1 Click to edit Master title style Statement of Cash Flows 14

2 Click to edit Master title style Summarize the types of 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. After studying this chapter, you should be able to:

3 Click to edit Master title style Summarize the types of cash flow activities reported in the statement of cash flows. Objective

4 Click to edit Master title style The statement of cash flows reports a firm’s major cash inflows and outflows for a period. It provides useful information about a firm’s ability to generate cash from operations, maintain and expand its operating capacity, meet its financial obligations, and pay dividends. 14-1

5 Click to edit Master title style 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 the investments in noncurrent assets. 3.Cash flows from financing activities are cash flows from transactions that affect the equity and debt of the business. 14-1

6 Click to edit Master title style Statement of Cash Flows— NetSolutions 14-1

7 Click to edit Master title style (payments for treasury stock, dividends, and redemption of debt securities) Financing Financing (payments for expenses) Operating Operating Sources (increases) of Cash Uses (decreases) of Cash (receipts from sales of noncurrent assets) Investing Investing (receipts from issuing equity and debt securities) Financing Financing (payments for acquiring noncurrent assets) Investing Investing (receipts from revenues) Operating Operating Cash Flows 14-1

8 Click to edit Master title style Cash Flows from Operating Activities The direct method reports the sources of operating cash and the uses of operating cash

9 Click to edit Master title style 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

10 Click to edit Master title style 10  Cash inflows from operating activities normally arise when cash is received from customers.  Cash outflows from operating activities normally arise when cash is paid to suppliers for merchandise, supplies, services and to employees for salaries and wages. 14-1

11 Click to edit Master title style 11 A primary advantage of the direct method is that it reports the sources and uses of operating cash flows in the statement of cash flow. A primary disadvantage of the direct method is that the necessary data may not be readily available and may be costly to gather. 14-1

12 Click to edit Master title style 12 A primary advantage of the indirect method is that it focuses on the differences between net income and cash flows from operations. Because the data are readily available, another advantage of the indirect method is that it is normally less costly to use than the direct method. 14-1

13 Click to edit Master title style 13 Cash Flows from Operations: Direct and Indirect Methods— NetSolutions same amount

14 Click to edit Master title style 14 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. 14-1

15 Click to edit Master title style 15 Cash Flows from Financing Activities  Cash inflows from financing activities normally arise from issuing debt or equity securities.  Cash outflows from financing activities normally include paying cash dividends, repaying debt, and acquiring treasury stock. 14-1

16 Click to edit Master title style 16 Noncash Investing and Financing Activities Noncash investing and financing activities are transactions that do not involve cash. The effect of such transactions is recorded in a separate schedule that appears at the bottom of the statement of cash flows. 14-1

17 Click to edit Master title style 17 I M P O R T A N T The financial statements, including the statement of cash flows, should not report cash flow per share. 14-1

18 Click to edit Master title style 18 Example Exercise For each of the following, identify whether it would be disclosed as an operating, financing, or investing activity on the statement of cash flows under the indirect method. a.Purchase patent b.Pay cash dividend c.Disposal of equipment d.Net income e.Purchase treasury stock f.Depreciation expense

19 Click to edit Master title style 19 For Practice: PE 14-1A, PE 14-1B Follow My Example a.Investing b.Financing c.Investing d.Operating e.Financing f.Operating

20 Click to edit Master title style 20 Prepare a statement of cash flows, using the indirect method. Objective

21 Click to edit Master title style 21 An efficient approach to preparing the statement of cash flows is to analyze the changes in the noncash balance sheet accounts. The logic of this approach is that a change in any balance sheet account (including Cash) can be analyzed in terms of changes in the other balance sheet accounts. 14-2

22 Click to edit Master title style 22 The analysis of Retained Earnings provides a good starting point for determining the cash flows from operating activities, which is the first section of the statement of cash flows. 14-2

23 Click to edit Master title style 23 Comparative Balance Sheet (Continued) 14-2

24 Click to edit Master title style 24 Comparative Balance Sheet (Concluded)

25 Click to edit Master title style 25 Retained Earnings The Retained Earnings account for Rundell Inc. reveals that the balance increased $80,000 during the year. ACCOUNT Retained Earnings ACCOUNT NO. 32 Balance Date Item Debit Credit Debit Credit 2008 Jan.1Balance202, Dec.31Net income108, , Cash dividends28, ,

26 Click to edit Master title style 26 ACCOUNT Retained Earnings ACCOUNT NO. 32 Balance Date Item Debit Credit Debit Credit 2008 Jan.1Balance202, Dec.31Net income108, , Cash dividends28, , The net income of $108,000 is entered on the statement (or working papers). To statement 14-2

27 Click to edit Master title style Operating Activities— Rundell Inc. Cash flows from operating activities: Net income $108,000 Adjustments to reconcile net income to net cash flow from operating activities: This phrase is added to indicate that accrual basis net income is being adjusted to arrive at cash flows from operations. 14-2

28 Click to edit Master title style 28 Next, we need to determine depreciation expense for the year. If it isn’t given in the income statement, sometimes it can be found by analyzing the various accumulated depreciation accounts. Depreciation 14-2

29 Click to edit Master title style 29 ACCOUNT Accumulated Depreciation—Building ACCT. NO. Balance Date Item Debit Credit Debit Credit 2008 Jan.1Balance58, Dec.31Depr. for year7, , to statement The comparative balance sheet (Exhibit 4: Slides 23 and 24) indicates that Accumulated Depreciation—Building increased by $7,000. By analyzing the account we can see that the increase is the result of the year-end adjusting entry. 14-2

30 Click to edit Master title style 30 The offsetting $7,000 debit is to an expense for depreciation. The effect on the income statement was to reduced net income; however, this expense did not require an outflow of cash. Therefore, the $7,000 is added back to net income in determining cash flows from operating activities. 14-2

31 Click to edit Master title style 31 Amortization is treated in the same manner as depreciation. Cash flows from operating activities: Net income $108,000 Adjustments to reconcile net income to net cash flow from operating activities: Depreciation 7,000 Operating Activities—Rundell Inc. 14-2

32 Click to edit Master title style 32 Gain on Sale of Land The ledger or income statement of Rundell Inc. indicates that the sale of land resulted in a gain of $12,000. This gain increased net income by $12,000, yet cash flows was provided by an investing activity (selling land) rather than an operating activity, so the gain is deducted from net income on the statement of cash flows. 14-2

33 Click to edit Master title style 33 Operating Activities—Rundell Inc. Cash flows from operating activities: Net income $108,000 Adjustments to reconcile net income to net cash flow from operating activities: Depreciation 7,000 Gain on sale of land(12,000)

34 Click to edit Master title style 34 Example Exercise Omni Corporation’s accumulated depreciation increased by $12,000, while patents decreased by $3,400 between balance sheet dates. There were no purchases or sales of depreciable or intangible assets during the year. In addition, the income statement showed a gain of $4,100 from sale of land. Reconcile a net income of $50,000 to net cash flow from operating activities.

35 Click to edit Master title style 35 For Practice: PE 14-2A, PE 14-2B Follow My Example Net income$50,000 Adjustments to reconcile net income from operating activities: Depreciation12,000 Amortization3,400 Gain on sale of land (4,100) Net cash flow from operating activities$61,300

36 Click to edit Master title style 36 Next, select current assets and current liabilities that impact cash flows and determine their increases and decreases. Exhibit 5 in (Slide 37) may prove to be helpful in determining how to treat increases and decreases in noncash current operating assets and current operating liabilities. Changes in Current Operating Assets and Liabilities 14-2

37 Click to edit Master title style 37 Adjustments to Net Income (Loss) Using the Indirect Method 14-2

38 Click to edit Master title style 38 Changes in Current Accounts Accounts Accounts receivable (net)$ 74,000$ 65,000 Inventories172,000180,000 Accounts payable (mdse.)43,50046,700 Accrued expenses payable26,50024,300 Income taxes payable7,9008,400 9,000 8,000* 3,200* 2, * December 31 Increase Decrease* Note that Cash and Dividends Payable are not included in this analysis. 14-2

39 Click to edit Master title style 39 Cash flows from operating activities: Net income $108,000 Adjustments to reconcile net income to net cash flow from operating activities: Depreciation 7,000 Gain on sale of land(12,000) Changes in current operating assets and liabilities: Increase in accounts receivable(9,000) Decrease in inventory8,000 Decrease in accounts payable(3,200) Increase in accrued expenses2,200 Decrease in income taxes payable(500) Operating Activities—Indirect Method 39 You will notice that increases actually decrease cash flows from operating activities, and decreases do just the opposite. 14-2

40 Click to edit Master title style 40 Statement of Cash Flows— Indirect Method for Rundell Inc. (Operating Activities Section) 40 Same information as Slide 39, only in final form. 14-2

41 Click to edit Master title style 41 Example Exercise Victor Corporation’s comparative balance sheet for current assets and current liabilities was as follows: Dec. 31, 2009Dec. 31, 2008 Accounts receivable$ 6,500$ 4,900 Inventory12,30015,000 Accounts payable4,8005,200 Dividends payable5,0004,000 Adjust net income of $70,000 for changes in operating assets and liabilities.

42 Click to edit Master title style 42 For Practice: PE 14-3A, PE 14-3B Follow My Example Net income$70,000 Adjustments to reconcile net income to net cash from from operating activities: Increase in accounts receivable(1,600) Decrease in inventory2,700 Decrease in accounts payable (400) Net cash flow from operating activities $70,700

43 Click to edit Master title style 43 Example Exercise Omicron, Inc. reported the following data: Prepare the cash flow for operating activities section of the statement of cash flows using the indirect method. Net income$120,000 Depreciation expense12,000 Loss on disposal of equipment15,000 Increase in Accounts receivable5,000 Decrease in Accounts payable(2,000)

44 Click to edit Master title style 44 For Practice: PE 14-4A, PE 14-4B Follow My Example Cash flows from operating activities: Net income$120,000 Adjustments to reconcile net income to net cash flow from operating activities: Depreciation12,000 Loss from disposal of equipment15,000 Changes in current operating assets and liabilities: Increase in accounts receivable(5,000) Decrease in accounts payable (2,000) Net cash flow from operating activities$140,000 44

45 Click to edit Master title style Cash Flows Used for Payment of Dividends ACCOUNT Dividends Payable ACCOUNT NO. Balance Date Item Debit Credit Debit Credit 2008 Jan.1Balance10,000 10Cash paid10,000— June20Dividends declared14,00014,000 July 10Cash paid14,000— Dec. 20Dividends declared14,00014,000 Note that while $28,000 in dividends were declared, only $24,000 were paid during the year.

46 Click to edit Master title style 46 Because paying of dividends affects equity and is an outflow of cash, it is a negative $24,000 cash flows from financing activities transaction. 14-2

47 Click to edit Master title style 47 Common Stock Common Stock increased by $8,000. ACCOUNT Common Stock ACCOUNT NO. Balance Date Item Debit Credit Debit Credit 2008 Jan.1Balance16,000 Nov. 14,000 shares issued/cash8,00024,

48 Click to edit Master title style 48 ACCOUNT Paid-in Capital in Excess of Par—Common Stock Balance Date Item Debit Credit Debit Credit 2008 Jan.1Balance80,000 Nov. 14,000 shares issued/cash40,000120,000 Analyzing the two accounts together, we can determine that the 4,000 shares were sold for $48,

49 Click to edit Master title style 49 Issuing common stock affects equity; therefore, we have a positive $48,000 cash flows from financing activities item. 14-2

50 Click to edit Master title style 50 Bonds Payable Bonds Payable decreased by $50,000. ACCOUNT Bonds Payable ACCOUNT NO. Balance Date Item Debit Credit Debit Credit 2008 Jan.1Balance150,000 June 30Retired by payment of cash at face amount50,000100,

51 Click to edit Master title style 51 Retiring bonds is a cash outflow reported as a negative item under cash flows from financing activities. 14-2

52 Click to edit Master title style 52 Building ACCOUNT Building ACCOUNT NO. Balance Date Item Debit Credit Debit Credit 2008 Jan.1Balance200,000 Dec.27Purchased for cash60,000260,000 By examining the Building account, we can determine that Rundell Inc. bought a building for $60,000 cash. 14-2

53 Click to edit Master title style 53 Purchasing a building involves a noncurrent asset, so this is a negative cash flows from investing activity. 14-2

54 Click to edit Master title style 54 Land ACCOUNT Land ACCOUNT NO. Balance Date Item Debit Credit Debit Credit 2008 Jan.1Balance125,000 June8Sold for $72,000 cash60,00065,000 Oct.12Purchased for $15,000 cash15,00080,000 The $45,000 decline in the Land account resulted from two separate transactions: a sale and a purchase

55 Click to edit Master title style 55 The first transaction, the sale of land, is classified as a positive cash flows from investing activity because land is a noncash asset. 14-2

56 Click to edit Master title style 56 The $12,000 gain was recorded earlier on Slide 33 as an operating activity. The purchase of land also is an investing activity. Click the button to view Slide 33. To return to this slide, type “56” and press the “Enter” key. 14-2

57 Click to edit Master title style 57 The second transaction is the purchase of land for cash of $15,000. This transaction is reported as an outflow of cash in the cash flows from investing activities section. 14-2

58 Click to edit Master title style 58 Statement of Cash Flows— Indirect Method for Rundell Inc. (Partial Statement)

59 Click to edit Master title style 59 Statement of Cash Flows— Indirect Method for Rundell Inc. (Partial Statement) The ending balance in the Cash account should match this amount. 14-2

60 Click to edit Master title style 60 Example Exercise Alpha Corporation purchased land for $125,000. Later in the year the company sold land with a book value of $165,000 for $200,000. How are the effects of these transactions are reported on the statement of cash flows? 60

61 Click to edit Master title style 61 For Practice: PE 14-5A, PE 14-5B Follow My Example The gain on sale of land is deducted from net income as shown below: Gain on sale of land$(35,000) Cash received for sale of land$200,000 Cash paid for purchase of land(125,000) The purchase and sale of land is reported as part of cash inflow form investing activities as shown below:

62 Click to edit Master title style 62 Financial Analysis and Interpretation Free cash flow is a measure of operating cash flow available for corporate purposes after providing sufficient fixed asset additions to maintain current productive capacity and dividends. 14-3

63 Click to edit Master title style 63 Cash flow from operations Less: Investments in fixed assets to maintain current production Free cash flow 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. 14-3