Chapter 10: Statement of Cash Flows SCF Note:omit Direct Method from full SCF problems.

1. 1 Chapter 10: Statement of Cash Flows (SCF)Note:omit Direct Method from full SCF problems. SCF required for financial statements by SFAS 95 (1987). Primary purpose is to provide relevant information about cash receipts and cash disbursements of the company during the year. Serves to complement the other financial statements. Focus is on cash flows, not income. Reconciles the balance sheet and the income statement.

2. 2 General Information on SCF Explains change in cash and cash equivalents, where cash equivalents are defined as short-term, highly liquid investments. Cash equivalents are defined as short-term, highly liquid investments near to maturity. Examples of cash equivalents are Treasury bills and money market funds. Format of SCF includes the following 3 sections: cash flow from operating activities. cash flow from investing activities. cash flow from financing activities.

3. 3 Cash Flows from Operating Activities CF from operating activities is based on the income statement, and converts income activity to a cash basis in its presentation. There are two formats for the presentation of CF from operating activity: direct method: this technique shows cash received from customers and cash paid to various entities for operating activities (omit from further discussion). indirect method: this technique starts with net income and makes adjustments to net income to convert it to a cash basis. The direct method is more informative, but the vast majority (over 98%) of companies present only the indirect method.

4. 4 Cash Flows from Investing Activities CF from investing activities explain the changes in cash from the purchase or sale of the company�s (primarily) long-term assets. Examples of investing activity includes: cash paid for purchase of equipment, land, buildings, investments, intangible assets, and most other long term assets. cash received from sale of equipment, land, buildings, investments, intangible assets, and most other long term assets.

5. 5 Cash Flows from Financing Activities CF from financing activities explain the changes in cash from the issue or retirement of the company�s (primarily) long-term liabilities and equity. Examples of financing activity includes: cash received from issue of bonds, mortgages and other long-term debt. cash received from issue of common stock and preferred stock. cash paid for the retirement of long-term debt. cash paid for the repurchase of stock (treasury stock). cash paid for dividends. To find dividends, analyze the change in retained earnings: Beg. RE + NI - Div. = End. RE Note: issuance and payment on notes payable (even short-term) is classified as financing activity, as long is the note is non-trade (not for inventory purchase).

6. 6 CF from Operations (indirect method)- Suggestions for Calculations To understand the adjustments to get from net income to CF from operations, we will classify the adjustments into 3 categories: (1) Non-cash items. (2) Double counted gains and losses. (3) Change in related (accrual basis) assets and liabilities Remember: net income includes many activities that are non-cash, or only partly cash. That is what we are trying to reverse out of net income, to get to the cash portion.

7. 7 (1) Indirect Method - Noncash Items Non-cash activities include -Depreciation expense. For example: Depreciation Expense xx Accumulated Depreciation xx -Amortization expense on intangible assets such as patents. Amortization Expense xx Patents xx -Bad debt expense on the estimation of uncollectibles: Bad Debt Expense xx Allowance for Bad Debts xx Since these expenses originally reduced net income, the amount of these expenses would need to be added back to net income to get to cash from operations.

8. 8 (2)Indirect Method-Double Counted Items The double counted items come from gains and losses on investing and financing activity. For example, assume that land is sold for $10,000 cash, and the original cost was $9,000: Cash 10,000 Land 9,000 Gain on Sale of Land 1,000 In this case, the $10,000 cash received would be shown in Investing. However, if the gain is not adjusted out of net income, we would be �double counting� that effect.

9. 9 (2)Indirect Method - Double Counted Items Therefore, any gains or losses from sale of investing assets (equipment, land, buildings, investments, intangibles). The adjustment to reverse out the effects would be: add the amount of loss to net income. subtract the amount of the gain from net income. The same holds true for gains and losses from the early extinguishment of debt (like the gains/losses from the retirement of bonds). add the amount of loss to net income. subtract the amount of the gain from net income.

10. 10 (3) Indirect Method - Change in Related Assets and Liabilities The third category examines the change in the assets and liabilities that relate to the remaining income statement items, after the items in (1) and (2) have been removed. The adjustment for the effect of these changes is to effectively �squeeze� the income statement item from the accrual basis of accounting to the cash basis of accounting.

11. 11 (3) Indirect Method - Change in Related Assets and Liabilities For example, assume that total sales revenue recognized for the year is $100,000. At the beginning of the year, A/R were $2,000; at the end of the year, A/R were $3,000. What amount of cash was collected from customers? To analyze this effect, we must analyze the A/R account, and how it is increased and decreased.

12. 12 (3) Indirect Method - Change in Related Assets and Liabilities

13. 13 (3) Indirect Method - Change in Related Assets and Liabilities A/RB + Sales - A/RE = Cash Collections 2,000 + 100,000 - 3,000 = Cash Collections 99,000 = Cash Collections Note that, to convert from accrual basis sales revenues to cash basis sales revenues, an increase in A/R should be subtracted from net income to convert net income to a cash basis. Correspondingly, a decrease in A/R should be added to net income to convert net income to a cash basis.

14. 14 (3) Indirect Method - Change in Related Assets and Liabilities This pair of rules can be expanded to a general set of rules to convert NI from accrual to cash basis: Subtract increases in related assets. Add decreases in related assets. Add increases in related liabilities. Subtract decreases in related liabilities. (Assets Opposite, Liabilities Same)

15. 15 (3) Indirect Method - Change in Related Assets and Liabilities The types of assets that relate to the income statement are primarily current assets, but not always. To decide, you must look at each asset and its related income statement component. Also, remember that we are looking at the remaining assets and liabilities (after the eliminations in parts 1 and 2). Since we have already eliminated depreciation expense and amortization expense, etc., we would not include the changes in these related assets (Accum. Depr., Patents, etc.).

16. 16 (3) Indirect Method - Change in Related Assets and Liabilities Examples of related assets are: Accounts Receivable. Inventories. Supplies Prepaid Expenses. Other current assets. Examples of related liabilities include: Accounts Payable. Interest Payable. Income Tax Payable. Unearned Revenues. Other current liabilities. Now work Exercise 10-15.

17. 17 Additional Issues - SCF Investing and financing activities often require additional information to evaluate. A change in equipment could be from both sales and purchases. Sales of PP&E also involve accumulated depreciation. Sales of most investing assets also involve gains and losses. When needed, the best way to get to �cash from sale� is to reconstruct the journal entry.

18. 18 Additional Issues - SCF The FASB requires that significant noncash investing and financing activities be disclosed in a supplementary schedule to the SCF. Examples of significant noncash investing and financing activities include: conversion of bonds to stock. purchase of assets with issue of stock. purchase of assets with debt. declaration (but not payment) of cash dividend. stock dividends and stock splits. Now work Problems 10-19, 27 and 31.

19. Ex. 10-19(Indirect Method Only) CF from Operations (000s) Net Income $150 Depr. Exp. 25 (Category 1) Decr. Inventory 9 (Category 3) Incr. A/R (5) Incr. A/P 6 CF from Operations $185

20. Ex. 10-12 (Indirect Method Only) Where (if anywhere) would the following activities be reflected in the SCF? a. Supplementary Schedule (not paid so not part of SCF) b. Financing c. Operating (adjustment) d. Not in SCF e. (Omit - not covered in this chapter) f. Not shown - indirect method only shows the noncash adjustments.

21. Ex. 10-12 (Indirect Method Only) Where (if anywhere) would the following activities be reflected in the SCF? g. Financing h. Financing i. Not show in indirect method. Only adjustments to non-cash items are shown. j. Cash received in investing; also adjustment to operating for gain. k. If for cash - Financing If to purchase inventory - Operating l. Financing

22. Ex. 10-12 (Indirect Method Only) Where (if anywhere) would the following activities be reflected in the SCF? m. Supplementary Schedule (significant non-cash activity) n. Cash received - investing; also adjust gain from operating section. o. Adjust amortization expense from operating section.

23. Ex.10-29 (Indirect Method, 20X2 ) CF from Operations Net Income (1,100 - 400 - 500) $ 200 Depr. Exp. (from A/D change) 25 Incr. A/R (200) Decr. Inventory 150 Decr. A/P (50) CF from Operations $ 125

24. Ex.10-29 CF from Investing Purch. Bldg. $(200) Purch. Land. (100) CF from Investing $ (300)

25. Ex.10-29 CF from Financing Cash paid for dividends $ (50)* Issue Bonds 100 Purch. Treasury Stock (100) CF from Financing $ (50) * BRE + NI - Div. = ERE 150 + 200 - Div = 300 50 = Div

26. Ex.10-29 Summary CF from Op. $125 CF from Invest. (300) CF from Financing (50) Net decrease in cash $ (225)

27. Problem 10-31 (Indirect Method Only) First analyze Supplementary Data, and note sections affected. 1. Op. (net income) 2.Op. (+) 3.Op. (+) 4. Inv. (-) for 1/3; the rest is Supp. Schedule 5.Supp. Schedule 6.Inv. (+) for cash; operating (-) for gain adjust. 7.Inv. (-) 8. Supp. Schedule 9. Inv. (+) 10.Fin. (-) ADD 11: Issued S.T. N/P for cash $5,600. Fin (+)

28. Ex. 10-33 (Indirect Method Only) CF from Operations Net Income $33,600 Depr. Expense 11,200 (Category 1) Amort. Expense 1,400 Gain on Sale LTI. (2,800) (Category 2) Loss on Sale Mach. 2,800 Incr. A/R (7,000) (Category 3) Decr. Inventory 2,800 Incr. Prepaids (1,400) Decr. A/P (5,600) Decr. Accrued Wages (1,400) CF from Operations $33,600

29. Ex. 10-33 CF from Investing Purch. Machinery $(7,000) Sale of Machinery 9,800 Purch. Bldg. Addition (42,000) Sale of LTI 16,800 CF from Investing $(22,400)

30. Ex. 10-33 CF from Financing Issue S.T. Nontrade N/P $ 5,600 Cash paid for dividends* CF from Financing *RE(B) + NI - Div = RE(E) 21,000 + 33,600 - Div = 39,200 15,400 = Div. Declared (No Dividends Payable, so $15,400 must also be Dividends Paid.)

31. Ex. 10-33 Summary CF from Op. $33,600 CF from Invest. (22,400) CF from Financing (9,800) Net increase in cash $ 1,400 (see change in cash, first line on B/S)

32. Ex. 10-33 Summary Note: the SCF would also include the following information in a Supplementary Schedule for significant non-cash investing and financing activities: Supplementary Schedule: Machinery purchased with a note $14,000 Machinery purchased with common stock $35,000 Common stock issued to retire a note $ 7,000