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Statement of Cash Flows - Lecture Notes

Statement of Cash Flows - Lecture Notes



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Published by Steven Sanderson

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Published by: Steven Sanderson on Oct 19, 2007
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1.The basic financial statements (income statement, retained earnings statement andthe balance sheet) are prepared under the accrual basis. Under this basis revenueis recorded when earned and expenses are recorded when incurred. These basicfinancial statements were difficult for managers to utilize since you could possibly have a high level of income but a low level of cash since under theaccrual basis concept, the revenue was recorded when earned and not when it wasreceived.2.Does net income under accrual basis equate to high levels of cash?
Why?(a)The revenue could be awaiting collection in the form of receivables on the balance sheet(b)Investment is made in plant and equipment will require the use of cash but does not reduce income, since the equipment is an asset. When willthe cost of the equipment acquisition be recovered? The recovery of theinitial acquisition of the equipment begins, and the reduction of incomeoccurs, as the equipment is being depreciated.(c)Cash received could be used to pay for additional inventory.Inventory can remain in stock for up to two months or more, until it issold. Once the inventory is sold, the a receivable is created and thisreceivable can remain outstanding (uncollected) for three months or longer. As a result a company may have to wait five months or longer toturn the initial investment in inventory back into cash when the receivableis collected.(d)Payment of liabilities for general operating expenses. The payment of theliability reduces cash but does not reduce net income when paid.3. Therefore a company could be profitable under accrual basis accounting and havea significant cash flow problem.4.Cash is the necessary element which runs the business. We need to know wherethe cash comes from (sources, or inflows) and where it is spent (uses or outflows).5.Presenting a comparative balance sheet and income statement does not show anydetails of what occurred during the year. All we know is the beginning andending balances. We can derive a net change based upon dollar amount and percentages but the details are not disclosed.1
6.Therefore to obtain informative data relations to cash a separate statement must be prepared and analyzed.7.The statement is called the Statement of Cash Flows (SCF).8.The SCF should detail results of a companies transactions classified in threecategories:a.Operating activities b. Investing activitiesc.Financing activities9.As part of the budgeting and planning process, budgeted financial statements andthe SCF should be prepared during the last quarter of the current year for theforthcoming year.This allows management to budget and predict the cash inflows and outflows on amonthly basis.The early identification of potential cash overages and/or shortages will allowmanagement to plan better.If cash flow is slow:a.Secure the availability of a revolving credit line for future use. b.Try to meet with members of the accounting department anddiscuss ways to improve cash flows such as-acceleration of the collection of receivables-deferral of payments of liabilities and expenses (however you do not want to damage your credit rating on your relationship with the vendors or suppliers by delaying payments too long).-Consider delaying acquisitions of capital equipment, etc.c.If cash flows are available (based upon the budgeted data)-consider the acquisition of plant and equipment-investments in marketable equity securities short terminvestments ( you do not want the cash to sit idle withoutearning interest)-
***give all the accountants huge bonuses (unfortunatelyI am just kidding!!) ***
10.The actual reporting results per the SCF should be compared with the budgetedstatement and investigate unusual favorable or unfavorable variances in an effortto increase operational efficiency.2
11.When preparing the SCF what sources should be analyzed?-Income statement-Balance sheet (comparative)-Retained earnings-General ledger for specific details affecting accountsdetected by the examination of the appropriate financialstatements-Inquires of management-Minutes of Board of Directors meetings12.Who can utilize information processed by the SCF?-Management-Investors-Creditors13.The SCF can be prepared using the direct or indirect method. NOTE: This method relates to the preparation of the SCF operating activitiessection.The investing and financing section is completed the same way regardless if theindirect or direct method is used.14.Indirect Method:a.Known as the reconciliation method b.Starts with net income (accrual basis) and reconciles to cash provided or used by operating activities.c.Used by the majority of companies in annual reports (Accounting Trendsand Techniques).d.Used by the majority of the companies that prepare annual reports as per Accounting Trends and Techniques (Book which summarizes all thereporting practices of the Fortune 100 Companies)3

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