13-cash Flow Statement

Introduction

chapter 13

Cash Flow Statement Accounting Matters!

You Have to Spend Money to Make Money Big-ticket leisure travel has become big business. And perhaps no company has tapped into this market more thoroughly than Vancouver-based Intrawest Corporation. Intrawest is the world's largest developer and operator of destination resorts, whose flagship Whistler/Blackcomb resort will play host to the Winter Olympic Games in 2010. The secret to the company's success is its growth formula: Start with a resort. Build a village so people stay longer. This attracts more visitors who come more often and spend more money. Build more real estate attractions, drawing in more people. This leads to the creation of shops, hotels, convention centres, and restaurants. The result: a year-round destination resort that puts the company into a financial position where it can invest in more locations. It's a fine balance of spending money to make money and making sure there is enough cash flow to cover debt. In 2003, Intrawest's formula needed a bit of tweaking. While resort operations were cash flow–positive, the real estate business was cash flow–negative. To solve this problem, the company formed two partnerships with outside investors to create Leisura Developments, which takes on the most capitalintensive development projects. “As a result, the amount of capital that we are required to invest in new real estate projects is significantly reduced,” says David Blaiklock, Intrawest's vice president and corporate controller. The initial result was indeed significant. Cash flow from operating activities for the 2004 fiscal year was U.S. $422.9 million, compared to a negative cash flow of U.S. $20.9 million in 2003. Intrawest generated U.S. $303.1 million in free cash flow in 2004, which it used to reduce debt. “A significant component of that cash flow was the one-time impact of introducing this partnership http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_1.xform?course=crs1562&id=ref (1 of 3)14/04/2008 3:43:33 PM

Introduction

structure,” Mr. Blaiklock stresses. Still, by selling real estate projects to Leisura, the company's cash flow requirements will be reduced. As for the 2010 Olympics, their impact on cash flow can only be positive. Since Whistler/Blackcomb already hosts World Cup alpine ski events, no infrastructure investment is required. The federal and provincial governments are spending millions on improvements to the highway from Vancouver to Whistler, which will increase real estate values and the number of resort visitors. The new athletes' village will provide affordable housing for resort employees. And then there's the prestige that comes with having been an Olympic host city. Although Whistler/Blackcomb is already a world-class destination, the Olympics will only generate more interest and more visitors, and thus more cash.

Intrawest: www.intrawest.com

The Navigator

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_1.xform?course=crs1562&id=ref (2 of 3)14/04/2008 3:43:33 PM

Introduction

Read Feature Story Scan Study Objectives Read Chapter Preview Read text and answer Before You Go On Work Using the Decision Toolkit Review Summary of Study Objectives Review Decision Toolkit—A Summary Work Demonstration Problem Answer Self-Study Questions Complete assignments

Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_1.xform?course=crs1562&id=ref (3 of 3)14/04/2008 3:43:33 PM

Study Objectives and Preview

Study Objectives After studying this chapter, you should be able to: 1. Describe the purpose and format of the cash flow statement. 2. Prepare a cash flow statement using one of two approaches: (a) the indirect method or (b) the direct method. 3. Use the cash flow statement to evaluate a company's liquidity and solvency.

Preview of Chapter 13 The balance sheet, statement of earnings, and statement of retained earnings do not always show the whole picture of the financial condition of a company. In fact, looking at the financial statements of some well-known companies, a thoughtful investor might ask questions like these: How did Andrés Wines pay $3 million of dividends in a year when it had no cash but bank indebtedness instead? How did the Wilfrid Laurier University Students' Union increase its cash balance by more than $400,000 in a year in which it only earned a little more than $100,000? How did Rogers Communications finance its $25-million purchase of the SkyDome (now called the Rogers Centre)? Answers to these and similar questions can be found in this chapter, which presents the cash flow statement. The chapter is organized as follows:

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_2.xform?course=crs1562&id=ref (1 of 2)14/04/2008 3:44:15 PM

Study Objectives and Preview

Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_2.xform?course=crs1562&id=ref (2 of 2)14/04/2008 3:44:15 PM

Reporting of Cash Flows

Reporting of Cash Flows The three financial statements that we have studied so far present only partial information about a company's cash flows (cash receipts and cash payments). For example, comparative balance sheets show the increase in property, plant, and equipment during the year, but they do not show how the additions were financed or paid for. The statement of earnings shows net earnings, but it does not indicate the amount of cash generated by operating activities. The statement of retained earnings shows cash dividends declared, but not the cash dividends paid during the year. None of these statements reports the change in cash as a result of operating, investing, and financing activities during the period.

Purpose of the Cash Flow Statement study objective 1 Describe the purpose and format of the cash flow statement. The main purpose of the cash flow statement is to provide information about cash receipts, cash payments, and the net change in cash that result from the operating, investing, and financing activities of a company during a specific period. Reporting the causes of changes in cash is useful because investors, creditors, and other interested parties want to know what is happening to a company's most liquid resource—its cash. As the feature story about Intrawest demonstrates, to understand a company's financial position, it is essential to understand its cash flows. The information in a cash flow statement should help investors, creditors, and others assess the following aspects of a company's financial position: 1. The investing and financing transactions during the period. By examining a company's investing and financing activities, a financial statement reader can better understand why assets and liabilities increased or decreased during the period. 2. The company's ability to generate future cash flows. Investors and others examine the relationships between items in the cash flow statement. From these, they can better predict the amounts, timing, and uncertainty of future cash flows than they can from accrual-based data. 3. The company's ability to pay dividends and meet obligations. If a company does not have enough cash, it cannot pay employees, settle debts, or pay dividends. Employees, creditors, shareholders, and customers are particularly interested in this statement because it alone shows the flow of cash in a business. 4. The reasons for the difference between net earnings and cash provided (used) by operating activities. Net earnings provide information on the success or failure of a business. However, some people are critical of accrual-based net earnings because these earnings require estimates, allocations, and assumptions. As a result, the reliability of net earnings is often doubted. Cash flow is less susceptible to earnings management than net earnings. Although we suggest that relying on cash http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_3.xform?course=crs1562&id=ref (1 of 6)14/04/2008 3:44:30 PM

Reporting of Cash Flows

flows only and ignoring accrual accounting is inappropriate, comparing cash provided or used by operating activities to net earnings can reveal important information about the “quality” of the reported net earnings—that is, this comparison can show how good net earnings are as a measure of actual performance.

Accounting Matters! Investor Perspective During the 1990s, analysts increasingly used cash-based measures, such as cash provided by operating activities, instead of, or in addition to, net earnings. The reason for the change was that they had lost faith in accrual-based measures. Sadly, nowadays even cash flow is not always what it seems to be.

Take, for example, Alliance Atlantis Communications Inc. The company reported cash flow provided by operating activities of $686.5 million in 2001. Looks impressive, right? However, in 2002, the company's cash flow statement for 2001 was restated to report cash used by operating activities of $59.9 million. What happened? Accounting standard-setters decided that money spent to acquire, develop, and produce films and television programs was an operating expense, not an investment. In other words, Atlantis' cash flow did not actually change, but its reporting did. The moral of this story is that accounting principles can alter not only reported earnings, but also cash flow. Source: Fabrice Taylor, “Show Me the Real Money,” Report on Business Magazine, November 2002, 109.

Format of the Cash Flow Statement The general format of the cash flow statement is organized around the three activities of operating, investing, and financing. Transactions within each activity are as follows: 1. Operating activities include the cash effects of transactions that create revenues and expenses. They affect net earnings.

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_3.xform?course=crs1562&id=ref (2 of 6)14/04/2008 3:44:30 PM

Reporting of Cash Flows

2. Investing activities include (a) purchasing and disposing of investments and long-lived assets and (b) lending money and collecting the loans. They affect short-term investments that are not cash equivalents, and they affect long-term asset accounts. 3. Financing activities include (a) obtaining cash from issuing debt and repaying the amounts borrowed and (b) obtaining cash from shareholders and paying them dividends. They affect short-term notes payable, and longterm liability and shareholders' equity accounts. Illustration 13-1 lists typical cash receipts and cash payments in each of the three activities. Operating activities—statement of earnings items and changes in noncash working capital Cash inflows: From the sale of goods or services From returns on debt investments (interest) and on equity investments (dividends) Cash outflows: To suppliers for inventory To employees for services To governments for taxes To lenders for interest To others for expenses Investing activities—changes in short-term investments and long-term assets Cash inflows: From the sale of property, plant, and equipment From the sale of debt or equity investments From the collection of principal on loans to other companies Cash outflows: To purchase property, plant, and equipment To purchase debt or equity investments To make loans to other companies Financing activities—changes in short-term notes payable, long-term liabilities, and equity Cash inflows: From the sale of shares (preferred and common) From the issue of debt (notes and bonds) Cash outflows: To shareholders as dividends To redeem long-term debt or reacquire share capital Illustration 13-1 Cash receipts and payments classified by activity

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_3.xform?course=crs1562&id=ref (3 of 6)14/04/2008 3:44:30 PM

Reporting of Cash Flows

As you can see, some cash flows relating to investing or financing activities are classified as operating activities. For example, receipts of investment revenue (interest and dividends) are classified as operating activities. So are payments of interest to lenders. Why are these considered operating activities? Because these items are reported in the statement of earnings, where results of operations are shown. Note the following general guidelines: (1) Operating activities involve items that determine income (statement of earnings and noncash working capital items). (2) Investing activities involve cash flows that result from changes in short-term investments and long-term asset items. (3) Financing activities involve cash flows that result from changes in short-term notes payable, and long-term liability and shareholders' equity items. Illustration 13-2 shows these general guidelines. There are exceptions, of course, but these relationships between operating, investing, and financing activities and the statement of earnings and balance sheet are the most common.

Illustration 13-2 Operating, investing, and financing activities A sample cash flow statement, presenting operating, investing, and financing activities, is shown in Illustration 133 in condensed format.

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_3.xform?course=crs1562&id=ref (4 of 6)14/04/2008 3:44:30 PM

Reporting of Cash Flows

Illustration 13-3 Format of cash flow statement Alternative Terminology The cash flow statement is also commonly known as the statement of changes in financial position. The cash flow statement covers the same period of time as the statements of earnings and retained earnings. The section that reports cash flows from operating activities always appears first. It is followed by the investing activities section and then the financing activities section. Note also that the individual inflows and outflows from investing and financing activities are reported separately. Thus, the cash outflow for the purchase of equipment is reported separately from the cash inflow from the sale of equipment. Similarly, the cash inflow from the issue of debt securities is reported separately from the cash outflow for the retirement of debt. If a company did not report the inflows and outflows separately, some of the investing and financing activities would be hidden. This would make it more difficult for the user to assess future cash flows. The reported operating, investing, and financing activities result in net cash either provided or used by each activity. The amounts of net cash provided or used by each activity are then totalled. The result is the net increase or decrease in cash for the period. This amount is then added to or subtracted from the beginning-of-period cash balance to obtain the end-of-period cash balance. The end-of-period cash balance should agree with the cash balance reported on the balance sheet.

Definition of Cash http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_3.xform?course=crs1562&id=ref (5 of 6)14/04/2008 3:44:30 PM

Reporting of Cash Flows

The cash flow statement is often prepared using cash and cash equivalents as its basis rather than just cash. You will recall from Chapter 7 that cash equivalents are short-term, highly liquid investments that are readily convertible to cash within a very short period of time. Generally, only money-market instruments due within three months qualify by this definition. Sometimes short-term or demand loans are also deducted from this amount. Because of the varying definitions of “cash” that can be used in this statement, companies must clearly define cash equivalents when they are included. Since cash and cash equivalents are viewed as the same, transfers between the cash account and the cash equivalent accounts are not treated as cash receipts and cash payments. These transfers are therefore not reported in the cash flow statement.

Significant Noncash Activities In addition, it is important to recognize that not all of a company's significant activities involve cash. The following are examples of noncash activities: 1. Issues of common shares to purchase assets 2. Conversions of debt into equity 3. Issues of debt to purchase assets 4. Exchanges of property, plant, and equipment Significant investing and financing activities that do not affect cash are not reported in the body of the cash flow statement. However, these activities are reported in a note to the financial statements. The reporting of these activities in a note satisfies the full disclosure principle.

Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_3.xform?course=crs1562&id=ref (6 of 6)14/04/2008 3:44:30 PM

Before You Go On #1

Before You Go On . . . Review It 1. What is the main purpose of a cash flow statement? 2. How does the cash flow statement help users understand a company's financial position? 3. What amounts does Loblaw report in its 2003 cash flow statement for (a) operating activities, (b) investing activities, and (c) financing activities? The answers to these questions are provided at the end of this chapter.

4. What is a cash equivalent? 5. Where are significant noncash activities reported? Give an example. Do It Plano Moulding Corp. had the following cash transactions: (a) Issued common shares. (b) Sold an available-for-sale debt security. (c) Purchased a tractor-trailer truck. Made a cash down payment and financed the remainder with a mortgage note payable. (d) Paid interest on the mortgage note payable. (e) Collected cash for services provided. Classify each of these transactions by type of cash flow activity. Indicate whether the transaction would be reported as a cash inflow or cash outflow, or as a noncash activity. Action Plan Identify the three types of activities used to report all cash inflows and outflows. Report as operating activities the cash effects of transactions that create revenues and expenses and are used to determine net earnings. Report as investing activities the transactions that (a) acquire and dispose of investments and longlived assets, and (b) lend money and collect loans. http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_4.xform?course=crs1562&id=ref (1 of 2)14/04/2008 3:44:46 PM

Before You Go On #1

Report as financing activities the transactions that (a) obtain cash by issuing debt or repay the amounts borrowed, and (b) obtain cash from shareholders or pay them dividends. Solution (a) Financing activity, cash inflow (b) Investing activity, cash inflow (c) Investing activity, cash outflow for down payment. Remainder is noncash investing (tractor-trailer truck) and financing (mortgage note payable) activity (d) Operating activity, cash outflow (e) Operating activity, cash inflow

Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_4.xform?course=crs1562&id=ref (2 of 2)14/04/2008 3:44:46 PM

Preparing the Cash Flow Statement

Preparing the Cash Flow Statement study objective 2 Prepare a cash flow statement using one of two approaches: (a) the indirect method or (b) the direct method. The cash flow statement is prepared differently from the other three financial statements. First, it is not prepared from an adjusted trial balance. The statement requires detailed information on the changes in account balances that occurred between two periods of time. An adjusted trial balance does not provide the necessary data. Second, the cash flow statement deals with cash receipts and payments. As a result, the accrual concept is not used in the preparation of a cash flow statement. The information to prepare this statement usually comes from three sources: 1. The comparative balance sheet indicates the amounts of the changes in assets, liabilities, and shareholders' equity from the beginning to the end of the period. 2. The statement of earnings helps the reader determine the amount of cash provided or used by operating activities during the period. 3. Additional information includes transaction data that are needed to determine how cash was provided or used during the period. There are four steps to prepare the cash flow statement from these data sources, as shown in Illustration 13-4.

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_5.xform?course=crs1562&id=ref (1 of 4)14/04/2008 3:44:55 PM

Preparing the Cash Flow Statement

Illustration 13-4 Steps in preparing the cash flow statement

Indirect and Direct Methods In order to perform step 1 and determine the cash provided (used) by operating activities, net earnings must be converted from an accrual basis to a cash basis. This conversion may be done by either of two methods: indirect or direct. The indirect method converts total net earnings from an accrual basis to a cash basis. The direct method converts each individual revenue and expense account to a cash basis, identifying specific cash http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_5.xform?course=crs1562&id=ref (2 of 4)14/04/2008 3:44:55 PM

Preparing the Cash Flow Statement

receipts and payments. Both methods arrive at the same total amount for “net cash provided (used) by operating activities.” The only difference is which items they disclose. Note that the two methods only produce differences in the operating activities section. The investing activities and financing activities sections are not affected by the choice of the indirect or direct method. Most companies use the indirect method. They prefer this method for three reasons: (1) it is easier to prepare; (2) it focuses on the differences between net earnings and net cash flow from operating activities; and (3) it tends to reveal less company information to competitors. The CICA allows the use of both the indirect and direct methods, but encourages companies to use the direct method of reporting operating activities. Despite the CICA's preference for the direct method, it is rarely used in Canadian practice. Less than one percent of the companies in Canada use the direct method. The authors of Financial Reporting in Canada state, “We continue to be surprised by the failure to use the direct method for presenting this important figure. It is difficult to believe that investors would not find information on the various functional cash flows (e.g., payments to employees) more useful than the information on the adjustments required to convert net income into cash flows from operating activities (e.g., amortization expense).”

Accounting Matters! Investor Perspective The cash flow statement ought to be one of the most important tools for any investor. But, all too often, this statement provides little insight into a company's operations. Take, for example, Hudson's Bay Company. The Bay's business is pretty simple. It buys clothes, housewares, and other products, puts them in its stores, and sells them.

When you look at the operating activities section of The Bay's cash flow statement, however, you find references to amortization and “net change in operating working capital.” Nowhere does it tell you how much cash The Bay received from its customers or how much it paid its suppliers. So why do companies choose not to report this information in their cash flow statement? “It gives material information, so managements don't want to use it,” says Richard Rooney, president of Burgundy Asset Management. Rooney would like to see the direct method of preparing the operating activities section of the cash flow statement become mandatory. “Something like this is comprehensible, easy to understand, and I think it would be harder to fudge—though where there's a will, there's a way.”

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_5.xform?course=crs1562&id=ref (3 of 4)14/04/2008 3:44:55 PM

Preparing the Cash Flow Statement

Source: Derek DeCloet, “Show Investors the Cash Flow,” Financial Post, March 28, 2002, IN3.

On the following pages, in two separate sections, we describe the use of the indirect and direct methods of preparing the cash flow statement. Section 1 illustrates the indirect method. Section 2 illustrates the direct method. These sections are independent of each other. When you have finished the section(s) assigned by your instructor, turn to the concluding section of the chapter—“Using Cash Flows to Evaluate a Company.”

Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_5.xform?course=crs1562&id=ref (4 of 4)14/04/2008 3:44:55 PM

Indirect Method

Section 1

Indirect Method

study objective 2a Prepare a cash flow statement using the indirect method. To explain and illustrate the indirect method, we will use financial information from Computer Services Corporation to prepare a cash flow statement. Illustration 13-5 presents Computer Services' current- and previousyear balance sheet, its current-year statement of earnings, and related financial information.

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_6.xform?course=crs1562&id=ref (1 of 15)28/04/2008 8:36:56 AM

Indirect Method

Illustration 13-5 Comparative balance sheet, statement of earnings, and additional information We will now apply the four steps to the information provided for Computer Services Corporation.

Step 1: Operating Activities Determine the Net Cash Provided (Used) by Operating Activities by Converting Net Earnings from an Accrual Basis to a Cash Basis To determine the net cash provided (or used) by operating activities under the indirect method, net earnings is adjusted for items that did not affect cash. A useful starting point is to understand why net earnings must be converted to net cash provided by operating activities. Under generally accepted accounting principles, companies use the accrual basis of accounting. As you have learned, this basis requires that revenue be recorded when it is earned and that expenses be matched against the revenue they helped generate. Earned revenues may include credit sales that have not been collected in cash. Expenses incurred, such as amortization or cost of goods sold, may not have been paid in cash. Consequently, http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_6.xform?course=crs1562&id=ref (2 of 15)28/04/2008 8:36:56 AM

Indirect Method

under the indirect method, accrual-based net earnings must be adjusted to convert certain items to the cash basis. The indirect method starts with net earnings and converts it to net cash provided or used by operating activities. Illustration 13-6 shows three types of adjustments that are made to adjust net earnings for items that affect accrualbased net earnings but do not affect cash. The first two types of adjustments are found on the statement of earnings. The last type of adjustment—changes to current asset and current liability accounts—is found on the balance sheet.

Illustration 13-6 Adjustments to convert net earnings to net cash provided by operating activities The next three sections explain each type of adjustment.

Amortization Expense Computer Services' statement of earnings shows an amortization expense of $9,000. Although amortization expense reduces net earnings, it does not reduce cash. Recall that the entry to record amortization is:

This entry has no effect on cash, so amortization expense is added back to net earnings in order to arrive at net cash provided by operating activities: Operating activities Net earnings $145,000 Adjustments to reconcile net earnings to net cash provided by operating activities: Amortization expense 9,000 Net cash provided by operating activities

154,000

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_6.xform?course=crs1562&id=ref (3 of 15)28/04/2008 8:36:56 AM

Indirect Method

Amortization is often listed in the cash flow statement as the first adjustment to net earnings. It is important to understand that amortization expense is not added to operating activities as if it were a source of cash. As shown in the journal entry above, amortization does not involve cash. It is added to cancel the deduction created by the amortization expense in the determination of net earnings.

Gains and Losses on the Sale of Assets Computer Services' statement of earnings reports a $3,000 loss on the sale of equipment. With the additional information provided, we can reconstruct the journal entry to record the sale of equipment:

Illustration 13-1 states that cash received from the sale of long-lived assets should be reported in the investing activities section of the cash flow statement. Consequently, all gains and losses from investing activities must be eliminated from net earnings to arrive at cash from operating activities. In our example, Computer Services' $3,000 loss should not be included in the operating activities section of the cash flow statement. This amount is eliminated by adding the $3,000 back to net earnings to arrive at net cash provided by operating activities: Operating activities Net earnings $145,000 Adjustments to reconcile net earnings to net cash provided by operating activities: Amortization expense $9,000 12,000 Loss on sale of equipment 3,000 Net cash provided by operating activities

157,000

If a gain on sale occurs, the gain is deducted from net earnings in order to determine net cash provided by operating activities. For both a gain and a loss, the actual amount of cash received from the sale is reported as a source of cash in the investing activities section of the cash flow statement. If we did not eliminate gains and losses and remove them from net earnings, they would be counted twice—once in the operating activities section (as part of net earnings), and again in the investing activities section (as part of the cash proceeds from the sale). Gains and losses are also possible in other circumstances, such as when debt is retired. The same adjustment guidelines apply as described for gains and losses on the sale of assets, except that the other side of the transaction is reported in financing activities, rather than investing activities.

Changes in Noncash Current Asset and Current Liability http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_6.xform?course=crs1562&id=ref (4 of 15)28/04/2008 8:36:56 AM

Indirect Method

Accounts A final adjustment in converting net earnings to net cash provided by operating activities involves examining all changes in current asset and current liability accounts. Most current asset and current liability accounts result from operating activities. For example, accounts receivable indicate credit sales that have been recorded as revenue but for which cash collections have not yet been received. Prepaid expenses, such as insurance, reflect insurance that has been paid for, but which has not yet expired and therefore has not been recorded as an expense. Similarly, income tax payable reflects income tax expense incurred by the company but not yet paid. As a result, we need to adjust net earnings for these accruals and prepayments to determine net cash provided by operating activities. We do this by analyzing the change in each current asset and current liability account to determine each change's impact on net earnings and cash. There are situations when current asset and current liability accounts do not result from operating activities. Shortterm investments are an example of a current asset that does not relate to operating activities. Short-term investments are shown in the investing activities section of the cash flow statement if they are not part of cash equivalents. Short-term notes payable are an example of a current liability that does not relate to operating activities. These are shown instead in the financing section of the cash flow statement.

Changes in Noncash Current Assets The adjustments required for changes in noncash current asset accounts are as follows: increases in current asset accounts are deducted from net earnings and decreases in current asset accounts are added to net earnings, to arrive at net cash provided by operating activities. We will observe these relationships by analyzing Computer Services' current asset accounts. Decrease in Accounts Receivable. When accounts receivable decrease during the year, revenues on an accrual basis are lower than revenues on a cash basis. In other words, more cash was collected during the period than was recorded as revenue. Computer Services' accounts receivable decreased by $10,000 (from $30,000 to $20,000) during the year. For Computer Services, this means that cash receipts were $10,000 higher than revenues. Illustration 13-5 shows that Computer Services had $507,000 in sales revenue reported on its statement of earnings. To determine how much cash was collected in connection with this revenue, it is useful to analyze the Accounts Receivable account:

If sales revenue (assumed to be sales on account) journalized during the period was $507,000 (Dr. Accounts Receivable; Cr. Sales Revenue), and the change in Accounts Receivable during the period was a decrease of $10,000, then cash receipts from customers must have been $517,000 (Dr. Cash; Cr. Accounts Receivable). Consequently, revenues reported on the accrual-based statement of earnings were lower than cash collections. To http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_6.xform?course=crs1562&id=ref (5 of 15)28/04/2008 8:36:56 AM

Indirect Method

convert net earnings to net cash provided by operating activities, the $10,000 decrease in accounts receivable must be added to net earnings because $10,000 more cash was collected than was reported as accrual-based revenue in the statement of earnings. When the Accounts Receivable balance increases during the year, revenues on an accrual basis are higher than cash receipts. Therefore, the amount of the increase in accounts receivable is deducted from net earnings to arrive at net cash provided by operating activities. Increase in Inventory. Assuming a perpetual inventory system is being used, the Merchandise Inventory account is increased by the cost of goods purchased. It is decreased by the cost of goods sold. When inventory increases during the year, the cost of goods purchased is greater than the cost of goods sold expense recorded in the statement of earnings. Any increase in the Inventory account must be deducted from net earnings, in a manner similar to the increase in the Accounts Receivable account explained above. Inventory increased by $5,000 for Computer Services Corporation. Because the Inventory account is increased by the purchase of goods (Dr. Inventory; Cr. Accounts Payable) and is decreased by the cost of goods sold (Dr. Cost of Goods Sold; Cr. Inventory), Computer Services must have purchased $5,000 more inventory than it sold. Therefore, because the cost of goods sold reported on the statement of earnings is $150,000, purchases of merchandise during the year must have been $155,000:

To convert net earnings to net cash provided by operating activities, the $5,000 increase in inventory must be deducted from net earnings. The increase in inventory means that the cash-based expense must be increased, which has the effect of reducing net earnings. This deduction does not completely convert an accrual-based figure to a cash-based figure. It does not tell us how much cash was paid for the goods purchased. It just converts the cost of goods sold to the cost of goods purchased during the year. The analysis of accounts payable—shown later—completes this analysis by converting the cost of goods purchased from an accrual basis to a cash basis. Increase in Prepaid Expenses. Prepaid expenses increased during the period by $4,000. This means that the cash paid for expenses is higher than the expenses reported on the accrual basis. In other words, cash payments were made in the current period, but expenses have been deferred to future periods. To determine how much cash was paid relative to the operating expenses, it is useful to analyze the Prepaid Expenses account. Operating expenses, as reported on the statement of earnings, are $111,000. Accordingly, payments for expenses must have been $115,000:

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_6.xform?course=crs1562&id=ref (6 of 15)28/04/2008 8:36:56 AM

Indirect Method

To adjust net earnings to net cash provided by operating activities, the $4,000 increase in prepaid expenses must be deducted from net earnings to determine the cash paid for expenses. If prepaid expenses decrease, reported expenses are higher than the expenses paid. therefore, the decrease in prepaid expenses is added to net earnings to arrive at net cash provided by operating activities. These adjustments may not completely convert accrual-based expenses to cash-based expenses. For example, if Computer Services Corporation had any accrued expenses payable, these would also have to be considered before we could completely determine the amount of cash paid for operating expenses. Computer Services does not have any accrued expenses payable related to operating expenses. However, if it did, they would be treated in the same manner as income tax payable, which will we look at in the next section when we adjust for the changes in the current liability accounts. Income tax payable is actually an example of an accrued expense payable; however, it is dealt with separately because income tax expense is reported by itself on the statement of earnings. The following partial cash flow statement shows the impact on operating activities of changes in noncash current asset accounts, in addition to those adjustments described earlier: Operating activities Net earnings Adjustments to reconcile net earnings to net cash provided by operating activities: Amortization expense Loss on sale of equipment Decrease in accounts receivable Increase in inventory Increase in prepaid expenses

$145,000 $ 9,000 3,000 10,000 (5,000) (4,000)

Net cash provided by operating activities

13,000 158,000

Changes in Current Liabilities The adjustments required for changes in current liability accounts are as follows: increases in current liability accounts are added to net earnings, and decreases in current liability accounts are deducted from net earnings, to arrive at net cash provided by operating activities. We will observe these relationships by analyzing Computer Services' current liability accounts, Accounts Payable and Income Tax Payable. Increase in Accounts Payable. The Accounts Payable account is increased by purchases of merchandise (Dr. Inventory; Cr. Accounts Payable) and decreased by payments to suppliers (Dr. Accounts Payable; Cr. Cash). We determined the amount of purchases made by Computer Services in the analysis of the Inventory account earlier: $155,000. Using this figure, we can now determine that payments to suppliers must have been $139,000:

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_6.xform?course=crs1562&id=ref (7 of 15)28/04/2008 8:36:56 AM

Indirect Method

To convert net earnings to net cash provided by operating activities, the $16,000 increase in accounts payable must be added to net earnings. The increase in accounts payable means that less cash was paid for the purchases than was deducted in the accrual-based expenses section of the statement of earnings. The addition of $16,000 completes the adjustment required to convert the cost of goods purchased to the cash paid for these goods. In summary, the conversion of the cost of goods sold on the accrual-based statement of earnings to the cash paid for goods purchased involves two steps: First, the change in the Inventory account adjusts the cost of goods sold to the accrual-based cost of goods purchased. Second, the change in the Accounts Payable account adjusts the accrualbased cost of goods purchased to the cash-based payments to suppliers: Cost of goods sold Add: Increase in inventory Cost of goods purchased Less: Increase in accounts payable Cash payments to suppliers

$150,000 5,000 155,000 16,000 $139,000

Remember that adjustments to accrual-based expense accounts result in an adjustment in the opposite direction to net earnings. That is, when an expense account such as Cost of Goods Sold is increased because of an increase in inventory, this amount must be deducted from net earnings. This is because expenses reduce net earnings. Likewise, when Cost of Goods Sold is decreased because of an increase in accounts payable, this amount must be added to net earnings. If a periodic inventory system was in use, the accounts for purchases and related expenses, rather than Cost of Goods Sold, would be adjusted in a similar way for any change in accounts payable. There would be no change in the Inventory account throughout the period in a periodic inventory system. Decrease in Income Tax Payable. When a company incurs income tax expense but has not yet paid its taxes, it records income tax payable. A change in the Income Tax Payable account reflects the difference between the income tax expense incurred and the income tax actually paid during the year. Computer Services' Income Tax Payable account decreased by $2,000. This means that the $47,000 of income tax expense reported on the statement of earnings was $2,000 less than the $49,000 of taxes paid during the period, as shown in the following T account:

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_6.xform?course=crs1562&id=ref (8 of 15)28/04/2008 8:36:56 AM

Indirect Method

To adjust net earnings to net cash provided by operating activities, the $2,000 decrease in income tax payable must be deducted from net earnings. If the amount of income tax payable had increased during the year, the increase would be added to net earnings to reflect the fact that income tax expense deducted on the accrual-based statement of earnings was higher than the cash paid during the period. The partial cash flow statement in Illustration 13-7 shows the impact on operating activities of the changes in current liability accounts, and also shows the adjustments described earlier for amortization expense, gains and losses, and changes in noncash current asset accounts. The operating activities section of the cash flow statement is now complete.

Illustration 13-7 Net cash provided by operating activities—indirect method Helpful Hint Whether the indirect or direct method (Section 2) is used, net cash provided by operating activities will be the same. In summary, Illustration 13-7 shows that the accrual-based net earnings of $145,000 resulted in net cash provided by operating activities of $172,000, after adjustments for noncash items.

Summary of Conversion to Net Cash Provided by Operating Activities—Indirect Method http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_6.xform?course=crs1562&id=ref (9 of 15)28/04/2008 8:36:56 AM

Indirect Method

As shown in the previous pages, the cash flow statement prepared by the indirect method starts with net earnings. It then adds or deducts items to arrive at net cash provided (or used) by operating activities. The adjustments generally take one of three forms: (1) noncash expenses such as amortization, (2) gains and losses on the sale of assets, and (3) changes in noncash current asset and current liability accounts. Illustration 13-8 summarizes these changes. Adjustment Required to Convert Net Earnings to Net Cash Provided (Used) by Operating Activities Noncash charges

Amortization expense

Add

Gains and losses

Gain on sale of asset Loss on sale of asset

Deduct Add

Changes in noncash current asset and current liability accounts

Increase in current asset account

Deduct

Decrease in current asset account Increase in current liability account Decrease in current liability account

Add Add Deduct

Illustration 13-8 Adjustments required to convert net earnings to net cash provided by operating activities

Step 2: Investing Activities Determine the Net Cash Provided (Used) by Investing Activities by Analyzing Changes in Short-term Investment and Long-Term Asset Accounts Investing activities affect long-term asset accounts, such as property, plant, and equipment, and intangible assets. Short-term investments (other than those classified as cash equivalents) are also reported as investing activities. To determine the investing activities, the balance sheet and additional information provided in Illustration 13-5 must be examined. Helpful hint Investing and financing activities are measured and reported in the same way under the direct and indirect methods. The change in each noncurrent account (and short-term investments and notes payable) is analyzed to determine what effect, if any, the change had on cash. Computer Services has three long-term asset accounts that must be http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_6.xform?course=crs1562&id=ref (10 of 15)28/04/2008 8:36:56 AM

Indirect Method

analyzed: Land, Buildings, and Equipment. Increase in Land. Land increased by $110,000 during the year, as reported in Computer Services' balance sheet. The additional information states that this land was purchased by issuing long-term bonds. Issuing bonds for land has no effect on cash, but it is a significant noncash investing activity that must be disclosed in a note to the statement. Increase in Building. The Building account increased by $120,000 during the year. What caused this increase? No additional information has been provided regarding this change. Whenever unexplained differences in noncurrent accounts occur, we assume the transaction was for cash. That is, we would assume in this case that a building was acquired, or expanded, for $120,000 cash. Increase in Accumulated Amortization—Building. Accumulated Amortization increased by $6,000 during the year. As explained in the additional information, this increase resulted from the amortization expense reported on the statement of earnings for the building:

Amortization expense is a noncash charge and was added back to net earnings in the operating activities section of the cash flow statement to cancel this charge. No further adjustment or reporting is necessary for amortization related to the building. Increase in Equipment. Computer Services' Equipment account increased by $17,000. The additional information explains that this was a net increase resulting from two different transactions: (1) a purchase of equipment for $25,000 cash, and (2) a sale of equipment that cost $8,000 for $4,000 cash. The T account that follows shows the reasons for the change in this account during the year:

The following entries show the details of the equipment transactions:

Each transaction should be reported separately on the cash flow statement. When a net change in a noncurrent balance sheet account has occurred during the year, the individual items that cause the net change should be reported separately. Note that this is different from our practice with working capital (current asset and current http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_6.xform?course=crs1562&id=ref (11 of 15)28/04/2008 8:36:56 AM

Indirect Method

liability) accounts, where we report only the net change. In this particular case, the purchase of equipment should be reported as a $25,000 out-flow of cash. The sale of equipment should be reported as a $4,000 inflow of cash. Note that it is the cash proceeds that are reported on the cash flow statement, not the cost of the equipment sold. Increase in Accumulated Amortization—Equipment. The accumulated amortization for equipment increased by $2,000. This change does not represent the overall amortization expense for the year. The additional information in Illustration 13-5 helps us determine the details of this change.

This account was decreased (debited $1,000) as a result of the sale of equipment, as described earlier. The account was also increased by $3,000 of amortization expense for the current period. As we have seen, there are two accounts affected by the sale of the equipment on Computer Services' statement of earnings (Amortization Expense and Loss on Sale of Equipment) and two accounts on the balance sheet (Equipment and Accumulated Amortization). In the cash flow statement, it is important to combine the effects of this sale in one place—in the investing activities section. The amortization expense and loss on sale reported in the statement of earnings are shown as additions to net earnings in the operating activities section of the cash flow statement. As we learned earlier in the chapter, they are added back to net earnings not because they are sources of cash but because they are noncash charges that must be added to net earnings to cancel the deduction from operating cash flows. So, no cash impact of the sale of the equipment ends up being included in the operating activities section. Rather, the cash proceeds received from the sale of the equipment are shown in their entirety in the investing activities section. The investing activities section of Computer Services' cash flow statement follows. It reports the changes in the accounts Land, Building, and Equipment. Investing activities Purchase of building Purchase of equipment Sale of equipment Net cash used by investing activities Note x: Significant noncash investing and financing activities Issue of bonds to purchase land

$(120,000) (25,000) 4,000 $(141,000) $110,000

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_6.xform?course=crs1562&id=ref (12 of 15)28/04/2008 8:36:56 AM

Indirect Method

Step 3: Financing Activities Determine the Net Cash Provided (Used) by Financing Activities by Analyzing Changes in Short-Term Notes Payable and Long-Term Liability and Equity Accounts The third step is to analyze the changes in long-term liability and equity accounts, including changes involving short-term notes payable. Computer Services has one long-term liability account, Bonds Payable, and two shareholders' equity accounts: Common Shares and Retained Earnings. Increase in Bonds Payable. Bonds Payable increased by $110,000. As indicated earlier, land was acquired by issuing these bonds. This noncash transaction is reported as a note to the cash flow statement because it is a significant financing activity. Increase in Common Shares. Computer Services' Common Shares account increased by $20,000. Since no additional information is provided about any reacquisition of shares, we assume that this change relates solely to the issue of additional common shares for cash. This cash inflow is reported in the financing activities section of the cash flow statement. Increase in Retained Earnings. What caused the net increase of $116,000 in Retained Earnings? This increase can be explained by two factors. First, net earnings increased retained earnings by $145,000. Second, the additional information provided in Illustration 13-5 indicates that a cash dividend of $29,000 was paid. This information could also have been deduced by analyzing the T account:

As noted earlier, these two changes must be reported separately. The net earnings is therefore reported in the operating activities section of the cash flow statement (and adjusted to a cash basis). The cash dividend paid is reported as a cash outflow in the financing activities section of the statement. The financing activities section of Computer Services' cash flow statement is shown below and reports the issue of common shares and payment of a dividend: Financing activities Issue of common shares Payment of cash dividend Net cash used by financing activities Note x: Significant noncash investing and financing activities Issue of bonds to purchase land

$ 20,000 (29,000) $(9,000) $110,000

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_6.xform?course=crs1562&id=ref (13 of 15)28/04/2008 8:36:56 AM

Indirect Method

Cash Flow Statement Using the previous information, we can now combine the sections and present a complete cash flow statement for Computer Services Corporation in Illustration 13-9. The statement starts with operating activities, follows with investing activities, and continues with financing activities. It concludes with the net change in cash, reconciled to the beginning- and end-of-period cash balances. Finally, a significant noncash investing and financing activity is reported in the note to the statement.

Illustration 13-9 Cash flow statement—indirect method

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_6.xform?course=crs1562&id=ref (14 of 15)28/04/2008 8:36:56 AM

Indirect Method

Helpful Hint Note that in the investing and financing activities sections, positive numbers indicate cash inflows (receipts) and negative numbers indicate cash outflows (payments). Computer Services' cash flow statement shows the following: Operating activities provided $172,000 of cash. Investing activities used $141,000 of cash. Financing activities used $9,000 of cash. There was a significant noncash investing and financing activity for $110,000.

Step 4: Net Change in Cash Determine the Net Increase (Decrease) in Cash. Compare the Net Change in Cash with the Change in Cash Reported on the Balance Sheet to Make Sure the Amounts Agree The comparative balance sheets in Illustration 13-5 indicate that the net change in cash during the period was an increase of $22,000. The $22,000 net increase in cash reported in the cash flow statement above agrees with this change. Notice how the cash flow statement links the statement of earnings with the beginning and ending balance sheet amounts. Net earnings from the statement of earnings is the starting point in determining operating activities. The changes in the balance sheet accounts are explained in terms of their impact on cash. These changes lead to the endof-period cash balances on the balance sheet and on the cash flow statement. Note: This concludes Section 1 on the preparation of the cash flow statement using the indirect method. unless your instructor assigns Section 2, you should turn to the concluding section of the chapter, “using Cash Flows to evaluate a Company.”

Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_6.xform?course=crs1562&id=ref (15 of 15)28/04/2008 8:36:56 AM

Before You Go On #2

Before You Go On . . . Review It 1. What is the format of the operating activities section of the cash flow statement using the indirect method? 2. Where is amortization expense shown on a cash flow statement using the indirect method? 3. Where are significant noncash investing and financing activities shown in a cash flow statement? Give some examples. Do It Presented below is information for Reynolds Ltd. Use the indirect method to prepare a cash flow statement. REYNOLDS LTD. Balance Sheet December 31 Assets

2006

2005

Cash $ 54,000 $ 37,000 Accounts receivable 68,000 26,000 Inventories 54,000 10,000 Prepaid expenses 4,000 6,000 Land 45,000 70,000 Buildings 200,000 200,000 Accumulated amortization-buildings (21,000) (11,000) Equipment 193,000 68,000 Accumulated amortization-equipment (28,000) (10,000) Totals

Change Increase/ Decrease $ 17,000 42,000 44,000 2,000 25,000 0 10,000 125,000 18,000

Increase Increase Increase Decrease Decrease Increase Increase Increase

$569,000 $396,000

Liabilities and Shareholders’ Equity Accounts payable Accrued expenses payable

$ 23,000 $ 50,000 10,000 0

$ 27,000 Decrease 10,000 Increase

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_7.xform?course=crs1562&id=ref (1 of 4)14/04/2008 3:45:19 PM

Before You Go On #2

Bonds payable Common shares Retained earnings

110,000 220,000 206,000

Totals

150,000 60,000 136,000

40,000 Decrease 160,000 Increase 70,000 Increase

$569,000 $396,000

REYNOLDS LTD. Statement of Earnings Year Ended December 31, 2006 Sales revenue Cost of goods sold Operating expenses Loss on sale of equipment

$890,000 $465,000 221,000 2,000

688,000

Earnings from operations Interest expense

202,000 12,000

Earnings before income tax Income tax expense

190,000 65,000

Net earnings

$125,000

Additional information: 1. Operating expenses include an amortization expense of $33,000. 2. Equipment with a cost of $166,000 was bought for cash. Equipment with a cost of $41,000 and a net book value of $36,000 was sold for $34,000 cash. 3. Bonds of $40,000 were redeemed at their face value for cash. Action Plan Determine the net cash provided (used) by operating activities. Operating activities generally relate to revenues and expenses, which are affected by changes in noncash current assets and current liabilities in the balance sheet, and noncash items in the statement of earnings. Determine the net cash provided (used) by investing activities. Investing activities generally relate to changes in noncurrent assets. Determine the net cash provided (used) by financing activities. Financing activities generally relate to changes in noncurrent liabilities and shareholders' equity accounts.

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_7.xform?course=crs1562&id=ref (2 of 4)14/04/2008 3:45:19 PM

Before You Go On #2

Determine the net increase (decrease) in cash. Reconcile to the end-of-period cash balance reported on the balance sheet. Solution REYNOLDS LTD. Cash Flow Statement—Indirect Method Year Ended December 31, 2006 Operating activities Net earnings Adjustments to reconcile net earnings to net cash provided by operating activities: Amortization expense Loss on sale of equipment Increase in accounts receivable Increase in inventories Decrease in prepaid expenses Decrease in accounts payable Increase in accrued expenses payable Net cash provided by operating activities Investing activities Sale of land Sale of equipment Purchase of equipment Net cash used by investing activities Financing activities Redemption of bonds Issue of common shares Payment of dividends Net cash provided by financing activities

$ 125,000

$ 33,000 2,000 (42,000) (44,000) 2,000 (27,000) 10,000

(66,000) 59,000

$ 25,000 34,000 (166,000) (107,000) $ (40,000) 160,000 (55,000)a 65,000

Net increase in cash Cash, January 1

17,000 37,000

Cash, December 31

$ 54,000

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_7.xform?course=crs1562&id=ref (3 of 4)14/04/2008 3:45:19 PM

Before You Go On #2

a$136,000

+ $125,000 − $206,000 = $55,000

Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_7.xform?course=crs1562&id=ref (4 of 4)14/04/2008 3:45:19 PM

Direct Method

Section 2

Direct Method

study objective 2b Prepare a cash flow statement using the direct method. To illustrate the direct method, we will use financial information from Computer Services Corporation to prepare a cash flow statement. Illustration 13-10 presents Computer Services' current- and previous-year balance sheet, its current-year statement of earnings, and related financial information.

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_8.xform?course=crs1562&id=ref (1 of 14)14/04/2008 3:45:36 PM

Direct Method

Illustration 13-10 We will now apply the four steps to the information provided for Computer Services Corporation.

Step 1: Operating Activities Determine the Net Cash Provided (Used) by Operating Activities by Converting Net Earnings from an Accrual Basis to a Cash Basis Under the direct method, net cash provided (or used) by operating activities is calculated by adjusting each item in the statement of earnings from the accrual basis to the cash basis. To simplify and condense the operating activities section, only major classes of operating cash receipts and cash payments are reported. The difference between the cash receipts and cash payments for these major classes is the net cash provided by operating activities. These relationships are shown in Illustration 13-11.

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_8.xform?course=crs1562&id=ref (2 of 14)14/04/2008 3:45:36 PM

Direct Method

Illustration 13-11 Major classes of cash receipts and payments An efficient way to apply the direct method is to analyze the items reported in the statement of earnings in the order in which they are listed. Cash receipts and cash payments related to these revenues and expenses are then determined by adjusting for changes in the related balance sheet accounts. Most current asset and current liability accounts result from operating activities. For example, accounts receivable indicate credit sales that have been recorded as revenue but for which cash has not yet been received. Prepaid expenses, such as insurance, reflect insurance that has been paid for, but which has not yet expired and therefore has not been recorded as an expense. Similarly, income tax payable reflects income tax expense incurred by the company but not yet paid. As a result, we need to adjust revenues and expenses reported on the statement of earnings for these accruals and prepayments to determine the net cash provided by operating activities. To do this, increases in current asset accounts are deducted from revenues and added to expenses to convert accrual-based statement of earnings amounts to cash-based amounts. Conversely, decreases in current asset accounts are added to revenues and deducted from expenses. Increases in current liability accounts are added to revenues and deducted from expenses

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_8.xform?course=crs1562&id=ref (3 of 14)14/04/2008 3:45:36 PM

Direct Method

to convert accrual-based statement of earnings amounts to cash-based amounts. Conversely, decreases in current liability accounts are deducted from revenues and added to expenses. We explain the reasoning behind these adjustments for Computer Services Corporation, first for cash receipts and then for cash payments, in the following sections.

Cash Receipts Computer Services has only one source of cash receipts—customers. Cash Receipts from Customers. The statement of earnings for Computer Services reported sales revenue from customers of $507,000. How much of that was cash receipts? To answer that, it is necessary to consider the change in accounts receivable during the year. When accounts receivable decrease during the year, revenues on an accrual basis are lower than revenues on a cash basis. In other words, more cash was collected during the period than was recorded as revenue. Computer Services' accounts receivable decreased by $10,000 (from $30,000 to $20,000) during the year. This means that cash receipts were $10,000 higher than revenues. To determine the amount of cash receipts, the decrease in accounts receivable is added to sales revenue. Thus, cash receipts from customers were $517,000, calculated as in Illustration 13-12.

Illustration 13-12 Formula to calculate cash receipts from customers—direct method Alternatively, when the Accounts Receivable balance increases during the year, revenues on an accrual basis are higher than cash receipts. In other words, revenues have increased, but not all of these revenues resulted in cash receipts. Therefore, the amount of the increase in accounts receivable is deducted from sales revenues to arrive at cash receipts from customers. Cash receipts from customers can also be determined from an analysis of the Accounts Receivable account, as shown below:

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_8.xform?course=crs1562&id=ref (4 of 14)14/04/2008 3:45:36 PM

Direct Method

Cash Receipts from Interest and Dividends. Computer Services does not have cash receipts from any source other than customers. If a statement of earnings details other revenue, such as interest and/or dividend revenue, these amounts must be adjusted for any accrued amounts receivable to determine the actual cash receipts. As in Illustration 13-12, increases in accrued receivables would be deducted from accrual-based revenues. Decreases in accrued receivable accounts would be added to accrual-based revenues.

Cash Payments Computer Services has many sources of cash payments—suppliers, operating expenses, interest, and income taxes. We will analyze each of these in the next sections. Cash Payments to Suppliers. Using the perpetual inventory system, Computer Services reported a cost of goods sold of $150,000 on its statement of earnings. How much of that was cash payments to suppliers? To answer that, it is necessary to find the cost of goods purchased for the year by adjusting the cost of goods sold for changes in inventory. When inventory increases during the year, the cost of goods purchased exceeds the cost of goods sold. To determine the cost of goods purchased, the increase in inventory is added to the cost of goods sold. Any decrease in inventory would be deducted from the cost of goods sold. Computer Services' inventory increased by $5,000 so its cost of goods purchased is $155,000 ($150,000 + $5,000). After the cost of goods purchased is calculated, cash payments to suppliers can be determined. This is done by adjusting the cost of goods purchased for the change in accounts payable. When accounts payable increase during the year, purchases on an accrual basis are higher than they are on a cash basis. To determine cash payments to suppliers, an increase in accounts payable is deducted from the cost of goods purchased. On the other hand, there may be a decrease in accounts payable. That would occur if cash payments to suppliers exceeded purchases. In that case, the decrease in accounts payable is added to the cost of goods purchased. For Computer Services, cash payments to suppliers were $139,000 ($150,000 + $5,000 − $16,000), as calculated in Illustration 13-13.

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_8.xform?course=crs1562&id=ref (5 of 14)14/04/2008 3:45:36 PM

Direct Method

Illustration 13-13 Formula to calculate cash payments to suppliers—direct method Cash payments to suppliers can also be determined from an analysis of the Inventory and Accounts Payable accounts below:

Cash Payments for Operating Expenses. Operating expenses of $111,000 were reported on Computer Services' statement of earnings. To determine the cash paid for operating expenses, we need to adjust this amount for any changes in prepaid expenses and accrued liabilities. If prepaid expenses increase during the year, the cash paid for operating expenses will be higher than the operating expenses reported on the statement of earnings. To adjust operating expenses to cash payments for services, any increase in prepaid expenses must be added to operating expenses. On the other hand, if prepaid expenses decrease during the year, the decrease must be deducted from operating expenses. Operating expenses must also be adjusted for changes in accrued liability accounts (e.g., Accrued Expenses Payable). While some companies record accrued liabilities separately, others combine them with accounts payable. In a merchandising company, such as Computer Services, the Accounts Payable account is often used only for purchases of merchandise inventory on account. Accrued liability accounts are used for all other payables. At this point in time, Computer Services does not have any accrued expenses payable related to its operating expenses. If it did, any changes in the Accrued Expenses Payable account would affect operating expenses as follows. When accrued expenses payable increase during the year, operating expenses on an accrual basis are higher than they are on a cash basis. To determine cash payments for operating expenses, an increase in accrued expenses payable is deducted from operating expenses. On the other hand, a decrease in accrued expenses payable is added to operating expenses because the cash payments exceed the operating expenses. Computer Services' cash payments for operating expenses were $115,000, calculated as in Illustration 13-14.

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_8.xform?course=crs1562&id=ref (6 of 14)14/04/2008 3:45:36 PM

Direct Method

Illustration 13-14 Formula to calculate cash payments for operating expenses—direct method Cash payments for operating expenses can also be determined from an analysis of the Prepaid Expenses account, as shown below:

Noncash Charges. Noncash charges on the statement of earnings are not reported on the cash flow statement. Computer Services reports two noncash expenses: amortization expense and a loss on the sale of equipment. Computer Services' amortization expense in 2006 was $9,000. Recall that the entry to record the amortization would be as follows:

This entry has no impact on cash. Amortization expense was shown separately on Computer Services' statement of earnings. Sometimes amortization expense is included in operating expenses. If the amount for operating expenses includes amortization expense, operating expenses must be reduced by the amount of amortization to determine the cash payments for operating expenses. Other charges to expense that do not require the use of cash, such as bad debt expense, are treated in the same manner as amortization. The $3,000 loss on the sale of equipment is also a noncash charge. The loss on the sale of equipment reduces net earnings, but it does not reduce cash. Thus, the loss on the sale of equipment is not reported on the cash flow statement. If there were a gain, it would not be reported either. Cash Payments to Employees. Some companies report payments to employees separately, removing these payments from their operating expenses. To determine payments to employees, you would have to know the salary expense amount on the statement of earnings and any salaries payable on the balance sheet. Cash payments to http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_8.xform?course=crs1562&id=ref (7 of 14)14/04/2008 3:45:36 PM

Direct Method

employees would equal the salary expense plus any decrease (or less any increase) during the period in salaries payable. Some companies condense their statements of earnings in such a manner that cash payments to suppliers and employees cannot be separated from cash payments for operating expenses (i.e., they do not disclose cost of goods sold or salary expense separately). Although the disclosure will not be as informative, for reporting purposes it is acceptable to combine these sources of cash payments. Cash Payments for Income Tax. The statement of earnings for Computer Services shows an income tax expense of $47,000 and a decrease in income tax payable of $2,000. When a company incurs income tax expense but has not yet paid its taxes, it records income tax payable. A change in the Income Tax Payable account reflects the difference between income tax expense incurred and income tax actually paid during the year. The relationship among cash payments for income tax, income tax expense, and changes in income tax payable is shown in Illustration 13-15.

Illustration 13-15 Formula to calculate cash payments for income tax—direct method Computer Services' Income Tax Payable account decreased by $2,000. This means that the $47,000 of income tax expense reported on the statement of earnings was $2,000 less than the $49,000 of taxes paid during the period, as detailed in the following T account:

All of the revenues and expenses in the statement of earnings have now been adjusted to a cash basis. The operating activities section of the cash flow statement is shown in Illustration 13-16.

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_8.xform?course=crs1562&id=ref (8 of 14)14/04/2008 3:45:36 PM

Direct Method

Illustration 13-16 Net cash provided by operating activities—direct method Helpful hint Whether the direct or indirect method (Section 1) is used, net cash provided by operating activities will be the same.

Step 2: Investing Activities Determine the Net Cash Provided (Used) by Investing Activities by Analyzing Changes in Short-term Investment and Long-Term Asset Accounts Investing activities affect long-term asset accounts, such as property, plant, and equipment, and intangible assets. Short-term investments (other than those classified as cash equivalents) are also reported as investing activities. To determine the investing activities, the balance sheet and additional information provided in Illustration 13-10 must be examined. Helpful hint Investing and financing activities are measured and reported in the same way under the direct and indirect methods. The change in each noncurrent account (and short-term investments and notes payable) is analyzed to determine what effect, if any, the change had on cash. Computer Services has three long-term asset accounts that must be analyzed: Land, Buildings, and Equipment.

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_8.xform?course=crs1562&id=ref (9 of 14)14/04/2008 3:45:36 PM

Direct Method

Increase in Land. Land increased by $110,000 during the year, as reported in Computer Services' balance sheet. The additional information states that this land was purchased by issuing long-term bonds. This transaction has no effect on cash, but it is a significant noncash investing activity that must be disclosed in a note to the statement. Increase in Building. The Building account increased by $120,000 during the year. What caused this increase? No additional information has been provided regarding this change. Whenever unexplained differences in noncurrent accounts occur, we assume the transaction was for cash. That is, we would assume in this case that a building was acquired, or expanded, for $120,000 cash. Increase in Accumulated Amortization—Building. Accumulated Amortization increased by $6,000 during the year. As explained in the additional information, this increase resulted from the amortization expense reported on the statement of earnings for the building:

As explained earlier, amortization expense is a noncash charge and does not affect the cash flow statement. Increase in Equipment. Computer Services' Equipment account increased by $17,000. The additional information explains that this was a net increase resulting from two different transactions: (1) a purchase of equipment for $25,000 cash, and (2) a sale of equipment that cost $8,000 for $4,000 cash. The T account below shows the reasons for the change in this account during the year:

The following entries show the details of the equipment transactions:

Each transaction should be reported separately on the cash flow statement. When a net change in a noncurrent balance sheet account has occurred during the year, the individual items that cause the net change should be reported separately. The sale of equipment should be reported as a $4,000 inflow of cash. The purchase of equipment should be reported as a $25,000 outflow of cash. Note that it is the cash proceeds that are reported on the cash flow statement, not the cost of the equipment sold. Increase in Accumulated Amortization—Equipment. The accumulated amortization for equipment increased by $2,000. This change does not represent the overall amortization expense for the year. The T account http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_8.xform?course=crs1562&id=ref (10 of 14)14/04/2008 3:45:36 PM

Direct Method

below helps us determine the details of this change.

As previously noted, amortization has no impact on cash and does not affect the cash flow statement. The impact of the sale of the equipment was reported as indicated above. The investing activities section of Computer Services' cash flow statement is shown below and reports the changes in the accounts Land, Building, and Equipment: Investing activities Purchase of building Purchase of equipment Sale of equipment Net cash used by investing activities Note x: Significant noncash investing and financing activities Issue of bonds to purchase land

$(120,000) (25,000) 4,000 $(141,000) $110,000

Step 3: Financing Activities Determine the Net Cash Provided (Used) by Financing Activities by Analyzing Changes in Short-Term Notes Payable and Long-Term Liability and Equity Accounts The third step is to analyze the changes in long-term liability and equity accounts, including changes involving short-term notes payable. Computer Services has one long-term liability account, Bonds Payable, and two shareholders' equity accounts: Common Shares and Retained Earnings. Increase in Bonds Payable. Bonds Payable increased by $110,000. As indicated earlier, land was acquired by issuing these bonds. This noncash transaction is reported as a note to the cash flow statement because it is a significant financing activity. Increase in Common Shares. Computer Services' Common Shares account increased by $20,000. Since no additional information is provided about any reacquisition of shares, we assume that this change relates solely to the issue of additional common shares for cash. This cash inflow is reported in the financing activities section of the cash flow statement. Increase in Retained Earnings. What caused the net increase of $116,000 in Retained Earnings? This increase can be explained by two factors. First, net earnings increased retained earnings by $145,000. Second, the additional information provided in Illustration 13-10 indicates that a cash dividend of $29,000 was paid. This http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_8.xform?course=crs1562&id=ref (11 of 14)14/04/2008 3:45:36 PM

Direct Method

information could also have been deduced by analyzing the T account:

Net earnings is not reported separately in the cash flow statement under the direct method. Rather, the cash components of the items (revenues and expenses) comprising net earnings are reported in the operating activities section, as we learned earlier. The cash dividend paid is reported as a cash outflow in the financing activities section of the statement. The financing activities section of Computer Services' cash flow statement is shown below and reports the issue of common shares and payment of a dividend: Financing activities Issue of common shares Payment of cash dividend Net cash used by financing activities Note x: Significant noncash investing and financing activities Issue of bonds to purchase land

$ 20,000 (29,000) $(9,000) $110,000

Cash Flow Statement Using the previous information, we can now combine the sections and present a complete cash flow statement for Computer Services Corporation in Illustration 13-17. The statement starts with operating activities, follows with investing activities, and continues with financing activities. It concludes with the net change in cash, reconciled to the beginning- and end-of-period cash balances. Finally, a significant noncash investing and financing activity is reported in the note to the statement.

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_8.xform?course=crs1562&id=ref (12 of 14)14/04/2008 3:45:36 PM

Direct Method

Illustration 13-17 Cash flow statement—direct method Helpful hint Note that in the investing and financing activities sections, positive numbers indicate cash inflows (receipts) and negative numbers indicate cash outflows (payments). Computer Services' cash flow statement shows the following: Operating activities provided $172,000 of cash. Investing activities used $141,000 of cash. Financing activities used $9,000 of cash. There was a significant noncash investing and financing activity for $110,000.

Step 4: Net Change in Cash http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_8.xform?course=crs1562&id=ref (13 of 14)14/04/2008 3:45:36 PM

Direct Method

Determine the Net Increase (Decrease) in Cash. Compare the Net Change in Cash with the Change in Cash Reported on the Balance Sheet to Make Sure the Amounts Agree The comparative balance sheets in Illustration 13-10 indicate that the net change in cash during the period was an increase of $22,000. The $22,000 net increase in cash reported in the cash flow statement agrees with this change. Note: This concludes Section 2 on the preparation of the cash flow statement using the direct method. You should now continue with the next—and concluding—section of the chapter, “Using Cash Flows to Evaluate a Company.”

Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_8.xform?course=crs1562&id=ref (14 of 14)14/04/2008 3:45:36 PM

Before You Go On #3

Before You Go On . . . Review It 1. What is the format of the operating activities section of the cash flow statement using the direct method? 2. Where is amortization expense shown on a cash flow statement using the direct method? 3. Where are significant noncash investing and financing activities shown on a cash flow statement? Give some examples. Do It Information for Reynolds Ltd. follows. Use the direct method to prepare a cash flow statement. REYNOLDS LTD. Balance Sheet December 31

Assets

2006

2005

Cash $ 54,000 $ 37,000 Accounts receivable 68,000 26,000 Inventories 54,000 10,000 Prepaid expenses 4,000 6,000 Land 45,000 70,000 Buildings 200,000 200,000 Accumulated amortization—buildings (21,000) (11,000) Equipment 193,000 68,000 Accumulated amortization—equipment (28,000) (10,000) Totals

Change Increase/ Decrease $ 17,000 42,000 44,000 2,000 25,000 0 10,000 125,000 18,000

Increase Increase Increase Decrease Decrease Increase Increase Increase

$569,000 $396,000

Liabilities and Shareholders' Equity Accounts payable Accrued expenses payable Bonds payable

$ 23,000 $ 50,000 10,000 0 110,000 150,000

$ 27,000 Decrease 10,000 Increase 40,000 Decrease

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_9.xform?course=crs1562&id=ref (1 of 4)14/04/2008 3:45:46 PM

Before You Go On #3

Common shares Retained earnings

220,000 206,000

Totals

60,000 136,000

160,000 Increase 70,000 Increase

$569,000 $396,000

REYNOLDS LTD. Statement of Earnings Year Ended December 31, 2006 Sales revenue Cost of goods sold Operating expenses Loss on sale of equipment

$890,000 $465,000 221,000 2,000

688,000

Earnings from operations Interest expense

202,000 12,000

Earnings before income tax Income tax expense

190,000 65,000

Net earnings

$125,000

Additional information: 1. Operating expenses include an amortization expense of $33,000. 2. Equipment with a cost of $166,000 was bought for cash. Equipment with a cost of $41,000 and a net book value of $36,000 was sold for $34,000 cash. 3. Bonds of $40,000 were redeemed at their face value for cash. 4. Accounts payable pertain to merchandise suppliers. Action Plan Determine the net cash provided (used) by operating activities. Operating activities generally relate to revenues and expenses shown on the statement of earnings, which are affected by changes in noncash current assets and current liabilities shown on the balance sheet. Determine the net cash provided (used) by investing activities. Investing activities generally relate to changes in noncurrent assets. Determine the net cash provided (used) by financing activities. Financing activities generally relate to changes in noncurrent liabilities and shareholders' equity accounts.

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_9.xform?course=crs1562&id=ref (2 of 4)14/04/2008 3:45:46 PM

Before You Go On #3

Determine the net increase (decrease) in cash. Reconcile to the end-of-period cash balance reported on the balance sheet.

REYNOLDS LTD. Cash Flow Statement—Direct Method Year Ended December 31, 2006 Operating activities Cash receipts from customers Cash payments To suppliers For operating expenses For interest For income tax Net cash provided by operating activities Investing activities Sale of land Sale of equipment Purchase of equipment Net cash used by investing activities Financing activities Redemption of bonds Issue of common shares Payment of dividends

$ 848,000a $(536,000)b (176,000)c (12,000) (65,000)

(789,000) 59,000

$ 25,000 34,000 (166,000) (107,000) $ (40,000) 160,000 (55,000)d

Net cash provided by financing activities

65,000

Net increase in cash Cash, January 1

17,000 37,000

Cash, December 31

$ 54,000

Calculations: receipts from customers: $890,000 − $42,000 = $848,00 bPayments to suppliers: $465,000 + $44,000 + $27,000 = $536,000 cPayments for operating expenses: $221,000 − $33,000 − $2,000 − $10,000 = $176,000 dPayment of dividends: $136,000 + $125,000 − $206,000 = $55,000 aCash

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_9.xform?course=crs1562&id=ref (3 of 4)14/04/2008 3:45:46 PM

Before You Go On #3

Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_9.xform?course=crs1562&id=ref (4 of 4)14/04/2008 3:45:46 PM

Using Cash Flows to Evaluate a Company

Using Cash Flows to Evaluate a Company study objective 3 Use the cash flow statement to evaluate a company's liquidity and solvency. Previous chapters have presented ratios that are used to analyze a company's liquidity and solvency. Most of those ratios used accrual-based numbers from the statement of earnings and balance sheet. Analysts often have doubts about accrual-based numbers because they feel that the adjustment process allows management too much discretion. These analysts like to supplement accrual-based analysis with measures that use information from the cash flow statement. In this section, we will introduce liquidity and solvency ratios that are cash-based rather than accrualbased. That is, instead of using numbers from the statement of earnings, we will use numbers from the cash flow statement. We will use the following selected information (in U.S. thousands) for Intrawest Corporation in our analysis: 2004

2003

Cash provided (used) by operating activities $ 422,865 $ (20,879) Current liabilities 406,371 645,886 Total liabilities 1,468,441 1,804,583

Liquidity Liquidity is the ability of a company to meet its immediate obligations. In Chapter 2, you learned that one measure of liquidity is the current ratio (current assets divided by current liabilities). One disadvantage of the current ratio is that it uses year-end balances of current asset and current liability accounts. These year-end balances may not be representative of the company's position during most of the year. Another disadvantage is that current assets and current liabilities include accrual-based numbers. A ratio that partially corrects this problem is the cash current debt coverage ratio. It is calculated by dividing cash provided by operating activities by average current liabilities. We say “partially corrects this problem” because even though the numerator uses cash-based numbers, the denominator, current liabilities, does not. The cash current debt coverage ratio for Intrawest is shown in Illustration 13-18, along with comparative information given for Vail Resorts, Inc. Intrawest is North America's #1 ski resort, Vail #2. We have also provided each company's current ratio. Unfortunately, although there are industry averages for the more commonly used accrual-based measures, no averages are readily available for cash-based measures.

Illustration 13-18 Cash current debt coverage

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_10.xform?course=crs1562&id=ref (1 of 4)14/04/2008 3:45:58 PM

Using Cash Flows to Evaluate a Company

Intrawest's cash provided by operating activities is less than its average current liabilities. Intrawest's cash current debt coverage ratio of 0.8 times means that only $0.80 of cash flow from operating activities has been generated to cover each dollar of current liabilities. The higher the cash current debt coverage ratio is, the better a company's liquidity is. Intrawest's current ratio is much stronger than its cash current debt coverage ratio. However, with the amount of the difference between the two measures, it is likely that Intrawest's current assets include a large amount of accruals (e.g., from revenue billed but not yet collected, from merchandise purchased on account, prepayments, etc.). This is not a problem, however, as long as the receivables are collectable and the inventory is saleable. Intrawest's cash current debt coverage ratio is slightly lower than that of Vail Resorts, even though its current ratio is much higher. As we have learned in previous chapters, additional ratios such as receivables turnover and inventory turnover must be calculated in order to properly assess a company's liquidity.

Decision Toolkit

Decision Checkpoints

Is the company generating sufficient cash from operating activities to meet its total obligations?

Info Needed for Decision

Tools to Use for Decision

Cash provided or used by operating activities and average current liabilities

How to Evaluate Results

A high value suggests good liquidity. Since the numerator contains a cash flow measure, it provides a useful supplement to the current ratio.

Solvency Solvency is the ability of a company to survive over the long term. In Chapter 2, you learned about one cash-based measure of solvency, free cash flow. Free cash flow describes the cash remaining from operating activities after adjusting for capital expenditures and dividends. As indicated in our feature story, Intrawest generated U.S. $303.1 million of free cash flow in 2004. This compares favourably to a negative free cash flow of U.S. $68.8 million in 2003 and is a benefit of Intrawest's partnership venture in Leisura Developments. Another cash-based measure of solvency is the cash total debt coverage ratio. It is similar to the cash current debt coverage ratio except that it uses total liabilities instead of current liabilities. The cash total debt coverage ratio is calculated by dividing cash provided by operating activities by average total liabilities. This ratio indicates a company's ability to repay its liabilities from cash generated from operating activities without having to liquidate productive assets such as property, plant, and equipment. The higher the cash total debt coverage ratio is, the more solvent a company is. The cash total debt coverage ratios for Intrawest and Vail Resorts are given in Illustration 13-19. For comparative purposes, the accrual-based counterpart, the debt to total assets ratio, is also provided for each company. You will recall from Chapter 2 that the debt to total assets ratio is

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_10.xform?course=crs1562&id=ref (2 of 4)14/04/2008 3:45:58 PM

Using Cash Flows to Evaluate a Company

calculated by dividing total liabilities by total assets.

Illustration 13-19 Cash total debt coverage Both companies have similar solvency positions, although Intrawest's solvency is slightly better than that of Vail Resorts. Its cash total debt coverage ratio of 0.3 times means that it is generating $0.30 to cover each dollar of total liabilities. This ratio is significantly less than its cash current debt coverage ratio of 0.8 times, so we know that Intrawest has a considerable amount of long-term liabilities. Intrawest's cash total debt coverage ratio is better than Vail Resorts', as is its debt to total assets ratio. Recall that the higher the cash total debt coverage ratio, the better the result, while the lower the debt to total assets ratio, the better the result. Since both ratios are moving in the same direction (i.e., both are better), we can conclude that there is no significant difference between the cash and accrual measures for the two companies. It is difficult to reach a conclusion about either company's solvency position without also knowing more about each company's ability to handle its debt (e.g., its times interest earned ratio). However, although both companies appear to be low on operating cash flow, it is reasonable to expect both of them to have a high debt to total assets ratio because of the amount of total liabilities that companies like these usually have.

Decision Toolkit

Decision Checkpoints

Info Needed for Decision

Is the company generating sufficient cash from operating activities to meet its current obligations?

Cash provided or used by operating activities and average total liabilities

Tools to Use for Decision

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_10.xform?course=crs1562&id=ref (3 of 4)14/04/2008 3:45:58 PM

How to Evaluate Results

A high value suggests the company is solvent; that is, it will meet its obligations in the long term.

Using Cash Flows to Evaluate a Company

Accounting Matters! Investor Perspective Another commonly used cash-based measure is EBITDA. It is an abbreviation for “earnings before interest, tax, depreciation, and amortization.” EBITDA is frequently cited in annual reports and in the financial press as a cash-based measure of earnings. Both Intrawest and Vail Resorts reported record amounts of EBITDA in fiscal 2004. For Vail Resorts, its 2004 EBITDA was the best reported in its 42-year history. Banks and other creditors prefer EBITDA over net earnings because it eliminates the effects of many accounting and financing decisions.

Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_10.xform?course=crs1562&id=ref (4 of 4)14/04/2008 3:45:58 PM

Using the Decision Toolkit

Using the Decision Toolkit The American Skiing Company is North America's #3 ski resort operator, after Intrawest and Vail Resorts. Selected financial statement data for the company follow (in U.S. thousands): 2004

2003

Cash used by operating activities $ (1,092) $ (7,999) Current assets 31,544 31,211 Total assets 475,305 430,800 Current liabilities 202,873 176,886 Total liabilities 413,901 671,762

Instructions Calculate the following cash- and accrual-based ratios for the American Skiing Company for 2004, and compare them to those provided in the chapter for Intrawest: (a) Cash current debt coverage and current ratio (b) Cash total debt coverage and debt to total assets.

Solution (a) Cash current debt coverage and current ratio

The American Skiing Company's liquidity, as shown by the cash current debt coverage and current ratio, is weak. It has only $0.20 of current assets to cover each $1 of current liabilities. Its cash flow from operating activities is negative, which means that the company basically has no cash

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_12.xform?course=crs1562&id=ref (1 of 2)14/04/2008 3:46:14 PM

Using the Decision Toolkit

flow to cover its current liabilities. Intrawest's liquidity is significantly stronger by comparison. (b) Cash total debt coverage and debt to total assets.

The American Skiing Company's solvency, as shown by the cash total debt coverage and debt to total assets ratios, is weak, similar to its liquidity. It has $0.87 of debt for each $1 of assets. Its cash flow from operating activities is negligible and negative so that it essentially has no cash flow to cover any of its liabilities. The American Skiing Company appears to have an “avalanche of debt.” A few winters with very little snow resulted in repeated and heavy losses. American Skiing now plans to limit expansion except in the golf and convention businesses, and will focus on improving its results at existing resorts. Obviously, Intrawest's solvency is significantly stronger by comparison. As we learned in the feature story, Intrawest has worked very hard to diversify its resorts into year-round destination.

Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_12.xform?course=crs1562&id=ref (2 of 2)14/04/2008 3:46:14 PM

Summary of Study Objectives

Summary of Study Objectives 1. Describe the purpose and format of the cash flow statement. The cash flow statement provides information about the cash receipts and cash payments resulting from the operating, investing, and financing activities of a company during a specific period. In general, operating activities include the cash effects of transactions that are used in the determination of net earnings. Investing activities involve cash flows resulting from changes in investments and long-term asset items. Financing activities involve cash flows resulting from changes in short-term notes payable, long-term liabilities, and shareholders' equity items. 2a. Prepare a cash flow statement using the indirect method. The preparation of a cash flow statement involves four steps: (1) Determine the net cash provided (used) by operating activities by converting net earnings from an accrual basis to a cash basis. (2) Analyze changes in short-term investment and noncurrent asset accounts and record them either as investing activities or as significant noncash transactions. (3) Analyze changes in short-term liability, noncurrent liability, and equity accounts and record them either as financing activities or as significant noncash transactions. (4) Compare the net change in cash with the change in cash reported on the balance sheet to make sure the amounts agree. 2b. Prepare a cash flow statement using the direct method. The preparation of the cash flow statement involves four steps: (1) Determine the net cash provided (used) by operating activities by converting net earnings from an accrual basis to a cash basis. (2) Analyze changes in short-term investment and noncurrent asset accounts and record them either as investing activities or as significant noncash transactions. (3) Analyze changes in short-term liability, noncurrent liability, and equity accounts and record them either as financing activities or as significant noncash transactions. (4) Compare the net change in cash with the change in cash reported on the balance sheet to make sure the amounts agree. 3. Use the cash flow statement to evaluate a company's liquidity and solvency. Liquidity can be measured by the cash-based cash current debt coverage ratio (cash provided [used] by operating activities divided by average current liabilities) and compared to the accrual-based current ratio (current assets divided by current liabilities). Solvency can be measured by the cash-based cash total debt coverage ratio (cash provided [used] by operating activities divided by average total liabilities) and compared to the accrual-based debt to total assets ratio (total liabilities divided by total assets).

Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_13.xform?course=crs1562&id=ref14/04/2008 3:46:24 PM

Decision ToolkitA Summary

Decision Toolkit—A Summary

Decision Checkpoints

Info Needed for Decision

Is the company generating sufficient cash from operating activities to meet its current obligations?

Cash provided or used by operating activities and average current liabilities

A high value suggests good liquidity. Since the numerator contains a cash flow measure, it provides a useful supplement to the current ratio.

Is the company generating sufficient cash from operating activities to meet its total obligations?

Cash provided or used by operating activities and average total liabilities

A high value suggests the company is solvent; that is, it will meet its obligations in the long term.

Tools to Use for Decision

Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_14.xform?course=crs1562&id=ref14/04/2008 3:46:38 PM

How to Evaluate Results

Demonstration Problem

Demonstration Problem The statement of earnings for Kosinski Manufacturing Inc. contains the following condensed information:

The $24,000 loss resulted from the sale of old machinery for $270,000 cash. New machinery was purchased during the year at a cost of $750,000. Dividends paid in 2006 totalled $200,000. The following current asset and current liability balances are reported on Kosinski's comparative balance sheet at December 31: 2006

2005

Cash $672,000 $130,000 Accounts receivable 775,000 610,000 Inventories 834,000 867,000 Accounts payable 521,000 501,000

Increase (Decrease) $542,000 165,000 (33,000) 20,000

Instructions (a) Prepare the cash flow statement using the indirect method. (b) Prepare the cash flow statement using the direct method.

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_15.xform?course=crs1562&id=ref (1 of 3)14/04/2008 3:46:48 PM

Demonstration Problem

Action Plan Apply the same data to the cash flow statement under both the indirect and direct methods. Note the similarities of the two methods: Both methods report the same information in the investing and financing sections. Note the difference between the two methods: The cash flows from operating activities sections report different information (however, the amount of net cash provided by operating activities is the same for both methods).

Solution to Demonstration Problem (a)

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_15.xform?course=crs1562&id=ref (2 of 3)14/04/2008 3:46:48 PM

Demonstration Problem

(b)

Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_15.xform?course=crs1562&id=ref (3 of 3)14/04/2008 3:46:48 PM

Glossary

Glossary Cash current debt coverage A cash-based ratio used to evaluate liquidity. It is calculated by dividing cash provided (used) by operating activities by average current liabilities. Cash total debt coverage A cash-based ratio used to evaluate solvency. It is calculated by dividing cash provided (used) by operating activities by average total liabilities. Direct method A method of determining net cash provided by operating activities by adjusting each item in the statement of earnings from the accrual basis to the cash basis. Financing activities Cash flow activities from short-term notes payable and noncurrent liability and equity items. These include (a) obtaining cash by issuing debt and repaying the amounts borrowed and (b) obtaining cash from shareholders and providing them with a return on their investment. Indirect method A method of determining net cash provided by operating activities in which net earnings are adjusted for items that do not affect cash. Investing activities Cash flow activities from short-term investments and noncurrent assets. These include (a) purchasing and disposing of investments and long-lived assets and (b) lending money and collecting on those loans. Operating activities Cash flow activities from transactions which create revenues and expenses and therefore are included in the determination of net earnings.

Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.

http://edugen.wiley.com/edugen/courses/crs1562/pc/c13/content/kimmel6792c13_13_23.xform?course=crs1562&id=ref28/04/2008 8:40:07 AM