 2,020,000 (Module 30.1, LOS 30.a, LOS 30.b) 3.B The income statement tax expense must first be adjusted to remove the impact of any changes to deferred tax assets and liabilities to arrive at tax payable. Tax payable represents the tax owed to the tax authorities on this period’s earnings. The tax-payable figure then must be adjusted for changes in tax-payable liabilities to arrive at the cash tax paid.Tax expense Increase in deferred tax liability Increase in deferred tax asset (10,000) Tax payable 160,000) Decrease in tax payable liability (90,000) Cash taxes paid (250,000) (Module 30.1, LOS 30.a, LOS 30.b) 4.B The cost of goods sold needs to be adjusted for both change in inventory and change in accounts payable. $ Cost af goods sold (400,000) Decrease in inventory 20,000, Purchases (1,380,000) Decrease in accounts payable (30,000) Cash paid to suppliers (1,410,000) (Module 30.1, LOS 30.a, LOS 30.b) 5.B Net income — profits from sale of land + depreciation + decrease in receivables - increase in inventories + increase in accounts payable - decrease in wages payable + increase in deferred tax liabilities = 120 - 2 + 25 + 20-10+7-5+15 = $170, Note that the profit on the sale of land should be subtracted from net income because this transaction is classified as investing, not operating. (Module 30.2, LOS 30.b) 6A Net income $78,000 Depreciation 12,000 Unrealized gain (15,000) Increase in accounts receivable (52,000) Increase in accounts payable 29,000 Cash flow from operations $52,000 (Module 30.2, LOS 30.b) 7.€ The indirect method reconciles the difference between net income and CFO. The direct method shows operating cash received and paid—and, therefore, provides more information on its face than the indirect method. (Module 30.2, LOS 30.b) Module Quiz 30.3 1.B Cash from sale of building - purchase of machinery = 40 - 20 = $20. (Module 30.3, LOS 30.b) 2.A Sale of preferred stock + issuance of bonds - principal payments on bank borrowings - repurchase of common stock ~ dividends paid = 35 + 50 - 15 - 30 - 10 = $30, Note that we did not include $45 of debt retired through issuance of3. 4.€ 5.B 6B 7.C 8A oA common stock because this was a noncash transaction. Knowing how to handle noncash transactions is important. (Module 30.1, LOS 30.b) The payment of interest on debt is an operating cash flow under US. GAAP. (Module 30.3, LOS 30.4) Depreciation does not represent a cash flow. To the extent that it affects the firm’s taxes, an increase in depreciation changes operating cash flows, but not investing cash flows. (Module 30.3, LOS 30.b) Issuing bonds is classified as a financing activity. (Module 30:3, LOS 30.b) The sale of land is classified as an investing activity. (Module 30.3, LOS 30.b) Financing cash flows are linked primarily to changes in long-term liabilities and equity. Changes in current assets and liabilities tend to be linked to operating cash flows. Changes in long-lived assets are typically linked to investing cash flows. (Module 30.3, LOS 30.b) Under IFRS, interest expense can be classified as either an operating cash flow or financing cash flow. (Module 30.3, LOS 30.4) Dividends received from investments are classified as operating cash flow under US. GAAP. (Module 30.3, LOS 30.4)