Stice | Stice | Skousen Statement of Cash Flows Revisited Intermediate Accounting,17E Statement of Cash Flows Revisited PowerPoint presented by: Douglas Cloud Professor Emeritus of Accounting, Pepperdine University © 2010 Cengage Learning

Absence of Transaction Data If we do not have access to detailed cash flow information, the preparation of a statement of cash flows involves analyzing the income statement and comparative balance sheets to determine how a business generated and used cash. (continues)

Absence of Transaction Data Accounts Receivable To demonstrate how to gather information for a statement of cash flows when we do not have ready access to detailed cash inflow and outflow information, we will use Western Reserve’s Accounts Receivable from Exhibit 21-2 (with the adjustments removed). (continues)

Absence of Transaction Data How do we explain the change in Accounts Receivable from $70,500 to $67,000? (continues)

Absence of Transaction Data We see from Item (1) on p. 1232 of the textbook that sales on account totaled $688,800. When Sales is credited, the normal debit is to Accounts Receivable. Let’s plug this into the work sheet. 688,800 (continues)

Absence of Transaction Data 688,800 692,300 ? Now we can determine the missing amount. Accounts Receivable $70,500 (dr.) + $688,800 ─ ? = $67,000 We solve the equation to find the missing amount, which is $692,300. (continues)

Absence of Transaction Data 688,800 692,300 When Accounts Receivable is credited, we can assume that Cash is debited. Examine entry (2) in Exhibit 21-2. This is how we arrive at the debit to Cash when the information is not given.

6-Step Process Compute how much the cash balance changed during the year. In Exhibit 21-2, Cash at the beginning of 2011 was $55,000 and $50,600 at the end of the year. Our “target” is to explain why Cash decreased $4,400. (continues)

6-Step Process Convert the income statement from an accrual-basis to a cash-basis summary of operations (see Exhibit 21-4, Slide 21-10). Eliminate expenses that do not involve the outflow of cash. Eliminate gains and losses associated with investing or financing activities. Adjust for changes in the balances of current operating assets and operating liabilities. (continues)

(continues)

6-Step Process Analyze the long-term assets to identify the cash flow effects of investing activities. Also examine certain investment securities accounts. Analyze the long-term debt and stockholders’ equity accounts to determine the cash flow effects of any financing transactions. Also examine changes in short-term loan accounts. (continues)

6-Step Process Make sure that the total net cash flow from operating, investing, and financing activities is equal to the net increase or decrease in cash as computed in step 1. Then prepare a formal statement of cash flows by classifying all cash inflows and outflows according to operating, investing, and financing activities. (continues)

6-Step Process Prepare supplemental disclosure, including the disclosure of any significant investing or financing transactions that did not involve cash.

An Illustration of the 6-Step Process Step 1: Compute how much the cash balance changed during the year Beginning Cash Balance $55,000 Ending Cash Balance (50,600) Decrease in cash $ (4,400) – The purpose of the statement of cash flows is to explain how the decrease in cash occurred.

An Illustration of the 6-Step Process Step 2: Convert the income statement from an accrual to a cash-basis summary of operations Add the amount of depreciation and amortization expense back to net income because no cash flow was associated with these expenses in the current period (adjustments A1 and A2). Add: Depreciation Expense $20,900 Amortization Expense 5,000 (continues)

An Illustration of the 6-Step Process Subtract the amount of gains and add the amount of losses because they are included in the computation of net income. Failure to adjust for them here would result in counting them twice. (adjustments B1 and B2). Add: Loss on sale of building $ 4,000 Less: Gain on sale of long-term investment $(6,500) (continues)

An Illustration of the 6-Step Process The accounts receivable account decreased because customers paid for more than they purchased this year. Thus, Western Resources has more cash than it would have had if customers had not paid down their accounts (adjustment C1). Add: Decrease in Accounts Receivable $3,500 (continues)

An Illustration of the 6-Step Process Unearned Sales Revenue goes up when customers pay for goods or services in advance. Thus, an increase in Unearned Sales Revenue represents cash collected over and above the sales amount (adjustment C2). Add: Increase in Unearned Sales Revenue $7,000 (continues)

An Illustration of the 6-Step Process By allowing the Inventory amount to decrease, Western Resources has conserved cash that otherwise would have been used to purchase inventory (adjustment C3). Add: Decrease in Inventory $1,500 (continues)

An Illustration of the 6-Step Process Western Resources paid for more than it bought from its suppliers during the year. The adjustment reflects this additional cash outflow (adjustment C4). Subtract: Decrease in Accounts Payable $(6,700) (continues)

An Illustration of the 6-Step Process Western Resources paid extra cash by paying in advance for services that it will use later (adjustment C5). Subtract: Increase in Prepaid Operating Expenses $(4,500) (continues)

An Illustration of the 6-Step Process A restructuring charge does not involve an immediate outlay of cash. Western has not yet paid any cash associated with the restructuring (adjustment C6). Add: Increase in Obligation for Employee Severance $11,700 (continues)

An Illustration of the 6-Step Process The amount of income tax expense reported in the financial statements is not the same as the amount of income tax that is owed to the taxing authorities for the year. In 2011 the deferred income tax liability for Western Resources increased by $2,700, indicating that some of the $24,000 income tax expense reported won’t actually be payable until some future year. (continues)

An Illustration of the 6-Step Process This means that the income taxes owed for 2011 operations are just $21,300 ($24,000 – $2,700). In Exhibit 21-2, Income Taxes Payable, which relates to the taxes that are payable right now decreased by $2,200 ($9,500 – $7,300) from December 31, 2010 to December 31, 2011 (adjustment C7). (continues)

An Illustration of the 6-Step Process Subtract: Decrease in Income Taxes Payable $(2,200) The increase in Deferred Income Tax Liability of $2,700 (adjustment C8) does not affect cash flow from operations.

The Indirect and Direct Methods The indirect method begins with net income as reported in the income statement and then details the adjustments needed to arrive at cash flow from operations. This method is shown in Exhibit 21-6 (Slide 21-28). The direct method involves simply reporting the information contained in the last column of the adjusted work sheet. The resulting Operating Activities section is shown in Exhibit 21-7 (Slide 21-29). (continues)

Illustration of the 6-Step Process Step 3: Analyze the long-term assets to identify the cash flow effects of investing activities The long-term investments account was reduced during the year by $96,000 ($106,000 – $10,000). Since no long-term investments were purchased, the entire $96,000 reduction represents the book value of the long-term investments sold during the year. (continues)

Illustration of the 6-Step Process By checking the income statement (Exhibit 21-2), we determine that there was a $6,500 gain on the sale of long-term investments. The cash proceeds of $102,000 can be determined as follows: Book Value of long-term investments sold $ 96,000 Plus: Gain on sales 6,500 Cash proceeds $102,000 (continues)

Illustration of the 6-Step Process Land increased by $108,500 ($183,500 – $75,000). Supplemental information tells us that payment for the land was a combination of $68,500 of cash and common stock valued at $40,000. Only the $68,500 cash outlay (shown below) will be displayed in the statement of cash flows. Increase in land account $108,500 – Payment with common stock (40,000) Cash outlay $ 68,500 (continues)

Illustration of the 6-Step Process Buildings and Equipment increased by $77,000 ($422,000 – $345,000) during 2011. A building costing $40,000 was sold for $10,000 during the year. With this data we can make the following computation: Beginning balance $345,000 Cost of building and equipment sold during the year (40,000) Ending balance without additional purchases $305,000 – (continues)

Illustration of the 6-Step Process A useful way to summarize all purchase and sale information for buildings and equipment is to reconstruct the T-accounts for the buildings and equipment account and the associated accumulated depreciation account. Purchased buildings and equipment for cash of $117,000. (continues)

Illustration of the 6-Step Process The patents account began the year with a $40,000 balance and ended with a $35,000 balance. The data indicate that no new patents were purchased during the year. However, amortization was applied to the patent as shown below: Beginning Patents $40,000 – Patent amortization recognized during year (5,000) + New patents purchased ??? Ending Patents $35,000 $0 (continues)

Illustration of the 6-Step Process The Investing Activities section of the SCF for Western Resources is as follows: Cash flows from investing activities: Sold building $ 10,000 Sold long-term investment 102,500 Purchased available-for-sale securities (2,000) Purchased land (68,500) Purchased buildings and equipment (117,000) Net cash used by investing activities $ (75,000) Assumed available-for-sale securities were purchased

Illustration of the 6-Step Process Step 4: Analyze the long-term debt and stockholders’ equity accounts to identify the cash flow effects of financing transactions In the absence of detailed information, it is possible to infer the amount of dividends declared, as follows: (continues)

Illustration of the 6-Step Process The increase in Western Resources’ dividends payable account indicates that not all of the $25,100 in dividends declared were paid in cash during the year. We can see this in the following calculation: Dividends declared $25,100 Less: Increase in Dividends Payable 4,400 Cash paid for dividends $20,700 (continues)

Illustration of the 6-Step Process The following information summarizes the cash flow effects of Western Resources’ financing activities in 2011: Cash flows from financing activities: Issued common stock $10,000 Borrowed short-term debt 7,500 Borrowed long-term debt 20,000 Paid dividends (20,700) Treasury stock purchases (3,200) Net cash used by financing activities $13,600

Illustration of the 6-Step Process Step 5: Prepare a formal statement of cash flows You will find the resulting statement of cash flows using the indirect method on Slides 21-42 and 21-43.

(continues)

Illustration of the 6-Step Process Step 6: Prepare supplemental disclosures Three categories of supplemental disclosure are associated with the statement of cash flows: Cash paid for interest and income taxes Reconciliation schedule Noncash investing and financing activities

International Cash Flow Statements The primary differences in cash flow reporting around the world relate to interest and income tax payments. IAS 7 allows dividends paid to be classified as either a financing activity (as in the United States) or as an operating activity. (continues)

International Cash Flow Statements Within the FASB there was great debate about how these items should be classified. The final version of SFAS No. 95 mandates that these items be classified as operating activities. Some have criticized IAS 7 because it allows too much classification flexibility. (continues)

International Cash Flow Statements Interest and dividends received: IAS 7 allows companies to classify them as either operating or investing activities. Interest paid: IAS 7 classifies it as either an operating activity or a financing activity; but it must be applied consistently. (continues)

International Cash Flow Statements Dividends paid: IAS 7 allows classification as either a financing activity or as an operating activity. Income taxes: IAS 7 requires classification as an operating activity, unless the income taxes can be specifically identified with a financing or investing activity.

United Kingdom Cash Flow Standard, FRS 1 Operating activities Returns on investments and servicing of finance Taxation Capital expenditures and financial investments Acquisitions and disposals Equity dividends paid Management of liquid resources Financing