MF

CHAPTER 9

The Statement of Cash Flows

Learning Objectives

1. Identify the purposes of the statement of cash flows

2. Report cash flows from operating, investing and financing activities

3. Prepare a statement of cash flows by the direct method

4. Compute the cash effects of a wide variety of business transactions

5. Prepare a statement of cash flows by the indirect method

Outline

Objective 1: Identify the purposes of the statement of cash flows

A. The statement of cash flows reports the entity’s cash flow (cash receipts and cash payments) during the period—where the cash came from, and how it was spent.

B. The period of time covered by the statement of cash flows and the income statement is the same.

C. The purposes of the statement are:

1. to predict future cash flows,

2. to evaluate management decisions,

3. to determine the ability to pay dividends to stockholders and principal and interest to creditors, and

4. to show the relationship of net income to changes in cash.

D. Cash includes cash on hand, cash in the bank, and cash equivalents. Cash equivalents are very liquid short-term investments such as money market investments and Treasury bills.

Objective 2: Report cash flows from operating, investing, and financing activities

A. Cash flows are classified as operating, investing, or financing activities.

1. Operating activities create revenues and expenses. The statement shows the cash inflows and outflows from these activities.

a. Operating activities relate to transactions that make up net income.

b. Cash flow from operating activities is the most important source of cash for a business.

2. Investing activities are increases and decreases in assets other than those involved in operating activities. The statement shows the cash inflows and outflows from these activities.

a. Investing activities relate to long-term asset accounts.

b. Investments in fixed assets suggest a strong company.

3. Financing activities involve obtaining funds from investors and creditors. The statement shows the cash flows from these activities.

a. Financing activities relate to long-term liabilities and owners’ equity accounts.

b. Both stock transactions and debt transactions are financing activities; however, paying interest on debt is considered an operating activity (because interest expense is a part of net income), while paying dividends on stock is considered a financing activity.

B. The FASB approved two formats for reporting operating activities—the direct method and indirect method.

1. The direct method lists cash receipts from specific operating activities and cash payments for each major operating activity. The FASB prefers the direct method.

2. The indirect method begins with net income and reconciles to cash flows from operating activities. Because most companies use an accrual method, many companies find the indirect method easier to use.

3. The total for operating activities and the total change in cash is the same for both methods. The investing activities and financing activities are exactly the same for both methods.

Objective 3: Prepare a statement of cash flows by the direct method

A. Preparation of the statement of cash flows involves these steps:

1. Identify the activities that increase or decrease cash.

2. Classify each activity as operating, investing, or financing.

3. Identify the cash effect of each transaction.

B. Cash flows from operating activities include:

1. Cash receipts:

a. Cash collections from customers

b. Cash receipts of interest and dividends

2. Cash payments:

a. Cash payments to suppliers for both inventory and operating expenses

b. Cash payments to employees

c. Cash payments for interest and income taxes

3. Depreciation, depletion, and amortization expense do not affect cash, and so are not listed on the statement of cash flows (direct method).

C. Cash flows from investing activities include:

1. Cash receipts:

a. Proceeds from the sale of plant assets

b. Proceeds from the sale of investments that are not cash equivalents

c. Cash receipts from the collection of loans (principal only)

2. Cash payments:

a. Payments for the acquisition of plant assets

b. Payments for the acquisition of investments that are not cash equivalents

c. Making loans

D. Cash flows from financing activities include:

1. Cash receipts:

a. Proceeds from the issuance of stock

b. Proceeds from the sale of treasury stock

c. Borrowing money (notes and bonds payable)

2. Cash payments:

a. Payments to retire the company’s own stock

b. Payments for the purchase of treasury stock

c. Repayment of debt (principal only)

d. Payments of dividends

E. Computerized accounting systems can easily generate the statement of cash flows from information already available in the accounts.

Objective 4: Compute the cash effects of a wide variety of business transactions

A. Cash flow from operating activities is computed by using the following approach:

+

Purchases

-

Payments

=

Revenue or expense Adjustment for the Amount for the

from the change in the related = statement of

income statement sheet account(s) cash flows

1. Collections from customers must be computed by converting sales revenue (accrual basis) to the cash basis:

a. Computation:

Beginning Ending

accounts + Sales – Collections = accounts receivable receivable

b. An increase in Accounts Receivable means that sales revenue is greater than collections. A decrease means that collections are greater than sales.

2. Payments to suppliers involve adjusting cost of goods sold (accrual basis) to the cash basis:

a. Compute purchases:

Beginning Ending

inventory inventory

b. Compute payments for inventory:

Beginning Ending

accounts accounts

payable payable

c. An increase in Inventory means that purchases were greater than the cost of goods sold. An increase in Accounts Payable means that purchases were greater than the cash payments.

3. Operating expenses often include noncash expenses, expenses that have not been paid, accrued liabilities, and expense paid in advance (prepaid). Cash payments for operating expenses adjust operating expenses (accrual basis) to the cash basis.

a. Compute payments of prepaid expenses:

Beginning Ending

prepaid + Payments = prepaid

expenses expense

b. An increase in Prepaid Expenses means that payments for prepaids were greater than the expenses recorded.

c. Compute payments of accrued liabilities:

Beginning Ending

accrued - Payments = accrued

liabilities liabilities

d. An increase in Accrued Liabilities means that expenses incurred were greater than cash payments.

e. Using the information gathered above, compute the payments for operating expenses:

Accrual of

expense at - + Payments =

year end

f. Total payments for operating expenses = payments in a., c., and e. above.

4. Payments to employees is determined by analyzing the salary or wage payable account.

a. Computation: + Payments

Beginning Ending

salary/wage + Salary/wage expense - Payments = salary/wage

payable payable

b. An increase in Salary/Wage Payable means that expenses were greater than the cash payments.

5. Payments for interest and income taxes follow the pattern illustrated for payments to employees.

B. Cash flow from investing activities can be identified by analyzing assets accounts.

1. An increase in an asset account (for example, Land) indicates that an asset has been acquired. This is reported as a cash outflow (use of cash).

2. A decrease in an asset account indicates that an asset has been sold. The amount of the decrease may not equal the amount of cash received (the cash inflow or source of cash) because the asset might have been sold at a price greater than or less than its book value.

3. Computation:

Beginning Book value Ending

plant asset + Acquistions - Depreciation - of plant = plant asset

balance (net) assets sold balance (net)

4. Sale proceeds = Book value of asset sold + Gain - Loss

5. The computation for investments is:

Beginning Book value of Ending

investment + Purchases - investments = investment

balance sold balance

6. The computation for loans and notes receivable is:

Beginning New loans Ending

Note receivable made note receivable

C. Cash flow from financing activities can be identified by analyzing liability and stockholders’ equity accounts.

1. An increase in liability or stockholders' equity account indicates that stock or debt has been issued. This is reported as a cash inflow (source of cash).

2. A decrease in a liability or stockholders' equity account indicates that debt or stock has been retired. This is reported as a cash outflow (use of cash).

3. Computation of debt issuances and payments:

Beginning Payment Ending

long-term debt + Issuances of new debt - of = long-term debt

balance debt balance

4. Computation of stock issuances and retirements:

Beginning Ending

stock + Issuances of new stock - Retirements = stock

balance balance

5. Computation of treasury stock purchases and sales:

Beginning Ending

treasury stock + Purchases - Cost of treasury stock sold = treasury stock

balance balance

6. Computation of dividend payments:

a. First, calculate the amount of dividends declared:

Beginning Ending

retained earnings + Net income - Dividends declared = retained earnings

balance balance

b. Then calculate the amount of cash payments for dividends:

Beginning Ending

dividends + = dividends

payable payable

D. Noncash investing and financing activities, such as acquisition of plant assets by issuing long-term debt, are reported in a separate schedule that accompanies the statement of cash flows.

F. The FASB requires that a reconciliation of net income to net cash flow from operating activities be present when the direct method is used. This reconciliation is the same as the cash flow from operating activities using the indirect method.

Objective 5: Prepare a statement of cash flows by the indirect method

A. Investing and financing activities are the same under both methods.

B. The indirect method begins with accrual-basis net income and makes adjustments to that number to arrive at net cash flow from operating activities.

C. The following items are included as adjustments to net income

1. Add depreciation, depletion, amortization, and any other expenses that reduce net income but not cash. Deduct revenues that do not provide cash, such as equity-method investment revenue.

2. Add losses and subtract gains on the sale of assets because they also affect income without affecting cash.

3. Add decreases in most current assets other than cash, because a decrease in a current asset means that the cash increase is not reflected in accrual-basis net income.

4. Subtract increases in most current assets other than cash, because an increase in a current asset, such as Inventory, indicates that the decrease in cash is not a decrease in accrual-basis net income.

5. Add increases in most current liabilities, because increases in current liabilities indicate that accrual-basis net income was reduced more than the cash payments.

6. Subtract decreases in most current liabilities, because decreases in current liabilities indicate that cash payments were greater than that reflected in accrual-basis net income.

7. Most current assets and liabilities result from operating activities. Exceptions are short-term investments and dividends payable.

D. Cash-flow information may be critical in helping to determine if a company is financially sound. Profitable companies usually have healthy cash flows. A negative cash flow warrants investigation.

E. Decision guidelines provide investors and creditors with a few suggestions on how to use cash-flow information.

+

-

+ Purchases – Cost of goods sold =

� EMBED Word.Picture.8 ���

-

Expiration of

prepaid expense

+ Accrual of expense at year end

Expiration of Ending

prepaid expense balance

+

- Collections =

Dividend Dividend

declarations payments

-