CHAPTER 12. The statement of cash flows categorizes cash receipts and cash payments as operating, investing, and financing activities.

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1 CHAPTER 12 Purpose of the Statement of Cash Flows The statement of cash flows is considered a major financial statement, as are the income statement, balance sheet, and statement of stockholders' equity. The statement of cash flows provides a great deal of information and answers certain questions that the other three statements do not. Its presentation is required whenever an income statement is prepared. The statement of cash flows shows the effects on cash and cash equivalents of the operating, investing, and financing activities of a company for an accounting period. The principal purpose of the statement of cash flows is to provide information about a company's cash receipts and cash payments during an accounting period. The secondary purpose of the statement of cash flows is to provide information about a company's operating, investing, and financing activities during the period. Classification of Cash Flows The statement of cash flows categorizes cash receipts and cash payments as operating, investing, and financing activities. Operating activities include receiving cash from customers for the sale of goods and services, receiving interest and dividends on loans and investments, and making cash payments for wages, goods and services purchased, interest, and taxes. Investing activities include purchasing and selling long-term assets and marketable securities (other than cash equivalents), as well as making and collecting on loans. Financing activities include issuing and buying back capital stock, as well as borrowing and repaying loans on a short- or long-term basis (issuing bonds and notes). Dividends paid are also included in this category, but the repayment of accounts payable or accrued liabilities is not. Significant Non-Cash Activities The statement of cash flows should be accompanied by a schedule of non-cash investing and financing transactions. Such transactions represent simultaneous investing and financing activities that do not, however, result in an inflow or outflow of cash.

2 These activities include: the issuance of stock for assets; the conversion of bonds into stock; the issuance of debt for assets; and the exchange of plant assets Format Of The Statement of Cash Flows The cash flows from operating activities always appears first. It is followed by the investing activities section and then the financing activities section. In the formal statement of cash flows, individual cash inflows and outflows from investing and financing activities are shown separately in their respective categories. (e.g., inflows from sale of plant assets is reported separately from outflows from investing in plant assets). The Corporate Life Cycle All products go through a series of phases called the product life cycle, and a corporation s cash flow reflects these phases. The phases (in order of their occurrence) are often referred to as follows: Introductory Phase. During this phase, the corporation is likely to have a cash deficit in its operations because the product s sales are small and the promotional expenses are great. There may also be a great deal of expenditures for research and development activities. During this phase, the corporation is likely to have a deficit in its investing activities because it is spending a great deal on investing in plant assets. These deficits will be covered through financing transactions. Growth Phase. During this phase, the sales revenue will increase. Despite this, the growth in its inventories and supplies and the need to increase the amount of credit offered to customers represent a significant need for cash in a corporation s operations. This phase is usually characterized by additional spending on research and development activities. During this phase, there is still a significant need for investments in plant assets. All of these needs will still require a cash infusion from financing transactions. Maturity Phase. A product in this phase is often referred to as a cash cow. A company s operations should produce cash flow, and there is a shrinking demand for investments in plant assets. As a result of the foregoing, there is little need for a cash infusion from financing transactions.

3 Decline Phase. During this phase cash from operations decreases. Cash from investing may become positive as the company liquidates unneeded plant assets. Again there is little need for cash infusions from financing transactions. Usefulness of the Statement of Cash Flows Investors and creditors may use the statement of cash flows to assess such things as the company's ability to generate positive future cash flows, its ability to pay its liabilities, its ability to pay dividends, and its need for additional financing. Management uses the statement of cash flows (among other things) to assess the business's debt-paying ability, determine its dividend policy, and plan its investing and financing needs. The Statement of Cash Flows also provides useful information to investors regarding the following: The Quality of Income. Corporations may appear to be very profitable, but the accruals may not be accompanied by the receipt of cash. The Cash Flow Statement can be useful in determining whether the cash flows from operations match the financial picture painted by the Income Statement or whether cash from financing is being used to mask problems with a corporation s operations. Investments. The Statement of Cash Flows is the only place where a corporation s investment in plant assets is detailed. This can be very important in determining whether a corporation is poised to continue to grow in the future. Preparing The Statement of Cash Flows To prepare the statement, one needs a comparative balance sheet, the current income statement, and additional information about transactions affecting noncurrent accounts during the period. The four steps in statement preparation are: determining cash flows from operating activities, determining cash flows from investing activities, determining cash flows from financing activities, and presenting all this information in the form of a statement of cash flows. Indirect and Direct Methods Cash flows from operating activities may be determined using either the direct method or the indirect method. The choice of which method to use only affects

4 the calculation of the Cash Flow From Operations. There is no difference in the Cash Flow From Investing Activities and the Cash Flow From Financing Activities. The direct and indirect methods produce the same results, and both are considered GAAP. The FASB, however, recommends the direct method, accompanied by a separate schedule (the indirect method) reconciling net income to net cash flows. Despite this, the indirect method is used by approximately 99% of all companies. When the direct method is used, the net cash flow from operating activities as computed using the indirect method must also be reported in a separate schedule. With the Direct Method, the cash flow from operations is calculated directly (from scratch). With the Indirect Method, however, the cash flow from operations is calculated by taking the net income of the company and then making adjustments. These adjustments are required because net income is calculated using the accrual method, and we are interested only in cash receipts reduced by cash disbursements (the cash method). These adjustments include: Adding back expenses that were deducted from net income but did not cost anything (e.g., depreciation expense, amortization expense, and depletion expense); Taking out capital gains and losses that do not relate to operations (e.g., sale of plant assets); Taking out expenses that were accrued but not yet paid (e.g., income taxes accrued but not paid in the current year) Taking out expenditures that cost cash but were not expensed this year (e.g., the purchase of inventory that was not sold or supplies that were not used up, and the payment of prepaid expenses still outstanding at the end of the year); Taking out income that was accrued but not yet received (e.g., credit sales where the account receivable is still outstanding, accrued interest not yet received); and Adding back cash receipts that were not treated as income (e.g., customers payments of accounts receivable that were generated in a prior year) Because of its widespread use, we will focus on the Indirect Method.

5 Indirect Method Consider the balance sheet equation: Assets = Liabilities + Owner s Equity Cash + Curr. Assets + LT Assets = Curr. Liab. + LT Liab. + Equity Cash + Curr. Assets + LT Assets = Curr. Liab. + LT Liab. + Equity Cash = - Curr. Assets - LT Assets + Curr.Liab.+ LT Liab. + Equity So cash changes in the opposite way from other assets and the same way as liabilities and equity. With the Indirect Method we assume that a change in a balance sheet account is matched by a change in cash. This is true for every change in the balance sheet accounts except for changes due to non-cash transactions (e.g., the purchase of an asset in exchange for stock). As a general rule, the changes for the following balance sheet accounts are assumed to affect the following activities: Activity Changes In These Accounts Fall Within The Activity In Question Operations Current Assets Current Liabilities Net Income and Loss Also add back non cash expenses like depreciation Investing Financing Long Term Assets Long Term Liabilities Stockholder s Equity (excluding Net Income) Illustration of the Indirect Method We are going to use the T-Account approach to the Indirect Method. It is a very simple approach to use because: You mechanically go through every balance sheet account; and You note every change with an equal amount of debits and credits. Because of these characteristics, it is difficult to skip an item.

6 A company has the following financial statements for the current and last years: Balance Sheet Assets Current Year Last Year Cash $164,800 $ 50,000 Accounts Receivable 165, ,000 Merchandise Inventory 350, ,000 Prepaid Rent 2,000 3,000 Furniture and Fixtures 148, ,000 Accumulated Depreciation Furniture and Fixtures (42,000) (24,000) Total Assets $788,000 $823,000 ======= ======== Liabilities Accounts Payable $143,400 $200,400 Income Taxes Payable 1,400 4,400 Notes Payable (Long-Term) 40,000 20,000 Bonds Payable 100, ,000 Equity Common Stock ($20 par value) 240, ,000 Paid-In Capital in Excess of Par Value 181, ,440 Retained Earnings 81,760 76, Total Liabilities & Equity $788,000 $823,000 ======== ========

7 Income Statement Net Sales $1,609,000 Cost of Goods Sold (1,127,800) Gross Margin $ 481,200 Operating Expenses (including Depreciation Expense (449,400) of $46,800) Income From Operations $ 31,800 Other Income/Expense Gain on Sale of Furniture and Fixtures $ 7,000 Interest Expense (23,200) Total Other Income/Expense (16,200) Income Before Income Taxes $ 15,600 Income Tax Expense (4,600) Net Income $ 11,000 ========= Additional information for the current year: Furniture and fixtures that cost $35,600 with accumulated depreciation of $28,800 were sold at a gain of $7,000. Furniture and fixtures were purchased in the amount of $39,600. A $20,000 note payable was paid and $40,000 was borrowed on a new note. Bonds Payable in the amount of $100,000 were converted into 2,000 shares of common stock. $6,000 in cash dividends were declared and paid.

8 From the Above Information, we can produce the following Statement of Cash Flows: Statement of Cash Flows Cash Flows From Operating Activities Net Income $11,000 Adjustments To Reconcile Net Income To Net Cash Provided By Operating Activities: Depreciation Expense $46,800 Decrease in Accounts Receivable 34,800 Decrease in Inventories 100,000 Decrease in Prepaid Expenses 1,000 Decrease in Accounts Payable -57,000 Decrease in Taxes Payable -3,000 Gain on Furniture and Fixtures -7,000 Total Adjustments 115,800 Net Cash Provided By Operating Activities: $126,600 Cash Flows From Investing Activities Sale of Furniture and Fixtures 13,800 Purchase of Furniture and Fixtures -39,600 Net Cash Used By Investing Activities: -25,800 Cash Flows From Financing Activities Issue Notes Payable 40,000 Payment of Dividends -6,000 Payment of Notes Payable -20,000 Net Cash Provided By Financing Activities: 14,000 Net Increase In Cash: 114,800 Cash At Beginning of Period: 50,000 Cash At End of Period: $164,800 Non-Cash Investing and Financing Activities: Conversion of Bonds Into Common Stock: $100,000 We will now produce the information that you need to construct this Statement.

9 Using the T-Account approach you create a T-account for every account on the Balance Sheet (except Cash). In each T-account, indicate the change in the asset from last year to the current year. For example, if an asset has increased by $8,000. Then place $8,000 on the debit side of that asset s T-Account. Similarly, if a liability has increased by $6,000, then place $6,000 on the credit side of that liability s T-Account. In the above example, you would set up the following T-Accounts: The Accounts Receivable have decreased by $34,800. This would be represented by a credit to the Accounts Receivable T-Account: Accounts Receivable $34,800 The Merchandise Inventory has decreased by $100,000: Merchandise Inventory $100,000 The Prepaid Rent has decreased by $1,000: Prepaid Rent $1,000 The Furniture and Fixtures have increased by $4,000: Furniture & Fixtures $4,000 The Accumulated Depreciation has increased by $18,000. Remember that this is a contra-asset account and it has a credit balance: Accumulated Depreciation $18,000

10 The Accounts Payable have decreased by $57,000: Accounts Payable $57,000 The Income Taxes Payable have decreased by $3,000: Income Taxes Payable $3,000 The Notes Payable have increased by $20,000: Notes Payable $20,000 The Bonds Payable have decreased by $100,000: Bonds Payable $100,000 The Common Stock has increased by $40,000: Common Stock $40,000 The Additional Paid-In Capital has increased by $60,000: Additional Paid-In Capital $60,000

11 The Retained Earnings has increased by $5,000: Retained Earnings $5,000 All of these figures above the line drawn in each T-Account represents the total change in the account and we must now duplicate it below the line in each account. Except for the non-cash transactions, we will explain the change with a corresponding entry in a large Cash T-Account that has been divided into three parts for Operations, Investing, and Financing: Operations Cash Investing Financing With the Indirect Method, we will work from the Net Income from the Income Statement. The Net Income increased the Corporation s Retained Earnings. The Net Income is also the basis for the calculation of Cash Flow From Operations. So, we enter the Net Income ($11,000) as a credit to Retained Earnings (It increased Retained Earnings) and a debit to Cash (It increased Cash). Thus we have equal debits and credits: Retained Earnings $5,000 $11,000

12 Cash Operations Net Income $11,000 Next, look at the additional information. We are told that $6,000 in cash dividends were declared and paid. Dividends reduce Retained Earnings (debit), and the payment of a cash dividend is an outflow of Cash. Thus, Cash is reduced (credit). We have equal debits and credits of $6,000: Retained Earnings $5,000 $6,000 $11,000 ============== ============== If you net the credit of $11,000 (Net Income) and debit of $6,000 (Dividends), we have explained how Retained earnings had a net increase of $5,000. The payment of a dividend involves equity, and therefore should be recorded as a financing transaction. Having explained the change in Retained Earnings, we draw a double line below the account to show that we are finished with this account. Cash Operations Net Income $11,000 Investing Financing Pay Dividends $6,000 Look at the Additional Information again. We see that Bonds Payable in the amount of $100,000 were converted into 2,000 shares of common stock. With a bond conversion, you take the carrying value of the bonds off the balance sheet, and issue stock for the exact amount of the carrying value. D. Bonds Payable $100,000 Cr. Common Stock $40,000 Additional Paid-In Capital 60,000

13 The 2,000 shares of common stock have a par value of $20. So, $40,000 is placed in Common Stock and the remainder of the carrying value of the bonds is placed in Additional Paid-In Capital. Bonds Payable $100,000 $100,000 ============= ============== Common Stock $40,000 $40,000 ============= ============= Additional Paid-In Capital $60,000 $60,000 =============== ============= We have now explained all of the changes to Bonds Payable, Common Stock and Additional Paid-In Capital, and we are through with these accounts. Cash was not involved in this transaction, and the transaction will appear in the schedule of non-cash transactions. Look at the Additional Information again. We see that a $20,000 note payable was paid and $40,000 was borrowed on a new note. Take each of these items separately. The payment of the $20,000 promissory note is a decrease to Notes Payable (Debit of $20,000) and a decrease to Cash (Credit of $20,000). The payment of a Note Payable involves a Long-Term Liability and therefore involves a financing transaction. We have equal debits (Notes Payable) and credits (Cash) of $20,000: $20,000 Notes Payable $20,000

14 Cash Operations Net Income $11,000 Investing Financing Pay Dividends $6,000 Pay Notes Payable $20,000 The borrowing of $40,000 increases Notes Payable (credit) and Cash (debit). Because it involves a Long-Term Liability, it is a financing transaction: Notes Payable $20,000 $20,000 $40,000 ============ ============= Cash Operations Net Income $11,000 Investing Financing Issue Notes Payable $40,000 Pay Dividends $6,000 Pay Notes Payable $20,000 We have explained the change in Notes Payable. Look at the Additional Information. Furniture and fixtures were purchased in the amount of $39,600. This is an increase to Furniture and Fixtures (debit) and a decrease in Cash (credit). The purchase involves Long-Term Assets and thus is an investing transaction: Furniture & Fixtures $4,000 $39,600

15 Cash Operations Net Income $11,000 Investing Purchase of Furniture $39,600 Financing Issue Notes Payable $40,000 Pay Dividends $6,000 Pay Notes Payable $20,000 From the Income Statement, we can see that the depreciation expense for the current year is $46,800. Depreciation Expense increases Accumulated Depreciation (credit). Depreciation does not cost any cash, but under the accrual method, it reduced Net Income. The purpose of the Indirect Method is to convert the accrual method Net Income into a cash method Net Income. Thus, we want to increase Cash From Operations by the amount of Depreciation Expense. If you have trouble with this logic, remember that we need an equal amount of debits and credits. You know that Depreciation Expense increases Accumulated Depreciation with a credit. So, Cash needs a debit of $46,800. Accumulated Depreciation $18,000 $46,800 Cash Operations Net Income $11,000 Plus Depreciation $46,800 Investing Purchase of Furniture $39,600 Financing Issue Notes Payable $40,000 Pay Dividends $6,000 Pay Notes Payable $20,000 Look at the Additional Information. Furniture and fixtures that cost $35,600 with accumulated depreciation of $28,800 were sold at a gain of $7,000. Note the journal entry from that sale: D. Cash $13,800 Accumulated Depreciation 28,800 Cr. Furniture and Fixtures $35,600 Gain 7,000

16 You want to do this journal entry to the T-Accounts noted in the journal entry: Accumulated Depreciation $18,000 $28,800 $46,800 ============= ============ Furniture & Fixtures $4,000 $39,600 $35,600 ============= ============ The debit to Cash for $13,800 is a cash inflow from the sale of a Long-Term Asset, which is an investing activity. We received $13,800 from that sale. The $13,800 sales price includes the gain from the sale. But the gain is part of Net Income, which appears under Operations. You are counting the gain twice Once in Operations and Once in Investing. You take the credit to gain and place it in operations to take the gain out of the Net Income. (The Credit will offset the Net Income, which is a Debit to Cash From Operations.) Cash Operations Net Income $11,000 Furniture Gain $7,000 Plus Depreciation $46,800 Investing Sale of Furniture $13,800 Purchase of Furniture $39,600 Financing Issue Notes Payable $40,000 Pay Dividends $6,000 Pay Notes Payable $20,000 We have explained the changes to Furniture & Fixtures and Accumulated Depreciation. The only accounts left unexplained are the current assets and current liabilities. These changes to the accounts are entered below the line in each T-Account and an offsetting debit or credit is entered to Cash Flow From Operations: Accounts Receivable $34,800 $34,800 =============== =============

17 Merchandise Inventory $100,000 $100,000 ============== ============= Prepaid Rent $1,000 $1,000 ============== ============= Accounts Payable $57,000 $57,000 =============== ============= Income Taxes Payable $3,000 $3,000 =============== ============= Cash Operations Net Income $11,000 Furniture Gain $7,000 Depreciation $46,800 Decrease in A/P $57,000 Decrease in A/R $34,800 Decrease in Tax Pay $3,000 Decrease in Inven. $100,000 Decrease in Prep. Rent $1,000 Cash Flow From Operations: $126,600 Investing Sale of Furniture $13,800 Purchase of Furniture $39,600 Cash Flow From Investing: -$25,800 Financing Issue Notes Payable $40,000 Pay Dividends $6,000 Pay Notes Payable $20,000 Cash Flow From Financing: $14,000 Total Cash Flow For Current Year: $114,800 Plus: Beginning Balance of Cash: $50,000 Ending Balance of Cash: $164,800 The Direct Method Under the direct method, (net) cash flows from operating activities are determined by taking cash receipts from sales, adding interest and dividends

18 received, and deducting cash payments for purchases, operating expenses, interest, and income taxes. Free Cash Flow Interpreting the Statement of Cash Flows includes examining important relationships such as cash-generating efficiency and free cash flow. Cash-generating efficiency is the ability of a company to generate cash from operations. Free cash flow is the cash available for new projects. It is the cash remaining after current operating commitments, such as commitments for operations, interest, income taxes, dividends, and net capital expenditures, have been met. Free Cash Flow = Cash From Operations - Capital Expenditures.- Dividends Financial Statement Analysis Cash From Operations is used to evaluate a corporation s liquidity and solvency. Current Cash Debt Coverage Ratio When examining a corporation s ability to pay its debts in the short term (liquidity), financial analysts look at the Current Cash Debt Coverage Ratio. In this ratio, you divide a corporation s cash from operations by average current liabilities: Cash Debt Coverage Ratio Cash Flow From Operations Average Current Liabilities When examining a corporation s ability to pay its debts in the long-term (solvency), financial analysts look at the Cash Debt Coverage Ratio. In this ratio, you divide a corporation s cash from operations by average total liabilities: Cash Flow From Operations Average Total Liabilities

Chapter 12. The statement of cash flows categorizes cash receipts and cash payments as operating, investing, and financing activities.

Chapter 12. The statement of cash flows categorizes cash receipts and cash payments as operating, investing, and financing activities. 1 Chapter 12 2 The statement of cash flows is a major financial statement as are the income statement, balance sheet, and statement of stockholders' equity. The statement of cash flows is required whenever