Module B:

External Users’ Assessments of Management of Debt and Equity

Financing Activities

How External Users Assess Management’s Debt and Equity

Financing Activities

• External users pay special attention to – cash flows reported in the financing activities

section of the SCF.– any separate SCF schedules that list/explain

significant investing and financing activities not affecting cash flows.

Observation

Footnotes provide a great deal of information about specific financing transactions:

– Long-term debt footnote provides information about terms of debt (amounts, maturities, rates).

– Lease footnote provides information about operating and capital leases.

Financing Activities in the SCF: Related Items’ Inclusions

Issuance of debt and equity securities (cash inflows).

Payments on debt and acquisitions of treasury shares (cash outflows).

Dividend payments (cash outflows).

Note: Interest payments are shown as operating cash flows on the SCF.

Items for which External Users May Prepare Informal Pro Forma

Adjustments to the SCF in the Quest to Increase Comparability Across Time and Across Firms

• Reclassify interest paid from operating to financing.

Many theorists believe that interest payments should be treated as financing activities. Such pro formas recast “interest” outflows (on operating leases) from operating to financing activities.

Meaningful? Very possibly!

• Reclassify significant financing activities not affecting cash (as shown on a separate SCF schedule).– Example: A direct exchange of common stock

for buildings is reported as a significant non-cash financing and investing activity.

– A pro forma adjustment can be “reported broadly” to include these items in SCF as if two events occurred:• Common stock was issued for cash.• A building was purchased for cash.

More meaningful to management? Very likely!

• “Capitalize” operating leases– The lease footnote provides information about

operating leases (off-balance-sheet financing)– Operating lease payments are shown as

operating activity cash outflows

– Reclassification would increase properties, operating interest expense, and the depreciation expense (excluded from the SCF).

Meaningful? Very possibly, in selected ratio data!

A pro forma adjustment can be made to “capitalize” the operating lease, increasing property, plant, and equipment and notes payable:• Operating lease payments are deducted

from operating activities section, but …• “Interest paid” on newly “capitalized” lease

is included in the operating activities section• Depreciation on newly capitalized asset is a

non-cash expense and would not be included in the SCF.