CHAPTER 14 Statement of Cash Flows

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 14-2 Reporting Format for the Statement of Cash Flows The Statement of Cash Flows must include the following three sections, as defined in FASB Statement 95: Operating Activities Investing Activities Financing Activities

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 14-3 Cash Flows from Operating Activities Inflows Receipts from sales. Commissions and fees. Interest and dividends received. Inflows Receipts from sales. Commissions and fees. Interest and dividends received. Outflows Payments for inventory. Salaries and wages. Operating expenses Interest on liabilities. Taxes. Outflows Payments for inventory. Salaries and wages. Operating expenses Interest on liabilities. Taxes.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 14-4 Cash Flows from Investing Activities Inflows Selling property, plant, and equipment. Selling investment securities. Collecting loans. Inflows Selling property, plant, and equipment. Selling investment securities. Collecting loans. Outflows Purchasing property, plant, and equipment. Purchasing investment securities. Lending to others. Outflows Purchasing property, plant, and equipment. Purchasing investment securities. Lending to others.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 14-5 Cash Flows from Financing Activities Inflows Borrowing. Issuing stock. Inflows Borrowing. Issuing stock. Outflows Repaying debt (excluding interest). Purchasing treasury stock. Paying dividends. Outflows Repaying debt (excluding interest). Purchasing treasury stock. Paying dividends.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 14-6 Significant noncash investing and financing transactions must be reported separately. Example: Issuing common stock in exchange for land. Significant noncash investing and financing transactions must be reported separately. Example: Issuing common stock in exchange for land. Noncash Investing and Financing Transactions

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The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 14-8 Cash flows from operating activities can be prepared using either the direct method or the indirect method. Let’s look at the direct method first. Cash Flows from Operating Activities

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 14-9 Accrual basis revenue includes sales that did not result in cash inflows. Cash received from customers can be computed as follows: Cash received from customers Decrease in receivables Increase in receivables + – = = Net sales Converting from Accrual to Cash-Basis Accounting

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Converting from Accrual to Cash-Basis Accounting We will use T-accounts to analyze changes in accounts. Let’s look at an example. We will use T-accounts to analyze changes in accounts. Let’s look at an example. The Accounts Receivable balance was $1,200 on 12/31/04 and $1,000 on 12/31/05. If accrual Sales Revenue for 2005 was $20,600, what were cash receipts from sales?

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Converting from Accrual to Cash-Basis Accounting 12/31/04 Balance 12/31/05 Balance Accrual Sales Revenue Accounts Receivable Cash receipts = $20,800 $1,200 + $20,600 - $1,000 The Accounts Receivable balance was $1,200 on 12/31/04 and $1,000 on 12/31/05. If accrual Sales Revenue for 2005 was $20,600, what were cash receipts from sales?

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Converting from Accrual to Cash-Basis Accounting The Salaries Payable balance was $900 on 12/31/04 and $1,000 on 12/31/05. If accrued Salaries Expense for 2005 was $2,700, what amount of cash was paid for salaries? Now let’s use T-account analysis for a liability account with an accrued expense.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Converting from Accrual to Cash-Basis Accounting 12/31/04 Balance 12/31/05 Balance Accrued Salaries Expense Salaries Payable Cash payments =$2,600 $900 + $2,700 - $1,000 The Salaries Payable balance was $900 on 12/31/04 and $1,000 on 12/31/05. If accrued Salaries Expense for 2005 was $2,700, what amount of cash was paid for salaries?

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Now that we have seen the T-account method of analysis, let’s use it to prepare a Direct Method Statement of Cash Flows for New South Corporation. We will begin with by analyzing changes in balance sheet accounts. Direct Method

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The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Direct Method Additional Information The corporation sold equipment for $300 cash during the year. The equipment had an original cost of $1,500 and accumulated depreciation of $1,100 at the time of sale. The corporation issued a $2,500 mortgage note in exchange for land during the year. There was a $1,500 cash dividend paid during the year. Additional Information The corporation sold equipment for $300 cash during the year. The equipment had an original cost of $1,500 and accumulated depreciation of $1,100 at the time of sale. The corporation issued a $2,500 mortgage note in exchange for land during the year. There was a $1,500 cash dividend paid during the year. Let’s get started analyzing the accounts. First, we will review the T-account analysis that we completed earlier. Then we will analyze the remaining balance sheet accounts starting with the current accounts.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin /31/04 Balance 12/31/05 Balance Accrual sales revenue Accounts Receivable Cash receipts = $20,800 12/31/04 Balance 12/31/05 Balance Accrued salaries expense Salaries Payable Cash Payments = $2,600

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin /31/04 Balance 12/31/05 Balance Cost of Goods Sold Inventory Purchases = 12/31/04 Balance 12/31/05 Balance Purchases Accounts Payable Cash Payments = $11,200 $11,500

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin /31/04 Balance 12/31/05 Balance Interest Revenue Interest Receivable Cash receipts = 12/31/04 Balance 12/31/05 Balance Interest Expense Interest Payable Cash payment = $600

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin /31/04 Balance 12/31/05 Balance Insurance Expense Prepaid Insurance Cash payment = 12/31/04 Balance 12/31/05 Balance Rent Revenue Unearned Rent Cash receipt = $300 $1,400

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin /31/04 Balance 12/31/05 Balance Other Operating Expenses Other Operating Expenses Payable Cash payment = $1,200 Now that we have analyzed the current accounts and found the cash receipts and cash payments related to operations, we are ready to prepare the Cash Flow from Operating Activities portion of the Statement of Cash Flows.

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The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Now, let’s continue to use the T-account analysis for the remaining noncurrent balance sheet accounts. Direct Method

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin /31/04 Balance 12/31/05 Balance Marketable Securities Cash paid = $1,600 12/31/04 Balance 12/31/05 Balance Land Mortgage issued for land = $2,500

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin /31/04 Balance 12/31/05 Balance Equipment Equipment sale Cash paid for equipment =$2,300 After completing the analysis of noncurrent assets, we are ready to prepare the Cash Flow from Investing Activities portion of the Statement of Cash Flows.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Cash Flow from Investing Activities Next, we will analyze noncurrent liabilities and equity so that we can prepare the Cash Flow from Financing Activities portion of the Statement of Cash Flows.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin /31/04 Balance 12/31/05 Balance Mortgage Payable Mortgage issued for Land = 12/31/04 Balance 12/31/05 Balance Bonds Payable Cash paid to retire bonds = $2,500 $3,000

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin /31/04 Balance 12/31/05 Balance Common Stock Cash received from stock sale = After completing the analysis of noncurrent liabilities and equity, we are ready to prepare the Cash Flow from Financing Activities portion of the Statement of Cash Flows. $2,000

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Cash Flow from Financing Activities Next, we will put the three sections together to complete the Statement of Cash Flows. Third item of additional information.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Notice that the Ending Cash Balance on the Statement of Cash Flows agrees with the 12/31/05 Cash balance on the Balance Sheet.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Now let’s look at the Indirect Method that is used by over 95% of all companies. Indirect Method

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin A Comparison of the Direct and Indirect Methods Net cash flow is the same for both methods. The Direct Method provides more detail about cash from operating activities. The investing and financing sections for the two methods are identical. Net cash flow is the same for both methods. The Direct Method provides more detail about cash from operating activities. The investing and financing sections for the two methods are identical.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 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.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Use this table when adjusting Net Income to Cash Flow from Operations. Indirect Method

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin We will use the Indirect Method to prepare the Cash Flows from Operating Activities for the New South Corporation. First, we will review the Balance Sheet and Income Statement for New South Corporation. Indirect Method

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The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin The Indirect Method begins with Net Income, which is then adjusted for the non-cash items included in net income. For New South Corporation, the only non-cash items are depreciation and a loss. The Indirect Method begins with Net Income, which is then adjusted for the non-cash items included in net income. For New South Corporation, the only non-cash items are depreciation and a loss.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin (Remember, we showed the balance sheets a few slides earlier.) To complete the Cash Flow from Operating Activities section, we must examine comparative balance sheets to determine the changes in current assets and current liabilities from the beginning of the period to the end of the period.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Statement of Cash Flows Indirect Method Example

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Remember that when we prepared the operating section using the Direct Method, we also arrived at Net Cash Flow from Operating Activities of $6,600.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Because the investing and financing sections are identical with either method of preparation, we will not repeat those sections of the statement. Indirect Method

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin The Financial Analyst A rapidly growing company might be short of cash in spite of large reported net income. Because accruals and deferrals affect operating income, cash flow from operating activities may be stable than operating income.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin The Financial Analyst The statement focuses attention on: Ability to generate cash from its operations. Management of current assets and current liabilities. Expenditures for long-term assets. Amount received from external financing.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin End of Chapter 14