FA2 Module 3. Cash Flow Statement

Module 3. Statement of Cash Flow
Definition and objectives
Classification of elements
Direct and indirect methods
Gains and losses
The T-account method
Accounts receivable
1. SCF: Definition and objectives
The Statement of Cash Flow (formerly
Statement of Changes in Financial Position)
shows the changes in Cash and Cash
Equivalents arising from the operating,
financing and investing activities of the
enterprise. This information is useful for:
1. understanding effects of operating,
financing and investing activities on cash;
2. assessing liquidity and solvency; and
3. assessing the firm=s ability to generate cash
from internal sources.
Cash and cash equivalents
Cash and cash equivalents include cash, plus
temporary investments that are highly liquid
(e. g., maturities of three months or less, like
treasury bills).
Investments in equities are excluded (no
maturity date).
Bank overdraft can be considered “negative”
cash equivalent if bank balance fluctuates
regularly between positive and negative.
2. Classification of elements
a. Operating activities
Definition Cash flows related to central
revenue-generating activities
Cash collected from customers
Outflow Cash paid to suppliers, salaries, etc.,
examples paid
2. Classification of elements
b. Investing activities
Definition Cash flows related to acquisition
or disposal of long-term assets and
non-cash investments
Cash from sale of non-cashExamples equivalent investments and longterm assets
Outflow Cash paid for non-cash-equivalent
examples investments, fixed assets
2. Classification of elements
c. Financing activities
Cash flows related to debt and
shareholders’ equity
Cash from issue of debt and shares
Redemption of shares, repayment of
2. Classification of elements - Choices
Interest paid
Dividends paid
Income taxes
Operating or Financing
Operating or Financing
Operating or Investing
Operating or Investing
Operating, but should be in
investing or financing if clearly
associated with investing or
financing transaction
Format of the SCF
Operating activities
Net cash flows from operations
Investing activities
Acquisitions of non-current assets
Dispositions of non-current assets
Net cash from (used by) investing activities
Financing activities
Issues of shares/debt
Redemption of shares/debt repayment
Net cash from (used by) financing activities
Net change in cash and cash equivalents
3. SCF: Direct and indirect methods
There are two methods of presentation of the
SCF: the direct and indirect methods. The
only difference is in the presentation of cash
from operating activities.
Direct method (preferred by IFRS)
Cash inflows from operations
Cash outflows related to operations
Net cash from operations
Indirect method
Net income
+/- diff. between accrual and cash acctg $
Net cash from operations
Direct method
Cash flows from operations are identified and
grouped by type (e. g., cash collected from
customers, cash paid to suppliers)
= Sales revenue (income stmt)
+decrease/-increase in AR
customers +inc./-dec. in customer advances
Cash paid = Expense item (income stmt)
for an
+inc./-dec. in associated asset
expense +dec./-inc. in associated liability
Example: A5-13
Indirect method
1. Starting point is net income.
2. Eliminate revenues and expenses that do
not provide or use cash (e. g.,
3. The resulting figure is adjusted for
changes in balance sheet accounts that are
associated with operating activities (e. g.,
accounts receivable, inventory, accounts
payable, etc.):
Indirect method (two-step presentation)
Net income
- Non-cash revenues
+ Non-cash expenses
Changes in non-cash working capital
- increases in associated assets
+decreases in associated assets
+ increases in associated liabilities
- decreases in associated liabilities
Net cash from operations
Example: A5-13
4. Gains and losses
Gains and losses arise from incidental and/or
peripheral transactions that tend to be
investing (e. g., sale of fixed asset) or
financing (e. g., retirement of debt) activities.
The gain or loss is generally the difference
between any net cash flow related to the
transaction and the book value of the asset or
liability in question. The cash flow should be
in the statement of cash flow; the gain or loss
should not.
Gains, losses and the cash flow statement
Direct method
Gains and losses are generally not included in
operating activities; the related cash flow is
presented in the appropriate SCF section.
Indirect method
Gains are deducted from, and losses added
back to, net income in the operating activities
section. The related cash flow is presented in
the appropriate SCF section.
Gain example: Hogan Ltd
Sales for the year were $70. Operating expenses
for the year were $40. Aside from depreciation
($5), there were no non-cash sales or expenses.
During the year, Hogan sold a piece of equipment
(cost = $22; accumulated depreciation = $7) for
$25. There were no other investing or financing
activities during the year. The tax rate is 20%
and all taxes were paid during the year.
Required: Prepare the income statement.
Prepare the cash flow statement using (1) the
direct method; and (2) the indirect method.
5. The T-account method
The T-account method is a quick, informal
way to organize information to prepare a cash
flow statement. It works best for indirect
method SCF. The steps are:
1. Prepare t-accounts for each balance sheet
account with the beginning and ending
balance. There are 3 cash and cashequivalent accounts, one for each of the
cash flow statement sections.
5. The T-account method
2. Go through the income statement and
additional information and “post” the
implied transactions to the t-accounts.
Non-cash income statement items are
posted to Cash from operating activities.
3. Go through each of the balance sheet
accounts and identify any unexplained
variations. Using the most obvious
explanation, assume and “post” the
5. The T-account method
4. Using the numbers in the three cash
accounts, assemble the cash flow
Often-used shortcut: Do not bother with taccounts for the working capital accounts –
usually, only the changes in these accounts
matter. The non-working capital accounts are
frequently affected by more than one cash
Example: A5-22
6. Accounts receivable
The usual cash flow statement treatment
accorded accounts receivable and cash
collections from customers is to add (subtract)
the decrease (increase) in accounts receivable.
The situation is usually more complicated
than that because:
– Bad debt expense is a non-cash expense
– Some accounts receivable are never collected
Accounts receivable transactions
Dr. Accounts receivable
Cr. Revenue
Dr. Cash
Cr. Accounts receivable
Dr. Bad debt expense
Est. bad debts
Cr. Allowance for doubtful accounts
Dr. Allowance for doubtful accounts write-offs
Cr. Accounts receivable
Gross accounts receivable method
Accounts receivable
Beginning balance
(Credit) Sales
Ending balance
Collections = Sales – write-offs
+ decrease in AR – increase in AR
SCF example: Gould Inc.
2011 2010
Accounts receivable
$70 $60
Allowance for doubtful accountants
Accounts receivable (net)
Bad debt expense
Other expenses (all paid in cash)
Net income
In 2011, $9 in accounts receivable were written off as
Prepare the operating activities section of the SCF.
Net accounts receivable method
Net accounts receivable (AR + AFDA)
Beg. Bal. (AR-AFDA) Bad debt expense
(Credit) Sales
Ending balance
Collections = Sales – bad debt expense
+ decrease in net AR – increase in net AR
Net cash from operating activities
(Credit sales, cash expenses except bad debt)
Direct method
Collections (sales
– write-offs +/chg in gross AR)
- Expenses paid
Indirect method
Net income
+ Bad debt expense
- Write-offs
+/- chg in gross AR
Collections (sales Net income
– bad debt expense +/- chg in net AR
– chg in net AR)
- Expenses paid