The
statement of cash flows is one of the four main statements required in the
preparation of a company's financial statements.
Instructions
(a)
Explain what the purpose is of the statement of cash flows, and identify at
least three reasons users might find it helpful.
(b)
What is the definition of cash? What can be included in cash equivalents? How
are bank overdrafts treated? State any differences between IFRS and ASPE.
(c)
Identify and describe the three categories of activities that must be reported in
the statement of cash flows. What is the relationship between these activities
and a company's statement of financial position?
(d)
Identify two methods of reporting cash flows from operations. Are both
permitted under GAAP? Explain. Which method do you prefer? Why?
(e)
Provide two examples of a non-cash investing and financing transaction, and
describe the financial reporting requirements for such transactions.
(f)
Assume that you overhear the following comment by an investor in the stock
market: "You can't always trust the net income number reported, because of
all the estimates and judgement that go into its determination. That's why I
only look at the cash flow from operations in analyzing a company."
Comment.
(a) The primary purpose of
the Statement of Cash Flows is to provide information concerning the cash
receipts and cash payments of a company during the period. The information
contained in the statement, together with related disclosures in other
financial statements, may help investors and creditors
1. Assess the company’s ability to generate
future net cash inflows.
2. Assess the company’s ability to meet its
obligations; e.g., pay dividends and meet needs for external financing.
- Analyze the differences between net
income and the associated cash receipts and payments.
(b) Cash is defined as cash
on hand and demand deposits. Cash
equivalents includes highly liquid investments with maturity dates of 3 months
or less from their date of purchase, and that have insignificant risk of change
in value. These definitions are the same
for IFRS and ASPE. Examples of these types of investments would
be treasury bills and commercial paper and money market funds. ASPE does not
allow any equity investment to be included in cash equivalents. IFRS
allows one type and that is a mandatory redeemable preferred share that will be
redeemed within 3 months of acquisition date.
Bank overdrafts may only be included in cash and cash equivalents if
they are an integral part of the company’s cash management policies and the
overdraft fluctuates between negative and positive balances throughout the
year. If the bank overdraft has been in
an overdraft position for the entire year, it will not be allowed to be
included in cash and cash equivalents.
This treatment is also the same under IFRS
and ASPE.
(c) The statement of cash flows classifies cash flows as those resulting
from operating activities, investing activities, and financing activities.
Cash inflows from operating activities include
receipts from the sale of goods and services, and interest and dividends that
appear on the income statement. Under IFRS , the organization may choose to report
interest and dividends received as either operating or investing
activities. Also included are all other
receipts (for example from rents and royalties) that do not arise from
transactions defined as financing and investing activities. Cash outflows from operating activities
include payments to buy goods for manufacture, resale payments to or on behalf
of employees for services, tax payments, and all other payments that do not
arise from transactions defined as financing and investing activities. Cash
inflows and outflows related to the sale and purchases of loans and equity
securities that are purchased for trading purposes are also included in
operating activities. Payments to creditors for interest can be included as a
financing or operating activity under IFRS . Under ASPE, the interest paid will be an
operating activity if the debt is classified as a liability and a financing
activity if the debt is classified as equity.
Under IFRS , dividends paid
may be classified as an operating activity or a financing activity. Under ASPE dividends paid are financing
activities.
Cash inflows from investing activities
include receipts from collections or sales of debt instruments of other
companies that are reported at amortized cost, and receipts from the sales of
various property, plant, and equipment.
Cash outflows for investing activities include payments for shares of
other companies, purchases of productive property, plant and equipment, and
debt instruments of other companies. Sales and purchases of debt instruments or
shares of other companies not purchased for trading purposes are included in
investing activities. Also under IFRS ,
investing activities could include dividends and interest received on these
investments, if this choice is made.
Cash
inflows from financing activities include proceeds from the company issuing its
own shares or its own debt. Cash
outflows for financing activities include payments to shareholders for
dividends (unless these dividends were reported as expenses on the income
statement, in which case they would be reported in operating activities) or
payments to debt holders for retirement of its own shares and bonds. Interest paid may also be classified as a
financing activity under IFRS .
Additionally, under IFRS , the
company may report dividends paid as an operating activity. Under ASPE, only if
the debt is classified as equity, can the interest paid be reported under
financing activities.
Cash
flow activities directly relate to the balance sheet in that the changes in the
balance sheet accounts ultimately translate into the change in cash over the
business cycle of an entity.
(d) Cash flows from operations may be presented using the direct method
or the indirect method. Under the direct method, the major classes of operating
cash receipts and cash payments are shown separately. The indirect method
involves adjusting net income to net cash flow from operating activities by
removing the effects of deferrals of past cash receipts and payments, accruals
of future cash receipts and payments, and non-cash items from net income. Both are permitted under IFRS and ASPE, although both standards strongly
encourage the use of the direct method.
In addition, new standards being proposed under IFRS
would allow only the direct method to be used.
The information
obtained from the indirect format can be easily linked back to the statement of
financial position and the income statement and therefore is useful from this
standpoint. On the other hand, the direct format allows for better information
on gross cash flows from customers and to suppliers and employees which enables
better forecasting of future cash flows.
(e) All
significant non-cash investing and financing transactions are not reported on
the statement but are required to be disclosed elsewhere on the financial
statements. Examples of common non-cash transactions are the conversion of debt
to equity and the acquiring of assets by assuming directly related liabilities
or issuing equity. For transactions that are part cash and part non-cash, only the cash
portion should be reported in the Statement of Cash Flows.
(f) From the perspective of an investor, while it
is true that it is difficult to assess the impact of estimates and judgement
used in the preparation of the income statement, using the cash flow from
operations of the statement of cash flow alone is not recommended when making
investment decisions. A great deal of insight into the nature of the
transactions reported on all financial statements can be derived from reading
the notes to the financial statements.
As well, financial statements must be viewed together in order to
properly assess performance, financial position, and ability to generate income
and cash into the future in order to ensure a return on investment to the
shareholder. While cash flow from
operating activities is a strong indicator and a very good tool, it should not
be used in isolation.
Readers should also be aware that accounting
policies can affect the cash flows from operations. Consider one company that
defers much “capital-type” expenditure versus another company that expenses
many similar ones. One company ends up reporting the cash outflow as an
investing flow whereas the other reports lower operating cash flows. This
reinforces the fact that cash flow from operations can be influenced by
accounting policy choice. Another example
is the treatment of leases. Operating leases are reflected as an operating
outflow, but payments on capital leases are shown partially as an operating
outflow (the interest portion) and partially as a financing outflow (the
principal portion of the payment). Securitization of receivables is another
example. When receivables are securitized, the cash inflows are reported as
operating activities and will result in an increase in operating cash
flows. This is, of course, not
sustainable cash flow since the sale of receivables has only resulted from
hastening the collection of the receivables and cannot recur annually.
