The Statement of Cash Flows

The Statement of Cash Flows
Chapter 12 Chapter 12 covers the statement of cash flows. ©2008 Pearson Prentice Hall. All rights reserved.

Learning Objective 1 Identify the purpose the statement of cash flows
Learning Objective 1 shows the purpose of the statement of cash flows. ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved.
Cash Flow Statement Shows cash receipts and payments during a period Purposes: Predicts future cash flows Evaluates management decisions Determines ability to pay dividends and interest Shows relationship of net income to cash flows The balance sheet reports financial position, and balance sheets from two periods show whether cash increased or decreased. But that doesn’t tell why the cash balance changed. The income statement reports net income and offers clues about cash, but the income statement doesn’t tell why cash increased or decreased. We need a third financial statement. The statement of cash flows reports cash flows—cash receipts and cash payments. The statement of cash flows serves these purposes: 1. Predicts future cash flows - Past cash receipts and payments are reasonably good predictors of future cash flows. 2. Evaluates management decisions. Businesses that make wise decisions prosper, and those that make unwise decisions suffer losses. The statement of cash flows reports how managers got cash and how they used cash to run the business. 3. Determines ability to pay dividends and interest. Stockholders want dividends on their investments. Creditors demand interest and principal on their loans. The statement of cash flows reports on the ability to make these payments. 4. Shows the relationship of net income to cash flows. Usually, high net income leads to an increase in cash, and vice versa. But cash flow can suffer even when net income is high. ©2008 Pearson Prentice Hall. All rights reserved.

Importance of Cash Flow
A company needs both net income and strong cash flow to succeed Companies want to earn net income because profit measures success. Without net income, a business sinks. There will be no dividends, and the stock price suffers. High net income attracts investors, but you can’t pay bills with net income. That requires cash. A company needs both net income and strong cash flow. Income and cash flow usually move together because net income generates cash. Sometimes, however, net income and cash flow take different paths. ©2008 Pearson Prentice Hall. All rights reserved.

Learning Objective 2 Distinguish among operating, investing and financing cash flows Learning Objective 2 addresses how to distinguish among operating, investing and financing cash flows. ©2008 Pearson Prentice Hall. All rights reserved.

Cash Flow Categories Operating activities Related to the transactions that result in net income Most important as they reflect core of the business Investing activities Related to long-term assets How a company uses its resources in the long-term Financing activities Related to long-term debt and equity How a company obtains resources A business engages in 3 types of business activities: Operating activities, Investing activities and Financing activities. Operating activities create revenues, expenses, gains, and losses—net income, which is a product of accrual-basis accounting. The statement of cash flows reports on operating activities. Operating activities are the most important of the 3 categories because they reflect the core of the organization. A successful business must generate most of its cash from operating activities. Investing activities increase and decrease long-term assets, such as computers, land, buildings, equipment, and investments in other companies. Purchases and sales of these assets are investing activities. Financing activities obtain cash from investors and creditors. Issuing stock, borrowing money, buying and selling treasury stock, and paying cash dividends are financing activities. Paying off a loan is another example. Financing cash flows relate to long-term liabilities and owners’ equity. ©2008 Pearson Prentice Hall. All rights reserved.

Formats for Operating Cash Flows
Indirect Reconciles net income to cash provided by operating activities Easier to prepare Direct Shows cash inflows and outflows by type Easier to interpret There are 2 ways to format operating activities on the statement of cash flows: (1) the indirect method, which reconciles from net income to net cash provided by operating activities. This method is most frequently used because it is easier to prepare. (2) the direct method, which reports all cash receipts and cash payments from operating activities. This approach is easier for the user to understand. The 2 methods use different computations, but they produce the same figure for cash from operating activities. The 2 methods do not affect investing or financing activities. ©2008 Pearson Prentice Hall. All rights reserved.

Learning Objective 3 Prepare a statement of cash flows by the indirect method Learning Objective 3 prepares a statement of cash flows by the indirect method. ©2008 Pearson Prentice Hall. All rights reserved. 8

The Indirect Method Net Income Reconciling adjustments: + Depreciation/depletion/amortization + Losses on sales of long-term assets - Gains on sales of long-term assets + or - changes in current assets & current liabilities Net cash provided by operating activities The indirect approach starts with net income, which is accrual accounting amount. Reconciling adjustments are made to net income to convert it to cash provided by operating activities. Non cash expenses, such as depreciation, depletion and amortization, are added. Any losses on sales of long-term assets (investments and plant assets) are added and gains are subtracted. Changes in current asset and current liability accounts are also added or subtracted. ©2008 Pearson Prentice Hall. All rights reserved.

Reconciling Items Goal: To convert accrual net income to operating cash flow Start with net income and adjust for noncash items Add back noncash expenses Subtract gains and add losses These amounts do not reflect cash flows Add or subtract changes in current assets and current liabilities The goal of the reconciling items is to convert net income to cash provided by operating activities. Since noncash expenses reduce net income, but did result in a cash flow. Therefore, these items are added back to net income. Gains and losses are the differences between the book value of the asset and cash received. They do not represent a cash amount. Therefore, to “take them out” of net income, gains are subtracted and losses are added. The cash proceeds will be reported in the investing section. Next, the increase or decrease in each current asset (except cash) and current liability is computed. This change will be added or subtracted as will be explained on the following slide. ©2008 Pearson Prentice Hall. All rights reserved.

Current Assets and Current Liabilities
Each account relates to an income statement item Accounts receivable Sales Salaries payable Salaries expense The change in each account is computed Change = Current year balance – prior year balance Current assets inverse relationship Subtract increases from net income; add decreases Current liabilities direct relationship Add increases to net income; subtract decreases Each noncash current asset and current liability relates to an income statement account. For example, accounts receivable goes with sales, and salaries payable goes with salaries expense. To convert the net income amount to a cash amount, the change is computed and added or subtracted. To compute the change in the account, subtract the prior year balance from the current year balance. With current assets, an inverse relationship exists between the change in the account and whether it is added or subtract. If a current asset increases, subtract the change. If it decreases, add it. The relationship between current liabilities and cash flow is direct. If a current liability increases, add the change. If it decreases, subtract it. ©2008 Pearson Prentice Hall. All rights reserved.

E12-15 Item O I or F + or - a. Net Income O + b. Cash dividend F - c.
Sale of LT investment I d. Loss on sale of equip. e. Amortization f. Issuance of LTNP g. Depreciation expense h. Issuance of stock ___ E12-15 helps to identify the cash flow categories (operating, investing or financing) and whether the amount is added or subtracted. This exercise assumes the indirect approach to the operating section. What type of account is stock? ©2008 Pearson Prentice Hall. All rights reserved.

Item O I or F + or - j. Increase in accts pay O + k. Purchase of equipment with note payable NIF l. Payment of long-term debt F - m. Purchase building I n. Accrual of salary expense N o. Purchase of long-term investment Some items are considered investing and/or financing, but do not involve cash. Letter (k) is an example. Purchasing equipment is an investing activity. Issuing a note payable is financing. However, no cash is involved. These events are required to be disclosed. ©2008 Pearson Prentice Hall. All rights reserved.

Item O I or F + or - p. Decrease in inventory O + q. Increase in prepaid expenses - r. Sale of land I s. Decrease in accrued liabilities For (p) (q) and (r) remember–current assets go the opposite way of the change, and current liabilities go the same way. ©2008 Pearson Prentice Hall. All rights reserved.

Preparing the Operating Section – Indirect Method
Use current year income statement for the following amounts Net Income Depreciation, depletion and amortization expense Gains or losses on sales of assets Use comparative balance sheets to compute the changes in current assets and current liabilities To prepare the operating section using the indirect method, you need a current year income statement and comparative balance sheets. From the income statement, the “bottom line”, net income, is the starting point. Then, find depreciation expense (and depletion and amortization if applicable) and add them to net income. Also, look in the “other income” section for any gains or losses. Next, use the balance sheet to compute the increase or decrease in each noncash current asset and current liability. Follow the rules to determine whether to add or subtract it. ©2008 Pearson Prentice Hall. All rights reserved.

The Indirect Method Add back to net income Here’s an illustration on how to use the income statement to obtain the amounts needed. Subtract from net income Use as first line in operating section ©2008 Pearson Prentice Hall. All rights reserved.

Added to net income Subtracted from net income Subtracted from net income This illustration shows how the preparer computed the change in the current asset and current liability accounts. Next, the add or subtract rules were followed. Added to net income ©2008 Pearson Prentice Hall. All rights reserved.

Remember: inverse relationship
Net Income $ 35,000 Reconciling items: Depreciation 18,000 Loss on sale of land 5,000 Changes in current assets & current liabilities Increase in current assets _______ Decrease in current liabilities (20,000) Net cash provided by operating activities $ 11,000 Remember: inverse relationship E12-17 will help practice on how to prepare the operating section using the indirect method. Start with net income and then add back depreciation expense and the loss. Overall, current assets increased, so that amount is subtracted. Current liabilities decreased, so that amount is subtracted as well. Combine all five amounts to determine net cash provided by operating activities. ©2008 Pearson Prentice Hall. All rights reserved.

Investing Activities Affect long-term assets: Plant assets Investments Notes receivable Purchases = outflows Sales = inflows After the operating section is prepared, the investing activities are analyzed. Investing activities affect long-term assets, such as plant assets, investments and notes receivable. When plant assets and investments are purchased, a cash outflow results. When sold, cash is received. Notes receivable result in outflows when loans are made; inflows result when collections are received. Loans made = outflows Collections = inflows ©2008 Pearson Prentice Hall. All rights reserved.

Computing Purchases and Sales of Plant Assets
Plant assets, net, beginning balance + Acquisitions - Depreciation Book value of assets sold = Plant assets, net, ending balance From Balance Sheet From Income Statement To prepare the investing section, each long-term asset account is analyzed from beginning to ending balance. These amounts can be obtained from the balance sheet. For plant assets, accumulated depreciation is combined with the asset account; thus, the term “net”. Cash paid to acquired plant assets, increases the net account and results in an outflow of cash. The depreciation amount can be found on the income statement. It is an “add-back” in the indirect approach to the operating section. Net plant assets are decreased by the book value of any assets sold. We will use this amount shortly to determine the cash inflows from sales. The end result is the ending balance. From Balance Sheet ©2008 Pearson Prentice Hall. All rights reserved.

Proceeds from Sales of Plant Assets
Compare book value of assets sold to gain or loss Gain or loss located on income statement Book value + Gain on sale Cash Proceeds To compute the cash received from the sale of a plant asset, compare the book value of the asset to the gain or loss reported on the income statement. If the asset was sold at a gain, add the gain to the book value to determine the cash proceeds. If it was sold at a loss, subtract the loss from the book value. Book value – Loss on sale ©2008 Pearson Prentice Hall. All rights reserved.

Computing Purchases and Sales of Investments
Investments, beginning balance + Purchases - Cost of investments sold = Investments, ending balance To compute cash proceeds of investments sold: Investments are bit simpler than plant assets as there is no accumulated depreciation. The investments account is increased by the cost of purchases and decreased by the cost of investments sold. If investments are sold, compare the cost to the gain or loss on the income statement. Add the gain or subtract the loss to compute the cash proceeds. Cost + Gain on sale Cash Proceeds Cost – Loss on sale ©2008 Pearson Prentice Hall. All rights reserved.

Computing Loans Made and Collections on Notes
Notes receivable, beginning balance + Loans made - Collections = Notes receivable, ending balance Notes receivable are increased when the company makes loans to outsiders. This results in an outflow of cash. Notes receivable are decreased when collections are made, which results in a cash inflow. ©2008 Pearson Prentice Hall. All rights reserved.

Issuance of new shares = inflows Cash dividends = outflows
Financing Activities Affect long-term liabilities & equity: Long-term Debt Notes payable Bonds payable Common stock and Paid-in Capital Retained earnings Payments = outflows Borrowings = inflows Financing activities, the third category, involve long-term liabilities and equity accounts. Long-term debt includes both notes payable and bonds payable. Cash inflows occur when the borrowing occurs. For bonds, this is when the bonds are issued. When loan payments or the bond face value is paid, a cash outflow occurs. The equity accounts include common stock and paid-in capital, both of which increase when stock is issued. Retained earnings (also an equity account) is decreased when dividends are declared. Cash dividends are a financing outflow. Issuance of new shares = inflows Cash dividends = outflows ©2008 Pearson Prentice Hall. All rights reserved.

Computing Issuance and Payments of Long-Term Debt
Long-term debt, beginning balance + Issuance of new debt - Payments of debt = Long-term debt, ending balance Long-term debt accounts are increased when new debt (a note payable or bond payable) is issued. The accounts are decreased when payments are made. For notes, this is the principal portion of the debt (not interest). For bonds, this is the face value (not interest). ©2008 Pearson Prentice Hall. All rights reserved.

Computing Issuance of Stock and Purchases of Treasury Stock
Common stock, beginning balance + Issuance of new stock = Common stock, ending balance Inflow of cash Treasury stock, beginning balance + Purchase of treasury stock = Treasury stock, ending balance If the common stock account increases during the year, it means the company issued new shares, which would bring cash in to the corporation. The treasury stock account, a contra-equity, is increased when the company purchases its own shares. This would result in an outflow of cash. Outflow of cash ©2008 Pearson Prentice Hall. All rights reserved.

Computing Dividend Payments
Retained earnings, beginning balance + Net Income - Dividends declared = Retained earnings, ending balance From income statement Retained earnings is increased by net income and decreased by dividends declared. The net income can be found on the income statement and is the starting point for the operating section (indirect method). Dividends declared often result in a cash outflow. ©2008 Pearson Prentice Hall. All rights reserved.

Noncash Investing and Financing Activities
Transactions that involve long-term assets, long-term debt and/or equity But do not increase or decrease cash Examples: Purchasing plant assets by signing a note payable Issuing stock for land Stock dividends Some transactions meet the criteria to be an investing and/or financing activity, but do not involve cash. These items are disclosed either at the bottom of the cash flow statement or in the disclosure notes. Some examples include: purchasing plant assets (investing) by signing a note payable (financing); issuing stock (financing) for land (investing); and stock dividends (financing) ©2008 Pearson Prentice Hall. All rights reserved.

Now that operating, investing and financing activities have been explained, they can all be put together to form a cash flow statement. Each category is totaled. Then, the three categories are combined and will equal the increase or decrease in the cash account. The increase or decrease is added to the beginning balance to equal the ending balance. This proves that the cash flow statement explains the change in cash. Proves that cash flow statement “works” ©2008 Pearson Prentice Hall. All rights reserved.

Direct Method FASB prefers as it provides clearer information Rarely used as it requires more calculations Refers to how operating section is prepared Investing and Financing activities always prepared using the direct method Goal: Convert each income statement item into a cash amount Or exclude if a noncash item The Financial Accounting Standards Board (FASB) prefers the direct method of reporting operating cash flows because it provides clearer information about the sources and uses of cash. But only about 1% of companies use this method because it takes more computations than the indirect method. Investing and financing cash flows are unaffected by the operating cash flows. ©2008 Pearson Prentice Hall. All rights reserved.

Direct Method Income Statement Cash Flow Statement Sales Collections from customers Payments to suppliers Cost of goods sold Payments to employees Salaries expense Under the direct method, accrual income statement items are converted in to cash inflows or outflows as illustrated above. Interest payments Interest expense Income tax paid Income tax expense ©2008 Pearson Prentice Hall. All rights reserved.

Direct Method Formulas
RECEIPTS Income Statement Balance Sheet Change From customers Sales + Decrease in accounts receivable - Increase in accounts receivable Of interest Interest revenue Decrease in interest receivable Increase in interest receivable The changes in current asset and current liability accounts are used to convert the income statement amounts to cash flow amounts. The income statement sales is connected to accounts receivable and interest revenue to interest receivable. ©2008 Pearson Prentice Hall. All rights reserved.

PAYMENTS Income Statement Balance Sheet Change To suppliers Cost of goods sold + Increase in inventory - Decrease in inventory AND Decrease in accounts Payable Increase in accounts payable To convert cost of goods sold, two balance sheet accounts are used–inventory and accounts payable. ©2008 Pearson Prentice Hall. All rights reserved.

PAYMENTS Income Statement Balance Sheet Change For expenses Operating expenses + Increase in prepaid - Decrease in prepaids OR Decrease in accrued liabilities Increase in accrued liabilities With operating expenses, it depends on if the expense is related to a prepaid (like insurance) or a liability (like property taxes payable). ©2008 Pearson Prentice Hall. All rights reserved.

PAYMENTS Income Statement Balance Sheet Change To employees Salaries expense + Decrease in salaries payable - Increase in salaries payable For interest Interest expense Decrease in interest payable Increase in interest payable Both salaries and interest expense usually have a related payable by the same name. ©2008 Pearson Prentice Hall. All rights reserved.

PAYMENTS Income Statement Balance Sheet Change For income taxes Income tax expense + Decrease in income tax payable - Increase in income tax payable Income taxes follow the same pattern as interest and salaries. ©2008 Pearson Prentice Hall. All rights reserved.

E12-27 Credit sales $60,000 Ending accounts receivable 32,000
Beginning accounts receivable 22,000 Increase in accounts receivable 10,000 Collections from customers Add or subtract? E12-27 provides practice on some of these direct method cash flow formulas. To convert credit sale to collections from customers, the change in accounts receivable is computed. In this case, receivables increased by $10,000. This increase is subtracted from credit sales. If more customers buy on account, how would that affect cash flow? ©2008 Pearson Prentice Hall. All rights reserved.

Cost of goods sold $111,000 Ending inventory 21,000 Beginning inventory 24,000 Decrease in inventory (3,000) Ending accounts payable 8,000 Beginning accounts payable 14,000 Decrease in accounts payable 6,000 Payments to suppliers $114,000 For cost of goods sold, both the change in inventory and accounts payable is computed. The decrease in inventory is subtracted, and the decrease in accounts payable is added to determine payments to suppliers. ©2008 Pearson Prentice Hall. All rights reserved.

Direct Method Noncash expenses not listed Depreciation, depletion and amortization Gains and losses not included Gain or loss does not equal cash received Cash proceeds included as an investing inflow Investing and financing activities reported as explained previously Notice with the direct method that noncash expenses, such as depreciation, are not listed. Also, gains and losses are not included. Gains and losses are not the same as cash proceeds. The cash received from the sale of long-term assets is reported in the investing section. The investing and financing sections of the cash flow statement are the same as explained previously. ©2008 Pearson Prentice Hall. All rights reserved.

The Statement of Cash Flows

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