Financial Accounting: Tools for Business Decision Making

1. Financial Accounting:Tools for Business Decision Making Kimmel, Weygandt, Kieso ELS Prepared by: Ellen L. Sweatt Georgia Perimeter College

2. Statement of Cash Flows Chapter 13 `

3. Chapter 13Statement of Cash Flows After studying Chapter 13, you should be able to: • Indicate the primary purpose of the statement of cash flows. • Distinguish among operating, investing, and financing activities. • Explain the impact of the product life cycle on a company's cash flows. • Prepare a statement of cash flows using one of two approaches: • (a) the indirect method, or • (b) the direct method. • Use the statement of cash flows to evaluate a company.

4. 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: • operating, • investing, and • financing activities of a company during a period.

5. What was the change in the cash balance? Questions the Statement of Cash Flow Answers Where did the cash come from? What was the cash used for?

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

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

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

9. 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

10. 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

11. 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

12. 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.

13. Significant Noncash Activities... • That do not affect cash are NOT reported in the body of the statement of cash flows. • Are reported: • In a separate schedule at the bottom of the statement of cash flows or • In a separate note or supplementary schedule to the financial statements.

14. 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.

15. Format of the Statement of Cash Flows Four parts: • operating • investing • financing • noncash investing and financing activities

16. The Product Life Cycle • A series of phases all products go through • The phases are often referred to as the: • introductory phase, • growth phase, • maturity phase, • and decline phase. • The phase a company is in affects its cash flows.

17. Introductory Phase To support asset purchases the company may issue stock or debt. Expect cash from operations to be negative, cash from investing to be negative, and cash from financing to be positive.

18. Introductory Phase • Occurs when the company is purchasing fixed assets and beginning to produce and sell • Expect the company to be spending considerable amounts to purchase productive assets, but not to be generating much cash from operations.

19. Growth Phase • The company is striving to expand its production and sales. • Expect to see the company start to generate small amounts of cash from operations. • Cash from operations continues to be less than net income during this phase because inventory must be purchased for future projected sales.

20. Growth Phase • Because sales are projected to be increasing, the size of inventory purchases must increase. • However, less inventory will be expensed on an accrual basis than purchased on a cash basis in the growth phase. • Cash collections on accounts receivable will lag behind sales, and because sales are growing, accrual sales during a period will exceed cash collections during that period.

21. Growth Phase • Cash needed for asset acquisitions continues to exceed cash provided by operations, requiring that the company make up the deficiency by issuing new stock or debt. • The company continues to show negative cash from investing and positive cash from financing.

22. Maturity Phase • Sales and production level off • Cash from operations and net income are approximately the same. • Cash generated from operations exceeds investing needs. • The company can actually start to retire debt or buy back stock.

23. Decline Phase • Sales of the product fall due to a weakening consumer demand. • Cash from operations decreases. • Cash from investing might become positive as the firm sells off excess assets, and cash from financing may be negative as the company buys back stock and retires debt.

24. Page 582 in book Impact of Product Life Cycle on Cash Flows

25. Why Report the Causes of Changes in Cash? Because investors, creditors, and other interested parties want to now what is happening to a company’s most liquid asset, CASH

26. Statement of Cash Flows Helps Users Evaluate 1. The entity's ability to generate future cash flows 2. The entity's ability to pay dividends and meet obligations 3. The reasons for the difference between net income and net cash provided (used) by operating activities 4. The cash investing and financing transactions during the period

27. Statement of Cash Flows Helps Answer the Following Questions • How did cash increase when there was a net loss for the period? • How were the proceeds of the bond issue used? • How was the expansion in the plant and equipment financed? • Why were dividends not increased? • How was the retirement of debt accomplished? • How much money was borrowed during the year? • Is cash flow greater or less than net income?

28. Sources of Information for the Statement of Cash Flows • Comparative balance sheet • Current income statement • Additional information

29. 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.

30. Page 587 in book Comparative Balance Sheet The comparative balance sheet for the beginning and end of 1997, showing increases or decreases appears as follows: COMPUTER SERVICES COMPANY Comparative Balance Sheet December 31

31. Current Income Statement Information in this statement helps the reader determine the amount of cash provided or used by operations during the period.

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

33. Page 588 in book Income Statement and Additional Information COMPUTER SERVICES COMPANY Income Statement For the Year Ended December 31, 1997 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 1997. No depreciation was taken in 1997.

34. Page 585 in book Steps in Preparing Statement of Cash Flows

35. Page 587 in book Comparative Balance Sheet The comparative balance sheet for the beginning and end of 1997, showing increases or decreases appears as follows: COMPUTER SERVICES COMPANY Comparative Balance Sheet December 31

36. Page 585 in book Steps in Preparing Statement of Cash Flows

37. 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 • direct

38. 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 and financing activities sections are the same.

39. Indirect Method • The indirect method is used extensively in practice. • Most companies favor the indirect method for the following 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.

40. Direct Method • 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.

41. Statement Of Cash Flows - Indirect Method • The transactions of Computer Services Company for the years 1997 and 1998 are used to illustrate the preparation of a statement of cash flows . • Computer services Company started in January 1, 1997, 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.

42. Step 2 - Indirect Method • Determine net cash provided or used by operating activities 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.

43. Page 589 in book Net Income Versus Net Cash Provided by Operating Activities

44. Step 2 - Indirect Method • Receivables, payables, prepayments, and inventories must be analyzed for their effects on cash. • 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.

45. Step 2 - Indirect Method • 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. • 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.

46. Step 2 - Indirect Method • 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.

47. Step 2 - Indirect Method • 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. • Any other revenues or expenses reported in the income statement were received or paid in cash, and no adjustment of net income is necessary.

48. Step 2 - Indirect Method The operating activities section of the statement of cash flows would appear as follows: COMPUTER SERVICES COMPANY Partial Statement of Cash Flows--Indirect Method For the Year Ended December 31, 1997 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

49. Page 587 in book Comparative Balance Sheet The comparative balance sheet for the beginning and end of 1997, showing increases or decreases appears as follows: COMPUTER SERVICES COMPANY Comparative Balance Sheet December 31

50. Page 588 in book Income Statement and Additional Information COMPUTER SERVICES COMPANY Income Statement For the Year Ended December 31, 1997 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 1997. No depreciation was taken in 1997.