Statement of Cash Flows Chapter 16 Statement of Cash Flows Accounting, 21st Edition Warren Reeve Fess © Copyright 2004 South-Western, a division of Thomson Learning. All rights reserved. Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc. PowerPoint Presentation by Douglas Cloud Professor Emeritus of Accounting Pepperdine University

What is “Cash Flow” Refer to Midstate Flooring Inc. Where did their cash come from? Where did their cash go?

Reporting Cash Flows The statement of cash flows reports cash flows by three types of activities: 1. Cash flows from operating activities – transactions that affect net income. 2. Cash flows from investing activities – transactions that affect noncurrent assets. 3. Cash flows from financing activities – transactions that affect equity and debt of the entity.

Reporting Cash Flows Decreases in Cash Operating Operating Investing Increases in Cash Decreases in Cash (receipts from revenues) Operating (payments for expenses) Operating (receipts from sales of noncurrent assets) Investing (payments for acquiring noncurrent assets) Investing (receipts from issuing equity and debt securities) Financing (payments for treasury stock, dividends, and redemption of debt securities) Financing

Merchandise purchases Payments of wages and other expenses Cash Flows from Operating Activities Typical cash inflows Typical cash outflows What are some of the typical cash inflows from operating activities?` What are some of the typical cash outflows from operating activities? Sales of goods and services Merchandise purchases Interest revenue Payments of wages and other expenses Dividend revenue Tax payments

Cash Flows from Investing Activities Typical cash inflows Typical cash outflows What are some of the typical cash inflows from investing activities? What are some of the typical cash outflows from investing activities? Sales of fixed assets Purchase of fixed assets Sale of long-term investments Purchase of long-term investments

Cash Flows from Financing Activities Typical cash inflows Typical cash outflows What are some of the typical cash inflows from financing activities? What are some of the typical cash outflows from financing activities? Paying cash dividends Issuing bonds and long-term notes payable Repaying debt Issuing preferred and common stock Acquiring treasury stock

Noncash Investing and Financing Activities Issuing bonds to acquire land Issuing common stock for convertible preferred stock Issuing a long-term note to acquire equipment Issuing a stock dividend

Statement of Cash Flows-- The Indirect Method

Step 1 The Indirect Method Start with the accrual basis net income (shown in the income statement, the Retained Earnings account, or the statement of stockholders’ equity).

The Indirect Method Find the net income. To statement Balance ACCOUNT Retained Earnings ACCOUNT NO. 32 Balance Date Item Debit Credit Debit Credit Jan. 1 Balance 202,300 Dec. 31 Net income 108,000 310,300 31 Cash dividends 28,000 282,300 To statement 2006

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Operating Activities – Indirect Method Cash flows from operating activities: Net income per income statement $108,000

Step 2 The Indirect Method Next, we need to determine depreciation expense for the year. If it isn’t given on the income statement, sometimes it can be found by analyzing the Accumulated Depreciation account.

Determine depreciation expense. The Indirect Method Determine depreciation expense. ACCOUNT Accumulated Depreciation--Building ACCOUNT NO. 17 Balance Date Item Debit Credit Debit Credit Jan. 1 Balance 58,300 Dec. 31 Depreciation for year 7,000 65,300 2006 to statement

Operating Activities – Indirect Method Cash flows from operating activities: Net income per income statement $108,000 Depreciation $ 7,000 Add: Because Depreciation Expense reduced net income but did not require an outflow of cash, it is added back to net income.

Step 3 The Indirect Method Select current assets and current liabilities that impact cash flow and determine the increases and decreases.

Changes in Current Accounts Accounts 2006 2005 Debit Credit Accounts receivable (net) $74,000 $65,000 Inventories 172,000 180,000 Accounts payable (mdse.) 43,500 46,700 Accrued expenses payable 26,500 24,300 Income taxes payable 7,900 8,400 9,000 8,000 3,200 2,200 500 Determine the debit or credit change of each item above.

Changes in Current Accounts Accounts 2006 2005 Debit Credit Accounts receivable (net) $74,000 $65,000 Inventories 172,000 180,000 Accounts payable (mdse.) 43,500 46,700 Accrued expenses payable 26,500 24,300 Income taxes payable 7,900 8,400 9,000 8,000 3,200 2,200 500 These debit changes are subtracted from net income in the operating activities section of the statement of cash flows. Think of these debits as deductions from net income in arriving at net cash flow from operations.

Changes in Current Accounts Accounts 2006 2005 Debit Credit Accounts receivable (net) $74,000 $65,000 Inventories 172,000 180,000 Accounts payable (mdse.) 43,500 46,700 Accrued expenses payable 26,500 24,300 Income taxes payable 7,900 8,400 9,000 8,000 3,200 2,200 500 These credit changes are added to net income in the operating activities section of the statement of cash flows. Think of these credits as additions to net income in arriving at net cash flow from operations.

Operating Activities—Indirect Method Cash flows from operating activities: Net income per income statement $108,000 Depreciation $ 7,000 Decrease in inventories 8,000 Increase in accrued expenses 2,200 17,200 $125,200 Inc. in accounts receivable $ 9,000 Dec. in accounts payable 3,200 Dec. in income taxes payable 500 Add:

Step 4 The Indirect Method Analyze the income statement to determine if there are any gains or losses from selling investments, equipment, etc.

Rundell Inc. Income Statement For the Year Ended December 31, 2006 Sales $1,180,000 Cost of merchandise sold 790,000 Gross profit $ 390,000 Operating expenses: Depreciation expense $ 7,000 Other operating expenses 196,000 Total operating expenses 203,000 Income from operations $ 187,000 Other income: Gain on sale of land $12,000 Other expense: Interest expense 8,000 4,0000 Income before income tax $ 191,000 Income tax 83,000 Net income $ 108,000 Gain on sale of land $12,000

Operating Activities—Indirect Method Cash flows from operating activities: Net income, per income statement $108,000 Depreciation $ 7,000 Decrease in inventories 8,000 Increase in accrued expenses 2,200 17,200 $125,200 Inc. in accounts receivable $ 9,000 Dec. in accounts payable 3,200 Dec. in income taxes payable 500 Gain on sale of land 12,000 24,700 Net cash flow from operating activities $100,500 Add: This gain was included in net income, but did not represent an operating cash flow.

The Indirect Method If there had been a loss on this sale, the loss would have been added to net income.

Operating Activities – Indirect Method Cash flows from operating activities: Net income per income statement $108,000 Depreciation $ 7,000 Decrease in inventories 8,000 Increase in accrued expenses 2,200 17,200 $125,200 Inc. in accounts receivable $ 9,000 Dec. in accounts payable 3,200 Dec. in income taxes payable 500 Gain on sale of land 12,000 24,700 Net cash flow from operating activity $100,500 Add: Deduct:

Cash Flows from Investing Activities Typical cash inflows Typical cash outflows What are some of the typical cash inflows from investing activities? What are some of the typical cash outflows from investing activities? Sales of fixed assets Purchase of fixed assets Sale of long-term investments Purchase of long-term investments

Cash Flows from Investing Activities Purchased a Building ACCOUNT Building ACCOUNT NO. 18 Balance Date Item Debit Credit Debit Credit Jan. 1 Balance 200,000 Dec. 27 Purchased for cash 60,000 260,000 2006

Cash Flows from Investing Activities Purchased a Building Purchasing a building involves a noncurrent asset, so this is a negative cash flows from investing activities item.

Cash Flows from Investing Activities Land Transactions ACCOUNT Land ACCOUNT NO. 16 Balance Date Item Debit Credit Debit Credit Jan. 1 Balance 125,000 June 8 Sold for $72,000 cash 60,000 65,000 Oct. 12 Purchased for $15,000 cash 15,000 80,000 2006

Cash Flows from Investing Activities Land Transactions The first transaction, the sale of land, results in a positive cash flow from investing activities because land is a noncash asset.

Cash Flows from Investing Activities Land Transactions The $12,000 gain was recorded earlier on Slide 29 as an operating activity. The purchase of land also is an investing activity. Click here to return to Slide 29. To return to this slide, type “43” and press the “Enter” key.

Cash Flows from Financing Activities Typical cash inflows Typical cash outflows What are some of the typical cash inflows from financing activities? What are some of the typical cash outflows from financing activities? Paying cash dividends Issuing bonds and long-term notes payable Repaying debt Issuing preferred and common stock Acquiring treasury stock

Cash Flows from Financing Activities Dividends ACCOUNT Dividends Payable ACCOUNT NO. 23 Balance Date Item Debit Credit Debit Credit Jan. 1 Balance 10,000 10 Cash paid 10,000 -- -- June 20 Dividends declared 14,000 14,000 July 10 Cash paid 14,000 -- -- Dec. 20 Dividends declared 14,000 14,000 2006 Total cash paid $24,000

Cash Flows from Financing Activities Because paying of dividends affects equity, it is a negative $24,000 cash flow from financing activities transaction.

Cash Flows from Financing Activities Sale of Common Stock ACCOUNT Common Stock ACCOUNT NO. 33 Balance Date Item Debit Credit Debit Credit Jan. 1 Balance 16,000 Nov. 1 4,000 shares issued for cash 8,000 24,000 2006

Cash Flows from Financing Activities Sale of Common Stock ACCOUNT Paid-In Capital in Excess of Par--Common ACCT. NO. 34 Balance Date Item Debit Credit Debit Credit Jan. 1 Balance 80,000 Nov. 1 4,000 shares issued for cash 40,000 120,000 2006

Cash Flows from Financing Activities Issuing common stock affects equity; therefore, we have a total positive cash flow of $48,000 from this financing activities transaction.

Cash Flows from Financing Activities Retirement of Bonds Payable ACCOUNT Bonds Payable ACCOUNT. NO. 25 Balance Date Item Debit Credit Debit Credit Jan. 1 Balance 150,000 June 30 Retired by payment of cash at face amount 50,000 100,000 2006

Cash Flows from Financing Activities This transaction is a negative cash flows from financing activities item because long-term debt is involved.

Statement of Cash Flows-- The Direct Method

Rundell Inc. Income Statement For the Year Ended December 31, 2006 Cash Basis Sales $1,180,000 Cost of merchandise sold 790,000 Gross profit $ 390,000 Operating expenses: Depreciation expense $ 7,000 Other operating expenses 196,000 Total operating expenses 203,000 Income from operations $ 187,000 Other income: Gain on sale of land $12,000 Other expense: Interest expense 8,000 4,000 Income before income tax $ 191,000 Income tax 83,000 Net income $ 108,000 This is an accrual basis income statement. The direct method of reporting cash flows will essentially convert this to a cash basis statement.

Rundell Inc. Income Statement For the Year Ended December 31, 2006 Cash Basis Sales $1,180,000 Cost of merchandise sold 790,000 Gross profit $ 390,000 Operating expenses: Depreciation expense $ 7,000 Other operating expenses 196,000 Total operating expenses 203,000 Income from operations $ 187,000 Other income: Gain on sale of land $12,000 Other expense: Interest expense 8,000 4,000 Income before income tax $ 191,000 Income tax 83,000 Net income $ 108,000 Cash collected from customers Changes Debit Credit Sales 1,180,000 Receivables 9,000 Note: The changes in the current balance sheet accounts are determined by comparing the beginning and ending balances. Receivables increased by $9,000 during the period.

Rundell Inc. Income Statement For the Year Ended December 31, 2006 Cash Basis Sales $1,180,000 Cost of merchandise sold 790,000 Gross profit $390,000 Operating expenses: Depreciation expense $ 7,000 Other operating expenses 196,000 Total operating expenses 203,000 Income from operations $187,000 Other income: Gain on sale of land $12,000 Other expense: Interest expense 8,000 4,000 Income before income tax $ 191,000 Income tax 83,000 Net income $ 108,000 $1,171,000 Cash collected from customers Changes Debit Credit Sales 1,180,000 Receivables 9,000 Cash 1,171,000 The increase in receivables represents a reduction in cash inflow relative to the accrual revenue reported on the income statement.

Rundell Inc. Income Statement For the Year Ended December 31, 2006 Cash Basis Sales $1,180,000 $1,171,000 Cost of merchandise sold 790,000 Gross profit $390,000 Operating expenses: Depreciation expense $ 7,000 Other operating expenses 196,000 Total operating expenses 203,000 Income from operations $187,000 Other income: Gain on sale of land $12,000 Other expense: Interest expense 8,000 4,000 Income before income tax $ 191,000 Income tax 83,000 Net income $ 108,000 Cash payments for merchandise Changes Debit Credit Cost of mdse. sold 790,000 Inventories 8,000 Accounts payable 3,200 Cash

Rundell Inc. Income Statement For the Year Ended December 31, 2006 Cash Basis Sales $1,180,000 $1,171,000 Cost of merchandise sold 790,000 Gross profit $390,000 Operating expenses: Depreciation expense $ 7,000 Other operating expenses 196,000 Total operating expenses 203,000 Income from operations $187,000 Other income: Gain on sale of land $12,000 Other expense: Interest expense 8,000 4,000 Income before income tax $ 191,000 Income tax 83,000 Net income $ 108,000 (785,200) Cash payments for merchandise Changes Debit Credit Cost of mdse. sold 790,000 Inventories 8,000 Accounts payable 3,200 Cash 785,200 minus plus A decrease in Inventories (credit change) and an decrease in Accounts Payable (debit change) have the opposite effects.

Rundell Inc. Income Statement For the Year Ended December 31, 2006 Cash Basis Sales $1,180,000 $1,171,000 Cost of merchandise sold 790,000 (785,200) Gross profit $ 390,000 Operating expenses: Depreciation expense $ 7,000 Other operating expenses 196,000 Total operating expenses 203,000 Income from operations $ 187,000 Other income: Gain on sale of land $12,000 Other expense: Interest expense 8,000 4,000 Income before income tax $ 191,000 Income tax 83,000 Net income $ 108,000 Depreciation Changes Debit Credit Depreciation expense 7,000 Accumulated depreciation 7,000 There is no cash flow for depreciation expense.

Rundell Inc. Income Statement For the Year Ended December 31, 2006 Cash Basis Sales $1,180,000 $1,171,000 Cost of merchandise sold 790,000 (785,200) Gross profit $ 390,000 Operating expenses: Depreciation expense $ 7,000 0 Other operating expenses 196,000 Total operating expenses 203,000 Income from operations $ 187,000 Other income: Gain on sale of land $12,000 Other expense: Interest expense 8,000 4,000 Income before income tax $ 191,000 Income tax 83,000 Net income $ 108,000 (193,800) Cash payments for operating expenses Changes Changes Debit Credit Operating expenses 196,000 Accrued expenses 2,200 Cash minus 193,800

Rundell Inc. Income Statement For the Year Ended December 31, 2006 Cash Basis Sales $1,180,000 $1,171,000 Cost of merchandise sold 790,000 (785,200) Gross profit $ 390,000 Operating expenses: Depreciation expense $ 7,000 0 Other operating expenses 196,000 (193,800) Total operating expenses 203,000 Income from operations $ 187,000 Other income: Gain on sale of land $12,000 Other expense: Interest expense 8,000 4,000 Income before income tax $ 191,000 Income tax 83,000 Net income $ 108,000 Changes Gain on sale of investments Debit Credit Cash 72,000 Investments 60,000 Gain on sale of invest. 12,000 The cash inflow of $72,000 will be shown in the investing section of the statement of cash flows and the gain is ignored.

Rundell Inc. Income Statement For the Year Ended December 31, 2006 Cash Basis Sales $1,180,000 $1,171,000 Cost of merchandise sold 790,000 (785,200) Gross profit $ 390,000 Operating expenses: Depreciation expense $ 7,000 0 Other operating expenses 196,000 (193,800) Total operating expenses 203,000 Income from operations $ 187,000 Other income: Gain on sale of land $12,000 0 Other expense: Interest expense 8,000 4,000 Income before income tax $ 191,000 Income tax 83,000 Net income $ 108,000 Cash paid for interest expense Changes Debit Credit Interest expense Cash 8,000 (8,000) There is no interest payable account at the end of the year.

Rundell Inc. Income Statement For the Year Ended December 31, 2006 Cash Basis Sales $1,180,000 $1,171,000 Cost of merchandise sold 790,000 (785,200) Gross profit $ 390,000 Operating expenses: Depreciation expense $ 7,000 0 Other operating expenses 196,000 (193,800) Total operating expenses 203,000 Income from operations $ 187,000 Other income: Gain on sale of land $12,000 Other expense: Interest expense 8,000 4,000 (8,000) Income before income tax $ 191,000 Income tax 83,000 Net income $ 108,000 Debit Credit Income tax expense Income tax payable 500 Cash Changes Cash paid for income taxes 83,000 plus (83,500) (83,500)

Rundell Inc. Income Statement For the Year Ended December 31, 2006 Cash Basis Sales $1,180,000 $1,171,000 Cost of merchandise sold 790,000 (785,200) Gross profit $ 390,000 Operating expenses: Depreciation expense $ 7,000 0 Other operating expenses 196,000 (193,800) Total operating expenses 203,000 Income from operations $ 187,000 Other income: Gain on sale of land $12,000 0 Other expense: Interest expense 8,000 4,000 (8,000) Income before income tax $ 191,000 Income tax 83,000 (83,500) Net income $ 108,000 $ 100,500 Two different viewpoints of income from operations Accrual Basis Cash Basis

Operating Activities—Direct Method Cash flows from operating activities: Cash inflows: Cash received from customers $1,171,000 Cash outflows: Cash payments for merchandise $785,200 Cash payments for operating expenses 193,800 Cash payments for interest 8,000 Cash payments for income tax 83,500 1,070,500 Net cash flow from operating activities $ 100,500

Financial Analysis and Interpretation Free Cash Flow Dell Corporation Cash flow from operations $4,195,000 Less: Cash used to purchase fixed assets to maintain productive capacity used up in producing income during the period (482000) Less: Cash used for dividends —– Free cash flow $3,713,000 Free cash flow as a percent of cash flow from operating activities 89%

Financial Analysis and Interpretation Free Cash Flow Cash flow from operations $4,195,000 Less: Cash used to purchase fixed assets to maintain productive capacity used up in producing income during the period (482000) Less: Cash used for dividends (—) Free cash flow $3,713,000 Free cash flow as a percent of cash flow from operations 89% Dell Corporation Use: To measure the financial strength of a business. A company that has positive free cash flow is able to fund internal growth, retire debt, and enjoy financial flexibility.

Chapter 16 The End

Some of the action has been automated, so click the mouse when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

After studying this chapter, you should be able to: Objectives 1. 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. 4. Calculate and interpret the free cash flow. After studying this chapter, you should be able to: