FINANCIAL ACCOUNTING AN INTRODUCTION TO CONCEPTS, METHODS, AND USES 12th Edition FINANCIAL ACCOUNTING AN INTRODUCTION TO CONCEPTS, METHODS, AND USES 12th Edition Chapter 4 -- Statement of Cash Flows: Effects Operating, Investing, Financing Activities on Cash Flows Clyde P. Stickney and Roman L. Weil

Learning Objectives 1. Understand why using the accrual basis of accounting to prepare the balance sheet and income statement creates the need for a statement of cash flows. 2.Understand the types of transactions that result in cash flows from operating, investing, and financing activities. 3.Develop an ability to prepare a statement of cash flows from a comparative balance sheet and income statement. 1. Understand why using the accrual basis of accounting to prepare the balance sheet and income statement creates the need for a statement of cash flows. 2.Understand the types of transactions that result in cash flows from operating, investing, and financing activities. 3.Develop an ability to prepare a statement of cash flows from a comparative balance sheet and income statement.

Learning Objectives 4.Distinguish between the direct and indirect methods of reporting and analyzing cash flows from operations. 5.Develop an ability to analyze the statement of cash flows, including the relation among cash flows from operating, investing, and financing activities for businesses in various stages of their growth. 4.Distinguish between the direct and indirect methods of reporting and analyzing cash flows from operations. 5.Develop an ability to analyze the statement of cash flows, including the relation among cash flows from operating, investing, and financing activities for businesses in various stages of their growth.

Chapter Outline 1. Need for a Statement of Cash Flows 2. Overview of the Statement of Cash Flows 3.Preparing the Statement of Cash Flows – Direct and indirect methods – T-account approach 4.An international perspective 5.Using Information in the Statement of Cash Flows 6.Ethical Issues and The Statement of Cash Flows Chapter Summary 1. Need for a Statement of Cash Flows 2. Overview of the Statement of Cash Flows 3.Preparing the Statement of Cash Flows – Direct and indirect methods – T-account approach 4.An international perspective 5.Using Information in the Statement of Cash Flows 6.Ethical Issues and The Statement of Cash Flows Chapter Summary

Statement of Cash Flows The statement of cash flows … a) explains the reasons for a change in cash. b) classifies the reasons for the change as an operating, investing or financing activity. c) reconciles net income with cash flow from operations. The statement of cash flows … a) explains the reasons for a change in cash. b) classifies the reasons for the change as an operating, investing or financing activity. c) reconciles net income with cash flow from operations.

Three Classifications of Cash Flows 1.Operations – cash flows related to selling goods and services; that is, the principle business of the firm. 2. Investing – cash flows related to the acquisition or sale of noncurrent assets. 3. Financing – long term and short term cash flows related to liabilities and owners’ equity; dividends are a financing cash outflow. 1.Operations – cash flows related to selling goods and services; that is, the principle business of the firm. 2. Investing – cash flows related to the acquisition or sale of noncurrent assets. 3. Financing – long term and short term cash flows related to liabilities and owners’ equity; dividends are a financing cash outflow.

Example of a Statement of Cash Flows Exhibit 4.1

Preparing the Statement of Cash Flows Firms could prepare the cash flow statement directly from the cash account. Most, however, find it more efficient to prepare the cash flow statement from the balance sheet and income statement. a) Direct and indirect methods. b) Algebraic formulation will present the underlying concept of Statement of cash flows. c) There are two approaches to producing the cash flow statement: columnar worksheet and t-account worksheet. Firms could prepare the cash flow statement directly from the cash account. Most, however, find it more efficient to prepare the cash flow statement from the balance sheet and income statement. a) Direct and indirect methods. b) Algebraic formulation will present the underlying concept of Statement of cash flows. c) There are two approaches to producing the cash flow statement: columnar worksheet and t-account worksheet.

Define Direct and Indirect Method  Direct method of presentation calculates cash flow from operations by subtracting cash disbursements to supplies, employees, and others from cash receipts from customers.  The indirect method calculates cash flow from operations by adjusting net income for noncash revenues and expenses.  Most firms present their cash flows using the indirect method.  Direct method of presentation calculates cash flow from operations by subtracting cash disbursements to supplies, employees, and others from cash receipts from customers.  The indirect method calculates cash flow from operations by adjusting net income for noncash revenues and expenses.  Most firms present their cash flows using the indirect method.

Algebraic Formulation Recall the basic accounting equation: Assets = Liabilities + Shareholders’ Equity or A = L + SE Assets are either cash (C) or non cash assets (N$A), so C + N$A = L + SE  C +  N$A =  L +  SE Where  means the change in the balance, Rearranging gives the basic equation for the statement of cash flows:  C =  L +  SE -  N$A Recall the basic accounting equation: Assets = Liabilities + Shareholders’ Equity or A = L + SE Assets are either cash (C) or non cash assets (N$A), so C + N$A = L + SE  C +  N$A =  L +  SE Where  means the change in the balance, Rearranging gives the basic equation for the statement of cash flows:  C =  L +  SE -  N$A

Algebraic Formulation (Cont.) C =  L +  SE -  N$A  The change in cash,  C, is the increase or decrease in the cash account.  This amount must equal changes in liabilities plus changes in shareholders’ equity minus changes in assets other than cash.  Thus, we can identify the causes in the change in the cash account by studying the changes in non-cash accounts. C =  L +  SE -  N$A  The change in cash,  C, is the increase or decrease in the cash account.  This amount must equal changes in liabilities plus changes in shareholders’ equity minus changes in assets other than cash.  Thus, we can identify the causes in the change in the cash account by studying the changes in non-cash accounts.

Two Approaches to Producing the Cash Flow Statement The basic formula can be implemented using either of two approaches: 1. Columnar worksheet -- changes in balance sheet accounts are classified by definition using a multicolumn worksheet. 2. T-Account worksheet -- changes are classified by analysis of the t- accounts. The basic formula can be implemented using either of two approaches: 1. Columnar worksheet -- changes in balance sheet accounts are classified by definition using a multicolumn worksheet. 2. T-Account worksheet -- changes are classified by analysis of the t- accounts.

Columnar Worksheet  Works well for relatively simple situations involving few transactions.  Enhances understanding of the cash flow statement.  Does not work as well as the T- account method when the number and complexity of transactions increases.  Works well for relatively simple situations involving few transactions.  Enhances understanding of the cash flow statement.  Does not work as well as the T- account method when the number and complexity of transactions increases.

Columnar Worksheet (Cont.) Begin with a comparative balance sheet. 1. Compute the change in each balance sheet account. 2. Classify each change as operating, investing or financing activity. 3. Make any needed adjustments (for example, for a sale of a long-lived asset). 4. Recast the classified changes in the form of a cash flow statement. Begin with a comparative balance sheet. 1. Compute the change in each balance sheet account. 2. Classify each change as operating, investing or financing activity. 3. Make any needed adjustments (for example, for a sale of a long-lived asset). 4. Recast the classified changes in the form of a cash flow statement.

Noncash Expenses  Noncash expenses, such as depreciation expense, are added back.  Items that are truly not sources of cash, even though they are associated with cash inflows; rather, a reversal of the accrual process that required the expenses to be recognized without regard for the cash flow.  Noncash expenses, such as depreciation expense, are added back.  Items that are truly not sources of cash, even though they are associated with cash inflows; rather, a reversal of the accrual process that required the expenses to be recognized without regard for the cash flow.

Changes in Specific Accounts Changes in Specific Accounts If noncash assets are increased, then cash was spent, so cash is an outflow, negative sign. If noncash assets are increased, then cash was spent, so cash is an outflow, negative sign. If noncash assets are decreased, then they provided cash so cash is an inflow, positive sign. If noncash assets are decreased, then they provided cash so cash is an inflow, positive sign. If liab. or S.E. increased, then cash was obtained, so cash in an inflow, positive sign. If liab. or S.E. increased, then cash was obtained, so cash in an inflow, positive sign. If liab. or S.E. decreased, then cash was spent, so cash in an outflow, negative sign. If liab. or S.E. decreased, then cash was spent, so cash in an outflow, negative sign. Non- cash Assets Liabilities and Shareholders’ Equity Liabilities and Shareholders’ Equity increase decrease

T-account Worksheet  The columnar works well when the change in each balance sheet account affects only one of the three types of activities. It becomes cumbersome for more complex (and realistic) situations.  The T-account approach is a direct extension of T-accounts - facilitates analysis of a transaction which involves more than one activity.  For example, the change in Retained Earnings can be due to both net income (operating activity) and dividends (financing activity).  The columnar works well when the change in each balance sheet account affects only one of the three types of activities. It becomes cumbersome for more complex (and realistic) situations.  The T-account approach is a direct extension of T-accounts - facilitates analysis of a transaction which involves more than one activity.  For example, the change in Retained Earnings can be due to both net income (operating activity) and dividends (financing activity).

T-account Worksheet 1.Obtain beginning and ending balance sheets. 2.Prepare a T-account worksheet with a master account, cash, divided into operating, investing and financing sections. 3.Explain the change in the master cash account by reconstructing the original entries in a summary form. 4.Make any necessary adjustments. 5.Recast the master account in the format of a cash flow statement. 1.Obtain beginning and ending balance sheets. 2.Prepare a T-account worksheet with a master account, cash, divided into operating, investing and financing sections. 3.Explain the change in the master cash account by reconstructing the original entries in a summary form. 4.Make any necessary adjustments. 5.Recast the master account in the format of a cash flow statement.

T-account Worksheet (Cont.) Cash beginning balance Operations Investing Financing ending balance Various Balance Sheet Accounts beginning balance ending balance ###### #### 1. adjustments are made to all balance sheet accounts to bring the beginning balance to the ending balance. 2. these are offset by an opposite entry in the cash account. 3. this part of the cash account becomes the cash flow statement.

Effects of Sale of Long-Term Assets on Cash Flows  A few transactions complicate the derivation of a cash flow statement from a comparative balance sheet, for example, the sale of a long- term (or fixed) asset.  Recall the journal entry for the sale of an asset:  A few transactions complicate the derivation of a cash flow statement from a comparative balance sheet, for example, the sale of a long- term (or fixed) asset.  Recall the journal entry for the sale of an asset: Cash ### Accumulated Depreciation ### Asset ### Gain (or loss) on sale ###

Sale of an Asset (Cont.)  Each of the four parts of the above journal entry require an adjustment in the cash flow statement.  The first line, cash, adds a line to the investing section.  The second line, a debit to accumulated depreciation, increases the depreciation expense above the change in the change in the accumulated depreciation account.  The third line, a credit to the asset, increases the amount of cash invested in long-lived assets above the change in the fixed asset accounts.  The fourth line, a gain or loss, is reversed out in the operating sections since this is not a cash flow.  Each of the four parts of the above journal entry require an adjustment in the cash flow statement.  The first line, cash, adds a line to the investing section.  The second line, a debit to accumulated depreciation, increases the depreciation expense above the change in the change in the accumulated depreciation account.  The third line, a credit to the asset, increases the amount of cash invested in long-lived assets above the change in the fixed asset accounts.  The fourth line, a gain or loss, is reversed out in the operating sections since this is not a cash flow.

Comparison of Cash Flow to Net Income  Net income is an accrual based concept and purports to show the long-term.  Cash flows purport to show the short term.  Consider the outlook for both short-term and long-term and consider that each is either good or poor.  A strong growing firm would show both good long-term and good short-term outlooks.  A failing firm would show both poor long-term and poor short term outlooks.  What about a firm with good cash flows (short-term) but poor net income (long-term)?  What about a firm with poor cash flows (short-term) but good net income (long-term)?  Net income is an accrual based concept and purports to show the long-term.  Cash flows purport to show the short term.  Consider the outlook for both short-term and long-term and consider that each is either good or poor.  A strong growing firm would show both good long-term and good short-term outlooks.  A failing firm would show both poor long-term and poor short term outlooks.  What about a firm with good cash flows (short-term) but poor net income (long-term)?  What about a firm with poor cash flows (short-term) but good net income (long-term)?

An International Perspective  The International Accounting Standards Board (IAS No. 7) recommends but does not require a statement of cash flows.  An approximation to a cash flow statement can be prepared from a comparative balance sheet with some additional information.  The International Accounting Standards Board (IAS No. 7) recommends but does not require a statement of cash flows.  An approximation to a cash flow statement can be prepared from a comparative balance sheet with some additional information.

Chapter Summary  The statement of cash flows is presented. It reports the effects on cash flows of a firm’s operating, investing and financing activities.  This information helps understand: 1.How operations affect liquidity, 2.The level of capital expenditures needed to support growth, and 3.The major changes in financing.  Two methods are presented to produce a cash flow statement from a comparative balance sheet.  The statement of cash flows is presented. It reports the effects on cash flows of a firm’s operating, investing and financing activities.  This information helps understand: 1.How operations affect liquidity, 2.The level of capital expenditures needed to support growth, and 3.The major changes in financing.  Two methods are presented to produce a cash flow statement from a comparative balance sheet.