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Outline Ch 16 Outline Ch 16 Document Transcript

  • Chapter 16 “How Well Am I Doing?”—Statement of Cash Flows Learning Objectives LO1. Know how to classify changes in balance sheet account balances as sources or uses of cash. LO2. Know the general rules for determining whether transactions should be classified as operating, investing, or financing activities. LO3. Prepare a statement of cash flows, using the indirect method to determine the net cash provided by operating activities. LO4. (Appendix 16A) Use the direct method to determine the net cash provided by operating activities. New in this Edition • Several new In Business boxes have been added. • The format of the statement of cash flows has been modified to make it easier to understand. Chapter Overview A. Purpose and Use of the Statement of Cash Flows. The purpose of the statement of cash flows is to highlight the major activities that directly and indirectly affect cash flows and hence affect the overall cash balance. Cash on the statement of cash flows is broadly defined to include both cash and cash equivalents. Cash equivalents consist of Treasury bills, commercial paper, and money market funds. B. Basic Approach. A cash flow statement of sorts could be constructed by simply summarizing all of the debits and credits to the cash accounts. However, such an approach would overlook all of the transactions that implicitly involve cash. For example, a company that purchases supplies on account implicitly borrows cash from the supplier. This implicit borrowing is not revealed if we just focus on the debits and credits to the cash account. 1. Focus on the balance sheet to explain cash flows. Implicit cash transactions can be uncovered by analyzing changes in balance sheet accounts. For example, an increase in accounts payable during a period indicates that the company increased its net borrowings from suppliers—an implicit source of cash. 2. The logical underpinnings of the balance sheet approach. The balance sheet approach to the construction of the cash flow statement involves examining changes to balance sheet accounts. The logic underlying this approach can be developed as follows: The balance sheet equation can be expressed as: Cash + Noncash Assets = Liabilities + Owners’ Equity 56
  • Since this equation is always true, it must be true of changes (denoted by ∆) in the accounts as well: ∆ Cash + ∆ Noncash Assets = ∆ Liabilities + ∆ Owners’ Equity Rearranging the equation slightly, we get: ∆ Cash = ∆ Owners’ Equity – ∆ Noncash Assets + ∆ Liabilities Ignoring a few technicalities, the change in Owner’s Equity during a period is equal to Net Income plus changes in Capital Stock, less Dividends. Thus, the above equation can be rewritten as: ∆ Cash = NI + ∆ Capital Stock – Dividends – ∆ Noncash Assets + ∆ Liabilities Each of the changes in the above equation can be broken down into increases (↑) and decreases (↓) as follows: ∆ Capital Stock = ↑ Capital Stock – ↓ Capital Stock ∆ Noncash Assets = ↑ Non-cash Assets – ↓ Noncash Assets ∆ Liabilities = ↑ Liabilities – ↓ Liabilities Thus: ∆ Cash = NI + (↑Capital Stock – ↓ Capital Stock) - Dividends - (↑ Noncash Assets – ↓ Noncash Assets) + (↑ Liabilities – ↓ Liabilities) Or, again rearranging things a bit: ∆ Cash = NI + (↓ Noncash Assets + ↑ Liabilities + ↑ Capital Stock) Sources - (↑ Noncash Assets + ↓ Liabilities + Dividends + ↓ Capital Stock) Uses Thus, the change in cash (i.e., net cash flow) can be found by starting with net income and then adding to it the other “sources” and subtracting the “uses.” This approach to constructing the statement of cash flows is followed explicitly in the indirect method and implicitly in the direct method. C. Organization of the Statement of Cash Flows. (Exercise 16-1.) The FASB requires that the statement of cash flows be divided into three sections: operating activities, investing activities, and financing activities. 1. Operating Activities. As a general rule, transactions that affect net income are classified as operating activities. Technically, the FASB defines operating activities as all the transactions that are not classified as investing or financing activities. Operating activities include: a. Net income. b. Changes in current assets. c. Changes in noncurrent assets that affect net income, such as depreciation and accrued interest earned. 57
  • d. Changes in current liabilities. (Exceptions: Debts to lenders who are not suppliers and dividends payable.) e. Changes in noncurrent liabilities that affect net income, such as interest accrued. 2. Investing Activities. As a general rule, transactions that involve acquiring or disposing of noncurrent assets are classified as investing activities. These transactions include acquiring or selling property, plant, and equipment and securities held for long-term investment. 3. Financing Activities. As a general rule, transactions (other than the payment of interest) that involve borrowing from creditors, and any transactions (except stock dividends and stock splits) involving the owners of the company, are classified as financing activities. D. Other Considerations in Preparing the Statement of Cash Flows. 1. Cash flows: gross or net. Whether gross amounts or net amounts are used on the statement of cash flows depends on the type of activity. For operating activities, transactions within an account may be netted against each other. For example, debits and credits to Accounts Receivables are netted against each other and only the net change is shown on the statement of cash flows. For investing and financing activities, gross amounts should be used. For example, if equipment is purchased and some is sold, the two amounts should be disclosed separately and not netted against each other. 2. Direct exchange transactions. Companies sometimes swap balance sheet items instead of settling in cash. For example, stock may be given in exchange for a building. Such direct exchange transactions are not reported on the statement of cash flows if they pertain to noncurrent accounts; instead, they are disclosed in a separate schedule. 3. Direct or indirect method. The net result of cash inflows and outflows arising from operating activities is referred to as the net cash provided by operating activities. This figure can be computed using either the direct method or the indirect method. a. Under the direct method, the income statement is reconstructed on a cash basis from top to bottom. b. Under the indirect method, the net cash provided by operating activities is computed by starting with net income (as reported on the income statement) and adjusting the net income figure to a cash basis. E. Net Cash Provided by Operating Activities—Indirect Method. (Exercises 16-2 and 16-4.) The indirect method begins with net income, which is then adjusted to a cash basis. The adjustments consist of adding or subtracting, as appropriate, changes in all of the noncash balance sheet accounts that affect net income. The major adjustments are explained below. 1. Depreciation, depletion, and amortization. Depreciation, depletion, and amortization charges are added back to net income under the indirect method. a. The usual explanation for this is that depreciation is an expense, but is not a cash flow. Therefore, to adjust net income to a cash basis, depreciation must be added back. Although this explanation is intuitively appealing, it is not correct. The real reason for adding back depreciation charges (i.e., credits) is that, according to the logic developed above, increases in contra-asset accounts have to be added back to net income to arrive at the net cash flow. (See Exhibit 16-2 in the text.) The total credits to accumulated depreciation should be added back to 58
  • net income even if 100% of the depreciation charges are capitalized in unsold inventories and depreciation expense is zero. b. The confusion about the reason for adding back depreciation illustrates that intuitive explanations for the adjustments on the statement of cash flows can sometimes lead us astray. The real reasons for making the adjustments are shown in Exhibits 16-2 and 16-3. To get from net income to net cash flow, we have to make adjustments for all of the changes in noncash balance sheet accounts. Accumulated depreciation is one of these accounts. Since it is a contra- asset account, increases in this account must be added back to net income. 2. Changes in current asset and current liability accounts. In general, increases in current assets and decreases in current liabilities are deducted from net income on the statement of cash flows. Decreases in current assets and increases in current liabilities are added to net income. 3. Gains and losses on sales of assets. Nothing causes more confusion among students than the treatment of gains and losses on the statement of cash flows. The complications arise because of the rule that the entire proceeds from the sale of an asset must appear in the investing activities section of the statement. The proceeds include the gain or loss, but so does net income. Therefore, to avoid double-counting, the gain or loss must be removed from net income. 4. Changes in the deferred income taxes account. Deferred Income Taxes is ordinarily a liability account. Increases in liability accounts are added to net income and decreases are deducted from net income when determining net cash flow. F. Preparing a Statement of Cash Flows. (Exercises 16-5 and 16-7.) Perhaps the easiest way to prepare a statement of cash flows is to follow the eight steps listed below: 1. Enter each balance sheet account on a worksheet, except for cash and cash equivalents. To avoid confusion, contra-asset accounts should be listed with the liabilities. 2. Compute the change in each balance sheet account. Break the change in retained earnings down into net income and dividends. 3. Using Exhibit 16-2 as a guide, code each entry as a source or use. 4. Write the sources as positive numbers and the uses as negative numbers. 5. Make necessary adjustments (for example, in gains and losses) to reflect gross, rather than net, changes in noncurrent accounts due to financing and investing activities. 6. Categorize each entry on the worksheet as an operating, investing, or financing activity. 7. Copy the data from the worksheet to the statement of cash flows section by section. 8. Prepare a reconciliation of the cash account. G. (Appendix 16A) Net Cash Provided by Operating Activities—The Direct Method. (Exercises 16-3, 16-6, and 16-8.) Under the direct method, the income statement is reconstructed on a cash basis from top to bottom. The general model used to determine the net cash provided by operating activities under the direct method is presented as part of Exhibit 16A-1. 59
  • 1. Similarities and differences in the handling of data. Under the direct method, adjustments are made directly to the revenues and expenses. Under the indirect method, adjustments are made to net income. The adjustments to arrive at the net cash provided by operations are the same for both the direct and indirect methods. However, the format differs between the two methods. a. Adjustments for accounts that affect revenue are the same in the two models. b. The adjustments for accounts that affect expenses are handled in opposite ways in the two models. While seemingly inconsistent, the effect on the cash flow is identical. Adding a number to net income has the same effect as deducting it from expenses. 2. Special rules. When using the direct method, companies provide the following breakdowns of cash received and cash paid out: a. Cash receipts: a) Cash collected from customers; b) Interest and dividends received; and c) Other operating cash receipts, if any. b. Cash payments: a) Cash paid to employees and to suppliers of goods and services; b) Interest paid; c) Income taxes paid; d) Other operating cash payments. 60
  • Assignment Materials Level of Suggested Assignment Topic Difficulty Time Exercise 16-1 Classification of transactions......................................................... Basic 15 min. Exercise 16-2 Net cash provided by operating activities (indirect method).......... Basic 15 min. Exercise 16-3 (Appendix 16A) Net cash provided by operating activities (direct method)..................................................................................... Basic 15 min. Exercise 16-4 Net cash provided by operating activities (indirect method).......... Basic 10 min. Exercise 16-5 Prepare a statement of cash flows (indirect method)...................... Basic 30 min. Exercise 16-6 (Appendix 16A) Adjust net income to a cash basis (direct method)..................................................................................... Basic 15 min. Exercise 16-7 Prepare a statement of cash flows (indirect method)...................... Basic 30 min. Exercise 16-8 (Appendix 16A) Net cash provided by operating activities (direct method)..................................................................................... Basic 15 min. Problem 16-9 Classification of transactions on a statement of cash flows............ Basic 20 min. Problem 16-10 Prepare a statement of cash flows (indirect method)...................... Basic 45 min. Problem 16-11 (Appendix 16A) Prepare and interpret a statement of cash flows (direct method).......................................................................... Basic 45 min. Problem 16-12 Prepare a statement of cash flows (indirect method)...................... Basic 30 min. Problem 16-13 (Appendix 16A) Prepare a statement of cash flows (direct method)..................................................................................... Basic 30 min. Problem 16-14 Prepare and interpret a statement of cash flows (indirect method). Medium 45 min. Problem 16-15 (Appendix 16A) Prepare and interpret a statement of cash flows (direct method).......................................................................... Medium 45 min. Problem 16-16 Missing data; statement of cash flows (indirect method)............... Difficult 60 min. Problem 16-17 Worksheet; prepare and interpret a statement of cash flows (indirect method)....................................................................... Difficult 75 min. Problem 16-18 (Appendix 16A) Adjusting net income to a cash basis (direct method)..................................................................................... Difficult 30 min. Problem 16-19 Missing data; statement of cash flows (indirect method)............... Difficult 45 min. Essential Problems: Problem 16-9, Problem 16-10 or Problem 16-12. Supplementary Problems: Problem 16-14, Problem 16-16 or Problem 16-19, Problem 16-17. Appendix 16A Essential Problems: Problem 16-11 or Problem 16-13. Appendix 16A Supplementary Problems: Problem 16-15, Problem 16-18. 61
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  • Chapter 16 Lecture Notes Helpful Hint: Before beginning the lecture, show students the 19th segment from the third tape of the McGraw-Hill/Irwin Managerial/Cost Accounting video library. This segment introduces students to many of the concepts discussed in chapter 16. The lecture notes reinforce the concepts introduced in the video. Chapter theme: This chapter explains how to classify transactions as operating, investing, or financing activities, and it explains how to create a statement of 1 cash flows. The indirect method of determining the net cash provided by operating activities is illustrated within the chapter and the direct method is demonstrated in the appendix. I. Purposes of the statement of cash flows A. The statement of cash flows can be used to answer crucial questions such as: i. Are cash flows sufficient to support ongoing operations? ii. Will the company be able to repay its debts? 2 iii. Will the company be able to pay its usual dividend? iv. Why do net income and net cash flow differ? v. To what extent will the company have to borrow money to make needed investments? 63
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  • “In Business Insights” All companies need to closely watch their cash flows. For example: “Focus on Cash” (page 749) • George Pilla is a finance consultant who works with new businesses like AP Engines, a company that provides billing software for Internet Protocol phone and cable service. • He has found that the burn rate (the rate at which cash is consumed by a company) is critical. “Running out of cash is the worst thing,” says Pilla, “and we are usually working three to six months ahead, trying to figure out when we’re going to run out of cash and how we’re going to fund the company.” II. The basic approach to a statement of cash flows A. Definition of cash i. In a statement of cash flows, cash is broadly defined to include both cash and cash equivalents. 1. Cash equivalents consist of short-term, 3 highly liquid investments such as Treasury Bills, commercial paper, and money market funds. a. These short-term liquid assets are usually included in marketable securities on the balance sheet. 65
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  • B. Constructing the statement of cash flows using changes in noncash balance sheet accounts ii. The net cash flow for a period is a function of the following: 4 1. Net income 2. Changes in noncash assets 3. Changes in liabilities 4. Changes in capital stock accounts 5. Dividends paid to stockholders iii. Changes in the accounts mentioned on the previous slide can be classified as either sources or uses of cash as shown on this slide. Notice: 1. Net income is always a source of cash. 2. Net loss is always a use of cash. 3. Decreases (increases) in noncash asset 5 accounts are always sources (uses) of cash. 4. Increases (decreases) in liability accounts are always sources (uses) of cash. a. Contra-assets follow the rules for liabilities 5. Increases (decreases) in capital stock accounts are always sources (uses) of cash. 6. Dividends paid to stockholders are always uses of cash. iv. Examples of sources and uses of cash 6 1. Increases in noncash asset accounts imply uses of cash. For example: 67
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  • a. If inventory is purchased on credit 6 from a supplier, it is implied that cash was used to acquire the inventory. 2. Increases in liability accounts imply sources of cash. For example: a. If inventory is purchased on credit 7 from a supplier, it is implied that an increase in a payable has the effect of increasing cash available for other uses. 3. Decreases in noncash asset accounts imply sources of cash. For example: a. If accounts receivable decreases when 8 a customer pays their bill, the company’s cash balance increases accordingly. 4. Decreases in liability accounts imply uses of cash. For example: 9 a. If a company makes a payment on a note payable, the company’s cash balance decreases accordingly. “In Business Insights” Cash flow measures can be manipulated by management. For example: “What’s Up at Amazon?” (page 752) • Robert Tracy, a CPA and an analyst on the staff of grantsinvestor.com, took a close look at Amazon’s financial statements and found that the company was holding its bills longer than it used to, especially at year-end. • The cash flow from this increase in accounts payable exceeded the cash flow from all other operating sources combined. 69
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  • • Whether this represents astute cash management or misleading financial engineering is debatable. What is not debatable is that, by stretching out payments into the new year, Amazon has presented a more liquid face to the world than it could otherwise have done. I. An example of a simplified statement of cash flows C. Ed’s Pizza Hut: constructing a simplified statement of cash flows v. Assume that comparative balance sheet account balances for Ed’s Pizza Hut were as shown. Notice: 10 1. The change in the cash balance is a decrease of $19,000. 11 vi. Assume the additional information as shown. vii. A summary of the sources of cash is as shown. Notice: 12 1. The total sources of cash is $66,000. viii. A summary of the uses of cash and the net cash flow is as shown. Notice: 13 1. The total uses of cash is $85,000. 2. The net cash flow is ($19,000). Notice: a. This amount agrees with the change in cash shown earlier when we looked at 71
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  • comparative balance sheet account 13 balances. ix. This simplified approach does not follow the 14 format required for external reporting purposes. It is for illustrative purposes only. “In Business Insights” The time lag between cash payments for raw material and cash receipts from sales can create cash flow problems. For example: “Plugging the Cash Flow Leak” (page 756) • John Fernsell owns Ibex Outdoor Clothing, a designer of high-grade wool outerwear located in Woodstock, Vermont. • Ibex orders wool from Europe in February but does not pay the mills until June when they ship fabric to the garment makers in California. • The garment factories send finished goods to Ibex in July and August and Ibex pays for them on receipt. Ibex ships to retailers in September and October, but does not get paid until November- January. In other words, from June to December Ibex spends large sums of money without taking in anything in return. • To reduce his cash flow problem, Fernsell is introducing a line of wool summer clothing so that some cash will be flowing in from May through July, when he must pay his suppliers for the winter clothing. 73
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  • I. Organization of the full-fledged statement of cash flows D. The three sections of the statement of cash flows x. Operating activities are those activities that enter into the determination of net income. Generally speaking, this includes: 1. All transactions affecting current assets. 15 2. All transactions affecting current liabilities (except for issuing and repaying a note payable). 3. All changes in noncurrent balance sheet accounts that directly affect net income such as the Accumulated Depreciation and Amortization account. Helpful Hint: Tell students that a rule of thumb for the sections of the statement of cash flows is that changes in current assets and liabilities are reported in the operating section, changes in long-term assets are reported in the investing section, and changes in long- term liabilities and stockholder’s equity are reported in the financing section. xi. Investing activities relate to transactions involving the acquiring or disposing of noncurrent assets. These transactions include: 16 1. Acquiring or selling property, plant and equipment. 2. Acquiring or selling securities (such as bonds and stocks of other companies) held for long-term investment. 75
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  • 3. Lending money to another entity and 16 subsequently collecting on the loan. xii. Financing activities relate to transactions involving borrowing from creditors or repaying creditors and engaging in transactions with the company’s owners. 17 1. Transactions with creditors that affect net income, such as interest on debt, are classified as operating activities. Helpful Hint: The proper classification of stock and bond transactions sometimes causes confusion. Emphasize that dividends received and interest earned are classified as part of operating activities instead of investing activities. The primary reason is that dividends received and interest earned are included in net income. Transactions involving the purchase and sale of stocks and bonds, however, are classified as investing activities. Helpful Hint: The proper classification of debt transactions also sometimes causes confusion. Emphasize that interest paid to debtors is classified as part of operating activities instead of financing activities. Again, the primary reason is that interest paid on debt is included in net income. Transactions involving taking out and retiring loans, however, are classified as financing activities. 77
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  • E. The format of the statement of cash flows (indirect method) xiii. General overview 18 1. Cash flows are divided into three categories – operating, investing, and financing activities. 2. The beginning cash balance is reconciled 19 with the ending cash balance. xiv. Operating activities 1. The general format for this section of the 20 statement is as shown. It includes those activities that enter into the determination of net income. “In Business Insights” The quality of a company’s earnings can be put to the test by comparing earnings to cash flows. More specifically: “Keep an Eye on the Cash Flow” (page 757) • David Zion, a Bear Sterns accounting analyst, advocates comparing net income on the income statement to cash flow from operating activities. He contends the closer a ratio of these two numbers is to one, the higher the quality of earnings. • Howard Schilit, who heads the Center for Financial Research & Analysis, advocates comparing the rates at which net income and operating cash are growing. If the two move in 79
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  • lockstep but cash flow lags, “it’s a terrific early warning sign.” • Negative cash flow from operations can be normal and indeed desirable for newly formed, fast growing companies. However, cash flows eventually need to pick up or investors begin to lose patience with companies that hemorrhage cash. 2. As a reminder, as shown in this table, sources of cash are added to net income and 21 uses of cash are deducted from net income. More specifically: a. Decreases in current noncash assets would be added to net income. 22 b. Increases in current liabilities would be added to net income. c. Increases in current noncash assets would be subtracted from net income. 23 d. Decreases in current liabilities would be subtracted from net income. e. Depreciation charges are treated the 24 same as current liabilities, thus they are added to net income. f. Gains are subtracted from net income 25 and losses are added to net income. Helpful Hint: Ask students why the cash provided by operating activities is important. The answer is that this figure provides a signal concerning the ability of operations to generate a positive cash flow. A company whose operations chronically generate negative cash flows is in trouble. 81
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  • xv. Investing activities 1. The general format for this section of the 26 statement is as shown. It includes those transactions that involve the acquisition or disposal of noncurrent assets. xvi. Financing activities 1. The general format for this section of the 27 statement is as shown. It includes those transactions that involve the receipts from or payments to creditors and owners. I. Other issues in preparing the statement of cash flows F. Cash flows: gross or net? xvii. For both financing and investing activities, items on the statement of cash flows should be presented in gross amounts rather than in net amounts. For example: 1. If Macy’s Department Stores purchases $50 million in property during the year and sells other property for $30 million, instead of 28 showing the net change of $20 million, the company must report the gross amounts of both transactions. xviii. The gross method of reporting does not extend to operating activities, where debits and credits to an account are netted against each other. 83
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  • G. Operating activities: direct or indirect method? xix. The net cash provided by operating activities can be computed by either the direct or indirect method. 1. The direct method reconstructs the income statement on a cash basis from top to bottom. For example: a. Cash collected from customers is used instead of revenue, and payments to suppliers is used instead of cost of sales. 2. The indirect method (also known as the reconciliation method) constructs the operating activities section of the statement of cash flows by starting with net income 29 and adjusting it to a cash basis. a. Items that do not affect cash flows are removed from net income thereby showing the reasons why net income differs from net cash provided by operating activities. xx. The FASB encourages the use of the direct method. However, if the direct method is used it must be accompanied by a supplementary reconciliation of net income with operating cash flows. In other words, the indirect method must also be shown. 1. If a company decides to use the indirect method for determining net cash flows from operating activities, there is no 85
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  • requirement that it also report the results using the direct method. 29 a. Not surprisingly, only about 1% of companies use the direct method to construct the statement of cash flows for external reports. H. Direct exchange transactions xxi. Direct exchange transactions occur when noncurrent balance sheet items are swapped. For example, a company might issue common stock in exchange for property. 30 1. These types of transactions are not reported on the statement of cash flows. However, such direct exchanges are disclosed in a separate schedule that accompanies the statement. I. An example of a full-fledged statement of cash flows (indirect method) I. Ed’s Pizza Hut revisited ii. Underlying assumptions 31 A. Let’s revisit the comparative balance sheet account balances for Ed’s Pizza Hut as shown. 2. Let’s also refresh our memory regarding the 32 following additional information as shown. 87
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  • xxii. Eight steps to preparing the statement of cash flows 1. The first step is to copy on to a worksheet 33 the title of each account appearing on the comparative balance sheets except for cash and cash equivalents and retained earnings. a. Contra asset accounts should be listed with the liabilities 2. The second step is to compute the change from the beginning balance to the ending 34 balance in each balance sheet account. Breakdown the change in retained earnings into net income and dividends. 3. The third step is to code each entry on the worksheet as a source or use of cash. a. The noncash assets are coded as shown. 35 b. The liabilities and depreciation are coded as shown. c. The capital stock account is coded as shown. d. The net income/loss and dividends are coded as shown. 4. The fourth step is to code sources of cash 36 as positive numbers and uses of cash as negative numbers as shown. 5. The fifth step is to make any necessary adjustments – including adjustments for gains and losses. 37 a. The net effect of these adjustments should equal zero. 6. The sixth step is to classify each entry on the worksheet as an operating, investing, 38 or financing activity as shown. 89
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  • 7. The seventh step is to copy the data from the worksheet into the statement of cash flows section by section. a. The net cash flow from operations would appear as shown. • The depreciation is added 39 back to net income to cancel out the reduction in net income caused by including this noncash expense in the income statement. b. The complete statement of cash flows would appear as shown. 8. The eighth step is to prepare a cash 40 reconciliation at the bottom of the statement as shown. 9. As a supplement to this statement, Ed’s Pizza Hut would also disclose the issuance of $50,000 of stock to a creditor as a 41 noncash financing activity. a. This amount was adjusted out of the worksheet in step 5. xxiii. Interpretation of the statement of cash flows 1. Ed’s Pizza Hut generated a net cash flow 42 from operations of ($48,000). This suggests that the company may not be generating sufficient cash flows on a continuing basis to sustain the business without liquidating assets or borrowing money. 91
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  • “In Business Insights” While people commonly assume that net earnings can be manipulated by management, operating cash flows can also be manipulated. For example: “Evaporating Cash Flow” (page 765) • After an investigation by the Securities and Exchange Commission, Dynergy Inc. moved $300 million tied to a complex natural-gas trading arrangement from the operating cash flow section of it already-published statement of cash flows to the financing section. This reduced the company’s reported operating cash flow for the year by 37%. • Enron’s cash flow from operations was overstated by almost 50% prior to revelations concerning its fraudulent accounting practices. “What’s Wrong with This Picture?” (page 767) • Getty Images owns the rights to over 70 million images and 30,000 hours of film. The company gets its revenues from licensing the use of these images. • Getty Images declared victory in its cash from operations, which it said had swelled to a robust $17.1 million in the second quarter, up from a deficit of $2.6 million in the first. • Does this mean that Getty collected its bills and whittled down its inventory? No! Both receivables and inventory were rising. The cash flow from operations came from not paying its bills. 93
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  • I. Appendix 16A: The direct method of determining the net cash provided by operating activities (Slide #43 is a title slide for the appendix) B. Computing net cash provided by operating activities xxiv. The direct method computes net cash provided by operating activities by reconstructing the income statement on a cash basis from top to bottom. 44 1. The amount of net cash provided by operating activities under the direct method will always agree with the amount computed using the indirect method. C. Similarities and differences in the handling of data xxv. The adjustments for accounts that affect revenue are the same in the direct and indirect methods. 1. In either case, increases in the accounts are deducted and decreases in the accounts are added. 45 xxvi. The adjustments for accounts that affect expenses are handled in opposite ways for the direct and indirect methods. Under the indirect method, the adjustments are made to net income, whereas under the direct method the adjustments are made to the expense accounts themselves. For example: 95
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  • 1. In the indirect method, an increase in prepaid expenses is deducted from net 45 income. However, in the direct method an increase in prepaid expenses is added to operating expenses. xxvii. Regarding gains and losses on sale of assets, no adjustments are needed at all under the direct method. 46 1. These gains and losses are ignored since they are not part of sales, cost of goods sold, operating expenses, or income taxes. Helpful Hint: Emphasize that the differences between the direct and indirect methods are mostly cosmetic. The adjustments to arrive at the net cash provided by operations are the same for both methods. Depreciation charges are added back, and adjustments are made for changes in current assets and liabilities. However, the format differs between the two methods, and students must be careful whether they add or subtract a particular adjustment. D. Ed’s Pizza Hut – an example xxviii.Key assumptions 47 1. Let’s revisit the comparative balance sheet account balances for Ed’s Pizza Hut as shown. 2. Let’s also assume that Ed’s Pizza Hut 48 prepared the income statement as shown. 97
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  • xxix. Computing net cash provided by operating activities 1. The first step is to translate sales revenue 49 ($1,000,000) into cash collections from customers ($1,017,000). 2. The second step is to translate cost of goods 50 sold ($750,000) into cash disbursements for purchases ($789,000). 3. The third step is to translate operating expenses ($277,000) into cash paid for operating expenses ($276,000). 51 a. There is no adjustment for income taxes because Ed’s Pizza Hut has a net loss of $27,000. 4. The net cash provided by operating activities is ($48,000). Notice: 52 a. This agrees with the net cash provided by operating activities that was computed using the indirect method. 99
  • Chapter 16 Transparency Masters 100
  • TM 16-1 AGENDA: STATEMENT OF CASH FLOWS 1. Purpose of the statement; definition of cash. 2. Basis of the statement of cash flows: analysis of balance sheet accounts. 3. Sources and uses of funds. 4. Organization of the statement of cash flows. 5. Cash provided by operations—the direct and indirect methods. 6. Steps in preparing a statement of cash flows. 7. Example of statement of cash flows. © The McGraw-Hill Companies, Inc., 2006. All rights reserved.
  • TM 16-2 THE STATEMENT OF CASH FLOWS PURPOSE The statement of cash flows shows the major uses and sources of cash during a period. It is used to understand what has happened to cash. DEFINITION OF CASH In the cash flow statement, cash is broadly defined to include cash and cash equivalents. Cash equivalents consist of short-term, highly liquid investments such as Treasury bills, commercial paper, and money market funds. ANALYSIS OF CASH FLOWS The cash flow statement is constructed by analyzing changes in balance sheet accounts. © The McGraw-Hill Companies, Inc., 2006. All rights reserved.
  • TM 16-3 ANALYSIS OF BALANCE SHEET ACCOUNTS (Exhibit 16-1) © The McGraw-Hill Companies, Inc., 2006. All rights reserved.
  • TM 16-4 SOURCES AND USES OF CASH (Exhibit 16-2) © The McGraw-Hill Companies, Inc., 2006. All rights reserved.
  • TM 16-5 ORGANIZATION OF STATEMENT OF CASH FLOWS The statement of cash flows contains three sections: 1. Operating activities. 2. Investing activities. 3. Financing activities. Each source and use of cash is classified as one of the above activities. OPERATING ACTIVITIES Transactions that enter into the determination of net income are generally classified as operating activities. INVESTING ACTIVITIES Transactions relating to acquiring or disposing of non-current assets are generally classified as investing activities. FINANCING ACTIVITIES Transactions involving creditors or owners of the company are generally classified as financing activities. (Exception: Interest is classified as an operating activity.) © The McGraw-Hill Companies, Inc., 2006. All rights reserved.
  • TM 16-6 CASH PROVIDED BY OPERATIONS The net cash provided by operating activities can be computed using either the direct method or the indirect method. DIRECT METHOD Under the direct method, the income statement is reconstructed on a cash basis from top to bottom. Operating cash outflows are subtracted from operating cash inflows to arrive at net cash flow from operating activities. INDIRECT METHOD Under the indirect method, the cash provided by operations is computed by starting with net income and adjusting the net income figure to a cash basis. In practice, the indirect method is used far more frequently than the direct method on external financial reports. © The McGraw-Hill Companies, Inc., 2006. All rights reserved.
  • TM 16-7 PREPARING A STATEMENT OF CASH FLOWS Preparing a statement of cash flows involves eight basic steps: 1. Copy the title of each balance sheet account onto a worksheet, except for cash and cash equivalents. Contra-asset accounts should be listed with the liabilities. 2. Compute the change in each balance sheet account. Break the change in retained earnings down into net income and dividends. 3. Classify each change as either a source or a use. 4. Write the sources as positive numbers and the uses as negative numbers. 5. Make necessary adjustments (for example, in gains and losses) to reflect gross, rather than net, changes in noncurrent accounts due to financing and investing activities. 6. Categorize each entry on the worksheet as an operating, investing, or financing activity. 7. Copy the data from the worksheet to the statement of cash flows. 8. Prepare a reconciliation of the cash account. © The McGraw-Hill Companies, Inc., 2006. All rights reserved.
  • TM 16-8 EXAMPLE OF STATEMENT OF CASH FLOWS Aspen Company Comparative Balance Sheets (in millions of dollars) Assets Year 2 Year 1 Cash................................................... $ 13 $ 6 Accounts receivable............................. 8 9 Inventory............................................ 21 15 Plant and equipment (Note 1 )............. 200 189 Less accumulated depreciation............. (98) (95) Investments........................................ 20 6 Total assets......................................... $164 $130 Liabilities & Stockholders’ Equity Accounts payable................................. $ 16 $ 10 Accrued liabilities................................. 1 3 Taxes payable..................................... 4 1 Bonds payable..................................... 36 20 Stockholders’ equity: Common stock.................................. 43 42 Retained earnings............................. 64 54 Total liabilities and equity..................... $164 $130 © The McGraw-Hill Companies, Inc., 2006. All rights reserved.
  • TM 16-9 EXAMPLE OF STATEMENT OF CASH FLOWS (cont’d) Aspen Company Income Statement, Year 2 (in millions of dollars) Sales........................................... $300 Less cost of goods sold................ 100 Gross margin............................... 200 Less operating expenses............... 175 Net operating income................... 25 Nonoperating items: Gain on sale of equipment......... 4 Income before taxes.................... 29 Less income taxes........................ 10 Net income.................................. $ 19 Note: The gain on sale of equipment consisted of the sale of equipment that had cost $7 million new for $6 million in cash. The equipment had accumulated depreciation of $5 million. Aspen Company Statement of Retained Earnings, Year 2 (in millions of dollars) Retained earnings, beginning........ $54 Add net income........................... 19 Total........................................... 73 Less dividends............................. 9 Retained earnings, ending............ $64 © The McGraw-Hill Companies, Inc., 2006. All rights reserved.
  • TM 16-10 STEPS #1 & #2 Noncash Assets Year 2 Year 1 Change Accounts receivable.................................... $8 $9 -1 Inventory.................................................. $21 $15 +6 Plant and equipment.................................. $200 $189 +11 Investments............................................... $20 $6 +14 Contra-assets, Liabilities, & Stockholders’ Equity Accumulated depreciation........................... $98 $95 +3 Accounts payable....................................... $16 $10 +6 Accrued liabilities....................................... $1 $3 -2 Taxes payable............................................ $4 $1 +3 Bonds payable........................................... $36 $20 +16 Common stock........................................... $43 $42 +1 Net income*.............................................. +19 Dividends*................................................. -9 *The change in retained earnings of $10 million is broken down into net income of $19 million and dividends of $9 million. © The McGraw-Hill Companies, Inc., 2006. All rights reserved.
  • TM 16-11 STEPS #3 & #4 Effect on Chang Cash Assets e Flows Accounts receivable............................. -1 Source +1 Inventory............................................ +6 Use -6 Plant and equipment............................ +11 Use -11 Investments........................................ +14 Use -14 Contra-assets, Liabilities, & Stockholders’ Equity Accumulated depreciation.................... +3 Source +3 Accounts payable................................. +6 Source +6 Accrued liabilities................................. -2 Use -2 Taxes payable..................................... +3 Source +3 Bonds payable..................................... +16 Source +16 Common stock.................................... +1 Source +1 Net income.......................................... +19 Source +19 Dividends............................................ -9 Use -9 Total (net cash flow)............................ +7 Note: The total effect on cash flows of +$7 million computed above exactly matches the change in the cash account for the period. Computed either way, this is the period’s net cash flow. © The McGraw-Hill Companies, Inc., 2006. All rights reserved.
  • TM 16-12 STEP #5 The gain on the sale of equipment was recorded as follows: Cash proceeds from sale of plant & equipment..... 6 Accumulated depreciation.................................... 5 Plant & equipment..................................... 7 Gain on sale of plant & equipment............. 4 To restate the changes in the noncurrent accounts to their gross amounts on the statement of cash flows, the following adjustments are necessary: Effect on Adjust- Adjusted Assets Cash Flows ments Effect Accounts receivable....................... +1 +1 Inventory..................................... -6 -6 Plant and equipment..................... -11 -7 -18 Investments................................. -14 -14 Contra-assets, Liabilities, & Stockholders’ Equity Accumulated depreciation.............. +3 +5 +8 Accounts payable.......................... +6 +6 Accrued liabilities.......................... -2 -2 Taxes payable............................... +3 +3 Bonds payable.............................. +16 +16 Common stock.............................. +1 +1 Net income................................... +19 +19 Dividends..................................... -9 -9 Additional entries Proceeds from sale of equipment... +6 +6 Gain on sale of equipment............. -4 -4 Total (net cash flow)..................... +7 0 +7 © The McGraw-Hill Companies, Inc., 2006. All rights reserved.
  • TM 16-13 STEP #6 Adjusted Classi- Assets Effect fication Cash............................................................... Accounts receivable......................................... +1 Operating Inventory........................................................ -6 Operating Plant and equipment....................................... -18 Investing Investments.................................................... -14 Investing Contra-assets, Liabilities, & Stockholders’ Equity Accumulated depreciation................................ +8 Operating Accounts payable............................................ +6 Operating Accrued liabilities............................................. -2 Operating Taxes payable................................................. +3 Operating Bonds payable................................................. +16 Financing Common stock................................................ +1 Financing Net income..................................................... +19 Operating Dividends........................................................ -9 Financing Additional entries Proceeds from sale of equipment..................... +6 Investing Gain on sale of equipment............................... -4 Operating Total (net cash flow)....................................... +7 © The McGraw-Hill Companies, Inc., 2006. All rights reserved.
  • TM 16-14 STEPS #7 & 8 Aspen Company Statement of Cash Flows For the Year Ended December 31, Year 2 Operating Activities Net income............................................................... $19 Adjustments to convert net income to a cash basis: Depreciation charges.............................................. $ 8 Decrease in accounts receivable.............................. 1 Increase in inventory.............................................. (6) Increase in accounts payable.................................. 6 Decrease in accrued liabilities.................................. (2) Increase in taxes payable........................................ 3 Gain on sale of equipment...................................... (4) 6 Net cash provided by operating activities.................... 25 Investing activities Additions to plant and equipment............................... $(18) Increase in investments............................................. (14) Proceeds from sale of equipment............................... 6 Net cash used for investing activities.......................... (26) Financing activities Increase in bonds payable......................................... $ 16 Increase in common stock......................................... 1 Cash dividends.......................................................... (9) Net cash provided by financing activities.................... 8 Net increase in cash (net cash flow)........................... 7 Cash, beginning balance............................................ 6 Cash, ending balance................................................ $ 13 © The McGraw-Hill Companies, Inc., 2006. All rights reserved.
  • TM 16-15 DIRECT METHOD Revenue....................................................... $300 Adjustments to cash basis: Increase in accounts receivable................... – Decrease in accounts receivable.................. + +1 Revenue adjusted to cash basis...................... 301 Cost of goods sold......................................... 100 Adjustments to cash basis: Increase in inventory.................................. + +6 Decrease in inventory................................. – Increase in accounts payable....................... – –6 Decrease in accounts payable...................... + Cost of goods sold adjusted to cash basis....... 100 Operating expenses....................................... 175 Adjustments to cash basis: Increase in accrued liabilities....................... – Decrease in accrued liabilities...................... + +2 Increase in prepaid expenses...................... + Decrease in prepaid expenses..................... – Depreciation charges.................................. – –8 Operating expenses adjusted to cash basis..... 169 Income tax expense...................................... 10 Adjustments to cash basis: Increase in accrued taxes payable............... – –3 Decreased in accrued taxes payable............. + Increase in deferred income taxes............... – Decrease in deferred income taxes.............. + Income taxes adjusted to cash basis.............. 7 Net cash provided by operating activities........ $ 25 © The McGraw-Hill Companies, Inc., 2006. All rights reserved.