Appendix B: Statement of Cash Flows

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Appendix B Statement of Cash Flows

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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.

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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.

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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.

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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.

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B. Cash Flows from Investing Activities

• CF from investing activities explain the changes
  in cash from the purchase or sale of the
  companys (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.

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C. Cash Flows from Financing Activities

• CF from financing activities explain the changes
  in cash from the issue or retirement of the
  companys (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.

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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.

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(1) Indirect Method - Noncash Items

• Noncash activities include
• -Depreciation expense. For example
• Depreciation Expense xx
• Accumulated Depreciation xx
• -Amortization expense on intangible assets such
  as patents and goodwill.
• Amortization Expense xx
• Goodwill xx
• -Bad debt expense on the estimation of
  uncollectibles
• Bad Debt Expense xx
• 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.

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(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 expense xx
• Discount on B/P xx
• or
• Premium on B/P xx
• Interest expense xx

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(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.

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(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
• Cash 10,000
• Land 9,000 Gain on Sale of Land 1,000
• 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.

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(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.
  

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(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.

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(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.

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

• A/RB Sales - A/RE 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.

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(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.).

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(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).

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Class Problem, Operating SectionIndirect 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

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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 9,000 2,200
• 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 6,800 2,200
• Interest Pay. 1,500 2,200 ( 700)
• Unearned Rev. 6,500 4,700 1,800

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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
  

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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.

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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.

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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.

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Class Problem - Direct Method

• Worksheet for calculations
• Income Statement Adjustments
  Cash
• Revenues 109,100 -2,200 Incr. 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

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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).

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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 PPE 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.

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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.