Challenges Faced in Cash Flow Statement Preparation

Question description

Review the available materials for the chapters covered this week, including the lecture, reading, publisher materials, demonstration problems and exercises at the end of the chapters. After reviewing these materials and attempting the assignment for the week, what challenges did you face? Do you have any questions on the material? . Horngren’s Accounting, The Financial Chapters Read chapter 16.http://gcumedia.com/digital-resources/pearson/2013/horngrens-accounting-the-financial-chapters-with-myaccountinglab_ebook_10e.php The Statement of Cash Flows

Introduction

Generally accepted accounting principles (GAAP) typically evolves in practice, rather than being written and then followed. An example of this evolution is the financial statement called, the statement of cash flows. Managers and business owners often asked why their companies were profitable, but did not have available cash, or had plenty of cash, but were operating at a loss. In response to this need, accountants developed the statement of cash flows to explain how cash was provided to the company or used by the company. The statement of cash flows is now a required financial statement according to GAAP. Since the statement of cash flows was developed long after the other three statements−the balance sheet, income statement, and statement of stockholders’ equity−it does not follow the same flow as the other statements and requires information from all of the other statements, as well as additional information, in order to be compiled. The statement of cash flows is useful because it shows an organization’s ability to produce future cash flows, provides an indication that the organization can meet its obligations, reports the differences between net income and net cash flows, and identifies the cash and noncash investing and financing activities during the period.

Internal Control Structure

In recent years, there has been great focus on the internal control system of an entity. The Sarbanes-Oxley Act of 2002 mandated that the system of internal control for all publicly traded companies be adequate in the prevention or detection of errors or irregularities in financial reporting and that corporate executives and boards of directors are responsible for these systems of internal control (Kimmel, Weygandt, & Kieso, 2009). The internal control structure is the system of all related methods and measures adopted within an organization to “safeguard its assets, increase efficiency of operations, and ensure compliance with laws and regulations” (Kimmel et al., pp. 327-328). The six basic principles of internal control activities are:

Establishment of responsibility

Segregation of duties

Documentation procedures

Physical controls

Independent internal verification

Human resource controls (Kimmel et al.)

Many of the internal control procedures of a company focus upon cash.

Cash and Cash Equivalents

Cash is the most liquid of all assets, and it is the most susceptible to fraudulent activity. In order to protect cash, management must have a strong internal control structure in place, including provisions that physically safeguard cash, procedures that limit employee access to cash, and measures to ensure accuracy in reporting. Holding money in a bank account and using a petty cash system for cash-on-hand will help to protect cash from theft and misuse. Cash management is critically important to decision makers that must have cash available to meet current needs, yet must avoid excess amounts of idle cash that produce no revenue. Analysis of cash is a key factor for potential creditors in decision making.

Cash equivalents are “short-term, highly liquid investments that are both (a) readily convertible to known amounts of cash, and (b) so near their maturity that they present insignificant risk of changes in interest rates” (Kieso, Weygandt, & Warfield, 2010, pp. 320-321). Cash equivalents usually have original maturity dates of three months or fewer. Examples of cash equivalents are treasury bills, commercial paper, and money market funds (Kieso et al., 2010). Cash equivalents are often shown with cash in a classification called cash and cash equivalents on the balance sheet.

Usefulness of the Statement of Cash Flows

Profitable operations do not always ensure positive cash flow. While net income is important, cash flow is also critical to a company’s success. Cash flow permits a company to expand operations, replace worn assets, take advantage of new investment opportunities, and pay dividends to its owners. Both managers and analysts need to understand the various sources and uses of cash that are associated with business activities.

The cash flow statement focuses attention on a firm’s ability to generate cash internally, its management of current assets and current liabilities, and the details of its investments and its external financing (Libby, Libby, & Short, 2004). It is designed to help both managers and analysts answer important cash-related questions such as these:

Will the company have enough cash to pay its short-term debts to suppliers and other creditors without additional borrowing?

Is the company adequately managing its accounts receivable and inventory?

Has the company made necessary investments in new productive capacity?

Did the company generate enough cash flow internally to finance necessary investment or did it rely on external financing?

Is the company changing the makeup of its external financing?

These questions and others can be answered through the preparation and examination of the statement of cash flows.

Operating, Investing, and Financing Activities

The statement has three main sections: (a) cash flows from operating activities, which are related to income from normal, recurring operations; (b) cash flows from investing activities, which are related to the acquisition and sale of productive assets; and (c) cash flows from financing activities, which are related to external financing of the enterprise. The net cash inflow or outflow for the year is the same amount as the increase or decrease in cash and cash equivalents for the year on the balance sheet. Cash equivalents are highly liquid investments with original maturities of less than three months. The operating activities section of the statement of cash flows can be prepared using direct or indirect methods; the investing and financing activities sections always are prepared directly.

Direct Method of Determining Cash Flows from Operating Activities

The direct method for reporting cash flows from operating activities accumulates all of the operating transactions that result in either a debit or credit to cash into categories of cash inflows and cash outflows. The most common inflows are cash received from customers and dividends as well as interest on investments. The most common outflows are cash paid for the purchase of services and goods for resale, salaries and wages, income taxes, and interest on liabilities. The statement of cash flows from operating activities is prepared by adjusting each item on the income statement from an accrual basis to a cash basis.

Indirect Method of Determining Cash Flows from Operating Activities

The indirect method for reporting cash flows from operating activities includes a conversion of net income to net cash flow from operating activities. The conversion involves additions and subtractions for:

1.Noncurrent accruals, including expenses (such as depreciation expense) and revenues that do not affect current assets or current liabilities.

2.Changes in each of the individual current assets (other than cash and short-term investments) and current liabilities (other than short-term debt to financial institutions and current maturities of long-term debt that relates to financing), which reflect differences in the timing of accrual-basis net income and cash flows.

Financial Accounting Standards Board (FASB) Statement No. 95 requires that when the indirect method is used, additional disclosures must be made, such as the interest and income taxes paid by the company, so that the user of the financial statements may approximate the direct method of determining cash flows from operating activities (Kieso et al., 2010).

Cash Flows from Investing Activities

Investing activities reported on the cash flow statement include cash payments to acquire fixed assets and short- and long-term investments and cash proceeds from the sale of fixed assets and short- and long-term investments.

Cash Flows from Financing Activities

Cash inflows from financing activities include cash proceeds from the issuance of short- and long-term debt and common stock. Cash outflows include cash principal payments on short- and long-term debt, cash paid for the repurchase of the company’s stock, and cash dividend payments. Cash payments associated with interest are a cash flow from operating activities.

Analysis of Cash Flow Ratios

Cash flow ratios are highly scrutinized by present and potential creditors. The statement of cash flows, in conjunction with ratio analysis, can indicate whether a borrower will be able to repay funds if borrowed. The following ratios are typically used by present and potential creditors in analyzing cash flow potential.

Free cash flow — (cash flow from operating activities − capital expenditures − cash dividends) measures the cash remaining from operations after the company makes investments in new assets and pays out the expected dividends to stockholders (Kimmel et al., 2009). Free cash flow gives the analyst a better idea of how much cash truly is available from cash flows from operations than looking at the statement of cash flows alone.

Quality of income ratio — (cash flow from operating activities ÷ net income) measures the portion of income that was generated in cash. A higher quality of income ratio indicates greater ability to finance operating and other cash needs from operating cash inflows. A higher ratio also indicates that it is less likely that the company is using aggressive revenue recognition policies to increase net income.

Capital acquisition ratio — (cash flow from operating activities ÷ cash paid for property, plant, and equipment) reflects the portion of purchases of property, plant, and equipment financed from operating activities without the need for outside debt or equity financing or the sale of other investments or fixed assets. A high ratio benefits the company because it provides the company with opportunities for strategic acquisitions (Libby et al., 2004).

Impact of Additional Cash Flow Disclosures

Noncash investing and financing activities are investing and financing activities that do not involve cash. They include, for example, purchases of fixed assets with long-term debt or stock, exchanges of fixed assets, and exchanges of debt for stock. These transactions are disclosed only as supplemental disclosures to the cash flow statement along with cash paid for taxes and interest under the indirect method.

Conclusion

The statement of cash flows is considered by many to be the most important of the financial statements in indicating a company’s ability to remain a going concern. Although a company’s mission, product, distribution chain, corporate culture, and marketing strategy are all key elements of a successful business, a company cannot survive in the short term without available cash. To employ workers, replenish inventory, and foster growth, a company must have sufficient cash available to pay for its current operating expenses, meet maturing long-term debt obligations, and supply working capital for opportunities that arise. There must exist a balance between having enough cash on hand to meet needs and keeping funds invested in the assets of a business. The statement of cash flows aids users in analyzing whether or not a company is successful in achieving this balance.

References

Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2010). Intermediate accounting (13^th ed.). Hoboken, NJ: John Wiley & Sons.

Kimmel, P. D., Weygandt, J. J., & Kieso, D. E. (2009). Accounting: Tools for business decision making (3rd ed.). Hoboken, NJ: John Wiley & Sons, Inc.

Libby, R., Libby, P., & Short, D. (2004). Financial accounting (4th ed.). Boston: McGraw-Hill/Irwin

The Statement of Cash Flows