1. Balance sheet (statement of financial position) AND

2. Income statement

The cash flow statement provides information to help investors, creditors and others assess:

• A company's ability to generate future cash flows
• A company's ability to pay dividends and meet obligations
• Reasons for the difference  between net income and net cash cash flow generated from operating activities
• The cash and non-cash investing and financing transactions during the period

Accrual Principle: Transactions that change a company's financial statements are recorded in the periods in which the economic events occur, not the periods in which cash is received or paid.

Net income reported by companies is an accrual-accounting measure of performance, not a cash-based measure.

Cash accounting: Only receipts and payments of cash are recorded.

Timing and matching problems, because the benefits and costs of doing business are often: 

• measured in the wrong period
• not matching with each other in the same period.
• This is why net income is an accrual-accounting based measure of performance.

These pose no problems if the performance measurement interval is sufficiently large. Otherwise they tend to lead to different performance evaluations.

Net income (an accrual accounting measure of performance) is more informative than operating cash flow because it mitigates timing and matching problems.

There is more room for manipulation. Because accrual accounting allows a company (managers) to shift the recognition of cash flows over time, some companies (managers) use accruals for earnings management purposes (--> borrow tomorrows income to boost today's net income)

Primary purpose: To provide information about a company's cash receipts and cash payments during a period.

Secondary objective: To provide cash-basis information about the company's operating, investing and financing activties.

Converts the items reported on the income statement from the accrual basis of accounting to cash. Cash from operating act is compared to net income. If cash from operating income is higher than net income, company's earnings are said to be of high quality, otherwise red flag.

Includes cash inflows from sales of goods and services, from returns on loans (interest) and on equity securities (dividends). Includes cash outflows to suppliers for inventory, to employees for services, to government for taxes, to lenders for interest, to others for expenses.

Changes in investments and long-term asset items.

Reports the purchase and sale of long-term investments and property, plant and equipment.

Includes cash inflows such as from sale of property, plant and equipment, and intangibles, from sale of debt or equity securities of other entities, from collection of principal on loans or other entities. 

Reports the exchange of significant items that did not involve cash. Reports amount of income taxes paid and interest paid.

Because public companies tend to use accrual accounting, the income statements they relieve each quarter may not necessarily reflect changes in their cash positions.

Because the income statement is prepared under the accrual basis, revenues reported may not have been collected. Similarly, expenses reported on the income statement might not have been paid --> the CFS has integrated all relevant information. 

Helps investors to see if company is having trouble with cash.

The company will be able to:

• Increase it dividends
• Reduce debt
• Buy back some of its stock
• Acquire new companies

All of these are good for stockholders.

The basis recommended by the IASB for the statement of cash flows is actually 'cash and cash equivalents'. Cash equivalents are short-term, highly liquid investments that are both:

• readily convertible to known amounts of cash
• so near their maturity that they present insignificant risk of changes in value

Generally, only investments with original maturities of three months or less qualify under this definition.

1. Comparative statements of financial position. 
2. Current income statement
3. Selected transaction data

Step 2: Determination net cash flow from operating activities.

• Company must determine revenues and expenses on a cash basis
• Elimination of the effects of income statement transactions that do not result in an increase or decrease in cash
• Convert net income to net cash flow from operating activities through either a direct method or indirect method

The direct method of presenting the statement of cash flows presents the specific cash flows associated with items that affect cash flow. Items that typically include: 

• Cash collected from customers
• Interest and dividends received
• Cash paid to employees
• Cash paid to suppliers
• Interest paid
• Income taxes paid

The advantage of the direct method over the indirect method is that it reveals operating cash receipts and payments.

Cash basis net income

• Depreciation and amortization expense
• Gain or loss on disposition of long-term assets
• Change in current assets and current liabilites

(1) Non-current (long-term) accruals:

• Depreciation
• Deferred income tax

(2) Current accruals: Changes in current operating assets and liabilities

• Accounts receivables
• Prepaid expenses
• Inventory
• Accounts payable

• Purchase of short-term non-trading equity investments
• Issuance of short-term non-trade note payable for cash
• Cash dividend payable

(1) Focuses on the differences between net income and net cash flow from operating activities.

(2) Provides link between the statement of cash flows and the income statement and statement of financial position.

(1) Shows operating cash receipts and payments.

(2) Information about cash receipts and payments is more revealing of a company's ability: 

• to generate sufficient cash from operating activities to pay its debts
• to reinvest in its operations 
• to make distribution to its owners

Under the indirect method of presenting the statement of cash flows, the presentation begins with net income or loss, with subsequent additions to or deductions from that amount for non-cash revenue and expense items, resulting in net income provided by operating activities.

These special problems are:

1. Adjustments to income (depreciation and amortization, post-retirment benefit costs, change in deferred income taxes, equity method of accounting, losses and gains, stock options)
2. Accounts receivables (net)
3. Other working capital changes
4. Net losses
5. Significant noncash transactions

When numerous adjustments are necessary, or other complicating factors are present, companies often use a worksheet to assemble and classify the data that will appear on the statement of cash flows. The worksheet aids in the preparation and is optional.

Because net income includes items that do not provide or use cash. An example would be an increase in accounts receivable.

If accounts receivable increased during the period, revenues reported on the accrual basis would be higher than the actual cash revenues received. Thus, accrual basis net income must be adjusted to reflect the net cash flow from operating activities.

It is the difference between cash revenues and cash expenses. The direct method adjusts the revenues and expenses directly to reflect the cash basis. This results in cash net income, which is equal to net cash flow from operating activities.

1. High cash revenues relative to low cash expenses
2. Sales of property, plant and equipment
3. Sales of investments
4. Issuance of debt or ordinary shares