Lecture 04 The Cash Flow Statement

Question 1

What is the cash flow statement?

Answer 1

• The cash flow statement (or statement of cash flows) is a detailed explanation of the change between the entity’s beginning and ending cash balance (i.e., the sources and uses of cash).
• As we will see, the cash flow statement actually explains the change from beginning to ending balance sheet ‘through the lens of the cash account.’

(Technical note: unlike the income statement, the cash flow statement does not involve any special temporary accounts; we therefore cannot simply download cash flows from the ledger as we can download revenues, cost of sales, etc.)

Question 2

What does the ‘cash and cash equivalents’ account contain?

Answer 2

cash: currency on hand, demand deposits with financial institutions, and other kinds of accounts with the characteristics of demand deposits.

cash equivalents: highly liquid, short-term investments that are readily convertible to known amounts of cash and so near maturity that they present insignificant risk of changes in value due to changes in interest rates. (Examples: treasury bills, commercial paper, certificates of deposit, and other instruments with maturity of no more than 3 months at the time of purchase and minimal credit risk.)

Cash in all other cards refers to ‘cash and cash equivalents’

Question 3

What are the two reasons cash flow information is useful and convenient?

Answer 3

1. Liquidity
2. Verifiability

Question 4

What is meant by liquidity when talking about the usefulness of cash flow information?

Answer 4

The ability to meet ongoing payment obligations is critical to avoiding potentially costly business disruptions. Accrual accounting is less suitable than cash flow data for predicting future liquidity.

Question 5

What is meant by verifiability when talking about the usefulness of cash flow information?

Answer 5

Accrual accounting requires more estimates and judgment than cash-basis accounting. Cash is easier to audit and harder to manipulate than accrual balances.

Question 6

When and why might cash flow information not be useful?

Answer 6

1. Cash inflows and outflows are not matched by transaction or event. Hence, net cash flow is not a useful number to assess an entity’s profitability and thus its expected future cash flows.
2. Cash flows are often lumpy and thus have a higher variance than the underlying economic resource flows captured by accrual accounting. Predictions based on cash flow data tend to have a higher estimation error than predictions based on accrual accounting data.

Question 7

What is the structure of a cash flow statement?

Answer 7

It consists of three sections:
1. Cash Flow from Operating Activities
2. Cash Flow from Investing Activities
3. Cash Flow from Financing Activities

Question 8

What constitutes cash flow from operating activities?

Answer 8

Cash paid and received as part of the entity’s business operations (purchasing and selling merchandise, producing goods, marketing products, administrating operations etc.)

Question 9

What constitutes cash flow from investing activities?

Answer 9

Cash paid and received in the acquisition and disposal of capital assets and investments, including any gains and losses. Investing activities relate to using capital to purchase (usually long-term) assets (the left-hand side of the balance sheet).

Question 10

What constitutes cash flow from financing activities?

Answer 10

Cash paid and received in the issuance and redemption of common stock, bonds, loans, and other financing instruments. Financing activities relate to raising and returning capital (the right-hand side of the balance sheet).

Question 11

What are additional items that can be found on a cash flow statement?

Answer 11

• Interest paid is (illogically) classified as an operating cash flow under US GAAP. Under IFRS, interest paid can be operating or financing.
• Dividends paid are financing cash flows under US GAAP. Under IFRS, they may be classified as either operating or financing cash flows.
• Interest and dividends received are operating cash flows under US GAAP. IFRS permits their classification as either operating or investing.
• Entities must disclose material non-cash investing and financing transactions and the amount of cash paid for interest and taxes.

Question 12

What is the form of the accounting equation useful for constructing the cash flow statement?

Answer 12

ΔCash = ΔLiabilities + ΔEquity - ΔNon-Cash Assets

Question 13

What is the direct method for calculating cash flows?

Answer 13

In the direct method for cash flows we collect all cash inflows and outflows line item by line item and add them up.

For investing and financing cash flows, the direct method is the only method used.

Question 14

What is the indirect method for calculating cash flows?

Answer 14

Instead of adding up cash receipts and payments, start with net income, reverse out all non-cash income items (e.g., depreciation), and add all non-income cash flows to arrive at cash flow from operations.

Question 15

What is the cookbook recipe for calculating operating cash flow by the indirect method?

Answer 15

Net income
+ Depreciation and amortization (and other non-cash expenses)
- Changes in operating asset accounts
+ Changes in operating liability accounts
+ Losses that do not pertain to operating activities (e.g., losses from disposal of property, plant and equipment)
- Gains that do not pertain to operating activities (e.g., gains on disposal of property, plant and equipment)
= Cash flow from operating activities