1 Chapter 12 `

2 Chapter 12 Statement of Cash Flows After studying Chapter 12, you should be able to: zIndicate the primary purpose of the statement of cash flows. zDistinguish among operating, investing, and financing activities. zExplain the impact of the product life cycle on a company's cash flows. zPrepare a statement of cash flows using one of two approaches: y(a) the indirect method, or y(b) the direct method. zUse the statement of cash flows to evaluate a company.

3 The Primary Purpose of the Statement of Cash Flows Is... zTo provide information about: ycash receipts, ycash payments, and ythe net change in cash resulting from: xoperating, xinvesting, and xfinancing activities of a company during a period.

4 Operating Activities... Include: yThe cash effects of transactions that create revenues and expenses and yEnter into determination of net income. Involve Income Statement Items

5 Investing Activities... Include: yPurchasing and disposing of investments and productive long-lived assets using cash and yLending money and collecting the loans. Involve Investments and Noncurrrent Asset Items

6 Financing Activities... Include: yObtaining cash from issuing debt and repaying the amounts borrowed and yObtaining cash from stockholders and paying dividends. Involve Noncurrent Liability and Stockholders’ Equity Items

7 Types of Cash Flows - Operating Activities zCash inflows: yFrom sale of goods or services yFrom interest on loans (interest received) and dividends on equity security investments zCash outflows: yTo suppliers for inventory yTo employees for services yTo government for taxes yTo lenders for interest yTo others for expenses Illustration 12-1

8 Types of Cash Flows - Investing Activities zCash inflows: yFrom sale of property, plant, and equipment yFrom sale of debt or equity securities of other entities yFrom collection of principal on loans to other entities zCash outflows: yTo purchase property, plant, and equipment yTo purchase debt or equity securities of other entities yTo make loans to other entities Illustration 12-1

9 Types of Cash Flows - Financing Activities zCash inflows: yFrom sale of equity securities (company's own stock) yFrom issuance of debt (bonds and notes) zCash outflows: yTo stockholders as dividends yTo redeem long-term debt or reacquire capital stock Illustration 12-1

10 Operating Activities - ALERT zSome cash flows relating to investing or financing activities are classified as operating activities. For example... yReceipts of investment revenue (interest and dividends) and yPayments of interest to lenders are classified as operating activities because these items are reported in the income statement.

11 Format of the Statement of Cash Flows Three activities: yoperating y investing yfinancing PLUS ynoncash investing and financing activities Body of Statement

12 Statement of Cash Flows Helps Users Evaluate 1. The entity's ability to generate future cash flows 2. The entity's ability to pay dividends and meet obligations 3. The reasons for the difference between net income and net cash provided (used) by operating activities 4. The investing and financing transactions during the period

13 COMPUTER SERVICES COMPANY Comparative Balance Sheet December 31, 2003

14 Income Statement and Additional Information COMPUTER SERVICES COMPANY Income Statement For the Year Ended December 31, 2003 Revenues$85,000 Operating expenses 40,000 Income before income taxes 45,000 Income tax expense 10,000 Net income $35,000 Additional Information: (a) Examination of selected data indicates that a dividend of $15,000 was declared and paid during the year. (b) The equipment was purchased at the end of No depreciation was taken in 2003.

15 Indirect and Direct Methods zConvert net income from an accrual basis to a cash basis. zThis conversion may be done by two methods: yindirect ydirect

16 Indirect and Direct Methods zBoth methods arrive at the same total amount for “Net cash” provided by operating activities. zThe methods differ in disclosing the items that make up the total amount. zThe choice of methods affects only the operating activities section; the investing and financing activities sections are the same.

17 Indirect Method zThe indirect method is used extensively in practice. zMost companies favor the indirect method for the following reasons: yit is easier to prepare yit focuses on the differences between net income and net cash flow from operating activities yit tends to reveal less company information to competitors.

18 Direct Method zThe FASB prefers the direct method but allows the use of either method. zWhen the direct method is used, the net cash flow from operating activities as computed using the indirect method must also be reported in a separate schedule.

19 Steps in Preparing Statement of Cash Flows $34, = $34,000

20 Statement Of Cash Flows - Indirect Method zThe transactions of Computer Services Company for the year ended 2003 are used to illustrate the preparation of a statement of cash flows. zComputer services Company started in January 1, 2003, when it issued 50,000 shares of $1 par value common stock for $50,000 cash. zThe company rented its office space and furniture and performed consulting services throughout the first year.

21 Steps in Preparing Statement of Cash Flows

22 Determine Net Cash Provided/Used By Operating Activities zAdjust net income for items that did not affect cash. zNet income must be converted because earned revenues may include credit sales that have not been collected in cash and expenses incurred that may not have been paid in cash.

23 Receivables, payables, prepayments, and inventories must be analyzed for their effects on cash. Determine Net Cash Provided/Used By Operating Activities

24 zComputer Services Company had revenues of $85,000 in its first year of operations. zHowever, CSC collected only $55,000 in cash. Accrual basis revenue was $85,000, cash basis revenue would be $55,000. zThe increase in accounts receivable of $30,000 must be deducted from net income. zIf accounts receivable decrease, the decrease must be added to net income. Determine Net Cash Provided/Used By Operating Activities

25 COMPUTER SERVICES COMPANY Statement of Cash Flows--Indirect Method (Partial) For the Year Ended December 31, 2003 Cash flows from operating activities Net income $35,000 Adjustments to reconcile net income to net cash provided by operating activities: Increase in accounts receivable $(30,000)

26 zAccounts payable - When accounts payable increase during a year, operating expenses on an accrual basis are higher than they are on a cash basis. zFor CSC, operating expenses reported in the income statement were $40,000. zSince Accounts Payable increased $4,000, $36,000 ($40,000 – $4,000) of the expenses were paid in cash. zTo convert net income to net cash provided by operating activities, an increase in accounts payable must be added to net income, a decrease subtracted. Determine Net Cash Provided/Used By Operating Activities

27 COMPUTER SERVICES COMPANY Statement of Cash Flows--Indirect Method (Partial) For the Year Ended December 31, 2003 Cash flows from operating activities Net income $35,000 Adjustments to reconcile net income to net cash provided by operating activities: Increase in accounts receivable $(30,000) Increase in accounts payable 4,000 (26,000) Net cash provided by operating activities $ 9,000

28 Steps in Preparing Statement of Cash Flows

29 Determine Net Cash Provided/Used By Investing and Financing Activities zNo data are given for the increases in Equipment of $10,000 and Common Stock of $50,000. Assume any differences involve cash. zThe increase in equipment is from a purchase of equipment for $10,000 cash. This purchase is reported as a cash outflow in the investing activities section. zThe increase of common stock results from the issuance of common stock for $50,000 cash. It is reported as an inflow of cash in the financing activities section of the statement of cash flows.

30 COMPUTER SERVICES COMPANY Comparative Balance Sheet December 31, 2003

31 Determine Net Cash Provided/Used By Investing and Financing Activities zReasons for the increase of $20,000 in the Retained Earnings. yNet income increased retained earnings by $35,000. REPORTED IN THE OPERATING ACTIVITIES SECTION. yThe additional information indicates that a cash dividend of $15,000 was declared and paid. REPORTED IN THE FINANCING ACTIVITIES SECTION.

32 COMPUTER SERVICES COMPANY Statement of Cash Flows--Indirect Method (Partial) For the Year Ended December 31, 2003 Cash flows from operating activities Net income $35,000 Adjustments to reconcile net income to net cash provided by operating activities: Increase in accounts receivable $(30,000) Increase in accounts payable 4,000 (26,000) Net cash provided by operating activities $ 9,000 Cash flows from investing activities Purchase of equipment (10,000) Cash flows from financing activities Issuance of Common Stock$50,000 Payment of cash dividends(15,000) Net cash provided by financing activities 35,000 Net increase in cash $34,000

33 Major Classes of Cash Receipts and Payments -- Direct Method

34 COMPUTER SERVICES COMPANY Statement of Cash Flows--Direct Method (Partial) For the Year Ended December 31, 2003 Cash flows from operating activities Cash receipts from customers $ 765,000 Cash payments To supplier$550,000 For operating expenses 158,000 For income taxes 48, ,000 Net cash provided by operating activities $ 9,000

35 Cash Provided By Operations – Capital Expenditures – Dividends Paid Free Cash Flow

36 Rather than using numbers from the income statement for assessment purposes, we use numbers from the statement of cash flows. Assessing Liquidity, Solvency, and Profitability Using Cash Flows The ratios are cash-based instead of accural-based.