Fundamentals of Financial Accounting 3e by Phillips, Libby, and Libby.

Fundamentals of Financial Accounting 3e by Phillips, Libby, and Libby.
McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Reporting and Interpreting the Statement of Cash Flows
Chapter 12 Reporting and Interpreting the Statement of Cash Flows PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Fred Phillips, Ph.D., CA Chapter 12: Reporting and Interpreting the Statement of Cash Flows

Learning Objective 1 Identify cash flows arising from operating, investing, and financing activities. Learning objective number 1 is to identify cash flows arising from operating, investing, and financing activities. 12-3

Business Activities and Cash Flows
The Statement of Cash Flows focuses attention on: Operations Cash received and paid for day-to-day activities with customers, suppliers, and employees. The Statement of Cash Flows shows each major type of business activity that caused a company’s cash to increase or decrease during the accounting period. The major types of business activities are: Operations – The Statement of Cash Flows shows the cash received and paid for day-to-day activities with customers, suppliers, and employees. Investing – The Statement of Cash Flows shows cash paid and received from buying and selling long-term assets. Financing – The Statement of Cash Flows shows cash received and paid for exchanges with lenders and stockholders. Investing Cash paid and received from buying and selling long-term assets. Financing Cash received and paid for exchanges with lenders and stockholders. 12-4

Business Activities and Cash Flows
Checking and Savings Accounts Currency Cash Equivalents Highly liquid short-term investments within three months of maturity. Part I Cash includes currency on hand. Part II Cash also includes checking accounts, savings accounts, and certain money market accounts. Part III The third component of cash is called cash equivalents. Cash equivalents are short-term, highly liquid investments that are easily converted into cash and that have very little risk of loss. An example of a cash equivalent would be a short-term Treasury Bill that is government issued, is within three months of its maturity date, and has very little risk associated with it. 12-5

Classifying Cash Flows
On your screen, you see a condensed Statement of Cash Flows from Under Armour, Inc. for Notice the three basic sections on the Statement of Cash Flows:  Operating Activities  Investing Activities  Financing Activities The statement also includes a reconciliation between beginning and ending cash and cash equivalents. We will be examining the sections of this statement in detail for the remainder of the chapter. 12-6

Operating Activities Cash inflows and outflows that directly relate to revenues and expenses reported on the income statement. Part I The cash flows from operating activities section of the Statement of Cash Flows shows us the inflows and outflows of cash that directly relate to income from normal operations reported on the income statement. Part II The Operating Activities Section includes cash inflows and cash outflows that result from the operations of the business and some incidental business transactions. Operating cash inflows include cash collected from customers, receiving dividends, and receiving interest. Operating cash outflows include purchasing services and goods for resale, Paying salaries and wages, paying income taxes, paying interest. 12-7

Direct and Indirect Reporting of Operating Cash Flows
Two alternative methods may be used when presenting the operating activities section of the statement of cash flows: The direct method reports the total cash inflow or outflow from each main type of transaction (that is, transactions with customers, suppliers, employees, etc.). The difference between these cash inflows and outflows equals the Net Cash Provided by (Used for) Operating Activities. The indirect method starts with net income from the income statement and adjusts it by eliminating the effects of items that do not involve cash (for example, depreciation) and including items that do have cash effects. Adjusting net income for these items yields the amount of Net Cash Provided by (Used for) Operating Activities. The point to remember about these two methods is that they are simply different ways to arrive at the same number. Net cash flows provided by (used for) operating activities is always the same under the direct and indirect methods. Also, the choice between the two methods affects only the operating activities section of the statement of cash flows, not the investing and financing sections. We will concentrate on the indirect method for now, and we will look at the direct method in a little more detail later in the chapter. Same result We will concentrate on the indirect method for now, and we will look at the direct method again later in the chapter. 12-8

Under Armour’s 2008 Investing Activities
Part I The Investing Activities Section includes cash inflows from the sale or disposal of property, plant, and equipment, and the sale or maturity of investments in securities and cash outflows for the purchase of property, plant, and equipment and the purchase of investments in securities. The difference between these cash inflows and outflows is reported on the statement of cash flows as a subtotal, Net Cash Provided by (Used for) Investing Activities. Part II Under Armour had two investing activities in 2008 that required cash: the purchase of equipment for $36 million and the purchase of intangible assets for $2 million. 12-9

Under Armour’s 2008 Financing Activities
Part I The Financing Activities Section includes cash inflows from borrowing from lenders through formal debt contracts and issuing stock to owners and cash outflows for repaying principal to lenders, repurchasing stock from owners, and paying cash dividends to owners. The difference between these cash inflows and outflows is reported on the statement of cash flows as a subtotal, Net Cash Provided by (Used for) Financing Activities. Part II Under Armour had the following financing activities in 2008: Long-term debt of $7 million was paid. $16 million in new long-term loans were issued. Shares of stock were issued for $12 million. Although exceptions exist, a general rule is that operating cash flows cause changes in current assets and current liabilities, investing cash flows affect noncurrent assets, and financing cash flows affect noncurrent liabilities or stockholders’ equity accounts. 12-10

Relationships Between Classified Balance Sheet and Statement of Cash Flow (SCF) Categories
Part I Let’s examine the relationship between the Classified Balance Sheet and Statement of Cash Flow (SCF) categories. Generally, operating cash flows cause changes in current assets and current liabilities. Part II Investing cash flows affect noncurrent assets. Part III Financing cash flows affect noncurrent liabilities or stockholders’ equity accounts. 12-11

Relationship to Other Financial Statements
Information needed to prepare a statement of cash flows: Comparative Balance Sheets. Income Statement. Additional details concerning selected accounts. We prepare a Statement of Cash flows by analyzing the income statement and changes in balance sheet accounts. So, we need the following information: Comparative balance sheets for the beginning and end of the period covered by the Statement of Cash Flows. An income statement for the period between the comparative balance sheet dates. Additional details concerning selected accounts that increase and decrease as a result of investing and/or financing activities that do not involve cash. 12-12

Relationship to Other Financial Statements
Recall that the basic Balance Sheet equation is: We can recast the equation as follows: The following equation is true: Part I The basic Balance Sheet equation is: Assets = Liabilities + Stockholders’ Equity Part II We can recast the basic balance sheet by dividing Assets into Cash plus Noncash Assets. Part III We can isolate cash on one side of the equation by subtracting Noncash Assets from both sides. Part IV Using this basic Balance Sheet equation, we are able to rearrange the terms to isolate cash on one side of the equation. As you can see from this relationship, our approach to preparing a Statement of Cash Flows will involve an analysis of the changes in all noncash Balance Sheet accounts. From this basic Balance Sheet equation, we develop our model to solve for the change in cash: 12-13

Learning Objective 2 Report cash flows from operating activities, using the indirect method. Learning objective number 2 is to report cash flows from operating activities, using the indirect method. 12-14

Cash Flows from Operating Activities - Indirect Method
The indirect method adjusts net income by analyzing noncash items. Changes in current assets and current liabilities. Cash Flows from Operating Activities - Indirect Method Net Income + Noncash expenses such as depreciation and amortization. + Losses and - Gains Part I We will begin by focusing on the indirect method, which is used by almost all companies. The indirect method starts with the accrual based net income and makes certain adjustments to arrive at Cash Flows from Operating Activities. Part II Adjustments to the accrual based net income include adding back any noncash expenses that are included to arrive at net income, such as depreciation and amortization. Adding these back on the Statement of Cash Flows basically cancels out the fact that they were originally subtracted to arrive at net income. Since these expenses do not represent cash outlays, we would not want them included in the Statement of Cash Flows. Part III We also have to make appropriate adjustments to reflect the change from accrual based revenues and expenses reported on the income statement to cash based revenues and expenses. This is accomplished by analyzing the changes in noncash current assets and current liabilities. Part IV Other items on the income statement to consider are gains and losses. Gains and losses result from the sale of assets. Gains are added on the income statement and losses are subtracted on the income statement to arrive at net income. Since gains and losses do not represent operating cash flows, we cancel out gains by subtracting them from net income and cancel out losses by adding them to net income in the operating section. The actual cash flow from the sale of the asset will be properly reported, in most cases, in the investing section. 12-15

Relationships to the Balance Sheet and the Income Statement
Change in account balances during the year This chart explains how to treat a change in a noncash current asset or current liability in the operating section of the Statement of Cash Flows. Maybe a couple of examples will help you see how this table works. Let’s start with current assets. If accounts receivable, a current asset, decreased during the year, this decrease would be added to net income. A decrease in accounts receivable means that customer cash payments on account exceeded customer charges on account during the period. This excess of cash receipts over sales on account is used to adjust the accrual based revenues reported on the income statement to the amount of total cash received from customers during the period. Similarly, if accounts receivable increased during the year, this increase would be subtracted from net income. An increase in accounts receivable means that customer charges on account exceeded customer cash payments on account during the period. This excess of sales on account over cash receipts is used to adjust the accrual based revenues reported on the income statement to the amount total cash received from customers during the period. Now, let’s look at how to treat changes in current liabilities. If salaries payable, a current liability, decreased during the year, this decrease would be subtracted from net income. A decrease in salaries payable means that the company’s cash payments for salaries were more than its salaries expense during the period. This excess of cash payments over salaries expense is used to adjust the accrual based expense reported on the income statement to the amount of total cash paid for salaries during the period. Similarly, if Salaries Payable increased during the year, this increase would be added to net income. An increase in salaries payable means the company recognized more salaries expense than its cash payments to employees during the period. This excess of salaries expense over cash payments is used to adjust the accrual based expense reported on the income statement to the amount of total cash paid for salaries during the period. Use this table when adjusting Net Income to Operating Cash Flows using the indirect method. 12-16

Statement of Cash Flows Indirect Method Example
Use the following financial statements for Under Armour, Inc. and prepare the Statement of Cash Flows for the year ended December 31, 2008. Let’s look at an example of how to prepare the Statement of Cash Flows using the indirect method. The next few slides present the necessary financial statements for Under Armour, Inc. 12-17

Here is the asset portion of a comparative balance sheet for Under Armour, Inc., for 2007 and Notice that the change in each account for the year is shown. 12-18

Here are the liability and equity sections of a comparative balance sheet for Under Armour, Inc. Notice again that the change in each account for the year is shown. 12-19

The Statement of Cash Flows using the indirect method will begin with Under Armor, Inc.’s net income from the Income Statement. Here is Under Armour, Inc.’s Income Statement for the year ended December 31, 2008. 12-20

Direct and Indirect Reporting of Operating Cash Flows
When using the indirect method, the schedule of operating activities has the format shown on the slide. Remember that because we start with accrual basis net income we must adjust net income for items that are included in net income but do not involve cash and for items that are not included in net income but do involve cash. For example, depreciation does not involve cash, but it was subtracted on the income statement to arrive at net income. By adding depreciation back, we eliminate the effect of having deducted it in the income statement. Based on our previous discussion, you should also be able to make similar statements as they pertain to the additions and subtractions of the changes in current assets and current liabilities. When using the indirect method, start with accrual basis net income and adjust it for: items that are included in net income but do not involve cash, and items that are not included in net income but do involve cash. 12-21

Next, adjust for the non-cash items included in net income.
For Under Armour, the only non-cash adjustment is for depreciation. Part I First, we start with the accrual-basis net income. Part II Then, we adjust net income for non-cash expenses and gains and losses. Depreciation is the only non-cash adjustment to accrual income. Will depreciation be added or subtracted from net income? 12-22

Accumulated Depreciation increased by $16, from $31 in the 2007 Balance Sheet to $47 in the 2008 Balance sheet. The same $16 is shown as Depreciation in the 2008 Income Statement. To complete the cash flows 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. Part I Depreciation is a non-cash expense that reduced income, so it is added to net income. Net income and depreciation are always the first two lines to appear in a statement of cash flows prepared using the indirect method. They begin the process of converting net income to operating cash flows. Part II Accumulated Depreciation increased by $16, from $31 in the 2007 Balance Sheet to $47 in the 2008 Balance sheet. The same $16 is shown as Depreciation in the 2008 Income Statement. Next, we need to adjust net income for the changes in the noncash current assets and current liabilities. 12-23

These five items were shown earlier in the current portions of Under Armour’s comparative Balance Sheets for 2007 and 2008 The changes in the current asset and current liability accounts are added or subtracted as appropriate. Refer back to Under Armour’s comparative Balance Sheets for 2007 and 2008 to confirm the changes in noncash current assets and current liabilities. Use the table shown and determine whether to add or subtract the change in noncash current assets and current liabilities. Since accounts receivable, a current asset, increased, the change needs to be subtracted from net income. Since inventory, a current asset, increased, the change needs to be subtracted from net income. Use the table to confirm the remaining additions and subtractions to net income that result in the $79,000,000 of cash provided by operations. 12-24

Report cash flows from investing activities.
Learning Objective 3 Report cash flows from investing activities. Learning objective number 3 is to report cash flows from investing activities. 12-25

Reporting Cash Flows from Investing Activities
We will need this additional data to prepare the investing portion of the statement. No disposals or impairments of equipment or intangibles occurred Equipment costing $36 million and intangibles costing $2 million were purchased with cash. The Investing Activities Section includes cash inflows from the sale or disposal of long-term assets and cash outflows for the purchase of long-term assets. Under Armour had two investing activities that required cash: the purchase of equipment for $36 million and the purchase of intangible assets for $2 million. 12-26

Reporting Cash Flows from Investing Activities
Under Armour, Inc., has two investing activities on the Statement of Cash Flows that required the use of cash: Purchase of equipment, and Purchase of intangible and other assets. Under Armour, Inc., has two investing activities on the Statement of Cash Flows that required the use of cash: Purchase of equipment, and Purchase of intangible and other assets. 12-27

Report cash flows from financing activities.
Learning Objective 4 Report cash flows from financing activities. Learning objective number 4 is to report cash flows from financing activities. 12-28

Reporting Cash Flows from Financing Activities
We will need this additional data to prepare the financing portion of the statement. No dividends were declared or paid. Long-term debt of $7 million was paid. $16 million in new long-term loans were issued. Shares of stock were issued for $12 million. The Financing Activities Section includes cash inflows from borrowing from lenders through formal debt contracts and issuing stock to owners and cash outflows for repaying principal to lenders, repurchasing stock from owners, and paying cash dividends to owners. Under Armour had the following financing activities: Long-term debt of $7 million was paid. $16 million in new long-term loans were issued. Shares of stock were issued for $12 million. 12-29

Under Armour, Inc., has three financing activities on the Statement of Cash Flows. The first financing activity is the increase in long-term debt caused by borrowing $16,000,000. The borrowed money is a cash inflow. Long-term debt increased because of $16 in new loans during the year. The long-term debt increase is a cash inflow. 12-30

The second financing activity is the payments on long-term debt resulting in a cash outflow of $7,000,000. The net effect of these two long-term debt transactions increased long-term debt by $9,000,000 from $14,000,000 on the 2007 Balance Sheet to $23,000,000 on the 2008 Balance Sheet. Payments on long-term debt resulted in a cash outflow of $7. The net effect of these two long-term debt transactions increased long-term debt by $9, from $14 on the 2007 Balance sheet to $23 on the 2008 Balance Sheet. 12-31

The third financing activity is the issuance of common stock resulting in a cash inflow of $12,000,000. Contributed Capital increased from $163,000,000 in the 2007 Balance Sheet to $175,000,000 in the 2008 Balance Sheet. The third financing activity is the issuance of common stock resulting in a cash inflow of $12. Contributed Capital increased from $163 in the 2007 Balance Sheet to $175 in the 2009 Balance Sheet. 12-32

Now we can reconcile the change in cash to the ending $102 cash balance that appears on the Balance Sheet. The three financing activities provided a total of $21,000,000. Total cash flow from operating activities, investing activities, and financing activities is an increase of $62,000, When this amount is added to the $40,000,000 cash balance at the beginning of the year, the total is equal to the $102,000,000 cash balance at the end of the year. 12-33

Noncash Investing and Financing Activities
Required Supplemental Information: Cash paid for taxes and interest. Significant non-cash investing and financing activities. In addition to the three major sections of the Statement of Cash flows, operating activities, investing activities, and financing activities, we must also disclose the amount of cash paid for taxes and interest and significant non-cash investing and financing activities. The exchange of shares of stock in the company for land would be an example a significant noncash investing and financing activity that must be disclosed. Under Armour, Inc., had two supplemental disclosures cash paid for interest and cash paid for income tax. 12-34

Learning Objective 5 Interpret cash flows from operating, investing, and financing activities. Learning objective number 5 is to interpret cash flows from operating, investing, and financing activities. 12-35

Evaluating Cash Flows Operating cash flows must be positive over the long-run for a company to be successful. An upward trend in operating cash flows over time indicates growth and efficient operations. When evaluating cash flow from operations, the most important consideration is that cash flows must be positive over the long-run for a company to be successful. It is difficult to survive with continual cash outflows from operations over long periods of time. Given that cash flow from operations are positive, an upward trend in the amount of these cash flows indicates growth and efficient operations. 12-36

Evaluating Cash Flows Quality of Income Ratio
Net Cash Flow from Operating Activities Net Income = A measure for determining what portion of a company’s income was generated in cash. A ratio near 1.0 indicates a high likelihood that revenues are realized in cash and that expenses are associated with cash outflows. Part I The quality of income ratio is calculated by dividing net cash flow from operating activities by net income. Part II The quality of income ratio measures the portion of income that was generated in cash. A ratio near 1.0 indicates a high likelihood that revenues are realized in cash and that expenses are associated with cash outflows. Part III Under Armour’s quality of income ratio is 2.08 for 2008. Quality of Income Ratio 79 38 = = 2.08 for Under Armour in 2008 12-37

Evaluating Cash Flows Capital Acquisitions Ratio
Net Cash Flow from Operating Activities Cash Paid for Property, Plant, and Equipment = A measure for determining whether a company is generating enough cash internally to purchase long-term assets. A ratio greater than 1.0 indicates that outside financing was not needed to purchase long-term assets. Part I The capital acquisitions ratio is calculated by dividing net cash flow from operating activities by cash paid for property, plant and equipment. The capital acquisitions ratio is a measure for determining whether a company is generating enough cash internally from its operations to purchase long-lived assets needed in the business. Part II A ratio greater than one indicates that outside financing was not needed to purchase property, plant and equipment. A ratio less than one indicates that outside financing, either borrowing or sale of stock, was needed to purchase property, plant and equipment. Part III Under Armour’s capital acquisitions ratio is 2.19 for 2008. Capital Acquisitions Ratio 79 36 = = for Under Armour in 2008 12-38

Learning Objective 6 Report and interpret cash flows from operating activities using the direct method. Learning objective number 6 is to report and interpret cash flows from operating activities using the direct method. 12-39

Reporting Operating Cash Flows with the Direct Method
Provides more detailed information Identifies cash inflows and outflows relationships Earlier in this chapter, we discussed the indirect method of presenting a company’s statement of cash flows. This method computes operating cash flows indirectly, by adding and subtracting items from Net Income. Because these items, by themselves, don’t mean a lot, analyses of operating cash flows are limited to using just the overall Net Cash Provided by (Used for) Operating Activities. In comparison, the direct method of presentation provides more detailed information on each input into overall operating cash flows, which allows analysts to conduct more detailed analyses. The direct method also provides financial statement users with more information to identify potential relationships between cash inflows and outflows. An increase in some activities, such as sales, generally leads to an increase in cash inflows from customers and cash outflows to inventory suppliers. However, an increase in sales activity only loosely affects other cash outflows, such as interest paid on loans. Knowing the detailed components of operating cash flows allows analysts to more reliably predict a company’s future cash flows. The direct method presents a summary of all operating transactions that result in either a debit or a credit to cash. It is prepared by adjusting each revenue and expense on the income statement from the accrual basis to the cash basis. Prepared by adjusting accrual basis to cash basis Investing and financing sections for the two methods are identical 12-40

Direct Method Operating Activities
Here is the operating activities section of the Statement of Cash Flows prepared using the direct method. The $79,000,000 of cash flow provided by operations is the same amount we saw with the indirect method. You might want return to the indirect method and compare the two statements. Remember that a very small percentage of companies use the direct method. Now, let’s see how we arrive at the individual cash flows by adjusting each revenue and expense on the income statement from the accrual basis to the cash basis. When we prepared the operating section using the indirect method, we also arrived at net cash inflow of $79. Let’s see how we arrive at these cash flows. 12-41

Direct Method Operating Activities
With the direct method, we convert each revenue and expense on the income statement to a cash flow. For example, since Accounts Receivable decreased, cash collections from customers were more than the amount of Sales Revenue recorded in Accounts Receivable. So, we add the decrease in receivables from net sales to obtain the cash inflow. We convert the expense accounts in the same manner. For example, since Prepaid Expenses increased, cash payments were greater than expenses recognized. And, since Accrued Liabilities increased, cash payments were less then the expenses recognized. We add the increase in prepaid expenses to SG&A Expenses and subtract the increase in Accrued Liabilities from SG&A Expenses to obtain cash outflow for expenses. With the direct method, we convert each revenue and expense on the income statement to a cash flow. 12-42

Reporting Sales of Property, Plant, and Equipment (Indirect Method)
Supplement 12A Reporting Sales of Property, Plant, and Equipment (Indirect Method) Supplement 12A: Reporting Sales of Property, Plant, and Equipment (Indirect Method)

Reporting Sales of Property, Plant, and Equipment (PPE) (Indirect)
Depreciation Expense Loss on Sale of PPE A loss on the sale of PPE is added back to net income just as depreciation expense is added back. Adding these noncash items restores net income to what it would have been had depreciation and the loss not been subtracted at all. Part I Amounts that were subtracted in determining net income but did not reduce cash are added back to net income to reverse the effect of their having been subtracted. Examples of these amounts are depreciation expense and loss on sale of equipment. Part II Similarly, amounts that were added in determining net income but did not increase cash are subtracted from net income to reverse the effect of their having been added. An example of this is the gain on sale of land. Just the opposite is true for a gain on the sale of PPE. Subtracting the gain reverses the effect of the gain having been added to net income. Gain on Sale of PPE 12-44

Spreadsheet Approach (Indirect Method)
Supplement 12B Spreadsheet Approach (Indirect Method) Supplement 12B: Spreadsheet Approach (Indirect Method)

Spreadsheet Approach (Indirect Method)
A spreadsheet can be used to ensure that no reportable activities are inadvertently overlooked. Reconstructing the events and transactions that occurred during the period helps identify the operating, investing and financing activities to be reported. An important advantage gained by using a spreadsheet is that it ensures that no reportable activities are inadvertently overlooked. Using a spreadsheet requires reconstructing the events and transactions that occurred during the period to help identify the operating, investing and financing activities to be reported. Let’s see how to use a spreadsheet to prepare a Statement of Cash Flows on the next few slides. Let’s see how to use a spreadsheet to prepare a Statement of Cash Flows on the next few slides. 12-46

We begin by entering the beginning and ending balances for each account on the comparative balance sheets. The cash inflows and outflows columns will be used later to explain the changes in each account balance. We begin by entering the beginning and ending balances for each account on the comparative balance sheet. The cash inflows and outflows columns will be used next to explain the increase or decrease in each account balance. 12-47 12-47

We will begin with operating activities.
Changes in balance sheet accounts are analyzed in terms of debits and credits in the top half of the spreadsheet and recorded as cash inflows and outflows in the bottom half of the spreadsheet. We will begin with operating activities. Changes in balance sheet accounts are analyzed in terms of debits and credits in the top half of the spreadsheet and recorded as cash inflows and outflows in the bottom half of the spreadsheet. The spreadsheet entries relating to operations are coded A-G. 12-48 12-48

Changes in balance sheet accounts are analyzed in terms of debits and credits in the top half of the spreadsheet and recorded as cash inflows and outflows in the bottom half of the spreadsheet. Now we will complete the analysis with investing and financing activities. The remaining changes in balance sheet accounts are also analyzed in terms of debits and credits in the top half of the spreadsheet and recorded as cash inflows and outflows in the bottom half of the spreadsheet. These changes relating to investing and financing activities are coded H-M. 12-49 12-49

The top of the completed spreadsheet is shown here.
Spreadsheet Approach (Indirect Method) The top of the completed spreadsheet is shown here. Here you see the completed top portion of the spreadsheet with entries A-M. 12-50

The bottom of the completed spreadsheet is shown here.
Spreadsheet Approach (Indirect Method) The bottom of the completed spreadsheet is shown here. Here you see the completed bottom portion of the spreadsheet with entries A-M. We can now prepare the Statement of Cash Flows with the information in the cash inflows and outflows columns from this portion of the spread sheet. 12-51

Chapter 12 Solved Exercises
E12-2, E12-3, E12-4, E12-5, E12-6, E12-7 Chapter 12 Solved Exercises: E12-2, E12-3, E12-4, E12-5, E12-6, E12-7

E12-2 Understanding the Computation of Cash Flows from Operating Activities (Indirect Method)
Suppose your company sells services of $150 in exchange for $100 cash and $50 on account. Required: Show the journal entry to record this transaction. 2. Identify the amount that should be reported as net cash flows from operating activities. Record Part I E12-2 Understanding the Computation of Cash Flows from Operating Activities (Indirect Method) Suppose your company sells services of $150 in exchange for $100 cash and $50 on account. Required: 1. Show the journal entry to record this transaction. Part II We debit the asset accounts Cash for $100 and Accounts Receivable for $50, and credit Service Revenue for $150. Part III Required: 2. Identify the amount that should be reported as net cash flows from operating activities Part IV The $100 increase in cash is reported as net cash flows from operating activities. The $100 increase in cash is reported as net cash flows from operating activities. 12-53

$150 of service revenue would be included in net income.
E12-2 Understanding the Computation of Cash Flows from Operating Activities (Indirect Method) Required: 3. Identify the amount that would be included in net income. 4. Show how the indirect method would convert net income (requirement 3) to net cash flows from operating activities (requirement 2). 5. What general rule about converting net income to operating cash flows is revealed by your answer to requirement 4? $150 of service revenue would be included in net income. Part I Required: 3. Identify the amount that would be included in net income. Part II $150 of service revenue would be included in net income. Part III Required: 4. Show how the indirect method would convert net income (requirement 3) to net cash flows from operating activities (requirement 2). Part IV The $50 increase in Accounts Receivable is subtracted from Net Income because Service Revenue ($150) was greater than Cash received ($100). Part V Required: 5. What general rule about converting net income to operating cash flows is revealed by your answer to requirement 4? Part VI When Accounts Receivable increases, Sales Revenue is greater than cash received, so subtract the increase to convert Net Income to Cash Flow from Operating Activities. When Accounts Receivable increases, Sales Revenue is greater than cash received, so subtract the increase to convert Net Income to Cash Flow from Operating Activities. 12-54

Show the journal entries to record these transactions.
E12-3 Understanding the Computation of Cash Flows from Operating Activities (Indirect Method) Suppose your company sells services for $300 cash this month. Your company also pays $100 in wages, which includes $20 that was payable at the end of the previous month and $80 for wages of this month. Required: Show the journal entries to record these transactions. Record Record Part I E12-3 Understanding the Computation of Cash Flows from Operating Activities (Indirect Method) Suppose your company sells services for $300 cash this month. Your company also pays $100 in wages, which includes $20 that was payable at the end of the previous month and $80 for wages of this month. Required: 1. Show the journal entries to record these transactions. Part II We record the sale with a debit to Cash and a credit to Service Revenue for $300. Part III We record the cash paid for wages with debits to Wages Payable for $20 and Wages Expense for $80, and a credit to Cash for $100. 12-55

Required: 2. Identify the amount that should be reported as Net Cash Flows from Operating Activities. 3. Identify the amount that would be included in Net Income. 4. Show how the indirect method would convert Net Income (requirement ) to Net Cash Flows from Operating Activities (requirement 2). The $200 increase in Cash ($300 – $100) should be reported as Net Cash Inflow from Operating Activities. $300 of Service Revenue would be included along with Wages Expense of $80, for a Net Income of $220. Part I Required: 2. Identify the amount that should be reported as Net Cash Flows from Operating Activities. Part II The $200 increase in Cash ($300 – $100) should be reported as Net Cash Inflow from Operating Activities. Part III Required: 3. Identify the amount that would be included in Net Income. Part IV $300 of Service Revenue would be included along with Wages Expense of $80, for a Net Income of $220. Part V Required: 4. Show how the indirect method would convert net income (requirement 3) to net cash flows from operating activities (requirement 2). Part VI The $20 decrease in Wages Payable is subtracted from Net Income because the amount of Cash paid ($100) for wages was more than Wages Expense ($80). 12-56

Required: 5. What general rule about converting Net Income to operating cash flows is revealed by your answer to requirement 4? When Wages Payable decreases, subtract that decrease to convert Net Income to Cash Flow from Operating Activities. Part I Required: 5. What general rule about converting net income to operating cash flows is revealed by your answer to requirement 4? Part II When Wages Payable decreases, subtract that decrease to convert Net Income to Cash Flow from Operating Activities. 12-57

Show the journal entries to record these transactions.
E12-4 Understanding the Computation of Cash Flows from Operating Activities (Indirect Method) Suppose your company sells services of $150 in exchange for $100 cash and $50 on account. Depreciation of $40 also is recorded. Required: Show the journal entries to record these transactions. Record Record Part I E12-4 Understanding the Computation of Cash Flows from Operating Activities (Indirect Method) Suppose your company sells services of $150 in exchange for $100 cash and $50 on account. Depreciation of $40 also is recorded. Required: 1. Show the journal entries to record these transactions. Part II We debit the asset accounts Cash for $100 and Accounts Receivable for $50, and credit Service Revenue for $150. Part III We record depreciation with a debit to Depreciation Expense and a credit to Accumulated Depreciation for $40. 12-58

Required: 2. Identify the amount that should be reported as Net Cash Flows from Operating Activities. 3. Identify the amount that would be included in Net Income. 4. Show how the indirect method would convert Net Income (requirement ) to Net Cash Flows from Operating Activities (requirement 2). The $100 increase in cash should be reported as Net Cash Flows from Operating Activities. Net Income would include $150 of Service Revenue and $40 of Depreciation Expense, or $110 in total. Part I Required: 2. Identify the amount that should be reported as Net Cash Flows from Operating Activities. Part II The $100 increase in cash should be reported as Net Cash Flows from Operating Activities. Part III Required: 3. Identify the amount that would be included in Net Income. Part IV Net Income would include $150 of Service Revenue and $40 of Depreciation Expense, or $110 in total. Part V Required: 4. Show how the indirect method would convert net income (requirement 3) to net cash flows from operating activities (requirement 2). Part VI The $40 of Depreciation Expense is added to Net Income because depreciation is a noncash expense that was deducted in computing Net Income. The $50 increase in Accounts Receivable is subtracted from Net Income because Service Revenue ($150) was greater than Cash received ($100). 12-59

Two general rules are revealed:
E12-4 Understanding the Computation of Cash Flows from Operating Activities (Indirect Method) Required: 5. What general rules about converting Net Income to operating cash flows are revealed by your answer to requirement 4? Two general rules are revealed: Always add back the amount of depreciation subtracted in the Income Statement to convert Net Income to Cash Flow from Operating Activities. When Accounts Receivable increases, Sales Revenue is greater than cash received, so subtract the increase to convert Net Income to Cash Flow from Operating Activities. Part I Required: 5. What general rule about converting net income to operating cash flows is revealed by your answer to requirement 4? Part II Two general rules are revealed: Always add back the amount of depreciation subtracted in the Income Statement to convert Net Income to Cash Flow from Operating Activities. When Accounts Receivable increases, Sales Revenue is greater than cash received, so subtract the increase to convert Net Income to Cash Flow from Operating Activities. 12-60

1. Show the journal entries to record these transactions
E12-5 Understanding the Computation of Cash Flows from Operating Activities Indirect Method) Suppose your company sells goods for $300, of which $200 is received in cash and $100 is on account. The goods cost your company $125. Your company also recorded wages of $70, of which only $30 has been paid in cash. Required: 1. Show the journal entries to record these transactions Record Part I E12-5 Understanding the Computation of Cash Flows from Operating Activities (Indirect Method) Suppose your company sells goods for $300, of which $200 is received in cash and $100 is on account. The goods cost your company $125. Your company also recorded wages of $70, of which only $30 has been paid in cash. Part II We debit the asset accounts Cash for $200 and Accounts Receivable for $100, and credit Sales Revenue for $300. Part III We record the cost of sales with a debit to Cost of Goods Sold and a credit to Inventory for $125. Record 12-61

Required: 1. Show the journal entries to record these transactions 2. Identify the amount that should be reported as Net Cash Flows from Operating Activities. 3. Identify the amount that would be included in Net Income. Record Net Cash Flows from Operating Activities would be $170, which equals the $200 received from customers minus the $30 paid to employees. Part I Required: 1. (continued) Show the journal entries to record these transactions Part II We debit Wages Expense for $70 and credit Wages Payable for $40 and Cash for $30. Part III Required: 2. Identify the amount that should be reported as Net Cash Flows from Operating Activities. Part IV Net Cash Flows from Operating Activities would be $170, which equals the $200 received from customers minus the $30 paid to employees. Part V Required: 3. Identify the amount that would be included in Net Income. Part VI Net income would be $105, which equals $300 of Sales Revenue minus Cost of Gods Sold ($125) and Wages Expense ($70). Net income would be $105, which equals $300 of Sales Revenue minus Cost of Goods Sold ($125) and Wages Expense ($70). 12-62

Three general rules are revealed:
E12-5 Understanding the Computation of Cash Flows from Operating Activities (Indirect Method) Required: 4. Show how the indirect method would convert Net Income (requirement 3) to Net Cash Flows from Operating Activities (requirement 2). 5. What general rules about converting Net Income to operating cash flows are revealed by your answer to requirement 4? Part I Required: 4. Show how the indirect method would convert Net Income (requirement 3) to Net Cash Flows from Operating Activities (requirement 2). Part II The $125 Inventory decrease is added to Net Income because it had been deducted when computing Net Income, but it did not affect cash this period. The $40 Wages Payable increase is added back because wages of $70 were subtracted when calculating net income, yet only $30 cash was actually paid. The $100 Accounts Receivable increase is deducted because Net Income includes the full $300 of Sales Revenue, but only $200 cash was received. Part III Required: 5. What general rules about converting Net Income to operating cash flows are revealed by your answer to requirement 4? Part IV Three general rules are revealed: Add back decreases in noncash Current Assets. Add back increases in Current Liabilities Deduct increases in noncash current Assets. Three general rules are revealed: Add back decreases in noncash Current Assets. Add back increases in Current Liabilities Deduct increases in noncash current Assets. 12-63

E12-6 Preparing and Evaluating a Simple Statement of Cash Flows
(Indirect Method) Suppose your company’s Income Statement reports $105 of Net Income, and its comparative Balance Sheet indicates the following. Required: 1. Prepare the operating activities section of the Statement of Cash Flows, using the indirect method. 2. Identify the most important cause of the difference between the company’s Net Income and Net Cash Flows from Operating Activities. E12-6 Preparing and Evaluating a Simple Statement of Cash Flows (Indirect Method) Suppose your company’s Income Statement reports $105 of Net Income, and its comparative Balance Sheet indicates the amounts shown on the screen. Required: 1. Prepare the operating activities section of the Statement of Cash Flows, using the indirect method. 2. Identify the most important cause of the difference between the company’s Net Income and Net Cash Flows from Operating Activities. 12-64

First, let’s determine the changes in Balance Sheet accounts.
E12-6 Preparing and Evaluating a Simple Statement of Cash Flows (Indirect Method) Required: 1. Prepare the operating activities section of the Statement of Cash Flows, using the indirect method. First, let’s determine the changes in Balance Sheet accounts. Part I First, let’s determine the changes in Balance Sheet accounts. Part II Cash increased by $170. Accounts Receivable increased by $100. Inventory decreased by $125. Wages Payable increased by $40. Retained Earnings increased by $105, the amount of Net Income. We will use the changes in noncash Current Assets to prepare the operating activities section of the Statement of Cash Flows. 12-65

(Indirect Method) Required: 1. Prepare the operating activities section of the Statement of Cash Flows, using the indirect method. Using the indirect method, we start with Net Income. We deduct the Accounts Receivable increase, add the inventory decrease, and add the Wages Payable increase to arrive at the net cash provided by operating activities of $170. 12-66

(Indirect Method) Required: 2. Identify the most important cause of the difference between the company’s Net Income and Net Cash Flows from Operating Activities. The most important cause of the difference is the $125 decrease in Inventory. Part I. Required: 2. Identify the most important cause of the difference between the company’s Net Income and Net Cash Flows from Operating Activities. Part II. Net Income is less than Net Cash Flows from Operating Activities by $65 ($170 - $105). The most important cause of the difference is the $125 decrease in Inventory. Part III The Inventory decrease indicates that Cost of Goods Sold (deducted in the Income Statement) was $125 more than the cash paid to purchase Inventory. In other words, the company sold Inventory but did not replace it, creating a net cash inflow for the period. The Inventory decrease indicates that Cost of Goods Sold (deducted in the Income Statement) was $125 more than the cash paid to purchase Inventory. In other words, the company sold Inventory but did not replace it, creating a net cash inflow for the period. 12-67

(Indirect Method) Suppose the income statement for Goggle Company reports $70 of net income, after deducting depreciation of $35. The company bought equipment costing $60 and obtained a long-term bank loan for $60. The company’s comparative balance sheet, at December 31, indicates the following. E12-7 Preparing and Evaluating a Simple Statement of Cash Flows (Indirect Method) Suppose the income statement for Goggle Company reports $70 of net income, after deducting depreciation of $35. The company bought equipment costing $60 and obtained a long-term bank loan for $60. The company’s comparative balance sheet, at December 31, 2009 and December 31, 2010 are shown on the screen. 12-68

(Indirect Method) Required: 1. Calculate the change in each balance sheet account, and indicate whether each account relates to operating, investing, and/or financing activities. Part I Required: 1. Calculate the change in each balance sheet account, and indicate whether each account relates to operating, investing, and/or financing activities. Part II Cash, Accounts Receivable, Inventory, Equipment, Accumulated Depreciation. Wages Payable, Long-term Debt, and Retained Earnings increased as shown. The increase in Retained Earnings is equal to the Net Income, indicating that the company did not pay a dividend. Inventory decreased and Contributed Capital was unchanged. Part III Changes in Current Assets and Current Liabilities relate to operating activities. Changes in Noncurrent Asset relate to investing activities. Changes in Noncurrent Liabilities and Contributed Capital relate to financing activities. 12-69

(Indirect Method) Required: 2. Prepare a statement of cash flows using the indirect method. Part I Required: 2. Prepare a statement of cash flows using the indirect method. Part II Using the indirect method, we start with Net Income. We add Depreciation, deduct the Accounts Receivable increase, add the inventory decrease, and add the Wages Payable increase to arrive at the net cash provided by operating activities of $170. Part III The only investing activity was the purchase of equipment for $60. Part IV The only financing activity was the increase in long-term debt of $60. 12-70

(Indirect Method) Required: 3. In one sentence, explain why an increase in Accounts Receivable is subtracted. 4. In one sentence, explain why a decrease in Inventory is added. The increase in Accounts Receivable indicates that sales on account were greater than cash collections. A decrease in Inventory indicates that Cost of Goods Sold (subtracted in the Income Statement) was greater than Inventory purchases. Part I Required: 3. In one sentence, explain why an increase in accounts receivable is subtracted. Part II The increase in Accounts Receivable indicates that sales on account were greater than cash collections. Part III Required: 4. In one sentence, explain why a decrease in Inventory is added. Part IV A decrease in Inventory indicates that Cost of Goods Sold (subtracted in the Income Statement) was greater than Inventory purchases. 12-71

(Indirect Method) Required: 5. In one sentence, explain why an increase in Wages Payable is added. 6. Are the cash flows typical of a start-up, healthy, or troubled company? Explain. The Wages Payable increase is added because more wages were subtracted when calculating net income than actually paid. A healthy company since operating cash flows are positive and financing inflows are sufficient to cover investing outflows. Part I Required: 5. In one sentence, explain why an increase in Wages Payable is added. Part II The Wages Payable increase is added because more wages were subtracted when calculating net income than actually paid. Part III Required: 6. Are the cash flows typical of a start-up, healthy, or troubled company? Explain. Part IV A healthy company since operating cash flows are positive and financing inflows are sufficient to cover investing outflows. 12-72

End of Chapter 12 End of chapter 12.

Fundamentals of Financial Accounting 3e by Phillips, Libby, and Libby.

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Fundamentals of Financial Accounting 3e by Phillips, Libby, and Libby.

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