Prepared by: C. Douglas Cloud Professor Emeritus of Accounting Pepperdine University © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Statement of Cash Flows Chapter 14

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 Describe the cash flow activities reported in the statement of cash flows.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Reporting Cash Flows

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cash Flows from Operating Activities  The direct method reports operating cash inflows (receipts) and cash outflows (payments) as follows: 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.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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:

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Over 99% of companies use the indirect method. 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.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Reporting Cash Flows

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cash Flows from Investing & Financing Activities Investing:  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. Financing:  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.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Noncash Investing 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

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. Prepare a statement of cash flows, using the indirect method.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Retained Earnings A good starting point for determining the cash flows from operating activities is to analyze Rundell, Inc.’s Retained Earnings account. Rundell, Inc.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. Rundell, Inc.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Adjustments to Net Income 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.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Rundell, Inc. STEP 2: 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.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Rundell, Inc.  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.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Adjustments to Net Income Rundell, Inc. Let’s start with depreciation. The amount used this year is $7,000.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Adjustments to Net Income Deduct the gain on the sale Rundell, Inc.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Select the current operating assets and liabilities that impact cash flows and determine their increases and decreases. Rundell, Inc.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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.. 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. Rundell, Inc.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Adjustments to Net Income 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. Rundell, Inc. 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.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Adjustments to Net Income Rundell, Inc.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. Rundell, Inc.

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

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Issuing company stock is a financing activity, so cash flows from financing activities increase by $48,000 ($8,000 + $40,000). Rundell, Inc.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The cash outflow for this purchase is shown in the Investing Activities section of the statement. Building Rundell, Inc.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 2 Rundell, Inc. LO 2

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Preparing the Statement of Cash Flows The completed statement of cash flows for Rundell Inc. using the indirect method is shown below. The increase in cash shown on the statement ($71,500) should match the increase in cash in Rundell Inc.’s Cash account. Note that Cash increased $71,500

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Direct Method  The direct method reports cash flows from operating activities as follows: Prepare a statement of cash flows, using the direct method.  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.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Direct Method  Under the direct method, the income statement is adjusted to cash flows from operating activities as follows:

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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

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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. ($8,000) $3,200 $790,000 = $785,20 0

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. $196,000 = $193,800 ($2,200) $0

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. $83,000 = $83,500 $0 $500

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. (continued)

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. Describe and illustrate the use of free cash flow in evaluating a company’s cash flow.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Appendix Spreadsheet Cash Flow Indirect Method