1. 1 Appendix B: Statement of Cash Flows

2. 2 General Information on SCF Required for financial statements by SFAS 95 (1987). Primary purpose is to provide relevant information about cash receipts and cash disbursements of the company during the year. Serves to complement the other financial statements. Focus is on cash flows, not income. Reconciles the balance sheet and the income statement.

3. 3 Content of Statement of Cash Flows Explains change in cash and cash equivalents. Cash equivalents are defined as short-term, highly liquid investments near to maturity. Examples of cash equivalents are Treasury bills and money market funds. Format of SCF includes the following three sections: A. Cash flow from operating activities. B. Cash flow from investing activities. C. Cash flow from financing activities.

4. 4 A. Cash Flows from Operating Activities CF from operating activities is based on the income statement, and converts income activity to a cash basis in its presentation. There are two formats for the presentation of CF from operating activity: – direct method: this technique shows cash received from customers and cash paid to various entities for operating activities. – indirect method: this technique starts with net income and makes adjustments to net income to convert it to a cash basis.

5. 5 A. Cash Flows from Operating Activities If the direct method is used, the indirect method must be presented in a supplementary schedule. The direct method is more informative, but the vast majority of companies present only the indirect method. FASB is considering a change to require the direct method.

6. 6 B. Cash Flows from Investing Activities CF from investing activities explain the changes in cash from the purchase or sale of the company’s (primarily) long-term assets. Examples of investing activity includes: – cash paid for purchase of equipment, land, buildings, marketable securities (available-for-sale and equity), intangible assets, and most other long term assets. – cash received from sale of equipment, land, buildings, marketable securities (available-for-sale and equity), intangible assets, and most other long term assets. – Note that the change in equity method investments held during the period is classified in the operating section of SCF, because the change deals with income, and will adjust income from equity to cash basis.

7. 7 C. Cash Flows from Financing Activities CF from financing activities explain the changes in cash from the issue or retirement of the company’s (primarily) long-term liabilities and equity. Examples of financing activity includes: – cash received from issue of bonds, mortgages and other long-term debt. – cash received from issue of common stock and preferred stock. – cash paid for the retirement of long-term debt. – cash paid for the repurchase of treasury stock. – cash paid for dividends. Note: use RE formula to find dividends: BRE + NI - Dividends = ERE Note that cash paid for dividends is classified as a financing activity. However, cash paid for interest is classified as an operating activity. Also, cash received for dividends and cash received for interest are both classified as operating activities.

8. 8 A. Cash Flow from Operations: Components of Indirect method To understand the adjustments to get from net income to CF from operations, we will classify the adjustments into 3 categories: (1) Noncash items. (2) Double counted gains and losses. (3) Change in related (accrual basis) assets and liabilities Remember: net income includes many activities that are noncash, or only partly cash.

9. 9 (1) Indirect Method - Noncash Items Noncash activities include -Depreciation expense. For example: Depreciation Expensexx Accumulated Depreciationxx -Amortization expense on intangible assets such as patents and goodwill. Amortization Expensexx Patent xx -Bad debt expense on the estimation of uncollectibles: Bad Debt Expensexx Allowance for Doubtful Accts.xx Since these expenses originally reduced net income, the amount of these expenses would need to be added back to net income to get to cash from operations.

10. 10 (1) Indirect Method - Noncash Items Another noncash activity deals with the amortization of premiums and discounts on bonds payable. These amortizations affect interest expense but not cash. There are two components to interest expense each period: (1) the cash paid for interest expense, and (2) the amortization of premiums or discounts (the noncash portion). To find the direction of the adjustment, isolate the noncash component (for amortization) of the interest expense entry: Interest expensexx Discount on B/Pxx or Premium on B/Pxx Interest expensexx

11. 11 (1) Indirect Method - Noncash Items Note that the amortization of a discount has a similar format to that of depreciation expense (debit expense in a non cash transaction). Therefore, to adjust for amortization of a discount, add the amount of the discount amortization back to net income. Since the amortization of a premium has the opposite effect on net income, we must subtract the amount of the premium amortization from net income to get to cash from operations.

12. 12 (2)Indirect Method - Double Counted Items The double counted items come from gains and losses on investing and financing activity. For example, assume that land is sold for $10,000 cash, and the original cost was $9,000: Cash10,000 Land9,000 Gain on Sale of Land1,000 In this case, the $10,000 cash received would be shown in Investing. However, if the gain is not adjusted out of net income, we would be “double counting” that effect.

13. 13 (2)Indirect Method - Double Counted Items Therefore, any gains or losses from sale of investing assets (equipment, land, buildings, AFS and equity investments, intangibles). The adjustment to reverse out the effects would be: – add the amount of loss to net income. – subtract the amount of the gain from net income. The same holds true for gains and losses from the early extinguishment of debt (like the gains/losses from the retirement of bonds). – add the amount of loss to net income. – subtract the amount of the gain from net income.

14. 14 (3) Indirect Method - Change in Related Assets and Liabilities The third category examines the change in the assets and liabilities that relate to the remaining income statement items, after the items in (1) and (2) have been removed. The adjustment for the effect of these changes is to effectively “squeeze” the income statement item from the accrual basis of accounting to the cash basis of accounting.

15. 15 (3) Indirect Method - Change in Related Assets and Liabilities For example, assume that total sales revenue recognized for the year is $100,000. At the beginning of the year, A/R were $2,000; at the end of the year, A/R were $3,000. What amount of cash was collected from customers? To analyze this effect, we must analyze the A/R account, and how it is increased and decreased.

16. 16 (3) Indirect Method - Change in Related Assets and Liabilities Accounts Receivable Cash Collection on A/R Beginning Balance Sales Ending Balance First assume that all sales are on account. Now note that the relationship can be expressed in a formula involving A/R and Sales: A/R Beginning + Sales - Cash Collections = A/R Ending Or: A/R Beginning + Sales - A/R Ending = Cash Collections

17. 17 (3) Indirect Method - Change in Related Assets and Liabilities A/R B + Sales - A/R E = Cash Collections 2,000 + 100,000 - 3,000 = Cash Collections 99,000 = Cash Collections Note that, to convert from accrual basis sales revenues to cash basis sales revenues, an increase in A/R should be subtracted from net income to convert net income to a cash basis. Correspondingly, a decrease in A/R should be added to net income to convert net income to a cash basis.

18. 18 (3) Indirect Method - Change in Related Assets and Liabilities This pair of rules can be expanded to a general set of rules to convert NI from accrual to cash basis: Subtract increases in related assets. Add decreases in related assets. Add increases in related liabilities. Subtract decreases in related liabilities. Assets Opposite Liabilities Same AOLS The types of assets that relate to the income statement are primarily current assets, but not always. To decide, you must look at each asset and its related income statement component. Also, remember that we are looking at the remaining assets and liabilities (after the eliminations in part 1). Since we have already eliminated depreciation expense and amortization expense, etc., we would not include the changes in these related assets (Accum. Depr., Patents, etc.).

19. 19 (3) Indirect Method - Change in Related Assets and Liabilities Examples of related assets are: Accounts Receivable. Dividends Receivable (relates to dividend income). Inventories. Prepaid Expenses. Deferred Tax Assets (because this relates to income tax expense). Examples of related liabilities include: Accounts Payable. Interest Payable. Income Tax Payable. Other Current Liabilities. Unearned Revenues (short and long term). Deferred Tax Liabilities (because this relates to income tax expense).

20. 20 Class Problem, Operating Section Indirect Method Given the following I/S for Company S: Revenues $109,100 COGS (56,000) Wage Exp. (15,200) Rent Exp. (9,000) Int. Exp. (2,900) Depr. Exp. (6,200) Loss on Sale (4,200) Inc. Tax Exp. (4,400) Net Income $ 11,200 Part 1: +6,200 Part 2: +4,200

21. 21 Class Problem, Operating Section Class Problem, Operating Section Selected Balance Sheet accounts, Company S Part 3 (indirect method): find the change in the related assets and liabilities (ignore the change in cash, as that is the amount we are trying to explain): 2006 2005 Incr.(Decr) A/R$11,200$ 9,0002,200 Inventory 15,000 15,600( 600) Prepaid Rent 1,200 1,800( 600) A/P 11,200 14,600 (3,400) Wages Pay. 9,000 6,8002,200 Interest Pay. 1,500 2,200( 700) Unearned Rev. 6,500 4,700 1,800 subtract add subtract add subtract add AOLS

22. 22 Class Problem Cash Flows From Operations: Net income$ 11,200 Add: Depreciation expense (Part 1) 6,200 Add: Loss on sale of equipment (Part 2) 4,200 Changes in related assets and liabilities (part 3): Incr. in Accounts Receivable (2,200) Decr. In Inventory 600 Decr. In Prepaid Rent 600 Incr. in Wages Payable 2,200 Incr. in Unearned Revenue 1,800 Decr. In Accounts Payable (3,400) Decr. In Interest Payable ( 700) Cash flows from operating activities$ 20,500

23. 23 CF from Operations - Direct Method The direct method converts individual revenues and expenses to a cash basis, and ignores noncash items in the totals. Each conversion is based on the difference between accrual basis and cash basis. These differences are found in the same adjustments that were made to net income under the indirect method.

24. 24 CF from Operations - Direct Method To create the operating section using the direct method, start with the income statement, making sure to carry the expenses as negative (-) amounts. Review the adjustments to net income as presented in the indirect method. Each of the adjustments relates to an item on the income statement. Attach the adjustment (or adjustments) to each item, maintaining the direction of the adjustment. For example, A/R relates to sales; Inventory and A/P relate to COGS.

25. 25 CF from Operations - Direct Method The total for each line is the resulting cash received, or cash paid, for the item. The total cash flow from operations is the same, but the amounts are derived directly and individually, rather than adjusting noncash items out of net income. The calculations for the direct method are on the next slide. Refer to the adjustments for the indirect method on Slide 22. Each line can be attached to something on the income statement. Some items adjust revenues and expenses to a cash basis; other items adjust the non-cash items to zero.

26. 26 Class Problem - Direct Method Worksheet for calculations: Income Statement Adjustments Cash Revenues 109,100-2,200Incr. A/R +1,800 Incr. U/R 108,700 COGS(56,000)+ 600 Decr. Inv -3,400 Decr. A/P (58,800) Wage Exp.(15,200)+2,200 Incr. W/P (13,000) Rent Exp. (9,000)+600 Decr. PP Rent ( 8,400) Int. Exp. (2,900)-700 Decr. Int. Pay (3,600) Depr. Exp. (6,200)+6,200 noncash-0- Loss on Sale(4,200)+4,200 noncash-0- Inc. Tax Exp.(4,400) no adjustment (4,400) Cash flow from operating activity $20,500

27. 27 Class Problem -Direct Method The operating section of the SCF is presented as: Cash flow from operations: Cash received from customers$ 108,700 Cash paid to suppliers (58,800) Cash paid for wages (13,000) Cash paid for rent ( 8,400) Cash paid for interest ( 3,600) Cash paid for income taxes ( 4,400) Cash flow from operations$ 20,500 (Note that the noncash (depreciation) and double counted (loss) items are omitted in the direct method).

28. 28 CF from Investing Activities Investing and financing activities often require additional information to evaluate. A change in equipment could be from both sales and purchases. Sales of PP&E also involve accumulated depreciation. Sales of most investing assets also involve gains and losses. The best way to get to “cash from sale” is to reconstruct the journal entry.

29. 29 Additional Issues - SCF The FASB requires that significant noncash investing and financing activities be disclosed in a supplementary schedule to the SCF. Examples of significant noncash investing and financing activities include: – conversion of bonds to stock. – purchase of assets with issue of stock. – purchase of assets with debt. – declaration (but not payment) of cash dividend. – stock dividends and stock splits.