PORTFOLIO

The Cash Flow Statement (Portfolio 5121)

BNA Tax and Accounting Portfolio 5121-3rd, The Cash Flow Statement (Accounting Policy and Practice Series), examines the cash flow statement required by the FASB Accounting Standards Codification (FASB ASC) 230, which is based in large part on FASB Statement No. 95, Statement of Cash Flows (FAS 95). 

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DESCRIPTION

BNA Tax and Accounting Portfolio 5121-3rd, The Cash Flow Statement (Accounting Policy and Practice Series), examines the cash flow statement required by the FASB Accounting Standards Codification (FASB ASC) 230, which is based in large part on FASB Statement No. 95, Statement of Cash Flows (FAS 95). Under ASC 230, as amended, most business enterprises (and not-for-profit organizations) must provide a cash flow statement for each period for which results of operations (or activities) are provided.
The cash flow statement explains the change during the period in cash and cash equivalents, and classifies cash inflows and outflows into a trichotomy relating to operating, investing, or financing activities. Additionally, cash flow subtotals are reported for each of three activities: net cash flow from operating activities (NCFO), net cash flow from investing activities (NCFI), and net cash flow from financing activities (NCFF).
ASC 230 permits several alternatives in preparing cash flow statements. Each reporting entity must decide whether to use the direct method or the indirect (reconciliation) method to report NCFO, and establish a classification policy with regards to cash equivalents. Certain cash flows may be reported on either a “gross” or “net” basis. All cash flows must be classified as relating to operating, investing or financing activities. This Portfolio examines the advantages and disadvantages of these alternatives. It also examines how the classification of certain cash flows under ASC 230 is consistent or inconsistent with the trichotomy.
Besides explaining the rules and alternatives, this Portfolio describes in practical terms how to apply ASC 230 to various types of business enterprises. It illustrates cash flow statements of a merchandising or manufacturing company under the direct method and the indirect method, explains how to prepare them, and also explains how to prepare worksheets to facilitate their preparation. The Portfolio also discusses the advantages and disadvantages of each method. It also includes worksheets that illustrate and explain the calculation of the foreign currency exchange rate effect on cash in two separate situations: when the foreign currency is the functional currency, and when the U.S. dollar is the functional currency. Additionally, this Portfolio includes illustrative cash flow statements of a railroad, a utility, a financial company, an insurance company, and a health care entity.
This Portfolio also examines the historical context in which the requirements of ASC 230 were developed as a means to better understand their purpose, strengths and weaknesses. It identifies and analyzes the inconsistencies and ambiguities of the various requirements, especially the classification rules, and illustrates some of these inconsistencies and ambiguities with examples from published cash flow statements. It also addresses in passing some of the major criticisms of ASC 230 and some of the proposals to amend its rules to make it more internally consistent and more useful to report users. Finally, this Portfolio explains how financial analysts adjust cash flow statement numbers for analytical purposes.
This Portfolio may be cited as BNA Tax and Accounting Portfolio 5121-3rd, Nurnberg, The Cash Flow Statement (Accounting Policy and Practice Series). Within the Accounting Portfolio Series, however, references to the Portfolios will include only the Portfolio numbers and titles.


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AUTHORS

HUGO NURNBERG, CPA, PH.D.
Hugo Nurnberg, Ph.D., Columbia University; M.B.A., Baruch College; B.S., Queens College. Licensed as a Certified Public Accountant (New York), Dr. Nurnberg frequently serves as an expert witness and manages continuing education programs for practicing accountants and nonfinancial executives. Dr. Nurnberg has authored numerous articles in leading journals, including Accounting Forum, Accounting Horizons, The Accounting Review, Journal of Accountancy, Journal of Accounting Research, Journal of Financial Statement Analysis, Journal of Business Finance and Accounting, The CPA Journal, and Issues in Accounting Education. A Professor of Accountancy at Baruch College of the City University of New York, Dr. Nurnberg has been a Visiting Professor at the University of Pennsylvania, Columbia University, the University of Chicago, Rutgers University, and St. John's University, and a Professor of Accounting at Michigan State University.
This Portfolio adapts and expands upon materials authored or co-authored by its author and published as journal articles in Accounting Forum, © 2006 by Blackwell Publishing for the University of South Australia and adapted with permission; Accounting Horizons and The Accounting Review, © 1982–2004 by the American Accounting Association and adapted with permission; and The CPA Journal, © 1990–2005 by the New York State Society of Certified Public Accountants and adapted with permission. This Portfolio also adapts materials authored by its author and published as an occasional paper by the Center for Excellence in Accounting and Security Analysis (CEASA) of Columbia Business School of Columbia University, © 2006 by CEASA and adapted with permission. The author acknowledges that partial support for this Portfolio has been received from CEASA.

TABLE OF CONTENTS

Detailed Analysis

I. Introduction and Scope of Portfolio

A. Pertinent Pronouncements

B. Nature of Cash Flow Statement

C. Historical Perspective

D. Scope of Portfolio

II. Objectives of Cash Flow Statement

III. Importance of Cash Flow Statement Classifications

IV. Net Cash Flow From Operating Activities Versus Free Cash Flow

V. Direct Versus Indirect Method of Reporting NCFO

Introductory Material

A. Mechanics of Direct and Indirect Method

1. Steps to Prepare Direct Method Cash Flow Statement

a. Compute Change in Cash for Period

b. Compute Operating Cash Inflows by Adjusting Operating Revenues Less Bad Debt Expense for Change in Net Accounts Receivables

c. Compute Operating Cash Outflows by Adjusting Operating Expenses for Changes in Inventories, Prepayments, and Payables

(1) Compute Payments to Inventory Suppliers

(2) Compute Payments to Employees and Other Suppliers

(3) Compute Interest Payments

(4) Compute Income Tax Payments

d. Compute Net Cash Flow From Operating Activities as the Difference Between Total Operating Inflows and Total Operating Outflows

e. Identify All Other Cash Inflows and Outflows, and Classify as Relating to Either Investing or Financing Activities

(1) Identify Investing Activities

(2) Identify Financing Activities-Issuance and Retirement of Bonded Debt

(3) Identify Financing Activities-Issuance and Retirement of Common Stock

(4) Identify Financing Activities-Dividend Payments

f. Sum All Investing Cash Inflows and Outflows to Determine Net Cash Flow From Investing Activities (NCFI)

g. Sum All Financing Cash Inflows and Outflows to Determine Net Cash Flow From Financing Activities (NCFF)

h. Sum Net Cash Flow From Operating Activities (NCFO), Net Cash Flow From Investing Activities (NCFI), and Net Cash Flow From Financing Activities (NCFF)

i. Compare Sum In Step h to Amount in Step a

2. Steps to Prepare Indirect Method Cash Flow Statement

a. Compute Change in Cash for Period

b. Compute Net Cash Flow From Operating Activities by Adjusting Net Income for Noncash Revenues and Expenses and Nonoperating Gains and Losses

c. Identify All Other Cash Inflows and Outflows, and Classify as Relating to Either Investing or Financing Activities

(1) Identify Investing Activities

(2) Identify Financing Activities-Issuance and Retirement of Bonded Debt

(3) Identify Financing Activities-Issuance and Retirement of Common Stock

(4) Identify Financing Activities-Dividend Payments

d. Sum All Investing Cash Inflows and Outflows to Determine Net Cash Flow From Investing Activities (NCFI)

e. Sum All Financing Cash Inflows and Outflows to Determine Net Cash Flow From Financing Activities (NCFF)

f. Sum Net Cash Flow From Operating Activities, Net Cash Flow From Investing Activities, and Net Cash Flow From Financing Activities

g. Compare Sum in Step f to Amount in Step a

B. Advantages of Indirect Method

C. Disadvantages of Indirect Method

D. Disadvantages of Direct Method

E. Advantages of Direct Method

F. Genesis of GAAP Compromise

G. Evaluation

VI. Classification Trichotomy Under FAS 95

Introductory Material

A. Operating Activities

B. Investing Activities

C. Financing Activities

VII. Implications of FAS 95 Trichotomy

Introductory Material

A. Classification by Nature

B. Arbitrariness of Three-Way Classification

1. Operating Versus Investing Activities

2. Operating Versus Financing Activities

3. Investing Versus Financing Activities

VIII. Classification Ambiguities and Inconsistencies Under FAS 95

Introductory Material

A. Interest Payments

1. GAAP Classification Rules

2. Materiality of Interest Payments

3. Historical Perspective

4. Evaluation of FASB Rationale

5. Bonded Debt

6. Debt Issuance Costs

7. Capitalized Interest

B. Interest and Dividend Collections

C. Income Taxes

1. Example

a. FAS 95 Presentation (No Tax Allocation)

b. Alternative Presentation (Tax Allocation)

2. Materiality Issues

3. Disadvantages of Income Tax Allocation

4. Advantages of Income Tax Allocation

5. Palliatives Acceptable Under GAAP

6. Palliatives Not Acceptable Under GAAP

7. Income Tax Refunds

D. Installment Sales and Purchases of Inventory

E. Sales-Type Lease Receivables

F. Installment Purchases and Sales of Plant Assets

G. Purchase and Sale of Rental Assets

1. Example

2. Evaluation

H. Casualty Insurance Settlements

I. Purchase and Sale of Debt and Equity Investments

1. Classification Issues Under Existing GAAP

2. Evaluation

J. Capitalized Software Development Cost

K. Capitalized Film Development Costs

L. Company-Owned Life Insurance

1. Classification of Annual Premiums

2. Classification of Death Benefits

3. COLI Materiality Issues

4. Evaluation of COLI Flows Under FAS 95 Trichotomy

M. Acquisitions and Dispositions of Businesses

1. Effect on Reported NCFO

2. Effect on FCF

3. Estimating Impact

N. Overdrafts

O. Notes Payable

P. Sale or Transfer of Receivables

Q. Payments to Settle Pension Liabilities

R. Sale-Leaseback Transactions

S. Repurchase Agreements and Reverse Repurchase Agreements

1. Income Statement Reporting

2. Cash Flow Statement Reporting Under Extant GAAP

3. Evaluation

T. Hedging Transactions

IX. Lack of Comparability and Transparency

X. Other Issues

A. Enterprises Exempt From FAS 95

B. Cash and Cash Equivalents

C. Gross Versus Net Presentation of Cash Flows

D. Foreign Currency Translation

E. Noncash Investing and Financing Transactions

1. Examples

2. Background of Current Disclosure Requirement

3. Current Disclosure Requirement

4. Ambiguities in Current Disclosure Requirements

5. Illustrations of Disclosures of Noncash Transactions in Published Reports

F. Third-Party Financing Transactions

G. Depreciation of Manufacturing Equipment

1. Issue

2. Practical Considerations

H. Cash Flow Per Share

I. Discontinued Operations

XI. Analytical Adjustment of Cash Flow Statement

Introductory Material

A. Prospective (Pro Forma) Cash Flows

B. Noncash Transactions

C. Prospective Income Tax Effects

D. Free Cash Flow for Valuation Purposes

E. Classification Adjustments

XII. Summary and Conclusions


WORKING PAPERS

Working Papers

TABLE OF WORKSHEETS

Worksheet 1 Underlying Facts for Comparing Direct and Indirect Method Cash Flow Statements

Worksheet 2 Illustrative Direct Method Cash Flow Statement

Worksheet 3 Illustrative Indirect Method Cash Flow Statement

Worksheet 4 Working Paper For Direct Method Cash Flow Statement

Worksheet 5 Working Paper for Indirect Method Cash Flow Statement

Worksheet 6 Tax Allocation Versus No Tax Allocation In Cash Flow Statement

Worksheet 7 Foreign Currency Exchange Rate Effect on Cash Balance-Current Rate Method

Worksheet 8 Foreign Currency Exchange Rate Effect on Cash Balance Temporal Method

Worksheet 9 Illustrative Indirect Method Cash Flow Statement-Retail Enterprise (J.C. Penney)

Worksheet 10 Illustrative Indirect Method Cash Flow Statement-Manufacturing Enterprise (General Motors Corp.)

Worksheet 11 Illustrative Direct Method Cash Flow Statement-Manufacturing Enterprise (Northrop Grumman Corp.)

Worksheet 12 llustrative Direct Method Cash Flow Statement-Manufacturing & Retail Enterprise (The Rowe Companies)

Worksheet 13 Illustrative Indirect Method Cash Flow Statement-Fast Food Enterprise (Wendy's International Inc.)

Worksheet 14 Illustrative Indirect Method Cash Flow Statement-Franchisor Enterprise (Emerging Vision Inc.)

Worksheet 15 Illustrative Indirect Method Cash Flow Statement-Service Enterprise (Accenture SCA)

Worksheet 16 Illustrative Indirect Method Cash Flow Statement-Software Enterprise (Microsoft Corp.)

Worksheet 17 llustrative Indirect Method Cash Flow Statement-Railroad Enterprise (Norfolk Southern)

Worksheet 18 Illustrative Indirect Method Cash Flow Statement-Electric Utility Enterprise (Delmarva Power & Light Co.)

Worksheet 19 llustrative Direct Method Cash Flow Statement-Financial Enterprise (Bank of Granite Corp.)

Worksheet 20 llustrative Indirect Method Cash Flow Statement-Financial Enterprise (Citigroup Inc.)

Worksheet 21 Illustrative Indirect Method Cash Flow Statement-Insurance Enterprise (MetLife Inc.)

Worksheet 22 Illustrative Indirect Method Cash Flow Statement-Healthcare Enterprise (HCA Inc.)

Worksheet 23 List of Significant Accounting Pronouncements Principally Discussed

Bibliography

OFFICIAL

AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS (AICPA)

Accounting Principles Board Opinions

AICPA Statements of Positions

AICPA Audit and Accounting Guides

AICPA Statements on Auditing Standards

EMERGING ISSUES TASK FORCE (EITF)

EITF Issues

FINANCIAL ACCOUNTING STANDARDS BOARD (FASB)

FASB Concepts Statements

FASB Statements of Financial Accounting Standards

Misc. FASB Materials

GOVERNMENT ACCOUNTING STANDARDS BOARD

GASB Statements

SECURITIES AND EXCHANGE COMMISSION (SEC)

Accounting Series Releases

Misc. SEC Materials

Miscellaneous

UNOFFICIAL

Articles and Books