1. Intermediate Accounting James D. Stice Earl K. Stice
Chapter 5
Statement of Cash Flows and Articulation
19th Edition
Intermediate Accounting
James D. Stice Earl K. Stice
PowerPoint presented by Douglas Cloud Professor Emeritus of Accounting, Pepperdine University
© 2014 Cengage Learning

2. What Good is a Cash Flow Statement?
We need the cash flow statement because:
Sometimes earnings fail.
Everything is on one page.
It is used as a forecasting tool.

3. The Big Loss Scenario
When a company reports large noncash expenses such as:
- write-offs
- depreciation
- provisions for future obligations
… earnings may give a gloomier picture of current operations than warranted.
(continued)

4. The Rapid Growth Scenario
Rapidly growing firms use large amounts of cash to expand inventory.
Cash collections on the growing accounts receivable often lag behind the need to pay creditors.
Reported earnings may be positive, but operations are actually consuming rather than generating cash.

5. The Reality Check Scenario
Companies entering phases in which it is critical that reported earnings look good, accounting assumptions can be stretched
Just before making a large loan application
Just before the initial public offering of stock
Just before being bought out by another company
(continued)

6. The Reality Check Scenario
Cash flow from operations, which is not impacted by accrual assumptions, provides an excellent reality check for earnings.
(continued)

7. Everything is on One Page
The cash flow statement includes information on operating, investing, and financing activities.
Everything you ever wanted to know about a company’s performance for the year is summarized in this one statement.
(continued)

8. It is Used as a Forecasting Tool
A pro forma cash flow statement is a prediction of what the actual cash flow statement will look like in future years if the operating, investing, and financing plans are implemented.

9. Statement of Cash Flows
A statement of cash flows explains the change during the period in cash and cash equivalents.
What is this?
(continued)

10. Cash Equivalent
A cash equivalent is a short-term, highly liquid investment that can be converted easily into cash.
To qualify as a cash equivalent, an item must be:
Readily convertible into cash
So near to its maturity that there is insignificant risk of changes in value due to changes in interest rates

11. Three Categories of Cash Flows
Operating activities include those transactions and events that enter into the determination of net income.
Cash receipts from selling goods or from providing services.
Receipts from Interest, dividends, and similar items.
Payments to purchase inventory and to pay wages, taxes, and similar expenses. 6 5

12. Three Categories of Cash Flows
The primary investing activities are the purchase and sale of land, buildings, equipment, and other assets not generally held for resale.
In addition, investing activities include those transactions and events that involve the purchase and sale of financial instruments not intended for trading purposes, as well as making and collecting loans.
(continued)

13. Three Categories of Cash Flows
Financing activities include those transactions and events whereby resources are obtained from, or repaid to, owners (equity financing) and creditors (debt financing):
Cash proceeds from issuing stocks or bonds.
Payments to reacquire stock (treasury stock) or to retire bonds.
Payment of dividends.
(continued)

14. Cash Flow Patterns
Most companies (73% in the United States in 2006) generate positive cash flow from operations.
In normal times, most companies use cash to expand or enhance long-term assets, so cash from investing activities is usually negative (83% of the time in the United States in 2006).
No general statement can be made about cash flow from financing activities.
(continued)

15. Noncash Investing and Financing Activities
Noncash investing and financing activities affect an entity’s financial position but not the entity’s cash flow. Examples include:
Equipment purchased with a note payable
Land acquired by issuing stock
Significant transactions should be disclosed separately.
These transactions do not appear in the statement of cash flows.

16. Operating Activities: Direct Method
The direct method is essentially a reexamination of each income statement item with the objective of reporting how much cash was received or disbursed in association with the item.
To prepare the operating section, each income statement item must be adjusted for the effects of accruals.

17. Operating Activities: Indirect Method
The indirect method begins with net income as reported on the income statement and adjusts the accrual amount for any items that do not affect cash flow.
Both the direct and indirect methods produce identical results—that is, the same amount of net cash provided by (or used in) operations.
(continued)

18. Operating Activities: Indirect Method
The adjustments for the indirect method are of three basic types:
Revenues and expenses that do not involve cash inflow or outflow.
Gains and losses associated with investing or financing activities.
Adjustments for changes in current operating assets and liabilities that indicate noncash sources of revenues and expenses.

19. Operating Activities: Direct Method
Sales and Cash Collected from Customers
Beginning accounts receivable $ 40
+ Sales
= Cash available for collection $190
 Ending accounts receivable
= Cash collected from customers $130
(continued)

20. Operating Activities: Direct Method
Cost of Goods Sold and Cash Paid for Inventory
Ending inventory $ 75
+ Cost of goods sold
= Required inventory $155
 Beginning inventory 100
= Inventory purchased this year $ 55
(continued)

21. Operating Activities: Direct Method
Wages Expense and Cash Paid for Wages
Beginning wages payable $ 7
+ Wages expense 25
= Total obligation to employees $32
– Ending wages payable 10
= Cash paid for wages $22
(continued)

22. Operating Activities: Direct Method
Depreciation Expense

23. Operating Activities: Indirect Method
Sales
The $20 increase in accounts receivable means that cash collected is $20 less than the $150 the sales number indicates. So, the necessary adjustment is to subtract the $20 to show that $130 was collected on account.
(continued)

24. Operating Activities: Indirect Method
Cost of Goods Sold
The $25 decrease in inventory means that although cost of good sold of $80 is included in the income statement, less cash was used to purchase inventory than suggested—add $25 to net income.
(continued)

25. Operating Activities: Indirect Method
Wages Expense
The $3 increase in wages payable indicates that only $22 of the $25 expense was paid in cash. The $3 increase in wages payable is added to net income.
(continued)

26. Operating Activities: Indirect Method
Depreciation Expense
The $30 depreciation expense is a noncash expense. Because it was subtracted in computing net income, it must be added back to net income because it was deducted from net income to determine the accrual net income.
(continued)

27. Important
Depreciation is not a source of cash. Because you added depreciation back to net income as an adjustment using the indirect method does not mean that there is an inflow of cash. However, depreciation does lower the amount of income taxes paid.
One advantage of the indirect method is that it highlights how cash flow can be improved in the short run by adjusting operating procedures.

28. Comparison of Direct and Indirect Methods
The shaded area is reported in the Operating Activities section of the statement of cash flows.
(continued)

29. Comparison of Direct and Indirect Methods
With the indirect method, only net income and the adjustments are reported. The Operating Activities section of the statement of cash flows includes the shaded information above.
5-29
(continued)

30. Preparing a Complete Statement of Cash Flows
Basic information to prepare the three sections of the cash flow statement comes from the balance sheet and income statement, as follows:
Operating—income statement adjusted for changes in current operating assets and liabilities.
Investing—changes in long-term assets.
Financing—changes in long-term liabilities and owners’ equity.
(continued)

31. Preparing a Complete Statement of Cash Flows
Step 1: Compute How Much the Cash Balance Changed During the Year
The statement of cash flow is not complete until the sum of cash from operating, investing, and financing activities exactly matches the total change in the cash balance during the year.

32. Preparing a Complete Statement of Cash Flows
Step 2: Convert the Income Statement from an Accrual-Basis to a Cash-Basis Summary of Operations
This is done in three steps:
(a) Eliminate expenses that do not involve the outflow of cash, such as depreciation expense.

33. Preparing a Complete Statement of Cash Flows
Step 2: Continued
(b) Eliminate gains and losses associated with investing or financing activities to avoid counting these items twice.

34. Preparing a Complete Statement of Cash Flows
Step 2: Continued
(c) Adjust for changes in the balances of current operating assets and operating liabilities.

35. Preparing a Complete Statement of Cash Flows
Step 3: Analyze the Long-Term Assets to Identify the Cash Flow Effects of Investing Activities.
Orchard Blossom reports two long-term asset accounts: Land and Buildings.

36. Investing Activities Cash Inflow Sale of plant assets
Sale of securities, other than trading securities
Collection of principal on loans
Cash Outflow
Purchase of plant assets
Purchase of securities, other than trading securities
Making of loans with other entities

37. Preparing a Complete Statement of Cash Flows
Step 4: Analyze the Long-Term Debt and Stockholders’ Equity Accounts to Determine the Cash Flow Effects of Any Financing Transactions.

38. Financing Activities Cash Inflow Cash Outflow
Issuance of own stock
Borrowings
Cash Outflow
Dividend payments
Repaying principal on borrowing
Treasury stock purchase

39. Preparing a Complete Statement of Cash Flows
Step 5: Prepare a Formal Statement of Cash Flows.
Based on our analyses of the income statement and balance sheet accounts, we have identified all inflows and outflow of cash for Orchard Blossom for the year, and we have categorized those cash flows based on the type of activity.
(continued)

40. Preparing a Complete Statement of Cash Flows
Step 6: Prepare Supplemental Disclosure.
Cash paid for interest and income taxes
Noncash investing and financing activities

41. Cash Flow to Net Income Ratio
Cash Flow Ratios
Cash Flow to Net Income Ratio
Cash from operations
Net income
Cash-flow-to-net-income ratio =
Measure of earnings quality
Tends to be greater than 1
Should remain fairly stable for the years for a specific company
(continued)

42. Cash Flow Adequacy Ratio
Cash Flow Ratios
Cash Flow Adequacy Ratio
Cash from operations
Capital expenditures and acquisitions
Cash flow adequacy ratio =
A cash cow is a business that is generating enough cash from operations to completely pay for all new plant and equipment purchases with cash left over to repay loans or distribute to owners.
This ratio indicates whether a business is a cash cow.
(continued)

43. Cash Times Interest Earned
Cash Flow Ratios
Cash Times Interest Earned
Cash from operations + Interest paid + Taxes paid
Interest expense
Cash times interest earned ratio =
Measures interest-paying ability
Generally, a higher ratio indicates more solvency

44. Articulation: How the Financial Statements Tie Together
In an accounting context, articulation means that the three primary financial statements are not isolated lists of numbers but are an integrated set of reports on a company’s financial health.

45. Forecasted Statement of Cash Flows
Compute the change in cash.
Convert the income statement from an accrual basis to a cash basis.
Analyze the long-term asset accounts.
Analyze the long-term debt and stockholders’ equity accounts.
Prepare the statement of cash flows.
Disclose any significant noncash activities.

46. Chapter 5 ₵
The End $