Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Chapter Fifteen “How Well Am I Doing?” Statement of Cash Flows

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 15-2 Purpose of the Statement of Cash Flows Are cash flows sufficient to support ongoing operations? Can we meet our obligations to creditors? Can we pay dividends? Why is there a difference between net income and net cash flow? Will the company have to borrow money to make needed investments?

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 15-3 Learning Objective 1 Classify changes in noncash balance sheet accounts as sources or uses of cash.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 15-4 Cash The term cash on the statement of cash flows refers broadly to both currency and cash equivalents. Cash T-bills Money Market Funds Commercial Paper Currency and Bank Accounts

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 15-5 Net Cash Flows for a Period Net Income Dividends Paid to Stockholders Changes in Noncash Assets Changes in Liabilities Changes in Capital Stock Constructing the Statement of Cash Flows Using Changes in Noncash Balance Sheet Accounts

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 15-6 Constructing the Statement of Cash Flows Using Changes in Noncash Balance Sheet Accounts

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 15-7 Constructing the Statement of Cash Flows Using Changes in Noncash Balance Sheet Accounts Example: Inventory is purchased on credit from a supplier. It is implied that cash was used to acquire the inventory. noncash asset uses Increases in noncash asset accounts imply uses of cash.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 15-8 Constructing the Statement of Cash Flows Using Changes in Noncash Balance Sheet Accounts It is implied that an increase in a payable has the effect of increasing cash available for other uses. liability sources Increases in liability accounts imply sources of cash. Example: Inventory is purchased on credit from a supplier.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 15-9 Constructing the Statement of Cash Flows Using Changes in Noncash Balance Sheet Accounts noncash assets sources Decreases in noncash assets accounts imply sources of cash. Example: Accounts receivable decreases when a company pays its bill. When the customer pays the bill, the company’s cash increases.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Constructing the Statement of Cash Flows Using Changes in Noncash Balance Sheet Accounts liability uses Decreases in liability accounts imply uses of cash. When the payment is made, cash decreases. Example: A company pays a note payable held by a creditor.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin A Simplified Statement of Cash Flows: An Example

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Additional Information:  There was a net loss for the year of $27,000.  Depreciation charges for the year were $6,000.  During the year, Ed sold land originally costing $32,000 for $32,000.  During the year, Ed paid dividends of $3,000 to the stockholders.  Ed issued $50,000 of common stock to settle the note due to Joe Doe. Additional Information:  There was a net loss for the year of $27,000.  Depreciation charges for the year were $6,000.  During the year, Ed sold land originally costing $32,000 for $32,000.  During the year, Ed paid dividends of $3,000 to the stockholders.  Ed issued $50,000 of common stock to settle the note due to Joe Doe. A Simplified Statement of Cash Flows: An Example

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin A Simplified Statement of Cash Flows: An Example Here is a summary of the sources of cash for Ed’s Pizza Hut.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin A Simplified Statement of Cash Flows: An Example Here is a summary of the uses of cash for Ed’s Pizza Hut. The net cash flow for Ed’s Pizza Hut is ($19,000): $66,000 in sources minus $85,000 in uses.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin A Simplified Statement of Cash Flows This simplified approach does not follow the format required for external reporting purposes. It is for illustrative purposes only.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Learning Objective 2 Classify transactions as operating, investing, or financing activities.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin The Full-Fledged Statement of Cash Flows: Operating Activities Operating activities are those activities that enter into the determination of net income. Transactions affecting current assets Transactions affecting current liabilities Changes in noncurrent balance sheet accounts that directly affect net income

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin The Full-Fledged Statement of Cash Flows: Investing Activities Investing activities relate to transactions involving the acquiring or disposing of noncurrent assets. Acquiring or selling property, plant and equipment Acquiring or selling securities Lending money to another entity and subsequently collecting on the loan

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin The Full-Fledged Statement of Cash Flows: Financing Activities Financing activities relate to transactions involving borrowing from creditors or repaying creditors and engaging in transactions with the company’s owners. Issuing stock and purchasing treasury stock Payment of dividends (note that interest on debt is classified as an operating activity) Issuing long-term debt and repayment of debt.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin The Full-Fledged Statement of Cash Flows: An Overview

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin The Full-Fledged Statement of Cash Flows: An Overview Operating Activities Investing Activities Financing Activities Reconciliation of the beginning cash balance with the ending cash balance Noncash Investing and Financing Activities

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Operating Activities Includes those activities that enter into the determination of net income.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Operating Activities Sources of cash are added to net income and uses of cash are subtracted from net income.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Operating Activities

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Operating Activities

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Depreciation and Amortization charges are added back to net income because they are decreases in noncash assets. Operating Activities

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Losses are added back to net income. Operating Activities Gains are subtracted from net income.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Includes transactions that involve the acquisition or disposal of noncurrent assets. Investing Activities

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Includes transactions involving receipts from or payments to creditors and owners. Financing Activities

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Other Issues: Gross or Net? For investing and financing activities, items on the statement of cash flows should be presented in gross amounts rather than in net amounts. Example: lAssume Macy’s purchases $50 million in property during the year and sells other property for $30 million. lInstead of showing the net change of $20 million, the company must report the gross amounts of both transactions. Example: lAssume Macy’s purchases $50 million in property during the year and sells other property for $30 million. lInstead of showing the net change of $20 million, the company must report the gross amounts of both transactions.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Other Issues: Direct Method or Indirect Method? Two Formats for Reporting Operating Activities Reports the cash effects of each operating activity Starts with accrual net income and converts to cash basis Direct MethodIndirect Method No matter which format is used, the same amount of net cash flows from operating activities is generated.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Learning Objective 3 Prepare a statement of cash flows using the indirect method to determine the net cash provided by operating activities.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin A Full-Fledged Statement of Cash Flows: An Example Let’s revisit the comparative balance sheet account balances for Ed’s Pizza Hut.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin A Full-Fledged Statement of Cash Flows: An Example Additional Information:  There was a net loss for the year of $27,000.  Depreciation charges for the year were $6,000.  During the year, Ed sold land originally costing $32,000 for $32,000.  During the year, Ed paid dividends of $3,000 to the stockholders.  Ed issued $50,000 of common stock to settle the note due to Joe Doe. Additional Information:  There was a net loss for the year of $27,000.  Depreciation charges for the year were $6,000.  During the year, Ed sold land originally costing $32,000 for $32,000.  During the year, Ed paid dividends of $3,000 to the stockholders.  Ed issued $50,000 of common stock to settle the note due to Joe Doe. Let’s also refresh our memory regarding the following additional information.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Preparing the Statement of Cash Flows: Step 1 List each account appearing on the comparative balance sheets except for cash and cash equivalents and retained earnings.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Preparing the Statement of Cash Flows: Step 2 Compute the change from the beginning balance to the ending balance for each account.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Preparing the Statement of Cash Flows: Step 3 Code each entry on the worksheet as a source or use of cash. Recall that the transaction involving the Notes Payable and Common Stock was noncash. {

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Preparing the Statement of Cash Flows: Step 4 Code sources of cash as positive numbers and uses of cash as negative numbers.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Preparing the Statement of Cash Flows: Step 5 Make any necessary adjustments, including adjustments for gains and losses. The net effect of these should equal zero. We need to make an adjustment for the noncash transaction relating to Notes Payable and Common Stock. {

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Preparing the Statement of Cash Flows: Step 6 Classify each entry as operating, investing or financing activity.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Preparing the Statement of Cash Flows: Step 7 Copy the data from the worksheet into the Statement of Cash Flows section by section.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Preparing the Statement of Cash Flows: Step 8 Prepare a cash reconciliation at the bottom of the statement.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin In addition, on the face of the statement or in a supplemental schedule, disclose the issuance of $50,000 of stock to a creditor, a noncash financing activity. Example – Indirect Method

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Interpretation of the Statement of Cash Flows Examine the operating activities section carefully.  Ed’s Pizza Hut generated a negative cash flow from operations of $48,000. This is usually a sign of fundamental difficulties.  Ultimately, a positive cash flow is necessary to avoid liquidating assets or borrowing money to pay for day-to-day activities. Examine the operating activities section carefully.  Ed’s Pizza Hut generated a negative cash flow from operations of $48,000. This is usually a sign of fundamental difficulties.  Ultimately, a positive cash flow is necessary to avoid liquidating assets or borrowing money to pay for day-to-day activities.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin The Direct Method of Determining the Net Cash Provided by Operating Activities Appendix 15A

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Learning Objective 4 Use the direct method to determine the net cash provided by operating activities. (Appendix 15A)

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Computing Net Cash Provided by Operating Activities The direct method computes net cash provided by operating activities by reconstructing the income statement on a cash basis from top to bottom. Cash provided by operating activities under the direct method will always agree with the amount computed using the indirect method.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Similarities and Differences in Handling Data Adjustments for accounts that affect revenue are the same in the direct and indirect methods. Adjustments for accounts that affect expenses are handled in opposite ways for the direct and indirect methods.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Direct Method: Gains and Losses Under the direct method, no adjustments for gains and losses on the sale of assets are needed.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin The Direct Method: An Example Let’s revisit the comparative balance sheet account balances for Ed’s Pizza Hut.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin The Direct Method: An Example Let’s assume that Ed’s Pizza Hut prepared this income statement.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin The Direct Method: An Example Step 1: Translate sales revenue into cash collected from customers.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin The Direct Method: An Example Step 2: Translate cost of goods sold into cash disbursements for purchases.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin The Direct Method: An Example Step 3: Translate operating expenses into cash paid for operating expenses. No adjustment for income taxes is required because Ed’s Pizza Hut has a net loss of $27,000.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin The Direct Method: An Example Notice that the net cash provided by operating activities agrees with that computed using the indirect method.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin End of Chapter 15