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. Involve Income Statement Items Operating Activities Include: • The cash effects of transactions that create revenues and expenses and • Enter into determination of net income.

11. Page 580 in Book 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. Involve Investments and Long-Term Asset Items Investing Activities Include: • Purchasing and disposing of investments and productive long-lived assets using cash and • Lending money and collecting the loans.

13. Page 580 in Book 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. Involve Long-Term Liability and Stockholders Equity Financing Activities Include: • Obtaining cash from issuing debt and repaying the amounts borrowed and • Obtaining cash from stockholders and paying them dividends.

15. Page 580 in Book 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

16. 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.

17. 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

24. 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.

25. 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.

28. 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.

31. 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.

48. 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.