COMM 321 Unit 1 Introduction

COMM 321 Unit 1: Introduction (Chapters 1 & 2) The Canadian Financial Reporting Environment Before studying the various accounting rules and statements, it’s necessary to understand why there is a need for accounting standards, how they are set, and signs that the preparers of financial information may not be following them. By law, any corporation, big or small, must produce a set of financial statements (F/S) for its shareholders as well as the government. For large corporations, the users of F/S can also include banks, equity analysts, credit rating agencies, customers, suppliers, managers, unions, regulators, potential shareholders, tax authorities, etc. All users are relying on the F/S in order to make decisions about the subject corporation. Lenders and investors, whether existing or potential, need to make decisions as to whether they will extend their financial resources (money) to the corporation. Suppliers and customers need to decide whether they will commit their resources to the corporation on an ongoing basis. All are looking to assess how management is performing. This leads to the objective of financial reporting. The objective of financial reporting is to communicate useful information about an entity to key decision makers that allows them to make resource allocation decisions and assess management stewardship. The reality of large corporations is the people or entities with funds at risk (investors and creditors) are not managing the corporation and further, they have investment alternatives. They need to be able to compare the income prospects and economic resources of all alternatives they are evaluating, and to assess the relative risks and returns of each. This creates a need for accounting standards – companies must prepare their F/S using the same principles and rules, thereby allowing users to easily understand their economic situation and compare it to others. Accounting Standards in Canada Standards in Canada must be set by CPA Canada (the organization for Chartered Professional Accountants). This is mandated by the Canadian Business Corporations Act and by the various securities commissions in Canada – both require F/S to be prepared in accordance with Generally Accepted Accounting Principles (GAAP) as set by CPA Canada. All standards can be found in the CPA Canada Handbook, available online (UW students can access it through the library for free). There are two sets of accounting rules or standards that have been mandated by CPA Canada. They are known by the acronyms IFRS and ASPE.  Publicly accountable enterprises and government business enterprises must follow IFRS: International Financial Reporting Standards  Private Companies, pension plans and non-profit enterprises can follow either IFRS or ASPE: Accounting Standards for Private Enterprises 1

Therefore, if a company’s shares are traded publicly (e.g. on the Toronto Stock Exchange), they must follow IFRS. If they are a private company, they can choose either IFRS or ASPE. Both IFRS and ASPE are principles based (vs. strict rules based), allowing for flexibility and the use of professional judgement by the accountant. The IFRS are set by the International Accounting Standards Board (IASB), based in London, England. The ASPE are set by the Accounting Standards Board (AcSB) of CPA Canada, based in Toronto, ON. The U.S. currently follows their own GAAP as set by the Securities and Exchange Commission (SEC), supported by FASB (the U.S. Financial Accounting Standards Board). The SEC has stated it desires to adopt IFRS for US companies but the timetable is unclear – many in the U.S. believe their GAAP is rules based whereas IFRS is principles based. IFRS has been adopted by most countries worldwide – the other major holdouts are China, which has stated it will adopt IFRS but has not set a date, and Japan where IFRS are optional but not required. The process for setting standards is as follows: 1. A need for a standard is identified and put on the agenda of the standard setting body by interested parties; the need is usually created by a new type of business transaction; for example, when the first interest rate swap was entered into by a bank and its customer – a swap is an agreement to exchange one set of cash flows for another – there was no accounting standard in place; as such, neither the bank nor its customer were entirely sure how they should account for the swap. 2. The board conducts its own research and analysis, then publishes an exposure draft for comment. 3. The exposure draft is sent to all interested parties for comments (this will include all major accounting firms as well as the corporations that are currently entering into these new types of transactions). 4. The board receives and evaluates the comments, incorporates them into the standard, possibly issuing a re-exposure draft if necessary. 5. The final standard is issued. 6. Standards are revised if and when necessary using the same approach (the IASB has a mandated 2-year post-implementation review of each standard). When a company enters into a business transaction, the accountants (and auditors) must decide how to account for the transaction in terms of how it should be presented on the F/S. In resolving accounting issues, there is a hierarchy that is followed. In order, it is:  The CPA Canada Handbook (Parts 1-4; Part 1 is IFRS, Part 2 is PE, Part 3 is Non-Profits, Part 4 is pension plans); if the transaction is covered by the CPA Canada Handbook, it must be accounted for in the prescribed manner  AcSB/IASB background information and basis for conclusions; this is an explanation for how the board reached its conclusions; this might provide guidance on how the transaction should be treated  AcSB/IASB implementation guidance  Pronouncements of standard setting bodies in other jurisdictions; for example if there is no Canadian standard but the U.S. has issued a standard, the U.S. standard will most likely be followed  Approved drafts of new standards  Exposure drafts or research studies  Accounting textbooks, journals, studies (many are referenced in CPA Canada Handbook)  Industry practice 2

F/S can, and has been , successfully sued for damages suffered by investors and creditors who relied on those F/S and the auditor’s report. Agency problem When it comes to the operation of businesses, an odd phenomenon occurs as the organization grows – the entities with the money at risk (bankers, bondholders, investors) are not the entities running the business day to day. All big corporations utilize agents – these are people who act for the entities with the money at risk. Examples include management, auditors, credit analysts, equity analysts, consultants, etc. The agency problem is the fact that sometimes agents will act in their own best interest rather than in the best interests of the shareholders or lenders. Examples of agent abuses that have occurred historically include:  Management concealing poor performance by altering financial statements  CEOs and CFOs intimidating junior staff to produce higher income numbers even when not warranted, through accounting misstatements  CEOs selecting close personal friends to sit on their board of directors  Senior executives giving themselves incentive compensation in life-changing dollar amounts (i.e. 8 and 9 figures) and tied to stock prices  Senior executives buying or selling their own company’s stock prior to good or bad news releases  Credit analysts rating companies higher than warranted in order to maintain fee revenues  Auditors approving financial statements they knew were wrong in order to maintain fee revenue, or in some cases, to maintain consulting revenue that dwarfed audit fees  Security analysts maintaining “buy” or “strong buy” ratings in order to win lucrative investment banking business In 2001/02, several large American multinationals went bankrupt, generating huge investor losses as well as job and pension losses. In many of these cases, F/S had been distorted to fraudulently conceal the underlying problems in the business. (Some of these frauds are topics for the COMM 321 group project.) Auditors, equity analysts and credit rating analysts had all failed to warn of any problems, even in as little as 3 weeks prior to the company going bankrupt. In response, the U.S. government passed the Sarbanes Oxley Act (2002). This act significantly changed the accounting, auditing and securities industries in the U.S, and was copied by many international jurisdictions, including Canada. The changes included:  Stronger independence rules for auditors, audit committees and securities analysts; for example, auditors could no longer accept consulting engagements from their audit customers  F/S must be signed and certified by CEO and CFO; prior to the act, only the auditors signed the F/S  Stronger jail sentences for executives who knowingly commit fraud and/or misrepresent their F/S; jail sentences handed out under the Act have been as high as 25 years  Protection for whistle blowers – these are people who spot illegal activity and report it  SEC given power over accounting and auditing industries through the Public Company Oversight Board (including power over accounting and auditing standards); previously this had been the sole domain of the U.S. accounting profession  Stronger reporting requirements for senior executive stock transactions ; executives now required to publicly report any stock purchases or sales 4

 Management and auditors must report on internal controls ; internal controls are the controls a company puts in place to ensure fraudulent transactions do not take place; the most common control is ensuring that an employee who has access to an asset does not have access to the accounting records that report on movement of that asset (e.g. the accounts receivable clerk would not have access to customer cheques arriving; warehouse staff would not have access to inventory records, etc.) The changes appear to be working. The number and size of frauds committed since the passage of the bill have declined. Further, before the act, it was relatively common for a University of Waterloo CPA co-op student to encounter fraud on several, if not every, work term. Today, many co-op students graduate without ever encountering fraud. Conceptual Framework for Financial Reporting In order to ensure accounting standards remain useful and consistent, standards setters use a conceptual framework to provide a guide for all standards and for the use of professional judgment by all accountants. The framework is presented pictorially in the textbook on page 2-31. The starting point is the users’ needs. This leads to the objective of financial reporting which as mentioned, is to provide useful information about the entity to existing and potential investors, creditors and other stakeholders to assist in making their resource allocation decisions and to assess the effectiveness of management stewardship. Other elements to the framework are: the qualitative characteristics of useful information, the elements of financial statements and the foundational principles of accounting. Qualitative Characteristics of useful financial information: 1. Fundamental Characteristics: a. Relevance - capable of making a difference; has predictive or confirmatory value b. Faithful Representation - complete, neutral and free from error 2. Enhancing Characteristics: a. Comparability - allows users to identify similarities and differences between entities; includes consistency b. Verifiability - different observers will reach same value c. Timeliness - to make their decisions d. Understandability – clear and concise to users; note that the standard for users is those who have reasonable business knowledge 3. Constraints: a. Materiality (if omitting it could influence decisions, it’s material); calculations indicative of materiality include 5% of pre-tax income, 1% or 2% of sales, 5% of assets b. Cost (cost of obtaining information must not be greater than benefit of providing it) Elements of Financial Statements: 1. Assets – owned by the company with the potential to provide future economic benefits 2. Liabilities – owed by the company, representing an obligation to transfer economic resources 3. Equity – the residual interest, representing assets less liabilities 4. Revenues – increases in economic resources resulting from an entity’s ordinary activities 5

the eyes of management, be written in plain language, focus on management strategy and amongst other things, mention the company’s vision, strategy and key performance drivers. COMM 321 Unit 2: The Income Statement (Chapter 4) Management Decision Making Management decisions in any corporation can be separated into:  Operating decisions – using the company’s resources to earn a profit  Investing decisions – using the company’s financial resources to invest in/dispose of assets  Financing decisions – obtaining the necessary funds to run the business (debt, equity, retaining profits) The results of all these decisions affect a company’s income. However, in assessing management stewardship, it makes sense to report financial performance in a way that showcases the results of these decisions separately, i.e. the results of operating decisions vs. financing decisions vs. investment decisions. The financial statement that reports a company’s financial performance is known as the Income Statement under ASPE and as the Statement of Comprehensive Income under IFRS (may also be split into a statement of profit or loss and statement of comprehensive income). The user’s objective is to evaluate past financial performance and be able to predict future financial performance and cash flows. It is therefore important to be able to assess which items are most likely recurring (will therefore impact next year) and which are not necessarily recurring. A clear distinction is between continuing operations and discontinued operations (any businesses which have been sold or shut down). Continuing operations are obviously the most important and are presented first. Within continuing operations, there will be an operating section and a non-operating section. Again, the intent is to allow the user to see the results of operating decisions, distinctly from investing and financing decisions, as well as to assess recurring income vs. income that is not necessarily recurring. Operating income should be the starting point in assessing recurring income. Key Accounts and Subtotals Within the Operating section: Sales – Cost of Goods Sold = Gross Profit – Selling General & Administrative Expenses (SG&A) = Operating Income Sales indicate whether the company is growing or shrinking. The gross profit is the profit the company generates from its products or services before deducting the costs of operating its business. For a distributor, the cost of goods sold is the actual cost of buying the inventory that has been sold. For a manufacturer, the cost of goods sold is the cost of manufacturing the goods that have been sold. Note that the cost includes all costs 7

associated with its factory – direct materials, direct labour and overhead . Hence depreciation of all factory equipment, all supervisor salaries, etc. are included in Cost of Goods Sold. SG&A is the cost of running the business and will include the costs of the sales, marketing, accounting, finance and human resource departments as well as all executives, all office equipment, office rent, etc. Operating income is therefore the profit before the impact of any financing or investment decisions. Analysts consider this to be one of the most if not the most important items on the income statement. It represents the profitability of the company’s main line of business. A healthy operating profit margin (i.e. operating income divided by sales) is a vital indicator of an attractive business. The next section is the Non-operating section which contains: Other Income and Gains (Investment Income, Interest Revenue, Rental Revenue, Asset Sales, Unusual Items) - Other Expenses & Losses (Investment Losses, Interest Expense, Asset Sales, Unusual Items) = Earnings from Continuing Operations before Tax - Income Tax Expense (on Income from Continuing Operations only) = Earnings from Continuing Operations Other Income is important since it will contain not just realized investment income but also unrealized investment income on investments held for trading purposes (realized means the investment has been sold; unrealized means the value of the investment has changed during the period but it has not yet been sold). Other Expenses for many companies will be where interest expense (the cost of financing using debt) resides. It is also important to recognize that the Income Tax Expense line will represent the tax expense associated with continuing operations only . This is to help the user in predicting next year’s Net Income. To arrive at Net Income, we must add or deduct any income or loss from discontinued operations. The discontinued operations are less important since they only impact the past. As such, the information will be summarized for the user and contain only the following: Income (Loss) from operations for the part of the year the business was owned and operated (this will be reported net of tax) Gain (Loss) on disposal (again, net of tax) Additional details will be presented in the notes to the financial statements. Note that discontinued operations should include those disposed of during the year and those held for sale at year-end. Earnings Per Share (EPS) Disclosures The income statement or Statement of Comprehensive Income also contains EPS information for the fiscal year. EPS must be segregated as follows: Income from Continuing Operations Income from Discontinued Operations Net Income 8

Comprehensive Income (IFRS only): Comprehensive Income comprises both Net Income as calculated above plus Other Comprehensive Income. Other Comprehensive Income (OCI) is simply a list of items that the IASB believes should be included in comprehensive income, but not net income. All items are non-cash, but are felt to be relevant to the user. The individual items are presented as separate line items, net of tax, after Net Income. The list includes:  Adjustments on revaluation of Property Plant & Equipment – this represents the difference between book value and fair value of certain property, plant and equipment; since real estate values may have changed considerably since land and buildings were purchased (e.g. businesses that have been operating for more than 25 years), there could be significant value tied up in the company’s land and buildings; although the company may not intend to sell the assets, it is still felt to be relevant to the user  Unrealized gains/losses on FX translation of foreign subsidiaries – many companies have subsidiaries in countries with highly volatile currencies (e.g. Argentina); the gain or loss in the value of the subsidiary due to currency volatility is felt to be relevant to the user  Actuarial gains/losses on defined benefit pension plans; these are plans in which the pensioner is paid a certain amount every year based on their final salary, i.e. an annuity; the company’s pension liability is the present value of this annuity; as interest rates change, the liability changes;  Changes in the fair value of a financial instrument used as a cash flow hedge; companies will often hedge future cash flows using derivative contracts, e.g. a liability to pay US$5 million in 5 years might be hedged using a 5-year US/CAD foreign exchange contract; as the US/CAD exchange rates change, the value of this contract goes up or down; although the company is unlikely to sell the contract as long as their liability remains intact, any gains or losses were felt to be relevant to the user  Unrealized gains/losses on investments measured using the Fair Value through OCI method (FV-OCI) – we’ll expand on this in Unit 9 but there are 3 methods of measuring investments when a company does not control or exert significant influence over the investee; the most popular methods are the other two: the cost/amortized cost model and the Fair Value through Net Income (FV-NI) model; however, for any unrealized gains/losses on FV-OCI investments, representing the change in value of these securities during the period, they must be included as OCI Just as Net Income is closed out every year to Retained Earnings, Other Comprehensive Income must also be closed out every year. The offset to OCI is an equity account called Accumulated Other Comprehensive Income which is reported in Shareholders’ Equity, after R/E. Hence for public companies, their Shareholders’ Equity contains Preferred Shares, Common Shares, Contributed Surplus (if applicable), Retained Earnings and Accumulated Other Comprehensive Income. Other Issues: Assets Held for Sale (i.e. Discontinued Operations) As mentioned, discontinued operations should include both those operations that were sold or closed during the year, plus any operations currently being sold. From an accounting perspective, assets being held for sale means:  There is an authorized plan to sell in place 10

 The asset is available for immediate sale  There is an active program to find a buyer in process  The sale is probable within a year  The asset is reasonably priced  Any changes to the plan are unlikely If all the above conditions are met, then the accounting treatment is as follows:  Income (Loss) for the period appears in the discontinued operations section of the Income Statement  No further depreciation is recorded on any asset  Asset is written down to the lower of its carrying value or its fair value less selling costs  Asset is presented separately on the Balance Sheet: IFRS – classify as current asset; ASPE – retain original classification of asset (either current or L-T) ASPE: Statement of Retained Earnings: Under ASPE, the Net Income is carried to the Statement of Retained Earnings. The Statement of Retained Earnings is a brief statement, normally in the following format: Balance, January 1 as reported Adjustment for prior period error or change in accounting policy if applicable Balance, January 1 as restated Add: Net Income Less: Cash Dividends Stock Dividends Balance, December 31 IFRS: Statement of Shareholders’ Equity: Under IFRS, Net Income and Comprehensive Income are carried to the Statemen of Shareholders’ Equity. We will discuss this statement later in the course, but it is presented more like a table than an actual statement, as shown below. Preferred Shares Common Shares Contributed Surplus Retained Earnings Accumulated OCI Total Opening Balance $ $ $ $ $ $$$ Any Restatement Opening Restated $ $ $ $ $ $$$ Issuance of Shares $ $ $ Repurchase of Shares ($) ($) ($) Possible $ Net Income $ $ OCI $ $ Comprehensive Income $ $ $ Dividends ($) $ Ending Balance $ $ $ $ $ $$$ * Negative numbers usually appear in brackets 11

 Inventories*  Trade and other receivables*  Cash and cash equivalents*  Total of assets held for sale*  Total of liabilities in assets held for sale*  Trade and other payables*  Provisions  Current tax assets and liabilities*  Deferred tax assets and liabilities*  Non-controlling interests  Issued capital and reserves attributable to owners Practice: A practice balance sheet and solution has been posted in Learn. Download the practice question in Excel – it’s in the format of a trial balance (also appears below) – and try to complete the balance sheet on your own in the typical North American format. Compare your answer to the solution. 13

Zeitz Corporation Trial Balance December 31, 2011 Debit Credit Accounts Payable 545,000 Accounts Receivable 515,000 Accrued Liabilities 96,000 Accumulated Depreciation - buildings 152,000 Accumulated Depreciation - equipment 60,000 Accumulated Other Comprehensive Income 80,000 Administrative Expenses 900,000 Allowance for Doubtful Accounts 25,000 Bonds Payable 1,000,000 Buildings 1,040,000 Cash 205,000 Common Shares 809,000 Correction of prior year's error (affects income) 140,000 Cost of Goods Sold 4,800,000 Equipment 600,000 Franchise 160,000 Interest Expense 211,000 Inventory 687,000 Investment Gains 63,000 Investment in Bonds (hold to maturity) 299,000 Land 260,000 Long Term Notes Payable 900,000 L-T Investment in Shares (FV through OCI 277,000 - market value = 345,000) Patent 195,000 Retained Earnings 218,000 Sales 7,960,000 Selling Expenses 1,860,000 S-T Notes Payable 98,000 Trading Securities 153,000 Unusal Gain 160,000 Wages Payable 136,000 12,302,000 12,302,000 1. What was Zeitz's income for the year? 2. Is the above Retained Earnings the opening or closing balance? 3. Prepare a Statement of Financial Position, ignoring income taxes 14

Note that cash subject to restrictions (e.g. sinking funds, or balances that must be maintained pursuant to a loan agreement) must be excluded. Cash received from (or used in) Operating Activities: This will be the cash flow related to the business’ primary revenue producing activities and other activities that are not investing or financing activities. Since it tells the user how much cash the main business is generating, many analysts regard this as the most important line in the entire set of financial statements. It includes receipts from customers, payments to suppliers, employees, tax authorities, insurers, etc. Operating cash flows are generally related to the changes in the working capital accounts , i.e. Current Assets and Current Liabilities. Cash received from (or used in) Investing Activities: This will be the cash flow related to the acquisition and disposal of long-term assets and investments . It tells the user whether the company is spending money on revenue generating assets or not. It includes purchases of land, buildings or equipment, purchases of investments, as well as the proceeds from the disposition of any assets. Investing cash flows are generally related to the cash change in the long-term asset accounts (Long-Term Investments, Property, Plant & Equipment). Cash received from (or used in) Financing Activities: This will be the cash flow related to changes in the company’s capital base – long term debt and equity . It tells the user how the company’s capital base is changing. It includes the proceeds from the issuance of debt or equity securities, the cost of repaying or redeeming debt, the amount spent on repurchasing the company’s own capital stock, as well as the payment of dividends. Financing cash flows are generally related to the cash change in the Long-Term Liability and Equity accounts. ** Note that significant non-cash transactions are excluded from the Statement of Cash Flows, although they would be disclosed elsewhere. These are transactions such as the acquisition of assets by assuming liabilities, the acquisition of another company by issuing shares, or the conversion of debt to equity. When a transaction is conducted partially using cash and partially non-cash, only the cash part affects the Statement of Cash Flows. For example, if a $60,000 asset is acquired for $50,000 cash plus 200 common shares, the acquisition of the asset would show up in the Cash Flow from Investing Activities as a purchase for $50,000. The remaining $10,000 (and the increase in common shares from the issuance of the 200 shares) would be disclosed in the notes. IFRS vs. ASPE A significant difference between ASPE and IFRS is the treatment of interest and dividends, both paid and received. Under ASPE interest or dividends paid or received that is included in Net Income must be presented under operating activities and interest or dividends paid that is deducted from retained earnings must be 16

presented under financing activities . Therefore, virtually all private companies show interest received and paid, as well as dividends received under operating activities and dividends paid under financing activities. IFRS allows the payment of interest or dividends to be treated as either operating or financing activities, and the receipt of dividends to be treated as either operating or investing activities. Direct vs. Indirect Method There are two methods of presenting the cash flow from operating activities: the direct method and the indirect method. Both IFRS and ASPE allow for the use of either method and the total cash flow from operating activities will be the same under either method . The U.S. requires companies using the direct method to also include the indirect method. As a result, virtually all North American companies use the indirect method only. Note that the decision only impacts the appearance of Cash Flow from Operating Activities . Cash Flow from Investing Activities and Cash Flow from Financing Activities will be the same under both methods. The direct method looks like a cash income statement. Instead of Sales , the top line is Cash Receipts from Customers . Instead of Cost of Goods Sold , it discloses Cash paid to Suppliers . Instead of Wages Expense , it discloses Cash paid to Employees . And so on. The indirect method on the other hand begins with Net Income and then adjusts for non-cash items. So depreciation and any gains or losses on disposal of assets are both backed out straight away. (Recall that a gain or loss on asset disposal is calculated as the Proceeds Received less the Net Book Value (NBV) of the asset; the proceeds are usually the cash item, but the NBV is the asset’s cost less the asset’s accumulated depreciation, which is non-cash.) After these two items, the changes in the working capital accounts are either added or subtracted. Direct Method The direct method uses data from both the income statement and balance sheet to arrive at the individual line items. It is a key takeaway from COMM 321 to be able to calculate the line items for the direct method once you have been given an income statement and a balance sheet. Keep in mind that you are calculating the impact on cash for the current year . In the following sections, assume a December 31 year-end. Cash Receipts from Customers: On the income statement, customers impact Net Sales; on the balance sheet, customers impact Accounts Receivable and Unearned Revenue. To arrive at the cash receipts from customers, the starting point is Sales. The January 1 balance in Accounts Receivable will have been collected by year-end but those receivables are not included in this year’s Sales. The December 31 Accounts Receivables were included in this year’s Sales but will not have been collected yet. So the cash received from most customers this year will be Net Sales + Opening Accounts Receivable – Ending Accounts Receivable. Unearned Revenues represent cash that a company has collected from customers before the company provides goods or services. As such they are a current liability – the company owes its customer goods or services. The journal entries are typically as follows. When the money is collected: DR Cash $$$ CR Unearned Revenue $$$ 17

The 2018 Prepaid Insurance is part of 2019 Insurance Expense but was not paid in 2019. The 2019 Prepaid Insurance was paid in 2019 but is not part of 2019 Insurance Expense. The cash paid to insurers in 2019 is: Cash Paid to Insurers = Insurance Expense – Opening Prepaid Insurance + Ending Prepaid Insurance = $16,500 – $3,000 + $4,500 = $18,000 Once all the calculations are complete, the operating activities section of the Statement of Cash Flows will look something like the following when the direct method is used. Cash receipts from customers Less: Cash paid to suppliers Cash paid to employees Cash paid to Lenders Cash paid to governments Cash paid to insurers/landlords Cash paid for Other Expenses = Cash provided by operating activities Indirect Method As mentioned, the indirect method begins with Net Income and then adjusts for non-cash items, starting with Depreciation and any gains/losses from asset disposals. However, changes in the company’s working capital accounts will impact cash flow from operating activities. How? Recall the accounting equation: Assets = Liabilities + Equity or A = L + E A company’s cash flow for the year is the change in its cash balance from January 1 to December 31 of that year, assuming a December 31 year-end. So in terms of an equation, we have: Cash Flow = Δ Cash for the year (C = Cash) A = L + SE Δ A = Δ L + Δ SE Δ (C + Non-Cash A) = Δ L + Δ SE Δ C = Δ L + Δ SE – Δ Non-Cash A Hence if non-cash assets increase , cash will decrease ; if non-cash assets decrease , cash will increase. If liabilities or equity increase , cash will increase ; if liabilities and equity decrease , cash will decrease . So for the indirect method, any increases in Accounts Receivable or Inventory are deducted from Net Income whereas any decreases are added. Any increases in Accounts Payable, Wages Payable or Taxes Payable would be added to Net Income whereas any decreases would be deducted. 19

So under the indirect method the operating activities section of the Statement of Cash Flows will look something like the following: Net Income + Depreciation - Gain (Loss) on Asset Disposal - Increases (Decreases) in C/A balances (other than Cash!) + Increases (Decreases) in C/L balances = Cash Flow from Operating Activities Comparing the Direct Method to the Indirect Method: Direct: Indirect: Favoured by standards setters Most popular in North America by far Favoured by lenders Reconciles to other statements (I/S, B/S) Quasi cash income statement Line items are not cash items More meaningful, relevant to those who want cash flow info since the line items are real activities Shows management of working capital and its effect on cash (e.g. reducing inventory, extending payables Considered easier to read Required by US even when direct method is used Cash Flow Statement – Example of Indirect and Direct Methods from Balance Sheet and Income Statement The following is a simple example of a Statement of Cash Flows. Note that we are given the Income statement and Balance Sheet, but all line items on the cash flow statement must be calculated. Be sure to note that the difference in account balances tells the reader what must have happened. For example, we see that equipment has increased from $49,500 to $135,000. Hence the company must have purchased equipment which will appear in the investing activities section. Similarly, we see the company’s Common Shares have increased – hence they must have issued common shares during the year (financing activities). Although we are not told that the company paid dividends, we can see they must have. The retained earnings started the year at $76,500 and the company earned $225,000. If we add the two together, we get $301,500. But the ending retained earnings balance is $216,000. Retained earnings are only impacted by net income and dividends. Hence the company must have paid out dividends of $85,500 – this will appear in the financing activities section. 20