CASH FLOW STATEMENT INTRODUCTION The cash flow statement is the fourth financial statement that businesses prepare.

The objective of the cash flow statement is to identify the change in cash during the year, including both the ending cash position of the firm and the sources and uses of cash in the business over the last year. The format and content of the cash flow statement have evolved over time, as a result of an increased emphasis on the cash position of a business. Net income, measured using accrual accounting, is considered to be the best indicator of current and future earnings of the business. Both creditors and investors want to invest in businesses that will be profitable, as a business that is not profitable over the long term will not be able to pay interest and principal to its creditors, nor will it be able to pay dividends to investors. The share price of a business that continually incurs losses will plummet, not increase. It is possible, however, that a profitable business will be unable to meet its obligations as they fall due as a result of inadequate cash on hand. A growing company may be acquiring more capital assets and inventory, and accounts receivable may be growing in proportion to the growth in sales, leaving the firm with very little cash on hand. Accordingly, presenting an income statement alone does not provide users of the financial statements with adequate information to assess the future prospects of the business. While a quick glance at the balance sheet can inform the users of the change in cash from the beginning to the end of the year, and the amount of cash on hand at year end, it is much more difficult to assess why the available cash on hand has changed. The cash flow statement provides this information. FORMAT OF THE CASH FLOW STATEMENT The cash flow statement reports cash flows under three categories: operating activities, investing activities, and financing activities. All sources and uses of cash must fall under one of these three categories. Operating activities Operating activities are the income generating activities of the business and are reported on the income statement. The operating activities section of the cash flow statement report the cash provided or used by the business when generating revenue and incurring expenses. Another way of looking at the operating activities section of the cash flow statement is as the income statement on a cash basis instead of an accrual basis. The operating activities should be the primary source of cash for a business over the long term, although in periods of growth operating activities may actually use funds. Use of the accrual basis for preparation of the income statement means that there are revenues and expenses recorded in period, even though the cash will be received or paid in a different period. To convert accrual income to cash basis income, it is

necessary to adjust for changes in accounts receivable, unearned revenue, accounts payable, inventory, prepaid expenses and other payables that affect the calculation of net income, such as salaries payable, income tax payable, interest payable, and employee deductions payable. The change in dividends payable is not included in the operating activities section of the cash flow statement, as dividends do not appear on the income statement. Other adjustments required to accrual net income are for non-cash revenue and expense items. The income statement includes amortization expense for the amortization of capital and intangible assets. Amortization expense is always a noncash item, as amortization is the matching of the cost of an asset to the revenues generated in the periods in which the asset is used. Recall that amortization of an asset is recorded as a debit to amortization expense and a credit to accumulated amortization, there is never an entry to cash. The cash outflow occurs when the asset is acquired or when the loan taken out to acquire the asset is paid. Other non-cash items are gains and losses reported on the income statement as part of non-operating items. These can occur when capital or intangible assets are sold, when investments are sold, or when bonds payable are reacquired by the corporation. In each of these situations, the cash is compared to the book value of the item being removed from the balance sheet and the difference is reported on the income statement as a gain or loss. A gain or loss is therefore not a cash item, but the difference between cash and book value. In addition, the proceeds from the sale of a capital or intangible asset or an investment are properly recorded as an investing activity on the cash flow statement. Cash used to reacquire bonds payable should be classified as a financing activity on the cash flow statement. When preparing the operating activities section of the cash flow statement, the income statement must be examined for non-cash revenues and expenses, and the current assets and liabilities section of the balance sheet should be examined. The changes in all current asset and liability accounts affecting the calculation of income should be recorded in the operating activities section. The change in the cash balances is not listed, as the cash flow statement reports the details of the change in the year. The operating activities section of the cash flow statement can usually be prepared by examining the balance sheet and income statement; supplementary information is usually not necessary. There are two different ways in which the information about operating activities can be presented. One is the indirect method, the other is the direct method. At the introductory accounting level, the direct method is presented only so that students will be familiar with the presentation when examining financial statements later in their lives and careers. When examining how to prepare a cash flow statement, the indirect method will be used. The details of these two methods will be reviewed later in this material. Regardless of whether the direct or indirect method is used, the operating activities section of the cash flow statement is always presented first. Either the investing activities section or the financing activities section may be presented as the second section of the cash flow statement.

Investing activities There are really two types of investments that a business makes. The first is the investment in productive assets that are used in the business to generate profits. Acquisition of land, building, equipment, furniture, fixtures, vehicles, patents, franchises, licences, and goodwill can all be considered productive assets. If the business does not have sufficient investment in these types of assets, the ability of the firm to operate in the short term and long term may be significantly impaired. The second type of investment is the investment of surplus funds of the business in shares and bonds of other corporations. The objective of this type of investment is to generate a higher return on the surplus cash than would be obtained by allowing the cash to remain in the operating bank accounts of the business. The distinction between these two types of investments is not important for the preparation of the cash flow statement, as they are reported in the same way. The distinction is very important, however, when interpreting the information presented in the cash flow statement. If a business obtains cash by selling its investment in shares and bonds of other companies, the ability of the business to continue to operate profitably in the future is not impaired. If the business obtains cash by selling its productive assets, the situation is different. In most situations, selling productive assets will result in fewer assets used to generate income and therefore lower net income in the future. Occasionally, a firm will discontinue operations or downsize and no longer need all of its assets for future operations. In this situation, future operations are not jeopardized. A point worth noting, however, is that investing activities cannot be looked upon as an ongoing source of funds. At some point the sale of investments will have a detrimental effect on the operations of the firm. When preparing the investing activities section of the cash flow statement, the long term assets section is evaluated. Supplementary information is normally required here, as it is common for a business to both buy and sell assets in the same period. The difference between the asset balances at the beginning and end of the year may be due to several different transactions. When preparing the cash flow statement, GAAP requires that cash used to acquire assets be shown separately from proceeds on the sale of assets, and it is necessary to separate tangible capital assets from intangibles and investments in shares/bonds. If a business borrows money to acquire an asset, there is no effect on cash flow and both the investment in assets and the debt incurred are excluded from the cash flow statement. Financing activities Financing activities can be broken down into transactions affecting three types of accounts: incurring or repaying long term debt; issuing or reacquiring shares; and payment of dividends. Dividends are the distribution of profits to the shareholders, or the return on their investment in the shares of the company. Accordingly, cash dividends paid are classified as a financing activity. Interest provides the return to creditors for their investment in the form of a loan to the business. However, interest is deducted as an expense in calculating net income, and is therefore classified as an

operating expense. Recently, some firms have begun classifying interest as a financing activity instead of an operating activity, but this is beyond the scope of introductory accounting. The financing activities section of the cash flow statement is normally prepared by examining the long term debt section of the balance sheet (and the current portion of long term debt in current liabilities, if any), the share capital section of the balance sheet, and the statement of retained earnings (for dividends declared) and the current portion of the balance sheet (for changes in dividends payable). As with investing activities, several transactions may affect one account, such as long term loans payable, within one year. As a result, supplementary information is usually necessary in order to properly prepare the cash flow statement. It is necessary to show both the cash provided by the issuance of long term debt, and the cash used to repay the principal portion of long term debt. Proof After the sources and uses of cash are reported as operating, investing and financing activities, the net increase or decrease in cash during the year is reported. The next step is normally a proof to show that this increase/decrease reflects the actual change in cash during the year. The difference between ending and beginning cash is calculated, and should agree to the net increase/decrease reported on the cash flow statement. CASH AND CASH EQUIVALENTS When trying to determine the increase or decrease in cash during the year, it is necessary to determine the accounts that comprise cash. The current assets Acash@ is always included, but two other accounts may be included as well. If a business has short term deposits such as treasury bills that may be cashed at any time, these short term deposits may be classified as cash. (If not classified as cash, any change in this account would be classified as an investing activity). Secondly, if the business has a demand loan, the demand loan is treated as a reduction in cash on hand. If the demand loan exceeds the cash and short term deposits, the surplus is treated as an overdraft or negative cash position. INDIRECT METHOD When using the indirect method, cash provided or used by operating activities is calculated indirectly, by starting with net income on an accrual basis from the income statement and adjusting to income on a cash basis, hence the name Indirect Method. The format varies in practice from business to business, but the following format will be used as the template for this course. Company Name Cash Flow Statement for the year ended ????

CASH PROVIDED (USED) BY: OPERATING ACTIVITIES Net income (loss) Adjust for non-cash items on income statement Amortization expense Gain on sale of equipment

Adjust for changes in non-cash working capital balances Accounts receivable Inventory Prepaid expenses Accounts payable Unearned revenue Interest payable Income tax payable Cash provided (used ) by operating activities INVESTING ACTIVITIES Proceeds from the sale of investments Purchase of capital assets Cash provided (used) by investing activities FINANCING ACTIVITIES Proceeds from the issuance of shares Reacquisition of long term debt ( Dividends paid Cash provided (used) by financing activities Increase (decrease) in cash and equivalents

) ( $

Proof: Cash and equivalents, end of year $ Cash and equivalents, beginning of year Increase (decrease) in cash and equivalents $ Several things are worth noting at this point. 1) Net income is a source of cash; if a loss is incurred on the income statement it is treated as a use of cash. 2) Whether the changes in current assets and liabilities should be added or deducted from net income depends on whether an increase or a decrease has occurred in each specific account. These adjustments will be examined in detail through the use of an example. 3) Gains recorded on the income statement have increased net income (remember a gain is recorded as a credit entry). To remove a gain from the calculation of net income, it must be deducted. Similarly, losses decrease net income and must be added back to net income to remove the non-cash item from the income statement. 4) Amortization expense is a non-cash item that has been deducted in calculating net income. Amortization expense must be added back. Please remember that you are starting with net income. To identify the correct adjustment you must determine whether the amount increased or decreased net income on the income statement, and

then reverse it. If it increased net income, it must be deducted. If it decreased net income, it must be added back. 5) In the investing activities section, purchase of an asset is a use of cash and should be in parentheses. 6) Sale of an asset is a source of cash equal to the proceeds on sale and should always appear without parentheses. The book value and gain or loss on the sale affects the income statement, but has no impact on the cash flow statement. The gain or loss is eliminated in the operating activities section of the cash flow statement, and the actual cash proceeds recorded as a source of funds in the investing activities section. 7) In the financing activities section, payment of cash dividends is always a use of funds, recorded with parentheses and therefore deducted. 8) Issuance of debt or shares, whether preferred or common, is a source of cash and should be recorded without parentheses in the financing activities section of the cash flow statement. 9) Repayment of debt is a use of cash and the amount paid is always in parentheses and deducted as a financing activity. 10) Reacquisition of shares is a use of cash and the amount paid is always in parentheses and deducted as a financing activity. Preparation of the proof of the change in the cash position from the beginning to the end of the year shows that the preparer is aware of what the increase or decrease should be. Always complete the proof on an exam, even if the increase(decrease) does not agree to the amount shown on the cash flow statement.

EXAMPLE:

Yoko Ono Enterprises Ltd. Balance Sheet as at March 31, 2001 ASSETS 2001 2000 $ 7,925 23,400 29,850 1,700 62,875

CURRENT Cash Accounts receivable Inventory Prepaid expenses CAPITAL Land Building Accumulated amortization - building Equipment Accumulated amortization - equipment

$ 18,325 18,300 32,650 1,900 71,175

50,000 60,000 225,000 225,000 ( 101,250) ( 90,000) 477,000 370,000 ( 135,300)

( 110,700) 515,450 GOODWILL, net 14,100 $600,725 LIABILITIES CURRENT Demand loan payable Accounts payable Income tax payable Interest payable Unearned revenue Dividends payable LONG TERM Bonds payable SHAREHOLDERS= EQUITY SHARE CAPITAL Preferred shares Common shares RETAINED EARNINGS 85,000 70,000 155,000 161,995 316,995 $600,725 34,000 80,000 114,000 44,995 158,995 $533,625 $ 5,000 31,420 2,100 1,300 2,910 6,000 48,730 235,000 $ 1,000 24,720 5,100 3,810 5,000 39,630 335,000 454,300 16,450 $533,625

Yoko Ono Enterprises Ltd. Statement of Income and Retained Earnings for the year ended March 31, 2001 Sales revenue Cost of goods sold Gross profit Operating expenses Advertising Amortization - capital assets Amortization - goodwill Computer software and support Office Property taxes Repairs and maintenance Salaries and employee benefits Telephone and internet Utilities $1,876,425 864,000 1,012,425 120,000 35,850 2,350 11,625 9,466 18,943 37,598 461,056 17,806 69,441 784,135

Operating income Other items Interest expense Gain on the sale of land Income before income taxes Income tax expense Net income (

228,290 32,500) 40,000 7,500 235,790 68,790 $ 167,000

Supplementary information: 1) Yoko sold a strip of land that was not in use for $50,000 cash. The original cost of the land was $10,000 in 1975. 2) Equipment with a cost of $107,000 was acquired for cash during the year. 3) Yoko had been unable to borrow additional funds to acquire the equipment, as the existing level of borrowings was considered too high. Yoko issued $51,000 in preferred shares to improve its cash position. 4) Yoko reacquired $100,000 in its own bonds payable on the bond market at book value. 5) $10,000 in common shares were reacquired at book value when there was a temporary drop in the market price of the shares. 6) Dividends of $50,000 were declared during the year; dividends of $49,000 were paid REQUIRED: Prepare the cash flow statement for Yoko Ono Enterprises Ltd. Yoko Ono Enterprises Ltd. Cash Flow Statement for the year ended March 31, 2001 CASH PROVIDED (USED) BY: OPERATING ACTIVITIES Net income Adjust for non-cash items on income statement Amortization expense Gain on sale of land Adjust for changes in non-cash working capital balances Accounts receivable Inventory Prepaid expenses Accounts payable Unearned revenue Interest payable Income tax payable Cash provided by operating activities $167,000 38,200 ( 40,000) 165,200 5,100 2,800) 200) 6,700 ( 900) 1,300 ( 3,000) 171,400 ( (

INVESTING ACTIVITIES Proceeds on the sale of land Purchase of equipment Cash provided (used) by investing activities FINANCING ACTIVITIES Proceeds on the issuance of preferred shares Dividends paid Repurchase of common shares Repayment of bonds payable Cash provided (used) by financing activities Increase in cash and equivalents Proof: Cash and equivalents, end of year Cash and equivalents, beginning of year Increase in cash and equivalents

50,000 ( 107,000) ( 57,000) ( ( ( ( $ 51,000 49,000) 10,000) 100,000) 108,000) 6,400

$ 13,325 6,925 $ 6,400

Things to note: 1) Cash and equivalents: Cash Demand loan 2) Change in the accrual accounts: Accounts receivable , opening closing Decrease

end $18,325 ( 5,000) 13,325

start $ 7,925 ( 1,000) 6,925

23,400 (18,300) 5,100

The receivables outstanding at the start of the year are presumed to have been collected in full during the current year, however they were recorded on the income statement last year, not this year. As the cash was received, it is necessary to add the opening accounts receivable to the net income reported for the current year. The receivables outstanding at the end of the year are included in the current year =s income statement, but the cash has not yet been received. The ending receivables must be deducted from net income to adjust to the actual cash amount received during the year. The amount to be added, opening receivables is greater than the amount to be deducted, so the net difference is added to net income in the operating activities section of the cash flow statement.

GENERAL RULE: An increase in current assets is a use of funds, while a decrease is a source of funds. If the difference is calculated by subtracting the ending from the opening balance, a result is in parentheses and deducted on the cash flow statement. A number without parentheses is added on the cash flow statement. Inventory, opening closing Increase 29,850 (32,650) ( 2,800)

Opening inventory was paid for last year when acquired, but is recorded on the current year income statement as cost of goods sold. Closing inventory has been paid for, but as it has not yet been sold it does not appear as an expense on the income statement. It will be included in cost of goods sold next year when sold. To convert accrual net income to cash flow, the opening inventory must be added back to net income to remove it from the expense, cost of goods sold. The closing inventory should be deducted from net income as the cash has been paid in the current year. As the deduction exceeds the add back, the difference between opening and closing inventory is deducted from net income. Prepaid expenses, opening closing Increase $ 1,700 ( 1,900) ( 200)

For prepaid expenses, opening balance represents the amount paid last year for an expense recorded on the income statement in the current period. The opening amount must therefore be added back to net income as the cash was not reduced in this year. The ending amount represents the amount paid in the current year, but to be expensed in future years. As the cash has been paid in the current year, but not deducted on the income statement, the closing amount must be deducted from net income. As the deduction exceeds the add back, the net increase is deducted from net income on the cash flow statement. Accounts payable, closing opening Increase 31,420 (24,720) 6,700

The closing accounts payable have been deducted as expenses on the income statement, but have not been paid in the current year. Accordingly, it is necessary to add the closing payable amount back to net income. The opening payables were deducted in calculating the net income for the previous year, but the cash was paid to the suppliers during the current year. It is necessary to deduct the opening payables from net income to reflect the cash paid in the current year. In this example, the add back exceeds the deduction and the difference between opening and closing payables is added to net income on the cash flow statement. GENERAL RULE: An increase in current liabilities is a source of funds, while a decrease is a use of funds. If the difference is calculated by subtracting the opening

from the ending balance, a result in parentheses is deducted on the cash flow statement. A number without parentheses is added on the cash flow statement. The rationale for changes in all the payables accounts (salaries, interest, income tax, property tax, employee benefits) is the same EXCEPT FOR DIVIDENDS PAYABLE. Please remember dividend payments are classified as financing activities and should never appear in the operating activities section of the cash flow statement. Income tax payable, ending opening Decrease Interest payable, ending opening Increase Unearned revenue, ending opening Decrease 1,300 added to net income 2,910 ( 3,810) ( 900) deducted from net income 2,100 ( 5,100) ( 3,000) deducted from net income 1,300

The ending unearned revenue represents cash received but not yet earned by the business. It has not been included in net income in the current year, so must be added to net income to reflect cash flow. The opening unearned revenue reflects the cash received in the previous year, but earned and included in net income in the current year. As the cash has not been received in the current year, the opening unearned revenue must be removed from net income. As the amount to be deducted exceeds the amount to be added to net income, the difference between opening and closing unearned revenue is deducted from net income. FINANCING AND INVESTING ACTIVITIES If a business has offsetting transactions within an account, both must be reported on the cash flow statement. If Yoko Ono had sold equipment with a cost of $100,000 for cash of $100,000 and purchased new equipment for $100,000 cash, the cash flow statement would show $100,000 proceeds as a source of cash and $100,000 use of cash to acquire equipment. The same is true if the business repays a loan and takes out a new loan in the year, or issues and reacquires shares. INTERPRETING THE CASH FLOW STATEMENT Preparation of a cash flow statement is a mechanical process, however interpreting a cash flow statement must take into consideration all the information available about the business. As stated earlier, operating activities must be the primary source of cash for a business over the long term. It is possible, however, that a successful company may report a use of cash from operating activities. This is quite common in the first year or two of

operations, when accounts receivable and inventory levels may be increasing dramatically. It also may occur when an established company is entering a growth stage and is significantly increasing revenues, which will again affect receivables and inventory. This growth in accounts receivable and inventory is inevitable when sales volume increases. For example, if a business allows customers 30 days to pay, and sales double in amount, the amount outstanding at any point in time should double. If a business wants to significantly increase its sales, it must have more inventory to sell. If the business was doing a good job of inventory management before, and sales double, it is logical that inventory would double as well. Sales cannot increase unless the merchandise is there to sell. Accordingly, growth in accounts receivable and inventory, usually accompanied by a proportionate increase in accounts payable as well, is expected and not a cause for concern if sales are increasing proportionately. If, however, receivables and inventory are increasing when sales have not changed, there is the possibility of high bad debts and obsolete or damaged inventory. Increased receivables could be the result of a failure to properly carry out credit checks on new customers or to respond to poor performance of existing customers that can no longer pay their debts as they become due. Increased inventory could occur because there is no longer sufficient demand for the product, or that inventory contains significant unsaleable items. It is important, then, to examine the balance sheet and income statement in addition to the cash flow statement when evaluating the cash flow position of a business. If changes in receivables and inventory are not consistent with changes in sales revenue, the user should be concerned. Investing activities must be carried on over the entire life of a business. A successful business must continue to replace its worn and obsolete equipment, even if sales volume is stable. In any year, then, a business may report investing activities as either a source or use of cash. Sometimes new assets will be acquired in one year, using cash, and the assets being replaced are sold the following year, providing cash. Investing activities cannot be the primary source of cash for a business, however. Eventually the firm=s productive capacity will be reduced if assets needed to operate the business must be sold to provide cash. Certainly during the start up phase of a business or during a period of expansion, investing activities may be a very significant use of cash. Financing activities also occur throughout the life of a business, and in any particular year a business may report that financing activities have been a source or use of cash. During the start up phase, expansion of the business, or when significant replacement of capital assets is necessary, financing activities are normally a source of cash. In other circumstances it is more common for financing activities to be a use of funds as debt is repaid and dividends paid. Share capital is considered permanent capital for a business, so share transactions are less common than issuing and repaying debt. Yoko Ono Enterprises Ltd. >s cash flow statement is fairly typical of an established firm. Operating activities provide a significant cash inflow, although the increase in accounts payable seems high, considering inventory has increased much less. Investing and financing activities have both used funds during the period, indicating Yoko Ono is

continuing to pay off debt even when assets are being replaced, a sign that cash flows are good. Even if Yoko had shown financing activities as a source of funds, it would not be a concern here. It would be a concern, however, if operating activities were a use of funds and the cash flow from financing activities was necessary in order for Yoko Ono to pay its liabilities as they come due. The cash on hand is low, in comparison to the total assets. With operating activities providing a healthy cash flow, this suggests that the cash flow is relatively stable so it is not necessary to keep large quantities of cash on hand.

DIRECT METHOD Yoko Ono Enterprises Ltd. Cash Flow Statement for the year ended March 31, 2001 CASH PROVIDED (USED) BY: OPERATING ACTIVITIES Cash from customers Cash paid to employees Cash paid to suppliers Cash paid for interest Cash paid for income taxes Cash provided by operating activities INVESTING ACTIVITIES Proceeds on the sale of land Purchase of equipment Cash provided (used) by investing activities FINANCING ACTIVITIES Proceeds on the issuance of preferred shares Dividends paid Repurchase of common shares Repayment of bonds payable Cash provided (used) by financing activities Increase in cash and equivalents Cash and equivalents, end of year Cash and equivalents, beginning of year Increase in cash and equivalents

1,880,625 ( 461,056) (1,145,179) ( 31,200) ( 71,790) 171,400 50,000 ( 107,000) ( 57,000) 51,000 ( 49,000) 10,000) ( 100,000) ( 108,000) $ 6,400

$ 13,325 6,925 $ 6,400

When the direct method is used to prepare a cash flow statement, the only difference is in the presentation of the operating activities. Instead of reconciling from net income reported on the income statement to cash flow from operations, the direct method prepares a highly summarized income statement on a cash basis, identifying cash received from customers and investments, and cash paid to suppliers, employees, and for interest and income taxes. The same accrual accounts must be adjusted for, but

these are allocated to the relevant line. For example, accounts receivable and unearned revenues are both received from customers and changes in these accounts are used to adjust sales revenue to obtain cash received from customers. The calculations are not shown here as they are beyond the scope of an introductory accounting course. The cash flow statement for Yoko Ono Enterprises Ltd. is presented so that students are aware of the existence and appearance of a direct method cash flow statement.