Prepared by: C. Douglas Cloud Professor Emeritus of Accounting Pepperdine University Statement of Cash Flows Chapter 14

Learning Objectives 1.Describe the cash flow activities reported in the statement of cash flows. 2.Prepare a statement of cash flows, using the indirect method. 3.Prepare a statement of cash flows, using the direct method. 4.Describe and illustrate the use of free cash flow in evaluating a company’s cash flow.

Learning Objective 1 Describe the cash flow activities reported in the statement of cash flows.

Reporting Cash Flows  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: 1.Generate cash from operations 2.Maintain and expand its operating capacity 3.Meet its financial obligations 4.Pay dividends LO 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 investments in the 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.

LO 1 Reporting Cash Flows

Cash Flows from Operating Activities  The direct method reports operating cash inflows (receipts) and cash outflows (payments) as follows: LO 1 The primary operating cash inflow is cash received from customers.  The primary operating cash outflows are cash payments for merchandise, operating expenses, interest, and income tax payments.

Reporting Cash Flows  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 as follows: LO 1

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

LO 1 Reporting Cash Flows  Whether the direct or indirect method is used, the amount of net cash flow from operating activities will be the same. This is illustrated in Exhibit 2 on the next slide.

Reporting Cash Flows LO 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. LO 1

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

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. LO 1

No Cash Flow Per Share  Cash flow per share should not be reported on a company’s financial statements for the following reasons: 1.Users may misinterpret cash flow per share as the per-share amount available for dividends. 2.Users may misinterpret cash flow per share as equivalent to earnings per share.

Learning Objective 2 Prepare a statement of cash flows, using the indirect method.

LO 2 The Indirect Method  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.  Any change in the Cash account can be determined by analyzing changes in liability, stockholders’ equity, and noncash asset accounts.

LO 2 The Indirect Method (continued) Rundell, Inc.

LO 2 (concluded) Rundell, Inc.

Retained Earnings A good starting point for determining the cash flows from operating activities is to analyze Rundell, Inc.’s Retained Earnings account. LO 2 Rundell, Inc.

Retained Earnings LO 2 The Retained Earnings account for Rundell Inc. is shown below. Rundell, Inc.

Retained Earnings The Retained Earnings account for 2012 indicates that the $80,000 ($108,000 – $28,000) change resulted from net income and cash dividends. The net income of $108,000 is the first amount reported in the Cash Flows from Operating Activities section. LO 2 Rundell, Inc.

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

LO 2 Rundell, Inc.

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

Rundell, Inc.

Step 2  Losses 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. LO 2

Rundell, Inc.

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. LO 2

Adjustments to Net Income LO 2 Rundell, Inc. Let’s start with depreciation

LO 2 Step 1:The comparative balance sheet indicates that Accumulated Depreciation—Building increased by $7,000. Rundell, Inc.

LO 2 Adjustments to Net Income Step 1:The account indicates that depreciation for the year was $7,000 for the building. Rundell, Inc.

Adjustments to Net Income LO 2 Rundell, Inc.

Adjustments to Net Income LO 2 Next, let’s look at this gain Rundell, Inc.

STEP 2. Deduct the gain on the sale of land of $12,000. The proceeds, which include the gain, are reported in the Investing section of the statement of cash flows. Thus, the gain of $12,000 is deducted from net income in determining cash flows from operating activities. Adjustments to Net Income LO 2 Rundell, Inc.

Adjustments to Net Income LO 2 Rundell, Inc.

LO 2 Step 3:Select the current operating assets and liabilities that impact cash flows and determine their increases and decreases. Rundell, Inc.

LO 2 Adjustments to Net Income Accounts receivable (net): The $9,000 increase is deducted from net income. This is because the $9,000 increase in Accounts Receivable indicates that sales on account were $9,000 more than the cash received from customers. Thus, sales (and net income) includes $9,000 that was not received in cash during the year. (continued) Rundell, Inc.

LO 2 Adjustments to Net Income Inventories: The $8,000 decrease is added to net income. This is because the $8,000 decrease in inventories indicates that the cost of merchandise sold exceeds the cost of merchandise purchased during the year by $8,000. Accounts payable (merchandise creditors): The $3,200 decrease is deducted from net income. This is because a decrease in Accounts Payable indicates that the cash payments to merchandise creditors exceed the merchandise purchased on account by $3,200. (continued) Rundell, Inc.

LO 2 Adjustments to Net Income Accrued expenses payable (operating expenses): The $2,200 increase is added to net income. This is because an increase in Accrued Expenses Payable indicates that operating expenses reported on the income statement exceed the cash payments for operating expenses by $2,200. Income taxes payable: The $500 decrease is deducted from net income. This is because a decrease in Income Taxes Payable indicates that taxes paid exceed the amount of taxes incurred during the year by $500. Rundell, Inc.

Adjustments to Net Income LO 2 Rundell, Inc.

Adjustments to Net Income LO 2 Rundell, Inc.

Transferring the previous slide to a formal statement of cash flows for Rundell, Inc., we can see that part of the statement is now complete. LO 2 Rundell, Inc.

Dividends Cash dividends of $28,000 were declared during LO 2 Rundell, Inc.

Dividends However, as can be seen from the Dividends Payable account, only $24,000 was paid. LO 2 Rundell, Inc.

Since dividend payments are a financing activity, the dividend payments totaling $24,000 are reported in the Financing Activities section. LO 2 Rundell, Inc.

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

Common Stock The Paid-In Capital in Excess of Par—Common Stock account increased by $40,000 during the year. LO 2 Rundell, Inc.

Issuing company stock is a financing activity, so cash flows from financing activities increase by $48,000 ($8,000 + $40,000). LO 2 Rundell, Inc.

LO 2 Bonds Payable Bonds Payable decreased by $50,000 during 2012, due to retiring the bonds. A check of Rundell’s income statement shows that there was no gain or loss on the retirement. Rundell, Inc.

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. LO 2

Building The Building account increased by $60,000. LO 2 Rundell, Inc.

The cash outflow for this purchase is shown in the Investing Activities section of the statement. Building LO 2 Rundell, Inc.

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

Land Earlier, as part of Step 2 in preparing the Operating Activities section, the $12,000 gain was deducted from net income. LO 2 Rundell, Inc.

The proceeds of $72,000 from the sale of land are reported in the Investing Activities section of the statement of cash flows. LO 2

Land 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 Investing Activities section. LO 2 Rundell, Inc.

LO 2 Rundell, Inc. LO 2

Preparing the Statement of Cash Flows The completed statement of cash flows for Rundell Inc. using the indirect method is shown in Exhibit 6 (next slide). The increase in cash shown on the statement ($71,500) should match the increase in cash in Rundell Inc.’s Cash account. LO 2 Rundell, Inc.

LO 2 Note that Cash increased $71,500 Rundell, Inc. LO 2

Learning Objective 3 Prepare a statement of cash flows, using the direct method.

The Direct Method LO 3  The direct method reports cash flows from operating activities as follows: The final amount reported in the Cash Flows from Operating Activities section will be the same whether the direct or indirect method is used. The methods differ in how the data are obtained, analyzed, and reported.

The Direct Method  Under the direct method, the income statement is adjusted to cash flows from operating activities as follows: LO 3

The Direct Method  Depreciation Expense is not adjusted or reported as part of cash flows from operating activities.  This is because depreciation does not involve a cash outflow.  Gains and losses are also not adjusted because the cash flow from operating activities is determined directly, rather than by reconciling net income.  Proceeds from the sale of land, which include any gains or losses, are reported as an investing activity. LO 3

Cash Received from Customers Rundell Inc. reports sales of $1,180,000 for To determine the cash received from customers, sales are adjusted by any increase or decrease in Accounts Receivable. Rundell, Inc. ($9,000) $1,180,000 = $1,171,000 $0

LO 3 Cash Payments for Merchandise Rundell Inc. reports cost of merchandise sold of $790,000. To determine the cash payments for merchandise, the $790,000 is adjusted for any increase or decrease in Inventories and Accounts Payable (assuming the accounts are owed to merchandise suppliers). Rundell, Inc.

LO 3 ($8,000) $3,200 $790,000 = $785,200 Cash Payments for Merchandise

Cash Payments for Operating Expenses Rundell Inc. reports total operating expenses of $203,000, which includes Depreciation Expense of $7,000. To determine cash payments for operating expenses, the other operating expenses (excluding depreciation) of $196,000 are adjusted for any increase or decrease in Accrued Expenses Payable. LO 3 Rundell, Inc.

LO 3 Cash Payments for Operating Expenses $196,000 = $193,800 ($2,200) $0

Interest Expense Rundell Inc. reports interest expense of $8,000. To determine the cash payments for interest, the $8,000 is adjusted for any increases or decreases in Interest Payable. LO 3 Rundell, Inc.

Interest Expense LO 3

Cash Payments for Income Taxes Rundell Inc. reports income tax expense of $83,000. To determine the cash payments for income taxes, the $83,000 is adjusted for any increases or decreases in Income Taxes Payable. LO 3 Rundell, Inc.

Cash Payments for Income Taxes LO 3 $83,000 = $83,500 $0 $500

Reporting Cash Flows from Operating Activities LO 3 (continued) Rundell, Inc.

LO 3 Reporting Cash Flows from Operating Activities Rundell, Inc.

Learning Objective 4 Describe and illustrate the use of free cash flow in evaluating a company’s cash flow.

Free Cash Flow  Free cash flow measures the operating cash flow available for a company to use after purchasing the property, plant, and equipment necessary to maintain current productive capacity. LO 4

Free Cash Flow 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.

Free Cash Flow Research in Motion, Inc., maker of BlackBerry® smartphones, had cash flow from operating activities of $1,452 million in a recent fiscal year. The statement of cash flows indicated that the cash invested in property, plant, and equipment was $834 million. The free cash flow would be computed as follows (in millions): LO 4 Cash flow from operating activities$1,452 Less: Investment in PP&E needed to maintain current production 834 Free cash flow$ 618

Appendix Spreadsheet (Work Sheet) for Statement of Cash Flows ­ The Indirect Method

Appendix