Wild FAP 19th Edition Chapter 16What explains the change in the cash balance?
PURPOSE OF THE STATEMENT
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The Statement of Cash flows helps users determine how a company obtains its cash and where it spends its cash. By providing this information, this statement helps explain the change in the cash balance from the beginning of the period to the end of the period.
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McGraw-Hill/Irwin
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Did the business borrow any funds or repay any loans?
Does the business have sufficient cash to pay its debts as they mature?
Did the business make any dividend payments?
IMPORTANCE OF CASH FLOWS
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While it is important for users to know how much cash a company has, it is also important to know how a company funded its operations. Did it have to borrow money or sell stock to help pay the operating expenses of the company? If so, users need to be aware of this so they can fully assess the cash flow position of the company. Cash flow information is also useful to determine if the business has sufficient cash to pay its debts or if the business paid dividends during the period.
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McGraw-Hill/Irwin
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Cash
Currency
Short-term, highly liquid investments.
Readily convertible into cash.
Sufficiently close to maturity so that market value is unaffected by interest rate changes.
MEASUREMENT OF CASH FLOWS
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Cash includes currency and cash equivalents. Cash equivalents are short-term, highly liquid investments that are easily converted into cash and that have very little risk of loss. An example of a cash equivalent would be a short-term Treasury Bill that is government issued, is very close to maturity, and has very little risk associated with it.
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McGraw-Hill/Irwin
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The Statement of Cash Flows includes the following three sections:
Operating Activities
Investing Activities
Financing Activities
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There are three basic sections on the Statement of Cash Flows:
Operating Activities
Investing Activities
Financing Activities
On the next few slides we will discuss each of these sections.
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Outflows
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The Operating Activities Section includes cash inflows and cash outflows that result from the operations of the business and some incidental business transactions. Operating cash inflows include cash received from customers in payment of goods sold. It also includes cash received as dividends and interest. Operating cash outflows include cash payments for salaries, supplies, inventory, taxes, and interest.
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McGraw-Hill/Irwin
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Outflows
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The Investing Activities Section includes cash inflows and cash outflows that result from the sale and purchase of fixed assets and investments. If a company purchases a piece of equipment, it would be classified as a cash outflow in the investing section. If a company has excess cash and invests it in the stock of another company, it would also be classified as a cash outflow in the investing section. If, in the future, this equity investment is sold, it would be classified as a cash inflow in the investing section.
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McGraw-Hill/Irwin
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Outflows
Issuing bonds and notes
Contributions by owners
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The Financing Activities Section includes cash inflows and cash outflows that result from transactions with the company’s creditors and stockholders. If a company borrows money from a bank, it would be classified as a cash inflow in the financing section. If, in the future, this debt is repaid, the amount of the principal payment would be classified as a cash outflow in the financing section. Remember that the interest payment is classified as a cash outflow in the operating section. If a company issues stock, it would be classified as a cash inflow in the financing section.
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McGraw-Hill/Irwin
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Retirement of debt by issuing equity securities.
Conversion of preferred stock to common stock.
Leasing of assets in a capital lease transaction.
C 3
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Some transactions involve investing activities and or financing activities but no cash. An example would be purchasing equipment and paying for it by issuing company stock. In this transaction, the purchase of equipment is an investing activity and the issuance of stock is a financing activity. But, not a single dollar of cash was exchanged in the transaction. As a result, this transaction would NOT appear on the Statement of Cash Flows. Because of their significance and the full disclosure principle, these noncash investing and financing transactions must be disclosed in the financial statements or the notes.
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McGraw-Hill/Irwin
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This is a summary of the components of a Statement of Cash Flows. You can see the operating, investing and financing sections that we just discussed are on the statement. There is also a cash reconciliation at the bottom of the statement that reconciles the change in cash with the beginning and ending cash balances. The ending cash balance on the Statement of Cash Flows should always equal the cash balance on the Balance Sheet.
Sheet1
[List of individual inflows and outflows]
Net cash provided (used) by operating activites
$ #####
[List of individual inflows and outflows]
Net cash provided (used) by investing activites
#####
[List of individual inflows and outflows]
Net cash provided (used) by financing activites
#####
$ #####
#####
$ #####
McGraw-Hill/Irwin
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McGraw-Hill/Irwin
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There are two acceptable methods to determine Cash Flows from Operating Activities:
Direct Method
Indirect Method
OF CASH FLOWS
While each method uses a different format to arrive at Net Cash Provided (Used) by Operating Activities, the end result is the same under each method.
C 4
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There are two acceptable formats for preparing the Cash Flows from Operating Activities:
1. The Direct Method.
2. The Indirect Method.
While each method uses a different format to arrive at Net Cash Provided (Used) by Operating Activities, the end result is the same under each method. In other words, they may use a different path to get to the end, but in the end, they both arrive at the same answer.
McGraw-Hill/Irwin
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McGraw-Hill/Irwin
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Let’s look at the Indirect Method for preparing the Cash Flows from Operating Activities section.
PREPARING THE STATEMENT
OF CASH FLOWS
Nearly all companies
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Now, let’s learn how to use the indirect method for preparing the Cash Flows from Operating Activities. The indirect method is used by almost all companies.
McGraw-Hill/Irwin
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McGraw-Hill/Irwin
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Compute the net increase or decrease in cash;
Compute and report net cash provided or used by operating activities;
Compute and report net cash provided or used by investing activities;
Compute and report net cash provided or used by financing activities;
Compute the net cash flow by combining net cash provided or used by operating, investing, and financing activities and then prove it by adding it to the beginning cash balance to show that it equals the ending cash balance.
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Compute the net increase or decrease in cash;
Compute and report net cash provided or used by operating activities;
Compute and report net cash provided or used by investing activities;
Compute and report net cash provided or used by financing activities;
Compute the net cash flow by combining net cash provided or used by operating, investing, and financing activities and then prove it by adding it to the beginning cash balance to show that it equals the ending cash balance.
We will follow these steps in the preparation of our example statement of cash flows.
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McGraw-Hill/Irwin
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+ Losses and - Gains
INDIRECT METHOD
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Net Income
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The indirect method starts with the accrual based net income and makes certain adjustments to arrive at Cash Flows from Operating Activities. Adjustments to the accrual based net income include adding back any noncash items that are included to arrive at net income, such as depreciation and amortization. Adding these back on the Statement of Cash Flows basically cancels out the fact that they were originally subtracted to arrive at net income. Since these items do not represent cash outlays, we would not want them included in the Statement of Cash Flows.
Other items on the income statement to consider are gains and losses. Gains and losses result from the sale of an asset. Gains are added on the income statement and losses are subtracted on the income statement to arrive at net income. Since the gain and loss do not represent an operating cash flow, we cancel out gains by subtracting them and cancel out losses by adding them to net income in the operating section. The actual cash flow from the sale of the asset will be properly reported, in most cases, in the investing section. We also have to make appropriate adjustments to reflect the change from accrual based revenues and expenses reported on the income statement to cash based revenues and expenses. This is accomplished by analyzing the changes in noncash current assets and current liabilities.
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McGraw-Hill/Irwin
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Use this table when adjusting Net Income to Operating Cash Flows.
INDIRECT METHOD
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This chart explains how to treat a change in a noncash current asset or current liability in the operating section of the statement of cash flows. Maybe a couple of examples will help you see how this table works. Let’s start with current assets. If Accounts Receivable, a current asset, decreased during the year, this decrease would be added to net income. A decrease in Accounts Receivable means that customer cash payments on account exceeded customer charges on account during the period. This excess of cash payments over charges is used to adjust the accrual based revenues reported on the income statement to report the total cash received from customers during the period. Similarly, if Accounts Receivable increased during the year, this increase would be subtracted from net income. An increase in Accounts Receivable means that customer charges on account exceeded customer cash payments on account during the period. This excess of charges over cash payments is used to adjust the accrual based revenues reported on the income statement to report the total cash received from customers during the period. Now, let’s look at how to treat changes in current liabilities. If Salaries Payable, a current liability, decreased during the year, this decrease would be subtracted from net income. A decrease in Salaries Payable means that the company paid off more in salaries than it charged to expense during the period. This excess of cash payments over charges is used to adjust the accrual based expense reported on the income statement to report the total cash paid for salaries during the period. Similarly, if Salaries Payable increased during the year, this increase would be added to net income. An increase in Salaries Payable means the company charged more to expense than it paid off during the period. This excess of charges over cash payments is used to adjust the accrual based expense reported on the income statement to report the total cash paid for salaries during the period.
Sheet:
INDIRECT METHOD EXAMPLE
East, Inc. reports $125,000 net income for the year ended December 31, 2009.
Accounts Receivable increased by $7,500 during the year and Accounts Payable increased by $10,000.
During 2009, East reported $12,500 of Depreciation Expense.
What is East, Inc.’s Operating Cash Flow using the indirect method for 2009?
P 2
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Now, let’s try an abbreviated example using East Incorporated. East Incorporated reported $125,000 in net income for the period. During the period, Accounts Receivable increased $7,500 and Accounts Payable increased $10,000. During the period, East Incorporated reported $12,500 in depreciation expense. What is East Incorporated’s cash flows from operating activities for the period?
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McGraw-Hill/Irwin
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Net income
McGraw-Hill/Irwin
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McGraw-Hill/Irwin
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Add noncash expenses such as depreciation, depletion, amortization, or bad debt expense.
INDIRECT METHOD EXAMPLE
Then, add back the noncash items such as depreciation expense.
McGraw-Hill/Irwin
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McGraw-Hill/Irwin
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Next, use the table and determine whether to add or subtract the change in noncash current assets and current liabilities. Since accounts receivable, a current asset, increased, the change needs to be subtracted from net income.
Sheet:
10,000
10,000
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Since accounts payable, a current liability, increased, the change needs to be added to net income.
Sheet:
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McGraw-Hill/Irwin
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If we used the Direct Method, we would get the same $140,000 for Cash Provided by Operating Activities.
INDIRECT METHOD EXAMPLE
10,000
10,000
$
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Now we can see that East Incorporated’s cash provided from operating activities is $140,000. If we used the direct method, we would see a different format but we would get the same amount ($140,000) for cash provided by operating activities.
McGraw-Hill/Irwin
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McGraw-Hill/Irwin
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Now let’s prepare a complete Statement of Cash Flows for B&G Company using the indirect method.
INDIRECT METHOD EXAMPLE
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Let’s get some additional practice using the indirect method by preparing a complete Statement of Cash Flows for B&G Company.
McGraw-Hill/Irwin
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McGraw-Hill/Irwin
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Here is a comparative balance sheet for B&G at December 31, 2010 and 2009. We have calculated the increase or decrease in each account to help in the preparation of the Statement of Cash Flows.
Sheet1
$ 597,000
$ 555,000
$ 42,000
(20,000)
(40,000)
(20,000)
$ 4,104,000
$ 3,650,000
Sales
$ 1,007,500.00
15,000
Bonds payable of $50,000 were redeemed for $50,000 cash.
Common stock was issued for $35,000 cash.
INDIRECT METHOD EXAMPLE
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Some additional information that we will need is that net income for the period is $105,000; $40,000 in cash dividends were paid during the period; $50,000 of bonds payable were paid with cash; and common stock was issued for $35,000. Now, we are ready to start the Statement of Cash Flows.
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McGraw-Hill/Irwin
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Then, analyze the changes in current assets and current liabilities.
P 2
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First, we start with the accrual-basis net income. Then, we adjust net income for noncash expenses, gains and losses. Last, we need to adjust net income for the changes in the noncash current assets and current liabilities.
Sheet1
360,000
325,000
35,000
(20,000)
(40,000)
(20,000)
$ 4,104,000
$ 3,650,000
Sales
$ 1,007,500.00
15,000
Statement of Cash Flows
$ 200,000
Book value
Supplemental Disclosure of Cash Flow Information:
Gain on sale
Taxes paid
80,000
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As you can see, depreciation expense is added back to net income. The changes in the noncash current assets and current liability accounts are then added or subtracted as appropriate. Remember that the direct method of preparing the cash flows from operating activities portion of the statement would yield the same result–$141,000. Only the format would differ.
Sheet1
360,000
325,000
35,000
(20,000)
(40,000)
(20,000)
$ 4,104,000
$ 3,650,000
Sales
$ 1,007,500.00
15,000
Statement of Cash Flows
$ 200,000
Book value
Supplemental Disclosure of Cash Flow Information:
Gain on sale
Taxes paid
141,000
80,000
P 2
Sheet1
360,000
325,000
35,000
(20,000)
(40,000)
(20,000)
$ 4,104,000
$ 3,650,000
Sales
$ 1,007,500.00
15,000
Statement of Cash Flows
$ 200,000
Book value
Supplemental Disclosure of Cash Flow Information:
Gain on sale
Taxes paid
141,000
80,000
P 3
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The investing section would be identical if prepared with the direct method. Last, we will complete the financing section.
Sheet1
360,000
325,000
35,000
(20,000)
(40,000)
(20,000)
$ 4,104,000
$ 3,650,000
Sales
$ 1,007,500.00
15,000
Statement of Cash Flows
$ 200,000
Book value
Supplemental Disclosure of Cash Flow Information:
Gain on sale
Taxes paid
141,000
80,000
25,000
(45,000)
Sheet3
McGraw-Hill/Irwin
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McGraw-Hill/Irwin
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Here is the completed Statement of Cash Flows. The financing section would be identical if prepared with the direct method.
Sheet1
360,000
325,000
35,000
(20,000)
(40,000)
(20,000)
$ 4,104,000
$ 3,650,000
Sales
$ 1,007,500.00
15,000
Statement of Cash Flows
$ 200,000
Book value
Supplemental Disclosure of Cash Flow Information:
Gain on sale
Taxes paid
141,000
80,000
25,000
(45,000)
Proceeds from issuance of common stock
35,000
(55,000)
$ 63,000
Sheet3
McGraw-Hill/Irwin
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McGraw-Hill/Irwin
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Let’s briefly compare the direct method with the indirect method for B&G. Remember that the only difference is in the operating activities section of the statement.
PREPARING THE STATEMENT
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Let’s briefly compare the direct method with the indirect method for B&G. Remember that the only difference is in the operating activities section of the statement.
McGraw-Hill/Irwin
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McGraw-Hill/Irwin
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ANALYZING THE CASH ACCOUNT
Let’s use this Cash account to prepare B&G Company’s Statement of Cash Flows using
the Direct Method.
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Let’s review this Cash Account and determine where each of the transactions will appear on B&G’s Statement of Cash Flows.
Receipts from customers will appear in the Operating Section.
Receipts from sale of land will appear in the Investing Section.
Receipts from stock issuance will appear in the Financing Section.
Payments for merchandise, wages, interest and taxes will appear in the
Operating Section.
Payments for equipment will appear in the Investing Section.
And finally, payments for bond retirement and dividends will appear in the
Financing Section.
Now, let’s look at a completed Statement of Cash Flows for B&G.
Sheet1
Cash
25,000
P 5
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Notice how the transactions are properly classified based on our analysis on the previous slide. The statement also includes the cash reconciliation at the end. The amounts for each of the three major sections of the statement are the same as we saw using the indirect method. Only the format of the operating activities section differs. Very, very few companies use the direct method. That is the reason we focused on the indirect method.
Sheet1
360,000
325,000
35,000
(20,000)
(40,000)
(20,000)
$ 4,104,000
$ 3,650,000
Sales
$ 1,007,500.00
15,000
Statement of Cash Flows
$ 200,000
Book value
Supplemental Disclosure of Cash Flow Information:
Gain on sale
141,000
80,000
25,000
(45,000)
Proceeds from issuance of common stock
35,000
(55,000)
[List of individual inflows and outflows]
Net cash provided (used) by operating activites$ #####
Cash flows from investing activities:
[List of individual inflows and outflows]
Net cash provided (used) by investing activites #####
Cash flows from financing activities:
[List of individual inflows and outflows]
Net cash provided (used) by financing activites #####
Net increase (decrease) in cash$ #####
Cash (and equivalents) balance at beginning of period#####
Cash (and equivalents) balance at end of period$ #####
Company Name
Increase
Decrease
Current
Retained earnings199,000 134,000 65,000
B&G Company
Comparative Balance Sheets
Net income105,000$
B&G Company
Cash flows from operating activities
Net income105,000$
Depreciation expense34,000$
B&G Company
Cash flows from operating activities
Net income105,000$
Depreciation expense34,000$
B&G Company
Cash flows from operating activities
Net income105,000$
Depreciation expense34,000$
Cash flows from investing activities
Proceeds from sale of land25,000
Purchase of equipment(70,000)
B&G Company
Cash flows from operating activities
Net income105,000$
Depreciation expense34,000$
Cash flows from investing activities
Proceeds from sale of land25,000
Purchase of equipment(70,000)
Cash flows from financing activities
Proceeds from issuance of common stock35,000
Redemption of bonds(50,000)
Payment of dividends(40,000)
Net increase in cash41,000
Cash, January 1, 201022,000
Cash, December 31, 201063,000$
Receipts from customers466,000 Payments for wages145,000
Receipts from sale of land25,000 Payments for interest10,000
Receipts from stock issuance35,000 Payments for taxes20,000
Payments for equipment70,000
Cash received from customers466,000$
Cash paid for merchandise(150,000)
Cash paid for wages(145,000)
Cash paid for interest(10,000)
Cash paid for taxes(20,000)
Cash flows from investing activities
Proceeds from sale of land25,000
Purchase of equipment(70,000)
Cash flows from financing activities
Proceeds from issuance of common stock35,000
Redemption of bonds(50,000)
Payment of dividends(40,000)
Net increase in cash41,000
Cash, January 1, 201022,000
Cash, December 31, 201063,000$