Statement of Cash Flows

Contents

1 Introduction

2 Statement of Cash Flows in US-GAAP
2.1 Historical evolution
2.2 Purposes
2.3 Definition of cash funds
2.4 Form and content
2.4.1 Operating activities
2.4.2 Investing activities
2.4.3 Financing activities
2.5 Notes
2.6 Preparing a statement of cash flows
2.6.1 Determine the positions of the statement
2.6.2 Formulas

3 Example
3.1 Given information
3.2 Preparing the statement
3.2.1 Operating activities
3.2.2 Investing activities
3.2.3 Financing activities

4 Conclusion

List of Figures

1 Classification of statement of cash flows

List of Tables

1 Format of statement of cash flows

2 Operating, investing and financing activities

3 Indirect method: Additions and deductions

4 Comparative balance sheet of McCoy Tyner Company

5 Income statement of McCoy Tyner Company

6 Statement of Cash Flows of McCoy Tyner Company

List of Abbreviations

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1 Introduction

This seminar paper will give an introduction to the statement of cash flows which is required as part of the financial statements of the US-GAAP. The statement facilitates the analysis of the liquidity, solvency, and financial flexibility of the firm. In german law a statement of cash flows was first introduced in 1998 by the KonTraG ¹.² In accor- dance with this law (resp. additions to existent law) german companies must publish such a statement when they are listed at the stock market.³ The mission and content of the statement in german law is not defined in German Commercial Code (HGB) but provided by the German Accounting Standards Committee (GASC) with German Accounting Standards No. 2 (GAS 2). It is drawn near IAS 7 of the International Ac- counting Standards and Statement of Financial Accounting Standards (SFAS) No. 95 of US-GAAP. The Security and Exchange Commission (SEC) sees cash flow statements of IAS 7 and SFAS No. 95 equally and excepts both.⁴ Because there are not many differences between SFAS No. 95 and IAS 7 this paper just focuses on the US-GAAP.⁵

The statement of cash flows is structured in three sections. To set up the first section – called operating activities – you can choose either a direct or and indirect method. Both methods show the same investing and financing cash flows, and both show the reconciliation of net income and net operating cash flows. The main difference is that only the direct method shows the actual operating cash flows such as collections from customers and payments to suppliers. The indirect method uses the reconciliation as its operating activities section, that is why it is also called reconciliation method. When describing the content or giving examples of the statement the indirect method is used always in this paper. In spite of the fact that after SFAS No. 95 the Financial Accounting Standards Board (FASB) is preferring the direct method most companies are using the indirect method. This is because in most cases companies do not store all relevant data in their information system to use the direct method. In the other two sections – investing and financing activities – the direct method must be used.⁶

In the second part this work will give an overview and is showing details of form and content of the statement of cash flows according to the SFAS No 95, as well as it is presenting information about how to prepare the statement. In the third section an example is given followed by an evaluation of the statement of cash flows.

2 Statement of Cash Flows in US-GAAP

2.1 Historical evolution

A statement of cash flow was first recommend 1963 in Accounting Principles Bulletin (APB) 3 Statement of Source and Application of Funds. The recommendations of APB 3 quickly gained strong support from all parts of the financial reporting community. In 1971, the APB issued APB 19, which required that a statemen t of changes in financial position is presented as a primary financial statement and is covered by the auditor’s opinion on the financial statements. By the 1980s, this title was used almost exclusively by all reporting entities in compliance with the opinion. The statements of changes in financial position that were presented invariably showed the change in working capital rather than cash flows. During the 1970s and 1980s, many advocated the use of a cash flow approach. In 1984, with the issuance of Concepts Statement 5, the FASB advocated that a statement of cash flows should be included in the entity’s primary financial statements. According to that statement, the statement of cash flows should reflect the entity’s cash receipts classified by major sources and its cash payments classified by major uses.⁷

Now the Statement of Financial Accounting Standard (SFAS) No. 95 Statement of Cash flows is effective. It establishes standards for cash flow reporting and is effective since July 15, 1988. Replacing the APB Opinion No. 19 it is part of the full set of financial statements in place of a statement of changes in financial position.⁸ It is broaden by other statements the last SFAS No. 115 which extends the duty to set up a cash flow statement to non profit organisations ⁹. SFAS No. 95 requires that a statement of cash flows classify cash receipts and payments according to whether they stem from operating, investing, or financing activities and provides definitions of each category.

2.2 Purposes

Next to the balance sheet as an list of assets and liabilities and to the income statement as a report of earnings and expanses the statement of cash flows should report the companies financial condition. Its purpose is to analyse the changes in cash from one period to another by showing the increase or decrease of net change in cash. The addressee of the financial statements such as investors, shareholders or the public should get additional information and asses: ¹⁰

- the firm’s ability to generate positive future cash flow,
- the ability to meet obligations,
- differences between net income,cash inflows and cash outflows,
- effects of firm’s investing and financing of cash and noncash assets on financial position.

Therefore the Statement of Financial Accounting Concepts(SFAC) No. 5 declares:

”A full set of financial statements for a period should show cash flows during the period”.¹¹

Because the statement of cash flows presents information about cash flows that the other statements either (a) do not provide or (b) provide only indirectly it was introduced by the Financial Accounting Standards Board (FASB) in 1988 to supply the other financial statements of the US-GAAP. The only exception to this is defined in SFAS No. 102. According to this some companies do not have to set up such a statement. Those are defined benefit pension plans, certain other employee benefit plans and certain investment companies.¹²

Cash flow is also important when analysing a troubled company. The balance sheet overvalue its assets because write offs are delayed. In addition leverage buyouts focus on cash flows. That is because net income is misleading (it is including non-cash items).

The statement of cash flows is an excellent complement to both the income statement and the balance sheet. The calculation of the cash flow is a change of cash over a period in comparison to the balance sheet which present a balance at the end of a period. Many investors use the cash flow statement to obtain an indication of the quality of earnings, and to understand major changes in balance sheet accounts. The reconciliation schedule leading to the important subtotal net cash flow from operations explains why net income for the period is not the same as the amount of cash provided by the same income-producing activities. As such, the statement of cash flows provides important information about the quality of earnings. The statement also helps understand the balance sheet, which shows only beginning and ending balances of accounts. It forms the basic question: Will the company succeed in keeping its creditors at bay? So the statement of cash flows is particularly useful in helping investors assess future cash flows. For an overview where to classify the statement see figure 2.2.

2.3 Definition of cash funds

Cash comprises cash on hand and demand deposits, but some other positions of the balance sheet must be considered. The SFAS No. 95 refer to cash and cash equivalents.

”Cash equivalents are short-term highly liquid investments that are a) readily convertible to known amounts of cash and b) so near their maturities that they present insignificant risk of changes in value because of the change in interest rates”. ¹⁴

In practice cash equivalents are treasury bills, commercial papers, money market funds and federal funds sold.¹⁵

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Figure 1: Classification of statement of cash flows 13

Companies establish a policy regarding which short-term, highly liquid investments they classify as cash equivalents which is to be disclosed in the notes. Here companies have to pay attention to the principle of consistency. Transactions that involve merely transfers from cash to cash equivalents (such as the purchase of a three-month treasury bill) are not to be reported on the statement of cash flows because the total of cash and cash equivalents is not altered by such transactions (see 2.5).

2.4 Form and content

The cash flow statement should be presented in vertical format in compliance with the minimum classification.¹⁶ Comparative figures of the previous period¹⁷ should be included and the statement of cash flows should be presented on a consistent basis.

In the header of the Statement of Cash Flows the company name, the covered period and the name of the statement must be declared. It is followed by a table with three subsections which covers

- operating activities,
- investing activities,
- financing activities,

and a net change in cash stated below (see table 1).

The list of individual cash inflows and cash outflows is determined by the activities of the company. For details confer table 2.

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Table 1: Format of statement of cash flows

2.4.1 Operating activities

The section operating activities captures everything else that does not belong to the sections financing and investing activities. In general operating activities are revenue- producing activities of the enterprise. In SFAS No. 95 it is said:

”Operating activities include all transactions and other events that are not defined as investing or financing activities. Operating activities generally involve producing and delivering goods and providing services. Cash flows from operating activities are generally the cash effects of transactions and other events that enter into the determination of net income.” ¹⁸

There is a minimum content with the following structure:¹⁹

- cash collected from customers, including lessees, licensees, and the like
- interest and dividends paid
- other operating cash receipts, if any
- cash paid to employees and other suppliers of goods or services, including suppliers of insurance, advertising, and the like
- income taxes paid
- other operating cash payments, if any

2.4.2 Investing activities

Cash flows from investing activities arise in connection with the use of the enterprise’s resources, which are intended to generate income on a long-term basis, generally over a period of more than one year.

Increases or decreases in cash related to the acquisition or disposal of long-term assets and investment of cash (for example short-term securities excluding trading securities) are reported as investing activities as long as they are not classified as cash funds or financing activities. Purchases and sales of tangible and intangible assets are included here. Other cash transactions relating to the normal conduct of the business are included in the operating section. There is no structure given by the FASB for this section but it lists items which should usually be within: ²⁰

- Cash inflows from investing activities:
- Receipts from collections or sales of loans made by the enterprise and of other entities’ debt instruments (other than cash equivalents and certain debt instruments that are acquired specifically for resale) that were purchased by the enterprise
- Receipts from sales of equity instruments of other enterprises (other than certain equity instruments carried in a trading account) and from returns of investments in those instruments
- Receipts from sales of property, plant, and equipment and other productive assets
- Cash outflows from investing activities:
- Disbursements for loans made by the enterprise and payments to acquire debt instruments of other entities (other than cash equivalents and certain debt instruments that are acquired specifically for resale)
- Payments to acquire equity instruments of other enterprises (other than cer- tain equity instruments carried in a trading account)
- Payments at the time of purchase or soon before or after purchase to acquire property, plant, and equipment and other productive assets

2.4.3 Financing activities

Financing activities are cash relevant activities that result in changes in the size and composition of the equity capital and borrowings of the enterprise. They are involving non-trade short-term debt, all long-term debt, and stockholders’ equity. Like the in- vesting activities financing activities section has as well no defined minimum structure. But from the given examples you can outline the following: ²¹

[...]

¹ ”Gesetz zur Kontrolle und Transparenz im Unternehmensbereich”

² See Coenenberg(2001), p. 677.

³ See 297 (1) no. 2 HGB.

⁴ See KPMG(1999), p. 158.

⁵ See Schildbach(2000), p. 281; Amen(1998), preface.

⁶ See Coenenberg(2001), p. 749.

⁷ See CPA Journal Online(1990).

⁸ See FASB, summary of SFAS No. 95.

⁹ See Niehus/Thyll(1998), p. 105.

¹⁰ See KPMG(1999), p 159; Wysocki(1998), p. 7.

¹¹ See FASB (1984), par. 13.

¹² See KPMG(1998),p. 159.

¹³ See Coenenberg(2001), p. 678.

¹⁴ See SFAS No. 95, par. 8.

¹⁵ See ibid. par. 9.

¹⁶ See Coenenberg(2001), p. 736; Niehus/Thyll(1998), p. 111.

¹⁷ See ARB 43, chap. 2, par. 1.

¹⁸ See SFAS No. 95. par. 21.

¹⁹ See ibid. par. 27.

²⁰ See SFAS No. 95, par. 16 f.

²¹ See Niehus/Thyll(1998), p. 111.