Cash Flow Statement

Question 1

cash flows from operating activities

Answer 1

cash inflows and outflows relating directly to revenues and expenses reported on the income statement

Question 2

cash flows from investing activities

Answer 2

cash inflows and outflows related to the purchase and disposal of long-lived productive assets and investments in the securities of other companies

Question 3

cash flows from financing activities

Answer 3

exchange of cash with creditors (debtholders) and owners (stockholders)

Question 4

what are the two approaches for presenting the operating activities section of the statement?

which one is more common?

do these methods give rise to different numbers?

Answer 4

the direct method and the indirect method

most companies use the indirect method

these methods are simply alternative ways to arrive at the same number

Question 5

the direct method

Answer 5

reports the components of cash inflows and outflows from operating activities:
- Cash collected from customers
* Cash payments to suppliers
* Cash payments for other expenses
* Cash payment for interest
* Cash payments for income taxes

Question 6

the indirect method

Answer 6

adjusts net income by eliminating noncash items

eg. net income + noncash expenses such as depreciation and amortization + losses - gains +/- changes in current assets and current liabiltiies = cash flows from operating activities

Question 7

what are the two steps of the indirect method

Answer 7

1. adjust net income for depreciation and amortization expense and gains and losses on sale of investing assets such as property, plant, and equipment and investment
2. adjust net income for changes in assets and liabilities related to operating activities

Question 8

the indirect method: depreciation expense

Answer 8

• Depreciation and amortization expense does not affect the cash account. (no cash flows actually occurs bcuz depreciation does not require outflow of money)
• Because depreciation and amortization expense is subtracted in computing net income but does not affect cash, we always ADD IT BACK to convert net income to cash flow from operating activities

Question 9

the indirect method: gains/loss on sales of assets

What happens when a company sells equipment (cost $100) for
a $200?

Answer 9

• If the company sold property, plant, and equipment at a gain or loss, the amount of cash received would be classified as an investing cash inflow.
• Because all of the cash received is an investing cash flow, an adjustment also must be made in the operating activities section to avoid double counting the gain or loss.
• Gains on sales of property, plant, and equipment are subtracted (counted as revenue but not technically operating cash inflow, is investing cash inflow) and losses on such sales are added to convert net income to cash flow from operating activities (loss in investing activities so should not be counted in operating)

Question 10

depreciation expense adjustment

intuition?

Answer 10

Net Income + Depreciation
Expense

depreciation is an expense so it lowers net income but no cash is actually being affected so we need to add it back to accurately portray cash flow from operating activities

Question 11

Gain on sale of long-term assets adjustment

intuition?

Answer 11

Net Income - Gain on sale of long-term assets

Total cash proceeds from sale of long-term assets are recorded in Cash Flow from Investing. We need to remove this item from Net Income to avoid double counting.

Question 12

Loss on sale of long-term assets adjustment

Intuition?

Answer 12

Net income + loss on sale of long-term assets

Total cash proceeds from sale of long-term assets are recorded in Cash Flow from Investing. We need to remove this item from Net Income to avoid double counting.

Question 13

increase in A/R adjustment

intuition?

Answer 13

Net income - A/R

intuition: we made more credit sales than what is collected from customers

Question 14

increase in inventories adjustment

intuition?

Answer 14

Net income - inventories

intuition: inventories purchased are more than inventories sold

Question 15

increase in A/P adjustment

intuition?

Answer 15

Net income + A/R

intuition: cash payments to suppliers are less than amounts purchased

Question 16

increase in prepaid expenses adjustment

intuition?

Answer 16

net income - prepaid expenses

intuition: we made more prepayments than services used (expenses)

Question 17

increase in accrued expense liabilities adjustment

intuition?

Answer 17

net income + accrued expenses

intuition: we incurred more expenses than we paid in cash

Question 18

summary for step 2 indirect method

we start from net income:
- subtract the changes when …
- add the change when …

Answer 18

We start from net income:
* subtract the changes when an operating asset increases or an
operating liability decreases
* add the change when an operating asset decreases or an
operating liability increases.

Question 19

why is cash flow from operating activities important

Answer 19

• investors will not invest in a company if they do not believe that cash generated from operations will be available to pay them dividends or expand the company
• creditors will not lend money if they do not believe that cash generated from operations will be available to pay back the loan

Question 20

Net Income has two components:
* Cash Flow from Operating Activities (Cash Component of Earnings)
* Everything else (Accrual Component of Earnings)

1. Which component is more consistent?
2. Which component is more factual (free from estimation errors and managerial biases)?
3. Which component better predicts future income?

Answer 20

The cash flow component of net income is more persistent and less prone to managerial manipulation. It is also a better predictor of future income.

Question 21

Why is the accrual component of net income less persistent?

Answer 21

• Gain/loss on disposal of asset
• Bad debt expense
• Depreciation expense

Question 22

Quality of Income Ratio =

Answer 22

Quality of Income Ratio = Cash Flow from Operating Activities / Net Income

Question 23

Which component of net income is easier to manipulate?

Answer 23

Accrual component of net income can be used as a sign of
earnings management.
* Why?
* Unethical managers sometimes attempt to reach earnings targets by
manipulating accruals and deferrals of revenues and expenses to
inflate income. Because these adjusting entries do not affect the cash
account, they have no effect on the cash flow statement.
* A growing difference between net income and cash flow from
operations can be a sign of such manipulations

Question 24

What does quality of income ratio measure? What does a higher ratio indicate?

Answer 24

In general, this ratio measures the portion of income that was generated
in cash.
* All other things equal, a higher quality of income ratio indicates greater ability to finance operating and other cash needs from operating cash inflows.
* A higher ratio also indicates that it is less likely the company is using aggressive revenue recognition policies to increase net income.

Quality of Income Ratio = Cash Flow from Operating Activities / Net Income

Question 25

Accounts related to cash flows from investing activities

Answer 25

• Property, plant, and equipment
• Intangible assets
• Investments in the securities of other companies

Question 26

investing activity: Purchase of property, plant, and equipment or intangible asset for cash

related balance sheet accounts:
cash flow effect:

Answer 26

related balance sheet accounts: Property, plant, and
equipment and intangible
assets (patents, etc.)

cash flow effect: outflow

Question 27

investing activity: sale of property, plant, and equipment or intangible asset for cash

related balance sheet accounts:
cash flow effect:

Answer 27

related balance sheet accounts: Property, plant, and
equipment and intangible
assets (patents, etc.)

cash flow effect: inflow

Question 28

investing activity: Purchase of investment securities for cash

related balance sheet accounts:
cash flow effect:

Answer 28

related balance sheet accounts: Short- or long-term
investments ( stocks and
bonds of other companies)

cash flow effect: Outflow

Question 29

investing activity: sale (maturity) of investment securities for cash

related balance sheet accounts:
cash flow effect:

Answer 29

related balance sheet accounts: Short- or long-term
investments ( stocks and
bonds of other companies)

cash flow effect: inflow

Question 30

what type of purchases are included in cash flows from investing activities?

does it matter if the assets were sold at a gain or a loss?

Answer 30

Only purchases paid for with cash or cash equivalents are
included.

• The amount of cash that is received from the sale of assets is included, regardless of whether the assets are sold at a gain or a loss.

We must report
individually the cash used
to purchase equipment
and the cash proceeds
received from the sale of
equipment.

Question 31

what are cash flows from financing activities associated with?

Answer 31

Financing activities are associated with generating capital from creditors and owners

Question 32

Accounts related to cash flows from financing activities:

Answer 32

• Short-term debt
• Long-term debt
• Changes in stockholders’ equity account
• Common stock and additional paid in capital: issuance of stock
• Payment of cash dividends: retained earnings
• Treasury stock: repurchase of stock with cash

Question 33

classification of interest on the cash flow statement

Answer 33

US GAAP: interest expense and interest
revenue are reported on the income
statement, the related cash flow is shown in
the operating section. This approach makes net
income more comparable to cash from
operating activities.