A statement of cash flows is shown in Graphic 21-2 on the next page. The statement lists all cash inflows and cash outflows during the reporting period. To enhance the informational value of the presentation, the cash flows are classified according to the nature of the activities that bring about the cash flows. The three primary categories of cash flows are (1) cash flows from operating activities, (2) cash flows from investing activities, and (3) cash flows from financing activities. Classifying each cash flow by source (operating, investing, or financing activities) is more informative than simply listing the various cash flows. Notice, too, that the noncash investing and financing activities—investing and financing activities that do not directly increase or decrease cash—also are reported. The GAAP requirement for the statement of cash flows was issued in direct response to FASB Concept Statement 1, which states that the primary objective of financial reporting is to “provide information to help investors and creditors, and others assess the amounts, timing, and uncertainty of prospective net cash inflows to the related enterprise.”1
Many companies have experienced bankruptcy because they were unable to generate sufficient cash to satisfy their obligations. Doubtless, many investors in the stock of these firms would have been spared substantial losses if the financial statements had been designed to foresee the cash flow problems the companies were experiencing. A noted illustration is the demise of W. T. Grant during the 1970s. Grant, a general retailer in the days before malls, was a blue chip stock of its time. Grant's statement of changes in financial position (the predecessor of the statement of cash flows) reported working capital from operations of $46 million in 1972. Yet, if presented, a statement of cash flows would have reported cash flows from operating activities of negative $10 million. In fact, the unreported cash flow deficiency grew to $114 million in 1973, while working capital from operations was reported as having increased by $1 million. That year, without the benefit of cash flow information, investors were buying Grant's stock at prices that represented up to 20 times its earnings.2
The statement of cash flows provides information about cash flows that is lost when reported only indirectly by the balance sheet and the income statement.
Statement of Cash Flows
More recently, even with cash flow information available, cash flow problems can go unnoticed. An example is the rapid growth and subsequent bankruptcy of the Wicks ‘N’ Sticks franchise. The company's drive for rapid growth led to a dependence on the sale of new franchises in order to generate cash flow instead of doing so in a more healthy way through its operations. As we see shortly, a statement of cash flows can indicate not just the amount of cash flows, but also whether those cash flows are coming from operations or from outside sources. Wicks ‘N’ Sticks was able to emerge from bankruptcy through restructuring and a new perspective on cash flow management.
Realize, too, that an unprofitable company with good cash flow can survive. Amazon.com provides an excellent example. Founded as an online seller of books in 1995, Amazon.com didn't actually make a profit for a decade, but it did raise huge amounts of cash by selling stock, so much so that it was able to weather 10 years of sizable losses. The financing cash inflows funded expansion into many new lines of business and made up for the continual losses. Amazon now has good operating cash flows and is profitable.
The Importance of Cash Flows in an Economic Decline
The near-collapse of Bear Stearns in the Spring of 2008 likely will be remembered as the single most dramatic event in exposing the fragility of Wall Street and precipitating the most severe financial crisis since the Great Depression. At the heart of Bear's calamity and the subsequent worldwide economic decline was a shortage of cash flows. First Bear Stearns; then Lehman Brothers; then AIG, Citigroup, Fannie Mae, and Freddie Mac. As we know, it didn't stop there. Each of these meltdowns involved a lack of measuring and monitoring the ebb and flow of cash.
When the financial industry is burdened with enormous amounts of uncollectible debt, as during the recent credit crisis, banks and others are reluctant to lend money. Cash becomes scarce. It's critical for companies to monitor their cash flows.
Let's say Lucky Strike Lures, Inc., manufactures fishing lures and sells them to a distributor. The distributor warehouses them before selling them to Bubba's Bait Shop, where they are put on display awaiting customers to buy them. During an economic downturn, the customers may delay buying the lures or not buy them at all. So, the lures stay in the store gathering dust, and Bubba's Bait can't pay for the lures that haven't sold. The distributor is then slow to pay Lucky Strike. Lucky Strike has bills to pay but no cash. In normal times, the company would go to the bank and borrow money. But in hard times, the bank is reluctant to lend. There is no quick fix as normal financing options are closed. Lucky Strike has cash flowing out, but not flowing in.
The survival and success of every business depends on its ability to create or otherwise attain cash. You can be profitable and still go broke. Companies must closely plan and monitor their cash flows to stay in business. During the recent economic decline, even some of the most well-known companies suffered the consequences of not following this principle.
Cash is king! Especially during an economic downturn.
The statement of cash flows for United Brands Corporation (UBC), shown in Graphic 21-2, is intended at this point in the discussion to illustrate the basic structure and composition of the statement. Later we will see how the statement of cash flows for UBC is prepared from the information typically available for this purpose. We will refer to UBC's statement of cash flows frequently throughout the chapter as the discussion becomes more specific regarding the criteria for classifying cash flows in the three primary categories and as we identify the specific cash flows to be reported on the statement. We will examine the content of the statement in more detail following a look at how this relatively recent financial statement has evolved to its present form over the course of the last several decades.
Cash and Cash Equivalents
Skilled cash managers will invest temporarily idle cash in short-term investments to earn interest on those funds, rather than maintain an unnecessarily large balance in a checking account. The FASB views short-term, highly liquid investments that can be readily converted to cash, with little risk of loss, as cash equivalents certain negotiable items such as commercial paper, money market funds, and U.S. Treasury bills that are highly liquid investments quickly convertible to cash. Short-term, highly liquid investments that can be readily converted to cash with little risk of loss.. Amounts held as investments of this type are essentially equivalent to cash because they are quickly available for use as cash. Therefore, on the statement of cash flows there is no differentiation between amounts held as cash (e.g., currency and checking accounts) and amounts held in cash equivalent investments. So, when we refer in this chapter to cash, we are referring to the total of cash and cash equivalents.
There is no differentiation between amounts held as cash and amounts held in cash equivalent investments.
Examples of cash equivalents are money market funds, Treasury bills, and commercial paper. To be classified as cash equivalents, these investments must have a maturity date not longer than three months from the date of purchase. Flexibility is permitted in designating cash equivalents. Each company must establish a policy regarding which short-term, highly liquid investments it classifies as cash equivalents. The policy should be consistent with the company's customary motivation for acquiring various investments and should be disclosed in the notes to the statement.3 A recent annual report of ExxonMobil Corporation provides this description of its cash equivalents (Graphic 21-3):
Disclosure of Cash Equivalents—ExxonMobil Corporation
Note 4: Cash Flow Information (in part)
The consolidated statement of cash flows provides information about changes in cash and cash equivalents. Highly liquid investments with maturities of three months or less when acquired are classified as cash equivalents.
Each firm’s policy regarding which short term, highly liquid investments it classifies as cash equivalents should be disclosed in the notes to the financial statements.
Transactions that involve merely transfers from cash to cash equivalents (such as the purchase of a three-month Treasury bill), or from cash equivalents to cash (such as the sale of a Treasury bill), should not be reported on the statement of cash flows. The total of cash and cash equivalents is not altered by such transactions.4 The cash balance reported in the balance sheet also represents the total of cash and cash equivalents, which allows us to compare the change in that balance with the net increase or decrease in the cash flows reported on the statement of cash flows.
Primary Elements of the Statement of Cash Flows
This section describes the three primary activity classifications: (1) operating activities, (2) investing activities, and (3) financing activities; and two other requirements of the statement of cash flows: (4) the reconciliation of the net increase or decrease in cash with the change in the balance of the cash account and (5) noncash investing and financing activities.
CASH FLOWS FROM OPERATING ACTIVITIES. The income statement reports the success of a business in generating a profit from its operations. Net income (or loss) is the result of netting together the revenues earned during the reporting period, regardless of when cash is received, and the expenses incurred in generating those revenues, regardless of when cash is paid. This is the accrual concept of accounting that has been emphasized throughout your study of accounting. Information about net income and its components, measured by the accrual concept, generally provides a better indication of current operating performance than does information about current cash receipts and payments.5 Nevertheless, as indicated earlier, the cash effects of earning activities also provide useful information that is not directly accessible from the income statement. The first cash flow classification in the statement of cash flows reports that information.
Cash flows from operating activities both inflows and outflows of cash that result from activities reported on the income statement. are both inflows and outflows of cash that result from activities reported in the income statement. In other words, this classification of cash flows includes the elements of net income, but reported on a cash basis. The components of this section of the statement of cash flows, and their relationship with the elements of the income statement, are illustrated in Graphic 21-4.
The cash effects of the elements of net income are reported as cash flows from operating activities.
Relationship between the Income Statement and Cash Flows from Operating Activities (Direct Method)
To see the concept applied, let's look again at the cash flows from operating activities reported by United Brands Corporation. That section of the statement of cash flows is extracted from Graphic 21-2 and reproduced in Graphic 21-5.
Cash Flows from Operating Activities (Direct Method)
|Cash Flows from Operating Activities:|
|Net cash flows from operating activities|| |
Cash flows from operating activities are the elements of net income, but reported on a cash basis.
Cash inflows from operating activities exceeded cash outflows for expenses by $22 million. We'll see later (in Illustration 21-1) that UBC's net income from the same operating activities was only $12 million. Why did operating activities produce net cash inflows greater than net income? The reason will become apparent when we determine, in a later section, the specific amounts of these cash flows.
You also should be aware that the generalization stated earlier that cash flows from operating activities include the elements of net income reported on a cash basis is not strictly true for all elements of the income statement. Notice in Graphic 21-5 that no cash effects are reported for depreciation and amortization of property, plant, and equipment, and intangibles, nor for gains and losses from the sale of those assets. Cash outflows occur when these assets are acquired, and cash inflows occur when the assets are sold. However, as described later, the acquisition and subsequent resale of these assets are classified as investing activities, rather than as operating activities.
Quite the opposite, the purchase and the sale of inventory are considered operating activities. The cash effects of these transactions—namely, (1) cash payments to suppliers and (2) cash receipts from customers—are included in the determination of cash flows from operating activities. Why are inventories and noncurrent assets treated differently when classifying their cash effects if both are acquired for the purpose of producing revenues? The essential difference is that inventory typically is purchased for the purpose of being sold as part of the firm's current operations, while a noncurrent asset is purchased as an investment to benefit the business over a relatively long period of time.
DIRECT METHOD OR INDIRECT METHOD OF REPORTING CASH FLOWS FROM OPERATING ACTIVITIES. The presentation by UBC of cash flows from operating activities illustrated in Graphic 21-2 and reproduced in Graphic 21-5 is referred to as the direct method the cash effect of each operating activity (i.e., income statement item) is reported directly on the statement of cash flows.. The method is named for the fact that the cash effect of each operating activity (i.e., income statement item) is reported directly on the statement of cash flows. For instance, UBC reports “cash received from customers” as the cash effect of sales activities, “cash paid to suppliers” as the cash effect of cost of goods sold, and so on. Then, UBC simply omits from the presentation any income statement items that do not affect cash at all, such as depreciation expense.
Another way UBC might have reported cash flows from operating activities is by the indirect method the net cash increase or decrease from operating activities is derived indirectly by starting with reported net income and working backwards to convert that amount to a cash basis.. By this approach, the net cash increase or decrease from operating activities ($22 million in our example) would be derived indirectly by starting with reported net income and working backwards to convert that amount to a cash basis. As we see later in the chapter, UBC's net income is $12 million. Using the indirect method, UBC would replace the previous presentation of net cash flows from operating activities with the one shown in Graphic 21-6.
|Cash Flows from Operating Activities:|
|Adjustments for noncash effects:|
| || Loss on sale of equipment|
| || Changes in operating assets and liabilities:|
| || Increase in accounts receivable|
| || Increase in accounts payable|
| || Increase in salaries payable|
| || Discount on bonds payable|
| || Decrease in prepaid insurance|
| || Decrease in income tax payable|
| || Net cash flows from operating activities|| |
By the indirect method, UBC derives the net cash increase or decrease from operating activities indirectly, by starting with reported net income and working backwards to convert that amount to a cash basis.
Be sure to note that the indirect method generates the same $22 million net cash flows from operating activities as did the direct method. Rather than directly reporting only the components of the income statement that do represent increases or decreases in cash, by the indirect method we begin with net income—which includes both cash and noncash components—and back out all amounts that don't reflect increases or decreases in cash. Later in the chapter, we explore the specific adjustments made to net income to achieve this result. At this point it is sufficient to realize that two alternative methods are permitted for reporting net cash flows from operating activities. Either way, we convert accrual-based income to cash flows produced by those same operating activities.
Notice also that the indirect method presentation is identical to what UBC reported earlier as the “Reconciliation of Net Income to Cash Flows from Operating Activities” in Note X of Graphic 21-2. Whether cash flows from operating activities are reported by the direct method or by the indirect method, the financial statements must reconcile the difference between net income and cash flows from operating activities. When a company uses the direct method, the company presents the reconciliation in a separate schedule as UBC did. That presentation is precisely the same as the presentation of net cash flows from operating activities by the indirect method. On the other hand, a company choosing to use the indirect method is not required to provide a separate reconciliation schedule because the “cash flows from operating activities” section of the statement of cash flows serves that purpose. Most companies use the indirect method.6 This is slated to change. A joint project of the FASB and IASB is under way that would require the direct method and disallow the indirect method.7
The FASB and IASB are working together on a project, Financial Statement Presentation, to establish a common standard for presenting information in the financial statements, including classifying and displaying line items and aggregating line items into subtotals and totals. This standard will have a dramatic impact on the format of financial statements. An important part of the proposal involves the organization of elements of the balance sheet (statement of financial position), statement of comprehensive income (including the income statement), and statement of cash flows into a common set of classifications.
The statement of cash flows is slated to change in several ways. First, though, we should note that the three major classifications of cash flows are retained. In fact, each of the other financial statements also will include classifications by operating, investing, and financing activities, providing a “cohesive” financial picture that stresses the relationships among the financial statements.
The FASB and IASB are working together on a standard that would have a dramatic impact on the format of financial statements.
Demonstrating the cohesiveness among the financial statements is a key objective of the Financial Statement Presentation project.
For each statement, though, operating and investing activities will be included within a new category, “business” activities. Each statement also will include three additional groupings: discontinued operations, income taxes, and equity (if needed). The new look for the financials would be:
One change planned for the statement of cash flows is to no longer permit a choice between the direct method and the indirect method, but to require the direct method, reasoning that it provides more useful information to investors. Another change is to eliminate the concept of cash equivalents in favor of cash only. Also, while we still will have operating, investing, and financing activities, some cash flows will switch categories. Under the new “management approach,” cash flows will be classified based on how related assets and liabilities are used by management. For instance, expenditures for property, plant and equipment likely would be classified as operating, because those assets are used in the “core” business. Investing activities would be limited primarily to investments in stock, bonds, and other securities.
| || (14.0K)|
The proposed new Standard would require the direct method.
It's important to understand, too, that regardless of which method a company chooses to report operating activities, that choice has no effect on the way it identifies and reports cash flows from investing and financing activities. We turn our attention now to those two sections of the statement of cash flows. Later in Part C, we'll return for a more thorough discussion of the alternative methods of reporting the operating activities section.
CASH FLOWS FROM INVESTING ACTIVITIES. Companies periodically invest cash to replace or expand productive facilities such as property, plant, and equipment. Investments might also be made in other assets, such as securities of other firms, with the expectation of a return on those investments. Information concerning these investing activities can provide valuable insight to decision makers regarding the nature and magnitude of assets being acquired for future use, as well as provide clues concerning the company's ambitions for the future.
Cash flows from investing activities both outflows and inflows of cash caused by the acquisition and disposition of assets. are both outflows and inflows of cash caused by the acquisition and disposition of assets. Included in this classification are cash payments to acquire (1) property, plant, and equipment and other productive assets (except inventories), (2) investments in securities (except cash equivalents and trading securities8), and (3) non-trade receivables.9 When these assets later are liquidated, any cash receipts from their disposition also are classified as investing activities. For instance, cash received from the sale of the assets or from the collection of a note receivable (principal amount only) represents cash inflows from investing activities. Be sure to realize that, unlike the label might imply, any investment revenue like interest, dividends, or other cash return from these investments is not an investing activity. The reason, remember, is that investment revenue is an income statement item and therefore is an operating activity.
For illustration, notice the cash flows reported as investing activities by UBC. That section of the statement of cash flows is extracted from the complete statement in Graphic 21-2 and reproduced in Graphic 21-7.
Cash Flows from Investing Activities
|Cash Flows from Investing Activities:|
|Purchase of short-term investment|
|Net cash flows from investing activities|
Cash outflows and cash inflows due to the acquisition and disposition of assets (other than inventory and assets classified as cash equivalents) are reported as cash flows from investing activities.
Cash flows from investing activities include investments in assets and their subsequent sale.
UBC reports as investing activities the cash paid to purchase both land and a short-term investment. The other two investing activities reported are cash receipts for the sale of assets—equipment and land—that were acquired in earlier years. The specific transactions creating these cash flows are described in a later section of this chapter.
The purchase and sale of inventories are not considered investing activities. Inventories are purchased for the purpose of being sold as part of the firm's primary operations, so their purchase and sale are classified as operating activities.
Also, the purchase and sale of assets classified as cash equivalents are not reported as investing activities. In fact, these activities usually are not reported on the statement of cash flows. For example, when temporarily idle cash is invested in a money market fund considered to be a cash equivalent, the total of cash and cash equivalents does not change. Likewise, when the cash is later withdrawn from the money market fund, the total remains unchanged. The exception is when cash equivalents are sold at a gain or a loss. In that case, the total of cash and cash equivalents actually increases or decreases in the process of transferring from one cash equivalent account to another cash equivalent account. As a result, the change in cash would be reported as a cash flow from operating activities. This is illustrated later in the chapter.
CASH FLOWS FROM FINANCING ACTIVITIES. Not only is it important for investors and creditors to be informed about how a company is investing its funds, but also how its investing activities are being financed. Hopefully, the primary operations of the firm provide a source of internal financing. Information revealed in the cash flows from operating activities section of the statement of cash flows lets statement users know the extent of available internal financing. However, a major portion of financing for many companies is provided by external sources, specifically by shareholders and creditors.
Cash flows from financing activities both inflows and outflows of cash resulting from the external financing of a business. are both inflows and outflows of cash resulting from the external financing of a business. We include in this classification cash inflows from (a) the sale of common and preferred stock and (b) the issuance of bonds and other debt securities. Subsequent transactions related to these financing transactions, such as a buyback of stock (to retire the stock or as treasury stock), the repayment of debt, and the payment of cash dividends to shareholders, also are classified as financing activities.
Cash inflows and cash outflows due to the external financing of a business are reported as cash flows from financing activities.
For illustration, refer to Graphic 21-8 excerpted from the complete statement of cash flows of UBC in Graphic 21-2.
Cash Flows from Financing Activities
|Cash Flows from Financing Activities|
|Retirement of bonds payable|
|Payment of cash dividends|
|Net cash flows from financing activities|| |
Cash flows from financing activities include the sale or repurchase of shares, the issuance or repayment of debt securities, and the payment of cash dividends.
The cash received from the sale of common stock is reported as a financing activity. Since the sale of common stock is a financing activity, providing a cash return (dividend) to common shareholders also is a financing activity. Similarly, when the bonds being retired were issued in a prior year, that cash inflow was reported as a financing activity. In the current year, when the bonds are retired, the resulting cash outflow is likewise classified as a financing activity.
At first glance, it may appear inconsistent to classify the payment of cash dividends to shareholders as a financing activity when, as stated earlier, paying interest to creditors is classified as an operating activity. But remember, cash flows from operating activities should reflect the cash effects of items that enter into the determination of net income. Interest expense is a determinant of net income. A dividend, on the other hand, is a distribution of net income and not an expense.
RECONCILIATION WITH CHANGE IN CASH BALANCE. One of the first items you may have noticed about UBC's statement of cash flows is that there is a net change in cash of $9 million. Is this a significant item of information provided by the statement? The primary objective of the statement of cash flows is not to tell us that cash increased by $9 million. We can readily see the increase or decrease in cash by comparing the beginning and ending balances in the cash account in comparative balance sheets. Instead, the purpose of the statement of cash flows is to explain why cash increased by $9 million.
Interest, unlike dividends, is a determinant of net income and therefore an operating activity.
To reinforce the fact that the net amount of cash inflows and outflows explains the change in the cash balance, the statement of cash flows includes a reconciliation of the net increase (or decrease) in cash with the company's beginning and ending cash balances. Notice, for instance, that on UBC's statement of cash flows, the reconciliation appears as:
The net amount of cash inflows and outflows reconciles the change in the company’s beginning and ending cash balances.
NONCASH INVESTING AND FINANCING ACTIVITIES. Suppose UBC were to borrow $20 million cash from a bank, issuing a long-term note payable for that amount. This transaction would be reported on a statement of cash flows as a financing activity. Now suppose UBC used that $20 million cash to purchase new equipment. This second transaction would be reported as an investing activity.
Instead of two separate transactions, as indicated by Graphic 21-2, UBC acquired $20 million of new equipment by issuing a $20 million long-term note payable in a single transaction. Undertaking a significant investing activity and a significant financing activity as two parts of a single transaction does not diminish the value of reporting these activities. For that reason, transactions that do not increase or decrease cash, but which result in significant investing and financing activities, must be reported in related disclosures.
These noncash investing and financing activities transactions that do not increase or decrease cash but that result in significant investing and financing activities., such as UBC's acquiring equipment (an investing activity) by issuing a long-term note payable (a financing activity), are reported in a separate disclosure schedule or note. UBC reported this transaction in the following manner:
| ||Noncash Investing and Financing Activities:|
| ||Acquired $20 million of equipment by issuing a 12%, 5-year note.|
Noncash investing and financing activities are reported also.
It's convenient to report noncash investing and financing activities on the same page as the statement of cash flows as did UBC only if there are few such transactions. Otherwise, precisely the same information would be reported in disclosure notes to the financial statements.10
Examples of noncash transactions that would be reported in this manner are:
Acquiring an asset by incurring a debt payable to the seller.
Acquiring an asset by entering into a capital lease.
Converting debt into common stock or other equity securities.
Exchanging noncash assets or liabilities for other noncash assets or liabilities.
Noncash transactions that do not affect a company's assets or liabilities, such as the distribution of stock dividends, are not considered investing or financing activities and are not reported. Recall from Chapter 18 that stock dividends merely increase the number of shares of stock owned by existing shareholders. From an accounting standpoint, the stock dividend causes a dollar amount to be transferred from one part of shareholders' equity (retained earnings) to another part of shareholders' equity (paid-in capital). Neither assets nor liabilities are affected; therefore, no investing or financing activity has occurred.
1 “Objectives of Financial Reporting by Business Enterprises,” FASB Statement of Financial Accounting Concepts No. 1, par 37.
2 Cheryl A. Zega, “The New Statement of Cash Flows,” Management Accounting, September 1988.
3 A change in that policy is treated as a change in accounting principle.
4 An exception is the sale of a cash equivalent at a gain or loss. This exception is described in more detail later in the chapter.
5FASB Statement of Financial Accounting Concepts No. 1, par. 44.
6 According to the AICPA, Accounting Trends and Techniques, 2008, a recent survey of 600 companies showed that 594 companies chose to use the indirect method, only 6 the direct method.
7 Discussion Paper, Preliminary Views on Financial Statement Presentation, FASB/IASB, October 16, 2008.
8 Inflows and outflows of cash from buying and selling trading securities typically are considered operating activities because financial institutions that routinely transact in trading securities consider them an appropriate part of their normal operations.
9 A nontrade receivable differs from a trade receivable in that it is not one associated with the company's normal trade; that is, it's not received from a customer. A trade receivable, or accounts receivable, is an operating asset. A nontrade receivable, on the other hand, might be a loan to an affiliate company or to an officer of the firm. To understand how the creation of a nontrade receivable is an investing activity, you might view such a loan as an investment in the receivable.
10 FASB ASC 230–10–50–6: Statement of Cash Flows–Overall–Disclosure–Noncash Investing and Financing Activities (previously “Statement of Cash Flows,” Statement of Financial Accounting Standards No. 95 (Stamford, Conn.: FASB, 1987), par. 74).