The Statement of Cash Flows

1
The Statement of Cash Flows
2
Key Points

• The structure and format of the statement of cash
  flows.
• Cash flows from operating, investing, and
  financing activities.
• How the statement of cash flows complements the
  other financial statements and how it can be used
  by those interested in the financial condition of
  a company.
• Important investing and financing transactions
  that do not appear on the statement of cash flows
  and how they are reported.
• Economic consequences associated with the
  statement of cash flows.
• Preparing a statement of cash flows from the
  information contained in two balance sheets, an
  income statement, and a statement of retained
  earnings.

3
The Primary Purpose of the Statement of Cash Flows

• The primary purpose of the statement of cash
  flows is to provide information about cash
  receipts, cash payments, and the net change in
  cash resulting from the operating, investing, and
  financing activities of a company
  during the period.

4
The Primary Purpose of the Statement of Cash Flows

• The statement of cash flows provides answers to
  the following important questions about an
  enterprise
• Where did the cash come from during the period?
• What was the cash used for during the period?
• What was the change in the cash balance during
  the period?
• The statement of cash flows also provides
  clues about whether a struggling
  company will survive or perish.

5
Steps in Preparing the Statement of Cash Flows

• Preparing the statement of cash flows involves
  three major steps.
• First, to see where you are headed, start by
  identifying the change in cash during the period.
  
• Has cash increased or decreased during the year?
• Second, determine the net cash provided/used by
  operating activities.
• Third, determine the net cash provided/
  used by investing and financing
  activities.

6
Format of the Statement of Cash Flows

• Four parts
• operating
• investing
• financing
• noncash investing and financing activities

7
Format of the Statement of Cash Flows

• As a general rule
• Operating activities involve income determination
  (income statement) items.
• Investing activities involve cash flows resulting
  from changes in investments and long-term asset
  items.
• Financing activities involve cash
  flows resulting from changes in
  long-term liability and stockholders'
  equity items.

8
Format of the Statement of Cash Flows

• The three activities--operating, investing, and
  financing--plus the significant noncash investing
  and financing activities make up the general
  format of the statement of cash flows.
• The section of cash flows from operating
  activities always appears first, followed by the
  investing activities and the financing
  activities sections.

9
Format of the Statement of Cash Flows

• The net increase (decrease) in cash for the
  period is then added or subtracted from the
  beginning-of-period cash balance to obtain the
  end-of-period cash balance.
• Any significant noncash investing and
  financing activities are reported in a
  separate schedule at the bottom of the
  statement.

10
Operating Activities

• Include
• The cash effects of transactions that create
  revenues and expenses and
• Enter into determination of net income.

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Types of Cash Flows -Operating Activities

• Cash inflows
• From sale of goods or services
• From returns on loans (interest received) and on
  equity securities (dividends received)
• Cash outflows
• To suppliers for inventory
• To employees for services
• To government for taxes
• To lenders for interest
• To others for expenses

12
Investing Activities

• Include
• Purchasing and disposing of investments and
  productive long-lived assets using cash and
• Lending money and collecting the loans.

13
Types of Cash Flows -Investing Activities

• Cash inflows
• From sale of property, plant, and equipment
• From sale of debt or equity securities of other
  entities
• From collection of principal on loans to other
  entities
• Cash outflows
• To purchase property, plant, and equipment
• To purchase debt or equity securities of
  other entities
• To make loans to other entities

14
Financing Activities

• Include
• Obtaining cash from issuing debt and repaying the
  amounts borrowed and
• Obtaining cash from stockholders and paying them
  dividends.

15
Types of Cash Flows -Financing Activities

• Cash inflows
• From sale of equity securities (company's own
  stock)
• From issuance of debt (bonds and notes)
• Cash outflows
• To stockholders as dividends
• To redeem long-term debt or reacquire capital
  stock

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Operating Activities - ALERT

• Some cash flows relating to investing or
  financing activities are classified as operating
  activities. For example...
• Receipts of investment revenue (interest and
  dividends) and
• Payments of interest to lenders are classified as
  operating activities because
  these items are reported in the
  income statement.

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Significant Noncash Activities...

• 1. Issuance of common stock to purchase assets.
• 2. Conversion of bonds into common stock.
• 3. Issuance of debt to purchase assets.
• 4. Exchanges of plant assets.

18
Preparing the Statement of Cash Flows

• The statement of cash flows is prepared
  differently from other basic financial
  statements.
• First, because the statement requires detailed
  information concerning the changes in account
  balances that occurred between two periods of
  time, an adjusted trial balance does not provide
  the data necessary for the statement.
• Second, the statement of cash flows deals
  with cash receipts and payments. The
  accrual concept is not used
  in the preparation of a
  statement of cash flows.

19
Sources of the Statement of Cash Flows

• The information to prepare this statement usually
  comes from three sources
• Comparative balance sheet
• Current income statement
• Additional information

20
Comparative balance sheet

• Information in this statement indicates the
  amount of the changes in assets, liabilities, and
  stockholders' equities from the beginning to the
  end of the period.

21
Current income statement

• Information in this statement helps the reader
  determine the amount of cash provided or used by
  operations during the period.

22
Additional information

• Additional information includes transaction data
  that are needed to determine how cash was
  provided or used during the period.

23
Indirect and Direct Methods

• In order to determine the cash provided/used by
  operating activities, net income must be
  converted from an accrual basis to a cash basis.
• This conversion may be done by either of two
  methods
• Indirect (adjust net income from the
  accrual to the cash basis
• Direct (List all cash collections and
  receipts

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Indirect and Direct Methods

• Both methods arrive at the same total amount for
  "Net cash provided by operating activities.
• The methods differ in disclosing the items that
  make up the total amount.
• The choice of methods affects only the operating
  activities section the investing activities, and
  financing activities sections are not affected by
  the choice of method.

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Indirect Methods

• The indirect method is used extensively in
  practice.
• Most companies favor the indirect method for the
  following three reasons
• it is easier to prepare,
• it focuses on the differences between net income
  and net cash flow from operating activities, and
• it tends to reveal less company information to
  competitors.

26
Direct Methods

• Those who favor the direct method, which is more
  consistent with the objective of a statement of
  cash flow because it shows operating cash
  receipts and payments.
• The FASB prefers the direct method but allows the
  use of either method.
• 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.
• We will not cover the direct method

27
STATEMENT OF CASH FLOWS - INDIRECT METHOD

• The transactions of Computer Services Company for
  the years 2004 and 2003 are used to explain and
  illustrate the preparation of a statement of cash
  flows using the indirect method.
• Computer services Company started in January 1,
  2004, when it issued 50,000 shares of 1 par
  value common stock for 50,000 cash.
• The company rented its office space and furniture
  and performed consulting services throughout the
  first year.

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Comparative Balance Sheet
The comparative balance sheet for the beginning
and end of 2004, showing increases or decreases
appears as follows COMPUTER SERVICES
COMPANY Comparative Balance Sheet December 31
29
Income Statement and Additional Information

• The income statement and additional information
  for Computer Services Company follow
• COMPUTER SERVICES COMPANY
• Income Statement
• For the Year Ended December 31, 2004
• Revenues 85,000
• Operating expenses 40,000
• Income before income taxes 45,000
• Income tax expense 10,000
• Net income 35,000
• Additional Information
• (a) Examination of selected data indicates that a
  dividend of 15,000 was declared and paid during
  the year.
• (b) The equipment was purchased at the end of
  2004. No depreciation was taken in 2004.

30
Steps in Preparing the Statement of Cash Flows -
Indirect Method

• Step 1--Determine the net increase or decrease in
  cash.
• Step 2--Determine net cash provided or used by
  operating activities under the indirect method by
  adjusting net income for items that did not
  affect cash.
• Step 3--Study the balance sheet to determine
  changes in noncurrent assets.

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Step 1

• Determine the net increase or decrease in cash.
• As shown in the previous balance sheet, Computer
  Services had no cash on hand at the beginning of
  2004 and a balance of 34,000 at the end of 2004.
  Therefore, cash increased by 34,000.

32
Step 2

• Determine net cash provided or used by operating
  activities under the indirect method by adjusting
  net income for items that did not affect cash.
• Net income must be converted because earned
  revenues may include credit sales that have not
  been collected in cash and expenses incurred that
  may not have been paid in cash.

33
Step 2

• Receivables, payables, prepayments, and
  inventories should be analyzed for their effects
  on cash.
• Increases in current assets are decreases in cash
  flow from operations. Decreases in current
  assets are increases in cash flow from operating
  activities
• Increases in current liabilities are increases in
  cash flow from operations. Decreases in current
  liabilities are decreases in cash flow from
  operations
• Accounts receivable--When accounts receivable
  increase during the year, revenues on an accrual
  basis are higher than revenues on a cash basis.
• Although operations of the period led to
  revenues, not all of these revenues resulted in
  an increase in cash.

34
Step 2

• Computer Services Company had revenues of 85,000
  in its first year of operations.
• However, CSC collected only 55,000 in cash.
  Although accrual basis revenue was 85,000, cash
  basis revenue would be only 55,000.
• Therefore the increase in accounts receivable of
  30,000 must be deducted from net income.
• If accounts receivable decrease, the decrease
  must be added to net income.

35
Step 2

• Accounts payable--When accounts payable increase
  during a year, operating expenses on an accrual
  basis are higher than they are on a cash basis.
• For Computer Services Company, operating expenses
  reported in the income statement were 40,000.
• However, since Accounts Payable increased 4,000
  only, 36,000 (40,000 - 4,000) of the expenses
  were paid in cash.
• To convert net income to net cash provided by
  operating activities, an increase in accounts
  payable must be added to net income.

36
Step 2

• Conversely, a decrease in accounts payable would
  have to be subtracted from net income.
• For Computer Services Company, the changes in
  accounts receivable and accounts payable were the
  only changes in current assets and current
  liability accounts.
• Therefore, any other revenues or expenses
  reported in the income statement were received or
  paid in cash, and no adjustment of net income is
  necessary.

37
Step 2

• The operating activities section of the statement
  of cash flows for Computer Services Company would
  appear as follows
• COMPUTER SERVICES COMPANY
• Partial Statement of Cash Flows--Indirect Method
• For the Year Ended December 31, 2004
• Cash from operating activities
• Net income 35,000
• Adjustments to reconcile net income to
• net cash provided by operating activities
• Increase in accounts receivable
  (30,000)
• Increase in accounts payable 4,000
  (26,000)
• Net cash provided by operating activities
  9,000

38
Step 3

• Study the balance sheet to determine changes in
  noncurrent assets.
• Changes in each noncurrent account are then
  analyzed using selected transaction data to
  determine the effect, if any, the changes had on
  cash.
• Computer Service Company's three noncurrent
  accounts are Equipment, Common Stock, and
  Retained Earnings, all three of which had
  increases during the year.

39
Step 3

• No transaction data are given for the increases
  in Equipment of 10,000 and Common Stock of
  50,000. When other explanations are lacking, we
  assume any differences involve cash.
• The increase in equipment is assumed to be a
  purchase of equipment for 10,000 cash. This
  purchase is reported as a cash outflow in the
  investing activities section.
• The increase of common stock is assumed to result
  from the issuance of common stock for 50,000
  cash. It is reported as an outflow of cash in
  the financing activities section of the statement
  of cash flows.

40
Step 3

• The reasons for the increase of 20,000 in the
  Retained Earnings account are determined by
  analysis.
• First, net income increased retained earnings by
  35,000.
• Second, the additional information indicates that
  a cash dividend of 15,000 was declared and paid.
  
• The 35,000 increase due to net income is
  reported in the operating activities section.
  The cash dividend paid is reported in the
  financing activities section.

41
Step 3

• The 20,000 increase in Retained Earnings in 2004
  is a net change.
• Having completed the three steps, we can prepare
  the statement of cash flows by the indirect
  method.
• The statement starts with the operating
  activities section, followed by the investing
  activities section, and then the financing
  section.

42
COMPUTER SERVICES COMPANY Statement of Cash
Flows--Indirect Method (Partial)For the Year
Ended December 31, 2004

• Cash flows from operating activities
• Net income 35,000
• Adjustments to reconcile net income to
• net cash provided by operating activities
• Increase in accounts receivable (30,000)
• Increase in accounts payable
  4,000 ( 26,000)
• Net cash provided by operating activities
  9,000
• Cash flows from investing activities
• Purchase of equipment (10,000)
• Cash flows from financing activities
• Issuance of Common Stock 50,000
• Payment of cash dividends (15,000)
• Net cash provided by financing activities
  35,000
• Net increase in cash 34,000

43
Step 3

• Computer Services Company's statement of cash
  flows for 2004 shows that operating activities
  provided 9,000 cash investing activities used
  10,000 cash and financing activities provided
  35,000 cash.
• The increase in cash of 34,000 reported in the
  statement of cash flows agrees with the increase
  of 34,000 shown as the change in the cash
  account in the comparative balance sheet.

44
Second Year Operations
Information related to the second year of
operations for Computer Services Company is as
follows COMPUTER SERVICES COMPANY Comparative
Balance Sheet December 31
45
Second Year Operations

• Information related to the second year of
  operations for Computer Services Company is as
  follows

46
Second Year Operations

• COMPUTER SERVICES COMPANY
• Income Statement
• For the Year Ended December 31, 2003
• Revenues 507,000
• Operating expenses 261,000
• Depreciation expenses 15,000
• Loss on sale of equipment 3,000 279,000
• Income from operations 228,000
• Income tax expense 89,000
• Net income 139,000

47
Second Year Operations

• Additional Information
• (a) In 2003 the company declared and paid a
  15,000 cash dividend.
• (b) The company obtained land through the
  issuance of 130,000 of long-term bonds.
• (c) An office building costing 160,000 was
  purchased for cash equipment costing 25,000 was
  also purchased for cash.
• (d) During 2003 the company sold equipment with a
  book value of 7,000 (cost 8,000 less
  accumulated depreciation 1,000) for 4,000 cash.

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Step 1

• Determine the net increase or decrease in cash.
• Cash increased 22,000 (56,000-34,000).

49
Step 2

• Determine net cash provided or used by operating
  activities under the indirect method by adjusting
  net income for items that did not affect cash.
• Net income on an accrual basis must be adjusted
  to arrive at net cash provided/used by operating
  activities.

50
Step 2

• Explanations for the adjustments to net income
  for computer CSC in 2003 are as follows
• Accounts Receivable--Accounts receivable
  decreases during the period because cash receipts
  are higher than revenues reported on an accrual
  basis.
• The decrease of 10,000 must be added to net
  income.

51
Step 2

• Prepaid Expenses--Prepaid expenses increase
  during a period because cash paid for expenses is
  greater than expenses reported on an accrual
  basis.
• Cash payments have been made in current period,
  but expenses (as charges to the income statement)
  have been deferred to future periods.

52
Step 2

• To convert net income to net cash provided by
  operating activities, the increase of 4,000 in
  prepaid expenses must be deducted from net
  income.
• If prepaid expenses decreased, net income would
  be increased by the amount of the decrease.

53
Step 2

• Accounts Payable--Like the increase in 2004, the
  2003 increase of 55,000 in accounts payable must
  be added to net income to convert to net cash
  provided by operating activities.

54
Step 2

• Depreciation expense--During 2003 Computer
  Services Company reported depreciation expense of
  15,000.
• An analysis of the accumulated depreciation
  accounts reveals that 11,000 related to the
  building and 4,000 related to the equipment.
• Depreciation and other charges that do not
  require the use of cash, such as amortization of
  intangible assets are added to net income.

55
Step 2

• Loss on Sale of Equipment--Computer Services
  Company reported a 3,000 loss on the sale of
  equipment (book value 7,000 less cash proceeds
  4,000).
• The loss reduced net income but did not reduce
  cash.
• Thus, the 3,000 loss is added to net income in
  determining net cash provided by operating
  activities.
• As a result of the previous adjustments, net cash
  provided by operating activities is 218,000
  illustrated as follows

56
Computer Services Company Statement of Cash
Flows (Partial)For the Year Ended December 31,
2003

• Cash flows from operating activities
• Net Income
  139,000
• Adjustments to reconcile net income
  to net cash
  provided by operating
  activities
• Depreciation expense
  15,000
• Loss on sale of equipment 3,000
• Decrease in accounts receivable 10,000
• Increase in prepaid expenses (4,000)
• Increase in accounts payable 55,000
  79,000
• Net cash provided by operating activities
  218,000

57
Class exercise

• Calloway company reported net income of 2.5
  million in 2003. Depreciation for the year was
  260,000, accounts receivable decreased by
  350,000 and accounts payable decreased by
  310,000. Compute Calloways cash flow from
  operating activities using the indirect method.

58
Calculating Depreciation

• Depreciation and amortization expense can usually
  be found on the statement of cash flows.
• However it is also possible to determine
  depreciation expense from the balance sheet
• Assume a company had Accumulated depreciation on
  equipment of 5,000 at the end of 2004 and
  6,000 at the end of 2005. Additionally, the
  company discarded old equipment originally
  costing 1,000 with a book value of 0 during
  2005.
• Compute depreciation expense for the year 2005

59
Calculating Depreciation

• The Accumulated depreciation account increases
  each year by the amount of depreciation expense
  charged.
• However the Accumulated depreciation account
  decreases when an asset is sold or discarded. The
  amount of this decrease is the accumulated
  depreciation relating to the disposed asset.
• For the example, the accumulated depreciation
  related to the discarded asset is equal to its
  purchase price since the assets book value is
  0.
• Recall book value is calculated
  Original cost accumulated
  depreciation, or 1,000 X
  0 in our example. (X 1,000)
• As a result the amount of depreciation expense
  the company recorded during the year is
  calculated
  Change in accumulated
  depreciation account accumulated depreciation
  on discarded asset or
  
  1,000 1,000 2,000

60
Calculation of amortization

• This same process can be used to calculate the
  amortization on intangibles.
• However, for intangibles there is no accumulated
  amortization account amortization is directly
  charged to the intangible account.
• Therefore, if the account is decreased and no
  additional information is given, the decrease is
  the amount of the amortization.
• If new intangibles are purchased or old ones sold
  these will also affect the intangible account and
  must be taken into consideration when determining
  the amount of amortization expense for the year.
• Lets return to our example

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Step 3

• Determining net cash provided/used by investing
  and financing activities
• After determining the net cash provided by
  operating activities, the remaining changes in
  balance sheet accounts must be analyzed in order
  to determine net cash provided/used by investing
  and financing activities.

62
Step 3

• Land--Land of 130,000 was purchased through the
  issuance of long-term bonds.
• Although the exchange of bonds payable for land
  has no effect on cash, it is a significant
  noncash investing and financing activity that
  must be disclosed.
• The issuance of the bonds payable would be
  recognized as a cash inflow in the financing
  section while the purchase of land would be
  recognized as a cash outflow.

63
Step 3

• Building--An office building was acquired using
  cash of 160,000.
• This transaction is a cash outflow reported in
  the investing activities section.

64
Step 3

• Equipment--The equipment account increased
  17,000.
• The additional information provided, reveals that
  this was a net increase resulting from two
  transactions
• a purchase of equipment for 25,000 and
• sale of equipment costing 8,000 for 4,000.
• The purchase of equipment should be shown as a
  25,000 outflow of cash and the sale of equipment
  should be shown as a cash inflow of 4,000.

65
Step 3

• Bonds Payable--The bonds payable account
  increased by 130,000. As indicated earlier the
  issuance of bonds for land is a noncash
  transaction reported in a separate schedule at
  the bottom of the statement of cash flows.

66
Step 3

• Retained Earnings--Retained Earnings increased by
  124,000.
• The increase is a net of
• (1) Net income of 139,000 that increased
  Retained Earnings and
• (2) dividends of 15,000 that decreased Retained
  earnings.
• Net income is converted to net cash provided by
  operations.
• Payment of the dividend is a cash outflow that is
  reported as a financing activity.
• Following is the completed statement for year 2

67
Computer Services Company Statement of Cash
Flows (Partial)For the Year Ended December 31,
2005

• Net cash provided by operating activities
  218,000
• Cash flows from investing activities
• Purchase of building (160,000)
• Purchase of equipment ( 25,000)
• Sale of equipment
  4,000
• Net cash used by investing act.
  (181,000)
• Cash flows from financing activities
• Payment of cash dividends 15,000
• Net Cash used by financing act.
  ( 15,000) Net Increase in cash
  22,000
• Cash at beginning of period
  34,000
• Cash at end of period 56,000
• Noncash investing and financing act.
• Issuance of bonds payable to buy land 130,000

68
Step 2Home Depot

• What method (indirect or direct) does the company
  use?
• The use of the indirect method requires adjusting
  the financial statement accounts from the accrual
  to the cash basis
• Although operations of the period
  led to revenues and expenses, not all
  of these revenues and expenses
  resulted in increases or decreases
  in cash.
• Lets do P 14-13 together