Statement of Cash Flows Principles of Financial Accounting, 11e 16 Statement of Cash Flows Principles of Financial Accounting, 11e Reeve • Warren • Duchac

1 Describe the cash flow activities reported in the statement of cash flows 16-3

1 The statement of cash flows reports a firm’s major cash inflows and outflows for a period. It provides useful information about a company’s ability to do the following: Generate cash from operations Maintain and expand its operating capacity Meet its financial obligations Pay dividends

1 Reporting Cash Flows The statement of cash flows reports cash flows from three types of activities: 1. Cash flows from operating activities are cash flows from transactions that affect net income. 2. Cash flows from investing activities are cash flows from transactions that affect the investments in noncurrent assets of the company. 3. Cash flows from financing activities are cash flows from transactions that affect the equity and debt of the company.

1 Exhibit 1 Cash Flows

Cash Flows from Operating Activities 1 Cash Flows from Operating Activities The direct method reports the sources of operating cash and the uses of operating cash.

1 The indirect method reports the operating cash flows by beginning with net income and adjusting it for revenues and expenses that do not involve the receipt or payment of cash.

1 The primary advantage of the indirect method is that it reconciles the difference between net income and net cash flows from operations. Also, the indirect method is less costly to use than the direct method. Over 99% of companies use the indirect method.

1 Cash Flows from Operations: Direct and Indirect Methods—NetSolutions Exhibit 2 The same

Cash Flows from Investing Activities 1 Cash Flows from Investing Activities Cash inflows from investing activities normally arise from selling fixed assets, investments, and intangible assets. Cash outflows from investing activities normally include payments to acquire fixed assets, investments, and intangible assets.

Cash Flows from Financing Activities 1 Cash Flows from Financing Activities Cash inflows from financing activities normally arise from issuing debt or equity securities. Cash outflows from financing activities normally include paying cash dividends, repaying debt, and acquiring treasury stock.

Noncash Investing and Financing Activities 1 Noncash Investing and Financing Activities Noncash investing and financing activities are transactions that do not directly affect cash. The effect of such transactions is recorded in a separate schedule that appears at the bottom of the statement of cash flows.

1 No Cash Flow Per Share Cash flow per share should not be reported on a company’s financial statements for the following reasons: Users may misinterpret cash flow per share as the per-share amount available for dividends. Users may misinterpret cash flow per share as equivalent to earnings per share.

1 Example Exercise 16-1 Follow My Example 16-1 Follow My Example 6-1 Classifying Cash Flows Identify whether each of the following would be reported as an operating, investing, or financing activity in the statement of cash flows. Purchase of patent d. Cash sale Payment of cash dividend e. Purchase of treasury stock Disposal of equipment f. Payment of wages expense i o f f i o Follow My Example 6-1 Follow My Example 16-1 Left-click the mouse for the coded answers (operating = o; investing i; financing = f) For Practice: PE 16-1A, PE 16-1B 16-15

Prepare a statement of cash flows, using the indirect method. 2 Prepare a statement of cash flows, using the indirect method. 16-16

2 Efficient Approach The indirect method of reporting cash flows from operating activities uses the logic that a change in any balance sheet account (including Cash) can be analyzed in terms of changes in other balance sheet accounts.

2 Income Statement and Comparative Balance Sheet Exhibit 3 (continued)

2 Income Statement and Comparative Balance Sheet (continued) Exhibit 3

2 Retained Earnings The analysis of Retained Earnings provides a good starting point for determining the cash flows from operating activities.

2 The Retained Earnings account for Rundell Inc. reveals that the balance increased $80,000 during the year. The net income of $108,000 is the first amount reported in the Cash Flows from Operating Activities section.

Adjustments to Net Income 2 Adjustments to Net Income Cash flows from operating activities: Net income $108,000 Adjustments to reconcile net income to net cash flow from operating activities: This phrase is added to indicate that accrual basis net income is being adjusted to arrive at cash flows from operations.

2 Adjustments to Net Income (Loss) Using the Indirect Method Exhibit 4 Step 1 Step 2 Step 3

2 Step 1 Expenses that do not affect cash are added. Such expenses decreased net income, but did not involve cash payments and, thus, are added to net income. Examples include depreciation of fixed assets and amortization of intangible assets.

2 Step 2 Loses and gains on disposal of assets are added or deducted. The disposal (sale) of assets is an investing activity, rather than an operating activity. Losses on disposal of assets are added back to net income. Gains on disposal of assets are deducted from net income.

2 Step 3 Changes in current operating assets and liabilities are added or deducted as follows: Increases in noncash current operating assets are deducted. Decreases in noncash current operating assets are added. Increases in current operating liabilities are added. Decreases in current operating liabilities are deducted.

2 Example Exercise 16-2 Adjustments to Net Income—Indirect Method Omni Corporation’s accumulated depreciation increased by $12,000, while patents decreased by $3,400 between balance sheet dates. There were no purchases or sales of depreciable or intangible assets during the year. In addition, the income statement showed a gain of $4,100 from sale of land. Reconcile a net income of $50,000 to net cash flow from operating activities. 16-27

2 Follow My Example 16-2 Net income………………………………………. $50,000 Example Exercise 16-2 (continued) 2 Follow My Example 16-2 Net income………………………………………. $50,000 Adjustments to reconcile net income to net cash flow from operating activities: Depreciation…………………………………. 12,000 Amortization of patents………………………. 3,400 Gain on sale of land………………………... (4,100) Net cash flow from operating activities…….. $61,300 For Practice: PE 16-2A, PE 16-2B 16-28

2 Exhibit 5 (continued on Slide 31) Cash Flows from Operating Activities—Indirect Method Exhibit 5 Step 1 Step 2 Step 3 (continued on Slide 31)

2 Step 1: The comparative balance sheets indicate that Accumulated Depreciation—Building increased by $7,000. The account, shown below, indicates that Accumulated Depreciation—Building increased by $7,000.

2 Exhibit 5 (continued on Slide 33) Cash Flows from Operating Activities—Indirect Method (continued) Exhibit 5 Step 1 (continued on Slide 33)

2 Step 2 The proceeds, which included the gain, are reported in the Investing section of the statement of cash flows. Thus, the $12,000 is deducted from net income in determining cash flows from operating activities.

2 Exhibit 5 (continued on Slide 36) Cash Flows from Operating Activities—Indirect Method (continued) Exhibit 5 Step 2 (continued on Slide 36)

2 Step 3 Next, select the current operating assets and liabilities that impact cash flows and determine their increases and decreases. Slide 35 may prove helpful.

2 December 31 Increase Accounts 2010 2009 Decrease* Accounts receivable (net) $ 74,000 $ 65,000 Inventories 172,000 180,000 Accounts payable (mdse.) 43,500 46,700 Accrued expenses payable 26,500 24,300 Income taxes payable 7,900 8,400 9,000 8,000* 3,200* 2,200 500* Note that Cash and Dividends Payable are not included in this analysis.

2 Cash Flows from Operating Activities—Indirect Method (concluded) Exhibit 5 Step 1 Step 2 Step 3

2 Example Exercise 16-3 Changes in Current Operating Assets and Liabilities—Indirect Method Victor Corporation’s comparative balance sheet for current assets and current liabilities was as follows: Dec. 31, 2011 Dec. 31, 2010 Accounts receivable $ 6,500 $ 4,900 Inventory 12,300 15,000 Accounts payable 4,800 5,200 Dividends payable 5,000 4,000 Adjust net income of $70,000 for changes in operating assets and liabilities to arrive at cash flows from operating activities. 16-37

2 Follow My Example 16-3 Net income…………………………………………….. $70,000 Example Exercise 16-3 (continued) 2 Follow My Example 16-3 Net income…………………………………………….. $70,000 Adjustments to reconcile net income to net cash flow from operating activities: Increase in accounts receivable………………. (1,600) Decrease in inventory…………………………... 2,700 Decrease in accounts payable………………… (400) Net cash flow from operating activities …..…..…. $70,700 For Practice: PE 16-3A, PE 16-3B 16-38

2 Example Exercise 16-4 Cash Flows from Operating Activities—Indirect Method Omicron, Inc. reported the following data: Net income $120,000 Depreciation expense 12,000 Loss on disposal of equipment 15,000 Increase in Accounts receivable 5,000 Decrease in Accounts payable (2,000) Prepare the cash flows for operating activities section of the statement of cash flows using the indirect method. 16-39

2 Follow My Example 16-4 Cash flows from operating activities: Example Exercise 16-4 (continued) 2 Follow My Example 16-4 Cash flows from operating activities: Net income……………………………………….. $120,000 Adjustments to reconcile net income to net cash flow from operating activities: Depreciation………………………………….. 12,000 Loss from disposal of equipment………... 15,000 Changes in current operating assets and liabilities: Increase in accounts receivable………….. (5,000) Decrease in accounts payable…………….. (2,000) Net cash flow from operating activities……... $140,000 For Practice: PE 16-4A, PE 16-4B 16-40

2 Dividends Cash dividends of $28,000 were declared during 2010. Note the entry highlighted in yellow.

2 Only $24,000 of the dividends was paid in 2010. Since dividend payments are a financing activity, the dividend payment is reported in the Financing Activities section.

2 Common Stock Rundell, Inc.’s Common Stock account increased by $8,000 during 2010.

2 Paid-in Capital in Excess of Par—Common Stock increased $40,000 during the year. Issuing company stock is a financing activity, so cash flows from financing activities increases by $48,000 ($8,000 + $40,000).

2 Bonds Payable Bonds Payable decreased $50,000 during 2010. A check with Rundell’s income statement show that there was no gain or loss on the retirement. Retiring a bond payable is a financing activity, so a cash outflow of $50,000 is reported in the Financing Activities section of the statement of cash flows.

2 Building The Building account increased by $60,000. The cash outflow for this purchase is shown in the Financing Activities section of the statement.

2 Land The $45,000 decline in the Land account was from two transactions.

2 Earlier, as part of Step 2 in preparing the Operating Activities section, the $12,000 gain was deducted from net income. Step 2 The proceeds of $72,000 from the sale of land are reported in the Investing Activities section of the statement of cash flows.

2 The October 12 transaction is the purchase of land for cash of $15,000. This transaction is reported as an outflow of cash in the Cash Flows from Investing Activities section.

2 Land Transactions on the Statement of Cash Flows Example Exercise 16-5 Land Transactions on the Statement of Cash Flows Alpha Corporation purchased land for $125,000. Later in the year the company sold land with a book value of $165,000 for $200,000. How are the effects of these transactions reported on the statement of cash flows? 16-50

2 Gain on sale of land……………….. $(35,000) Follow My Example 16-5 Example Exercise 16-5 (continued) 2 Follow My Example 16-5 The gain on sale of land is deducted from net income as shown below: Gain on sale of land……………….. $(35,000) The purchase and sale of land is reported as part of cash inflow from investing activities as shown below: Cash received for sale of land…… $200,000 Cash paid for purchase of land….. (125,000) For Practice: PE 16-5A, PE 16-5B 16-51

2 Exhibit 6 Statement of Cash Flows—Indirect Method payable

3 Free Cash Flow Free cash flow is a measure of operating cash flow available for corporate purposes after providing sufficient fixed asset additions to maintain current productive capacity and dividends.

3 Cash flow from operating activities Less: Investments in fixed assets to maintain current production Free cash flow Positive free cash flow is considered favorable. A company that has free cash flow is able to fund internal growth, retire debt, pay dividends, and enjoy financial flexibility.