McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Thirteen: Statement of Cash Flows

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Provides information about the cash receipts and cash payments of a business entity during the accounting period. Helps investors with questions about the company’s: Ability to generate positive cash flows. Ability to meet its obligations and to pay dividends. Need for external financing. Investing and financing transactions for the period. Helps investors with questions about the company’s: Ability to generate positive cash flows. Ability to meet its obligations and to pay dividends. Need for external financing. Investing and financing transactions for the period. Purpose of the Statement of Cash Flows

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 13-3

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved The Statement of Cash Flows must include the following three sections: Cash Flows from Operating Activities Cash Flows from Investing Activities Cash Flows from Financing Activities The Statement of Cash Flows must include the following three sections: Cash Flows from Operating Activities Cash Flows from Investing Activities Cash Flows from Financing Activities Classification of Cash Flows

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved _ Inflows from: Interest and dividends received. Sales to customers. Inflows from: Interest and dividends received. Sales to customers. Cash Flows from Operating Activities Operating Activities Outflows to: Suppliers of merchandise and services. Employees. Lenders for interest. Governments for taxes. Outflows to: Suppliers of merchandise and services. Employees. Lenders for interest. Governments for taxes.

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Cash Flows from Investing Activities + _ Inflows from: Selling investments and plant assets. Collecting of principal on loans. Inflows from: Selling investments and plant assets. Collecting of principal on loans. Outflows to: Purchase of investments and plant assets. Purchase debt or equity investments. Make loans. Outflows to: Purchase of investments and plant assets. Purchase debt or equity investments. Make loans. Investing Activities

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved _ Inflows from: Short-term and long-term borrowing. Owners (for example, from issuing stock). Inflows from: Short-term and long-term borrowing. Owners (for example, from issuing stock). Outflows to: Make payments on borrowed funds. Owners for dividends. Purchase treasury stock. Outflows to: Make payments on borrowed funds. Owners for dividends. Purchase treasury stock. Financing Activities Cash Flows from Financing Activities

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Cash Equivalents Cash Currency Short-term, highly liquid investments. Readily convertible into cash. So near maturity that market value is unaffected by interest rate changes. Short-term, highly liquid investments. Readily convertible into cash. So near maturity that market value is unaffected by interest rate changes. Cash and Cash Equivalents

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved The operating cash flows section can be prepared using either the direct method or the indirect method. Let’s look at the direct method for preparing the Statement of Cash Flows.

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Accrual basis revenue includes sales that did not result in cash inflows. Can be computed as: Cash Received from Customers Decrease in receivables Increase in receivables + – = = Net Sales Direct Method Cash Received from Customers

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved – = = The accounts receivable balance was $80,000 on 12/31/04 and $110,000 on 12/31/05. If accrual sales revenue for 2005 was $900,000, what was cash basis revenue? Decrease in receivables Increase in receivables Net Sales $900,000 Net Sales $900,000 Direct Method Cash Received from Customers Cash Received from Customers

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Cash Received from Customers = $870,000 $30,000 Increase in receivables – = Net Sales $900,000 Net Sales $900,000 Direct Method Cash Received from Customers The accounts receivable balance was $80,000 on 12/31/04 and $110,000 on 12/31/05. If accrual sales revenue for 2005 was $900,000, what was cash basis revenue?

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Let’s look at some simplified formulas for computing direct method cash flows.

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Direct Method Interest and Dividends Received

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Step 1 Step 2 Direct Method Cash Paid for Merchandise

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved How much did Martin Co. pay for inventory in 2005? a. $900,000 b. $923,000 c. $947,000 d. $877,000 Direct Method Cash Paid for Merchandise Purchases for 2005 were $935,000. Purchases = $900,000 + $35,000 Cash Paid for Merchandise in 2005 was $923,000. Cash Paid = $935,000 - $12,000 Purchases for 2005 were $935,000. Purchases = $900,000 + $35,000 Cash Paid for Merchandise in 2005 was $923,000. Cash Paid = $935,000 - $12,000

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved After deducting depreciation and other noncash expenses, the cash paid for expenses is affected by (1) whether the expense was prepaid, and (2) whether the expense was accrued. After deducting depreciation and other noncash expenses, the cash paid for expenses is affected by (1) whether the expense was prepaid, and (2) whether the expense was accrued. Direct Method Cash Payments for Expenses Cash Paid for Expenses = + Increase in prepaid expenses -Decrease in prepaid expenses + Decrease in accrued liabilities -Increase in accrued liabilities

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Now, let’s prepare a direct method Statement of Cash Flows for Martin Co.

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Direct Method

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Direct Method

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Direct Method

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Direct Method Additional Information Trading Securities were purchased during 2005 at a cost of $25,000. Equipment with a book value of $40,000 was sold during the year for $43,000. Equipment with a book value of $30,000 was destroyed during a freak flood in There was no insurance. Martin owns 25% of the common stock of another company and uses the equity method to account for this investment. Additional Information Trading Securities were purchased during 2005 at a cost of $25,000. Equipment with a book value of $40,000 was sold during the year for $43,000. Equipment with a book value of $30,000 was destroyed during a freak flood in There was no insurance. Martin owns 25% of the common stock of another company and uses the equity method to account for this investment.

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Direct Method Additional Information Martin’s tax rate is 40%. The Notes Payable to the bank carry a 12% rate. The payments are due on the first day of each month. The Bonds Payable carry a 9% rate. Interest is payable semiannually on July 1 & Jan. 1. Sold stock during 2005 for $50,000. Received received $10,000 dividends from its equity investment. Additional Information Martin’s tax rate is 40%. The Notes Payable to the bank carry a 12% rate. The payments are due on the first day of each month. The Bonds Payable carry a 9% rate. Interest is payable semiannually on July 1 & Jan. 1. Sold stock during 2005 for $50,000. Received received $10,000 dividends from its equity investment.

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Direct Method Cash Received from Customers Cash Paid to Employees

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Direct Method Cash Paid for Inventory Cash Paid for Interest

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Direct Method Cash Paid for Taxes Other Operating Cash Flows

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Direct Method Cash Flows From Operating Activities

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Equipment with a book value of $40,000 was sold for $43,000. Notes Payable decreased from $70,000 to $60,000 during Bonds Payable decreased from $250,000 to $150,000 during 2005.

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Notice that the Ending Cash Balance per the Statement of Cash Flows agrees with the 12/31/05 Cash balance on the Balance Sheet.

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Let’s look at the indirect method that is used by over 97% of all companies.

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Net Income Cash Flows from Operating Activities Indirect Method Changes in current assets and current liabilities as shown on the following table. + Losses and - Gains + Noncash expenses such as depreciation and amortization.

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Use this table when adjusting Net Income to Operating Cash Flows. Indirect Method

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Joyce, Inc. has prepared the Balance Sheet as of March 31, 2004, and March 31, The Income Statement for the year ended 3/31/05 has also been prepared. Joyce needs help preparing the Statement of Cash Flows using the indirect method. Indirect Method

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Indirect Method The $8,000 gain was the result of selling land costing $32,000 for $40,000 during the period.

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Indirect Method

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Indirect Method Joyce issued $50,000 of no par common stock to settle the $50,000 note payable.

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Indirect Method

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved With the indirect method, always start with the net income or net loss for the period. Indirect Method

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Indirect Method

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Indirect Method Accounts receivable decreased. 3/31/05 3/31/04 $23,000 - $40,000 = $(17,000) Accounts receivable decreased. 3/31/05 3/31/04 $23,000 - $40,000 = $(17,000)

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Indirect Method Accounts payable increased. 3/31/05 3/31/04 $38,000 - $27,000 = $11,000 Accounts payable increased. 3/31/05 3/31/04 $38,000 - $27,000 = $11,000

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Indirect Method Inventory increased. 3/31/05 3/31/04 $350,000 - $300,000 = $50,000 Inventory increased. 3/31/05 3/31/04 $350,000 - $300,000 = $50,000

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Indirect Method Salaries payable decreased. 3/31/05 3/31/04 $ 9,000 - $14,000 = $(5,000) Salaries payable decreased. 3/31/05 3/31/04 $ 9,000 - $14,000 = $(5,000)

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Add back non-cash expenses. Indirect Method

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Subtract gains. Indirect Method

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Indirect Method The operating cash flows amount comes from the schedule just prepared.

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Indirect Method Land originally costing $32,000 was sold for $40,000.

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Indirect Method Dividends of $20,000 were paid to owners during the year.

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Indirect Method Compute the net change in cash for the period.

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Indirect Method Complete the Statement of Cash Flows by reconciling beginning cash to ending cash.

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Note that the ending cash amount ties back to Joyce’s Balance Sheet at 3/31/05. Indirect Method

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved In addition, on the face of the statement or in a supplemental schedule, disclose the $50,000 noncash financing activity. Indirect Method Cash interest payments and cash tax payments must be disclosed.

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Cash Budgets are used by management to plan and forecast future cash flows. Managing Cash Flows

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Increase collection of accounts receivables. Keep inventory low. Delay payment of liabilities. Plan timing of major expenditures. Invest idle cash. Increase collection of accounts receivables. Keep inventory low. Delay payment of liabilities. Plan timing of major expenditures. Invest idle cash. Managing Cash Flows

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Cash Budgeting The ending cash balance of one month becomes the beginning cash balance of the next month.

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Financing is needed in June because the company must maintain a minimum cash balance of $10,000. Cash Budgeting

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved End of Chapter Thirteen