CHAPTER 1

Financial Information and Cash Flows

 CHAPTER 1
 The Purpose of Accounting
Financial Statements
The Importance of Cash Flow
Preparing a Statement of Cash Flows
Selling Long-Term Assets
Analysis of the Statement of Cash Flows and Management of Cash
Ethics
In Summary

Copyright © 2020 AME Learning Inc. 2

The Purpose of Accounting

Accounting is a standardized system to identify, measure and communicate all of the financial
activities of a company.

Companies must adhere to Generally Accepted Accounting Principles (GAAP), which

include International Financial Reporting Standards (IFRS) or Accounting Standards for
Private Enterprises (ASPE), when reporting results to external users.

In Canada, IFRS is required for public companies and it can be cumbersome and expensive to
maintain. ASPE offers private companies the option of a less costly and simpler system to
follow.

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The Purpose of Accounting

Financial accounting is the branch of accounting concerned with classifying, measuring and
recording the transactions of a business to prepare formal financial statements of the result for
a company’s external users.

This includes direct users such as investors, suppliers, lenders and tax authorities and indirect
users such as labour unions, employees and customers.

Management accounting is the branch of accounting concerned with preparing specialized

reports to assist a company in making informed business decisions.

It serves internal users such as owners and managers.

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The Purpose of Accounting

The Uniform System of Accounts for the Lodging Industry (USALI) is a voluntary set of
guidelines specifically for the hospitality industry.

These guidelines also include financial presentation for internal users and a standardized set of
financial ratios and operating metrics that are useful for evaluating the performance of
hospitality companies.

Accounting transactions are recorded on an accrual basis.

Copyright © 2020 AME Learning Inc. 5

Management accounting best serves which of the following user groups?

a. Employees

b. Managers

c. Investors

d. Tax authorities

0% 0% 0% 0%

Copyright © 2020 AME Learning Inc. 6

Management accounting best serves which of the following user groups?

b. Managers

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 CHAPTER 1
 The Purpose of Accounting
 Financial Statements
The Importance of Cash Flow
Preparing a Statement of Cash Flows
Selling Long-Term Assets
Analysis of the Statement of Cash Flows and Management of Cash
Ethics
In Summary

Copyright © 2020 AME Learning Inc. 8

Financial Statements

Financial accounting focuses mostly on four types of financial statements:

 balance sheet
 income statement
 statement of owner’s equity
 statement of cash flows

The main financial statements discussed in this section are the income statement and the
balance sheet.

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Financial Statements

Income Statement
An income statement indicates the net income or profit for a company for a period of time. It
reports all revenues earned (also referred to as sales) and all expenses incurred for that period.

A company earns revenue by providing a service or product and charging customers for that
service or product. Expenses are costs incurred during the period to generate revenue.

Net income is calculated by subtracting expenses from revenue. A positive number results in
net income, while a negative number results in a net loss.

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Financial Statements

Example

Consider the Crow’s Nest Fine Dining Income Statement.

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Financial Statements

Inventory and Cost of Sales

Inventory is a collection of physical goods that a company has purchased or manufactured to

sell to its customers.

An expense account called cost of goods sold or cost of sales is used to track the cost of
inventory that was sold during a particular period.

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Financial Statements

Balance Sheet

A balance sheet reports the assets, liabilities and equity of a company at a point in time.

Assets are items of resources that a company owns that will provide benefit to the company.

Liabilities are the debts or obligations that a company owes. Equity is the net worth of the
company.

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Financial Statements

Example

The comparative balance sheet for Crow’s Nest

Fine Dining is shown.

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On which of the following financial statements would cost of sales appear?

a. Balance Sheet

b. Income Statement

c. Statement of Owner's Equity

d. Statement of Cash Flows

0% 0% 0% 0%

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On which of the following financial statements would cost of sales appear?

b. Income Statement

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 CHAPTER 1
 The Purpose of Accounting
 Financial Statements
 The Importance of Cash Flow
Preparing a Statement of Cash Flows
Selling Long-Term Assets
Analysis of the Statement of Cash Flows and Management of Cash
Ethics
In Summary

Copyright © 2020 AME Learning Inc. 17

The Importance of Cash Flow

Why is cash so important?

Without cash, a company cannot pay its bills. Without cash, a company cannot purchase and
pay for new inventory or other assets required to run the company.

ASPE and IFRS both require the creation of the Statement of Cash Flows to track the sources
and uses of cash in a company.

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The Importance of Cash Flow

Three Categories of Cash Flow Activities

A business generates and consumes cash in one of the following three ways.

1 2 3

Operating Activities Investing Activities Financing Activities

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The Importance of Cash Flow

Cash Flow from Operating Activities

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The Importance of Cash Flow

Cash Flow from Investing Activities

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The Importance of Cash Flow

Cash Flow from Financing Activities

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Which of the following is not a cash flow from operating activities?

a. Collecting cash from customers

b. Paying cash to suppliers

c. Paying employee salaries

d. Repaying bank loans

0% 0% 0% 0%

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Which of the following is not cash flow from operating activities?

d. Repaying bank loans

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Which of the following is a cash flow from investing activities?

a. Selling Long-Term Assets

b. Issuing shares

c. Cash received from short-term investments

d. Receiving bank loans

0% 0% 0% 0%

Copyright © 2020 AME Learning Inc. 25

Which of the following is a cash flow from investing activities?

a. Selling Long-Term Assets

Copyright © 2020 AME Learning Inc. 26

 CHAPTER 1
 The Purpose of Accounting
 Financial Statements
 The Importance of Cash Flow
 Preparing a Statement of Cash Flows
Selling Long-Term Assets
Analysis of the Statement of Cash Flows and Management of Cash
Ethics
In Summary

Copyright © 2020 AME Learning Inc. 27

Preparing a Statement of Cash Flows

Two methods are used to prepare a statement of cash flows. Both methods are allowed under
both ASPE and IFRS.

The indirect method analyzes cash flow from operating activities indirectly by starting with
accrual-based net income, and adding or subtracting certain items from the income statement
and changes in current assets and current liabilities on the balance sheet.

The direct method calculates cash flow from operating activities by directly analyzing cash
received from sales and collections, and directly analyzing cash spent on expenses.

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Preparing a Statement of Cash Flows

A Step-by-Step Approach to Preparing the Statement of Cash Flows

The Statement of Cash Flows is easiest to prepare using the following six steps.

1. Calculate the net increase (decrease) in cash during the period.

2. Calculate the net cash provided (or used) by operating activities using the indirect method.
3. Calculate the net cash provided (or used) by investing activities.
4. Calculate the net cash provided (or used) by financing activities.
5. Calculate the total net cash provided (or used) by operating, investing and financing activities combined.
6. Verify that this total net cash flow equals the ending cash balance less the beginning cash balance.

Copyright © 2020 AME Learning Inc. 29

Preparing a Statement of Cash Flows

Step 1. Calculate the net increase (decrease) in cash during the period.
Example
Consider Crow’s Nest Fine Dining. The difference in the last column is used when preparing the statement of
cash flows. The first line of the balance sheet shows that the cash account increased from $39,614 in 2019 to
$68,512 in 2020. Therefore, the net increase in cash for the year was $28,898 during 2020.

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Preparing a Statement of Cash Flows

Step 2. Calculate the net cash provided (or used) by operating activities using the indirect
method.

The indirect method of analyzing cash flows from operating activities begins with the period’s
net income (from the income statement), which is then adjusted as necessary.

These adjustments include adding back non-cash expenses to net income, and deducting non-
cash increases from net income.

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Preparing a Statement of Cash Flows

Cash flow from operating activities

Non-cash and non-operating items from the income statement include things such as:

 depreciation and amortization

 gains (losses) from the sale of assets
 gains (losses) on the retirement of debt

Their amounts must be canceled by adjusting net income.

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Preparing a Statement of Cash Flows

Cash flow from operating activities

a) Net income of $59,960 comes from the income statement.

b) Depreciation expense of $4,326 is added to the net income.
c) Gain on sale of land, $10,000 is subtracted from net income.

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Preparing a Statement of Cash Flows

Cash flow from operating activities

Changes in Operating Assets and Liabilities
The last step in the cash flow from operating activities section is to add or subtract changes in
items related to operating activities that do not flow through the income statement.

Not all items on the income statement reflect the actual amount of cash received or spent.

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Preparing a Statement of Cash Flows

Changes in Operating Assets and Liabilities

Consider the change in accounts receivable to calculate the cash received from customers.

Revenue – Current Period Accounts Receivable + Prior Period Accounts Receivable

or
Revenue + (Prior Period Accounts Receivable – Current Period Accounts Receivable)
or
Revenue ± Change in Accounts Receivable

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Preparing a Statement of Cash Flows

Changes in Current Assets and Current Liabilities

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Preparing a Statement of Cash Flows

We see the rest of the cash flow from operating activities under the indirect method.

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Preparing a Statement of Cash Flows
Click to see the Statement of Cash Flows

d) If Accounts Receivable increases, it means that cash has not been collected. The result is a
decrease to cash. The Accounts Receivable balances showed an increase of $22,032 from
2019 to 2020 so deduct this amount from the cash.

e) Food and beverage inventory increased by $84,347. Cash must have been used to pay for
this additional inventory, so deduct this amount from the cash.

f) Prepaid Insurance increased by $599, which decreases the cash balance because cash was
used to pay for the addition to Prepaid Insurance.

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Preparing a Statement of Cash Flows
Click to see the Statement of Cash Flows

g) Accounts Payable increased by $30,715, which increases the cash balance because Crow’s
Nest has delayed paying its suppliers.

h) Salaries and Wages Payable decreased by $2,500, which decreases the cash balance because
Crow’s Nest would have used cash to pay salaries owed.

i) Interest Payable also decreased by $785, which means that Crow’s Nest used cash to pay
for the interest owed. This decreases the cash balance.

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Preparing a Statement of Cash Flows
Click to see the Statement of Cashflows

j) Income taxes payable increased by $3,011, which means that Crow’s Nest has delayed
payment of income taxes resulting in an increase to the cash balance.

k) The sum of these increases and decreases in current assets and current liabilities, along with
the adjustments to net income for non-cash items, indicates that, in total, cash decreased by
$22,251 due to operating activities.

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Preparing a Statement of Cash Flows

Step 3. Calculate the net cash provided (or used) by investing activities.
Cash inflows from investing activities normally arise from selling long-term assets,
investments, and intangible assets. This section of the statement of cash flows deals with the
way cash flow changes through the investment in or sale of Long-Term Assets.

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Preparing a Statement of Cash Flows

Example

l) The proceeds from the sale of the land of $60,000 is added to the updated cash balance since
the transaction represents a cash inflow.
m)The $20,251 purchase of equipment is deducted from the cash balance.
n) The net cash provided by investing activities is $39,749.

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Preparing a Statement of Cash Flows

Step 4. Calculate the net cash provided (or used) by financing activities

Cash flows from financing activities include:

 The results of borrowing money or receiving cash from issuing shares

 Payments such as dividend payments or loan principal repayments
 Cash impacts from changes in liabilities for which interest must be paid (e.g. current and
long-term portions of notes payable); and
 Cash impacts from changes in the balances of preferred shares, common shares, and
contributed surplus as a result of shares being issued.

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Preparing a Statement of Cash Flows

For Crow’s Nest, the following account balances changed between 2019 and 2020: notes
payable, retained earning and common shares.

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Preparing a Statement of Cash Flows

Cash Flow from Financing Activities

o) The notes payable is reported in two places on the balance sheet: From 2019 to 2020, the
current portion increased by $14,000 and the long-term portion increased by $6,400,
resulting in a total increase in Notes Payable of $20,400 ($14,000 + $6,400).

p) The $10,000 dividend payment represents a decrease to cash because cash was used (i.e.
cash outflow).

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Preparing a Statement of Cash Flows

Cash Flow from Financing Activities

q) The balance of common shares increased by $1,000 from 2019 to 2020. When shares are
sold, cash is received.

r) Net cash provided (used) by financing activities accounts for an increase in cash of
$11,400 ($20,400 − $10,000 + $1,000) and this balance is added to the statement of cash
flows.

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Preparing a Statement of Cash Flows

Step 5. Calculate the total net cash provided (or used) by operating, investing and
financing activities

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Preparing a Statement of Cash Flows

Step 6. Verify the total net cash flow

Reported cash balance at Reported cash balance at

Total of cash −
= the beginning of the year the end of the year
provided or used

Copyright © 2020 AME Learning Inc. 48

Preparation of a cash flow statement using the indirect method involves adding
which of the following items to net income?

a. Gain on sale of land

b. Depreciation Expense

c. Increase in inventory

d. Decrease in salaries payable

0% 0% 0% 0%

Copyright © 2020 AME Learning Inc. 49

Preparation of a cash flow statement using the indirect method involves adding
which of the following items to net income?

b. Depreciation Expense

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Which account can be analyzed to calculate the amount of dividends paid?

a. Common Shares

b. Retained Earnings

c. Accounts Payable

d. Accounts Receivable

0% 0% 0% 0%

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Which account can be analyzed to calculate the amount of dividends paid?

b. Retained Earnings

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 CHAPTER 1
 The Purpose of Accounting
 Financial Statements
 The Importance of Cash Flow
 Preparing a Statement of Cash Flows
 Selling Long-Term Assets
Analysis of the Statement of Cash Flows and Management of Cash
Ethics
In Summary

Copyright © 2020 AME Learning Inc. 53

Selling Long-Term Assets

When selling equipment or any other long-term asset that depreciates in value, determining the
book value of the item is an important step in calculating cash flow.

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The beginning and ending balances of accumulated depreciation are $50,000 and
$70,000 respectively. Depreciation expense for the year is $30,000. How much is
the accumulated depreciation related to the assets sold during the year?

a. $10,000

b. $20,000

c. $30,000

d. $50,000

0% 0% 0% 0%
$10,000 $20,000 $30,000 $50,000 55
Copyright © 2020 AME Learning Inc.
The beginning and ending balances of accumulated depreciation are $50,000 and
$70,000 respectively. Depreciation expense for the year is $30,000. How much is
the accumulated depreciation related to the assets sold during the year?

a. $10,000

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The beginning and ending balances of long-term investments are $50,000 and
$40,000 respectively. A gain on sale of long-term investments for the year is
$3,000. How much cash is received from the sale of investments during the year?
(Assume no investments were purchased.)

a. $7,000

b. $10,000

c. $13,000

d. $40,000

0% 0% 0% 0%
$7,000 $10,000 $13,000 $40,000 57
Copyright © 2020 AME Learning Inc.
The beginning and ending balances of long-term investments are $50,000 and
$40,000 respectively. A gain on sale of long-term investments for the year is
$3,000. How much cash is received from the sale of investments during the year?
(Assume no investments were purchased.)

c. $13,000

Copyright © 2020 AME Learning Inc. 58

 CHAPTER 1
 The Purpose of Accounting
 Financial Statements
 The Importance of Cash Flow
 Preparing a Statement of Cash Flows
 Selling Long-Term Assets
 Analysis of the Statement of Cash Flows and Management of Cash
Ethics
In Summary

Copyright © 2020 AME Learning Inc. 59

Analysis of the Statement of Cash Flows and Management of Cash

Once the statement of cash flows is completed, it is analyzed to see if there are any concerns.

Example

For Crow’s Nest Fine Dining, cash increased during the year. Part of that increase includes an
outflow of cash from operating activities of $22,251.

This could be a problem for the company, since it indicates that day-to-day operations are not
generating a cash inflow. The company is not being self-sufficient with its operations.

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Analysis of the Statement of Cash Flows and Management of Cash

Cash Flow from Operating Activities

Two major contributors to Crow’s Nest’s cash outflow for from operations were an increase in
accounts receivable and an increase in inventory.

Both can indicate trouble for the company. A major source of cash inflow was accounts
payable.

We can analyze the impact on cash flow for these three accounts.

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Analysis of the Statement of Cash Flows and Management of Cash

Cash Flow from Operating Activities

Accounts Receivable
An increase in accounts receivable can result from an increase in sales on account instead of
sales for cash, or from customers taking longer to pay their bills.

Either situation means the company is not receiving cash on a timely basis.

Companies should give regular attention to the collection of their receivables to ensure
accounts do not become delinquent.

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Analysis of the Statement of Cash Flows and Management of Cash

Cash Flow from Operating Activities

Inventory
A large increase in inventory could indicate that the company is buying too much inventory,
which eventually has to be paid for with cash.

Ideally, inventory will be sold (and converted to cash) soon after it is purchased.

Keeping inventory to the minimum required is one of the best ways to conserve cash.

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Analysis of the Statement of Cash Flows and Management of Cash

Cash Flow from Operating Activities

Accounts Payable
An increase in accounts payable can result from an increase in purchases on account or from
delaying payment of supplier invoices.

A company can conserve cash by delaying paying invoices until they are due.

The company must be careful so that it does not become delinquent in its payments to
suppliers. This can cause interest charges and damage to the company’s ability to obtain credit
in the future.

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Analysis of the Statement of Cash Flows and Management of Cash

Cash Flow from Investing Activities

Crow’s Nest purchased some new equipment during the year and also sold some land.

Considering the cash outflow from operations, the question may be asked whether the sale of
land was simply to raise some cash to pay for operating expenses.

Financing operations by selling long-term assets is not a sustainable practice—eventually there

will be no more property, equipment or other long-term assets left to sell.

Copyright © 2020 AME Learning Inc. 65

Analysis of the Statement of Cash Flows and Management of Cash

Cash Flow from Financing Activities

The financing activities section of the statement of cash flows is the only one showing a cash
inflow. This is primarily due to a large bank loan.

If regular increases of debt are required to finance operations, it is an indication that operations
are not sustainable and the company could go out of business.

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Free Cash Flow

Free cash flow is the amount of cash remaining after a company has covered its capital
expenditures with its operating activities. Free cash flow is calculated by deducting the net cash
used for investing activities from the net cash provided by operating activities.

Free Cash Flow = Net Cash Flow from Operating Activities − Net Cash Flow from Investing Activities

The higher the free cash flow, the better because it indicates how much cash a company can
have available for new investments in case a new opportunity arises.

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The amount of cash remaining after a business has covered its capital
expenditures with its operating activities is referred to as:

a. investing cash flow

b. financing cash flow

c. net cash flow

d. free cash flow

0% 0% 0% 0%

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The amount of cash remaining after a business has covered its capital
expenditures with its operating activities is referred to as:

d. free cash flow

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Net cash flows from operating, investing and financing activities are $50,000, −
$25,000 and −$10,000 respectively. How much is free cash flow?

a. −$25,000

b. $15,000

c. $25,000

d. $35,000

0% 0% 0% 0%
−$25,000 $15,000 $25,000 $35,000 70
Copyright © 2020 AME Learning Inc.
Net cash flows from operating, investing and financing activities are $50,000, −
$25,000 and −$10,000 respectively. How much is free cash flow?

c. $25,000

Copyright © 2020 AME Learning Inc. 71

 CHAPTER 1
 The Purpose of Accounting
 Financial Statements
 The Importance of Cash Flow
 Preparing a Statement of Cash Flows
 Selling Long-Term Assets
 Analysis of the Statement of Cash Flows and Management of Cash
 Ethics
In Summary

Copyright © 2020 AME Learning Inc. 72

Ethics

The following three situations should be viewed with caution when analyzing the cash flow
statement of a business.

 Some companies may stretch out their payables.

 Some companies may finance their payables
 Some companies may shorten their collection of receivables

Copyright © 2020 AME Learning Inc. 73

Suppose a hotel pressures a corporate client to pay in December for a banquet
that will take place in January. How will this impact the hotel's statement of cash
flows?

a. This year's cash flows will be higher than normal.

b. Next year's cash flows will be higher than normal.

c. This year's cash flows will be lower than normal.

d. There is no impact on this year's cash flows.

0% 0% 0% 0%
This year's Next year's This year's There is no
cash flows will cash flows will cash flows will impact on this
be higher than be higher than be lower than year's cash
normal normal normal flows 74
Copyright © 2020 AME Learning Inc.
Suppose a hotel pressures a corporate client to pay in December for a banquet
that will take place in January. How will this impact the hotel's statement of cash
flows?

a. This year's cash flows will be higher than normal.

Copyright © 2020 AME Learning Inc. 75

 CHAPTER 1
 The Purpose of Accounting
 Financial Statements
 The Importance of Cash Flow
 Preparing a Statement of Cash Flows
 Selling Long-Term Assets
 Analysis of the Statement of Cash Flows and Management of Cash
 Ethics
 In Summary

Copyright © 2020 AME Learning Inc. 76

In Summary

Define and explain the conceptual bases of accounting

 Accounting is a standardized system to identify, measure and communicate all of the

financial activities of a company.
 Accounting transactions are recorded on an accrual basis, which involves recording all
transactions when they occur, instead of when cash is received or paid.

Explain and interpret different components of financial statements

 Financial accounting focuses mostly on four types of financial statements: the balance
sheet, income statement, statement of owner’s equity and the statement of cash flows.
 Due to the requirement of accrual accounting, the statement of cash flows is prepared to
track the sources and uses of cash in a company.

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In Summary

Classify operating, investing and financing activities

 The statement of cash flows contains three sections: cash flow from operating activities,
cash flow from investing activities and cash flow from financing activities.
 The cash flow from operating activities shows the sources and uses of cash in the day-
to-day activities of the company.
 The cash flow from investing activities shows the sources and uses of cash for the
purchases and sales of long-term assets.
 The cash flow from financing activities shows the sources and uses of cash for financing
activities, such as borrowing money, paying off loans, issuing shares or paying
dividends.
 When companies have non-cash investing and financing activities, their total amount is
shown on a separate, final line on the statement of cash flows, and details of the
transactions are given in the notes to the financial statements.

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In Summary

Prepare a statement of cash flows using the indirect method

 The indirect method of preparing a statement of cash flows starts with accrual-based net
income from the income statement and adjusts it by adding or subtracting non-cash
items and changes in the current assets and current liabilities to calculate net cash flow
from operating activities.
 The indirect method tends to be more commonly used in preparing a statement of cash
flows since it is easier to prepare. The direct method tends to be easier to understand.

Calculate book value and cash received for selling long-term assets

 When selling long-term assets, an asset’s book value and gain (or loss) on disposal must
be taken into account in calculating cash proceeds from the disposal. Accumulated
depreciation is part of the calculation of book value.

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In Summary

Analyze the statement of cash flows and discuss basic cash management techniques

 Cash flow from operations is the best indicator of a company’s sustainability.

 Accounts receivable, inventory and accounts payable present opportunities to hep
manage operational cash flow.
 Cash inflow from investing and financing activities is not necessarily sustainable.
 Free cash flow is the amount of cash remaining after a company has covered its capital
expenditures with its operating activities . Investors often use free cash flow as a
measure of a company’s cash-generating ability and its overall financial health.

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In Summary

Discuss ethical issues related to cash flow

 Three situations should be viewed with caution when analyzing a company’s statement
of cash flows: some companies may stretch out their payables; some companies may
finance their payables; and some companies may shorten their collection periods.

Copyright © 2020 AME Learning Inc. 81