Operating ActivitiesFree Cash Flow

Homework

1-      Operating Activities

Evaluate the logic of reflecting key person life insurance in the operating activities of the cash flow statement and determine if this presentation is misleading to users of the financial statements.

-- Currently, Financial Accounting Standards Board (FASB) has not provided guidance on the appropriate section for reflecting key person life insurance. As a member of FASB, determine the guidance you would provide for key person insurance in the cash flow statement. Provide your rationale. [180 to 230 words][1-2 references]

The accounting for purchases of life insurance contracts commonly referred to as COLI (corporate-owned life insurance), BOLI (business-owned life insurance), or key-man insurance is addressed by Technical Bulletin 85-4. That Technical Bulletin requires that "the amount that could be realized under the insurance contract as of the date of the statement of financial position should be reported as an asset. The change in cash surrender or contract value during the period is an adjustment of premiums paid in determining the expense or income to be recognized under the contract for the period" (refer to paragraph 2). Although the asset is not specifically premeasured at fair value with changes reported in earnings, the amount recorded may at times be close to fair value. Therefore, the investment in a life insurance contract does not qualify for the embedded derivative scope exception in paragraph 12(b) of Statement 133 applicable to contracts that are carried at fair value with changes in value recorded in earnings.Investments in life insurance.A policyholder’s investment in a life insurance contract that is accounted for under FASB Technical Bulletin No. 85-4, Accounting for Purchases of Life Insurance, or FASB Staff Position FTB 85-4-1, “Accounting for Life Settlement Contracts by Third-Party Investors,” is not subject to this Statement. This [exception] does not affect the accounting by the issuer of the life insurance contract.

Reference:

CFO. (n.d.). Key-Person Insurance: a Cash-Flow Puzzle. Retrieved 12 1, 2013, from CFO: http://ww2.cfo.com/cash-flow/2012/04/key-person-insurance-a-cash-flow-puzzle/

FASB. (n.d.). FAS Accounting for purchase of Life insurance. Retrieved 12 1, 2013, from FASB: http://www.fasb.org/derivatives/issueb31.shtml

2- Free Cash Flow

--Analyze the impact of erroneous classifications in the operating activities section of the cash flow statement on free cash flow and how this distortion can impact the decisions made by financial statement users.

Free cash flow = cash flow from operating activities capital expenditures dividends An erroneous classification in the operating activities could lead substantially changes in free cash flow being higher or lower than what it should be. Generally users of financial statements typically set their own requirements based on which they evaluate the free cash flow of a company. Financial institutions, Banks, Investment banks analysts etc have their own set of requirements. The erroneous classifications in the operating activities section, the cash flows will mislead you how much cash the company generated from its core business, as opposed to peripheral activities such as investing or borrowing. This is the area you should focus most of your attention on because it paints the best picture of how well a firm's business operations are producing cash that will ultimately benefit shareholders.

In fiscal 1999, Sony Corporation reported (in yen) net income of ¥179,004 million. However, net cash provided by operating activities was ¥663,267 million. Cash generated from operations was much higher than income because income had been reduced by depreciation and amortization expense of ¥307,173 million, a noncash expense. Also, the company reduced its receivables and merchandise inventory, freeing up additional cash, although this was partially offset by an increase in film inventories In fiscal 1999, Sony Corporation reported (in yen) net income of ¥179,004 million. However, net cash provided by operating activities was ¥663,267 million. Cash generated from operations was much higher than income because income had been reduced by depreciation and amortization expense of ¥307,173 million, a noncash expense. Also, the company reduced its receivables and merchandise inventory, freeing up additional cash, although this was partially offset by an increase in film inventories

--Assess the importance of free cash flow in a growth company. Provide a brief scenario of a specific type of business that would benefit from free cash flow. [180 to 230 words][1-2 references]

Free cash flow is a measure of financial performance and is defined as cash flow available for distribution among any parties that hold security in a company. It matters, as it is a means for a company to boost shareholder value through, for example, mergers and acquisitions, R&D, paying dividends, or reducing debt. It can thus be viewed as an alternative bottom line .It is a very useful way to assess the financial health of a company as it is what is left after all the accounting assumptions built into the earnings have been stripped away. A company may seem to be generating high earnings, but only free cash flow indicates whether any real money has been generated in a designated period. Ultimately, the stock market’s estimate of how much free cash flow a company will generate in the future is reflected in the share price.

Even a profitable concern may have a negative cash flow. This does not necessarily signal financial problems—it may indicate that the company is making large investments with potentially high returns. Free cash flow can, of course, vary from year to year, depending on the capital expenditure (usually referred to as capex) and any changes in working capital. It is important to remember that how a company uses its free cash flow matters a lot. A company using its free cash flow on share buy-backs or to pay out dividends is more attractive to investors & vice versa.