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Chapter 14: Statement of Cash Flows

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  1. Chapter 14: Statement of Cash Flows

  2. 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 period. Serves to complement the other financial statements. Focus is on cash flows, not income. Reconciles the balance sheet and the income statement. General Information on SCF

  3. Explains change in cash and cash equivalents. 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 three sections: cash flow from operating activities. cash flow from investing activities. cash flow from financing activities. Content of Statement of Cash Flows

  4. 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. indirect method: this technique starts with net income and makes adjustments to net income to convert it to a cash basis. Cash Flows from Operating Activities

  5. If the direct method is used, the indirect method must be presented in a supplementary schedule. The direct method is more informative, but the vast majority of companies present only the indirect method. FASB is considering a change to require the direct method. Cash Flows from Operating Activities

  6. 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, marketable securities (available-for-sale and equity), intangible assets, and most other long term assets. cash received from sale of equipment, land, buildings, marketable securities (available-for-sale and equity), intangible assets, and most other long term assets. cash paid for issue of non-trade notes receivable (both short-term and long-term). cash received for repayment on non-trade notes receivable (both short-term and long-term). Cash Flows from Investing Activities

  7. General rule for investing activity: cash flows for purchase and sale of long-term assets. Exceptions to the rule: Short term notes receivable (non-trade) are included in the investing section. Long term notes receivable (trade) are notincluded in the investing section. Because they relate to trade, they are treated just like accounts receivable in the operating section. The change in equity method investments is classified in the operating section of SCF, because the change deals with income. (Purchase and sale of equity investments are classified in investing.) Note: Trade receivables are created when inventory is sold on account. Non-trade receivables are created when a company loans cash to employees or others (no sale is involved). Cash Flows from Investing Activities

  8. 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 paidfor the retirement of long-term debt, cash paid for the repurchase of treasury stock, cash paid for dividends, cash received for issue of non-trade notes payable (both short-term and long-term), and cash paid for retirement or repayment on non-trade notes payable (both short-term and long-term). Cash Flows from Financing Activities

  9. Note that cash paid for dividends is classified as a financing activity, but cash paid for interest is classified as an operating activity. Note that cash received for dividends and cash received for interest are both classified as operating activities. How is the cash paid for dividends different from the other activities? Why did the FASB choose to classify it as a financing activity? Cash Flows from Financing Activities

  10. General rule for financing activity: cash flows for issue and retirement of long-term liabilities and equity. Exceptions to the rule: Short term notes payable (non-trade)areincluded in the financing section. (Short term bank notes are very common examples.) Long term notes payable (trade) are not included in the financing section. Because they relate to trade, they are treated just like accounts payable in the operating section. (LT trade N/P are rare.) Note: trade payables are created when inventory is purchased on a note. Non-tradepayables are created when a company or borrows cash from a bank or others (no inventory purchase is involved). Cash Flows from Financing Activities

  11. To understand the adjustments to get from net income to CF from operations, we will classify the adjustments into 3 categories: (1) Noncash items. (2) Double counted gains and losses. (3) Change in related (accrual basis) assets and liabilities Remember: net income includes many activities that are noncash, or only partly cash. CF from Operations (Indirect Method)

  12. Noncash activities include -Depreciation expense. For example: Depreciation Expense xx Accumulated Depreciation xx -Amortization expense on intangible assets such as patents and goodwill. Amortization Expense xx Goodwill xx -Bad debt expense on the estimation of uncollectibles: Bad Debt Expense xx Allowance for Doubtful Accts. 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. (1) Indirect Method - Noncash Items

  13. Another noncash activity deals with the amortization of premiums and discounts on bonds payable. These amortizations affect interest expense but not cash. There are two components to interest expense each period: (1) the cash paid for interest expense, and (2) the amortization of premiums or discounts (the noncash portion). To find the direction of the adjustment, isolate the noncash component (for amortization) of the interest expense entry: Interest expense xx Discount on B/P xx or Premium on B/P xx Interest expense xx (1) Indirect Method - Noncash Items

  14. Note that the amortization of a discount has a similar format to that of depreciation expense (debit expense in a non cash transaction). Therefore, to adjust for amortization of a discount, add the amount of the discount amortization back to net income. Since the amortization of a premium has the opposite effect on net income, we must subtract the amount of the premium amortization from net income to get to cash from operations. (1) Indirect Method - Noncash Items

  15. 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. (2)Indirect Method - Double Counted Items

  16. Therefore, any gains or losses from sale of investing assets (equipment, land, buildings, AFS and equity 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. (2)Indirect Method - Double Counted Items

  17. The third category examines the change in the assets and liabilities that relate to the remainingincome 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. (3) Indirect Method - Change in Related Assets and Liabilities

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

  19. (3) Indirect Method - Change in Related Assets and Liabilities Accounts Receivable First assume that all sales are on account. Now note that the relationship can be expressed in a formula involving A/R and Sales: Beginning Balance Sales Cash Collection on A/R Ending Balance A/RBeginning + Sales - Cash Collections = A/REnding Or: A/RBeginning + Sales - A/REnding = Cash Collections

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

  21. 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. 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 part 1). 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.). (3) Indirect Method - Change in Related Assets and Liabilities

  22. Examples of related assets are: Accounts Receivable. Dividends Receivable (relates to dividend income). Trade Notes Receivable (short and long term). Inventories. Prepaid Expenses. Deferred Tax Assets (because this relates to income tax expense). Trading Investments (because they relate to unrealized gains and losses on the income statement as well as gains and losses on sale). Equity Investments (because this relates to “Income from Investment”). (3) Indirect Method - Change in Related Assets and Liabilities

  23. Equity Investments : When you evaluate the change in the equity investment account during the year, you are really calculating the “equity method income” in excess of the “dividend income”. During the year, the investor would increase the Investment account by “income from investment” and decrease the investment account for the amount of dividends declared from the investee. This can be expressed as: InvestB + Equity Income - Dividends = InvestE (3) Indirect Method - Change in Related Assets and Liabilities

  24. InvestB + Equity Income - Dividends = InvestE When analyzing related assets, the amount of the difference (if it is an increase), should be subtracted from net income to adjust to dividend income. The only other adjustment would be to analyze the change in dividends receivable to get all the way to cash received from dividend income. (3) Indirect Method - Change in Related Assets and Liabilities

  25. Examples of related liabilities include: Accounts Payable. Interest Payable. Income Tax Payable. Other Current Liabilities. Trade Notes Payable (short and long term). Unearned Revenues (short and long term). Deferred Tax Liabilities (because this relates to income tax expense). (3) Indirect Method - Change in Related Assets and Liabilities

  26. Part 1: Look for any noncash items in the income statement. Depreciation expense of $6,200 Part 2: Look for any double counted gains and losses on investing and financing activities. Loss on Sale of Investment of $4,200 Class Problem: E14-19 (Indirect)

  27. Part 3: To find cash flows from operations, first find the change in the related assets and liabilities (ignore the change in cash, as that is the amount we are trying to explain): 20062005 Incr.(Decr) A/R $11,200 $ 9,000 2,200 Inventory 15,000 15,600 ( 600) Prepaid Rent 1,200 1,800 ( 600) A/P 11,200 14,600 (3,400) Wages Pay. 9,000 6,800 2,200 Interest Pay. 1,500 2,200 ( 700) Unearned Rev. 6,500 4,700 1,800 Class Problem: E14-19 (Indirect)

  28. Cash Flows From Operations: Net income $ 11,200 Add: Depreciation expense (part 1) 6,200 Add: Loss on sale of equipment (part 2) 4,200 Subtract increases in related assets (part 3): Accounts Receivable (2,200) Add decreases in related assets (part 3): Inventory 600 Prepaid Rent 600 Add increases in related liabilities (part 3): Wages Payable 2,200 Unearned Revenue 1,800 Less decreases in related liabilities (part 3): Accounts Payable (3,400) Interest Payable ( 700) Cash flows from operating activities $ 20,500 Class Problem: E14-19 (Indirect)

  29. The direct method converts individual revenues and expenses to a cash basis, and ignores noncash items in the totals. Each conversion is based on the difference between accrual basis and cash basis. These differences are found in the same adjustments that were made to net income under the indirect method. CF from Operations - Direct Method

  30. To create the operating section using the direct method, start with the income statement, making sure to carry the expenses as negative (-) amounts. Review the adjustments to net income as presented in the indirect method. Each of the adjustments relates to an item on the income statement. Attach the adjustment (or adjustments) to each item, maintaining the direction of the adjustment. For example, A/R relates to sales; Inventory and A/P relate to COGS. CF from Operations - Direct Method

  31. The total for each line is the resulting cash received, or cash paid, for the item. The total cash flow from operations is the same, but the amounts are derived directly and individually, rather than adjusting noncash items out of net income. The calculations for the direct method are on the next slide. Refer to the adjustments for the indirect method on Slide 28. Each line can be attached to something on the income statement. Some items adjust revenues and expenses to a cash basis; other items adjust the non-cash items to zero. CF from Operations - Direct Method

  32. Exercise 14-19 calculations: Income Statement Adjustments Cash Revenues 109,100 -2,200 Incr. A/R +1,800 Incr. U/R 108,700 COGS (56,000) + 600 Decr. Inv -3,400 Decr. A/P (58,800) Wage Exp. (15,200) +2,200 Incr. W/P (13,000) Rent Exp. (9,000) +600 Decr. PP Rent ( 8,400) Int. Exp. (2,900) -700 Decr. Int. Pay (3,600) Depr. Exp. (6,200) +6,200 noncash -0- Loss on Sale(4,200) +4,200 noncash -0- Inc. Tax Exp.(4,400) no adjustment (4,400) Cash flow from operating activity $ 20,500 CF from Operations - Direct Method

  33. The operating section of the SCF is presented as: Cash flow from operations: Cash received from customers $ 108,700 Cash paid to suppliers (58,800) Cash paid for wages (13,000) Cash paid for rent ( 8,400) Cash paid for interest ( 3,600) Cash paid for income taxes ( 4,400) Cash flow from operations $ 20,500 (Note that the noncash (depreciation) and double counted (loss) items are omitted in the direct method). Class Problem: E14-19(direct)

  34. 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. The best way to get to “cash from sale” is to reconstruct the journal entry. CF from Investing Activities

  35. Back to E14-19. Assume the following additionalinformation: Equipment and Accum. Depr. were as follows: 20062005 Equip. 78,000 67,800 A/D 20,00015,800 Equip. (net) 58,000 52,000 Equipment costing $10,000, and having $2,000 accumulated depreciation was sold for cash. Equipment was purchased for cash of $20,200. CF from Investing Activities

  36. The calculations for investing activity are as follows: To find the cash received from sale of equipment, reconstruct the journal entry for the sale: Cash ? A/D 2,000 Loss on Sale 4,200 Equipment 10,000 The cash received must be $3,800. CF from Investing Activities

  37. Since the cash paid for the purchase of equipment is $20,200, the Investing section of the SCF would be: Cash received from sale of equip. $ 3,800 Cash paid for purchase of equip. (20,200) Net cash used for investing activities $(16,400) CF from Investing Activities

  38. Back to E14-19. Assume the following additional information relating to bonds payable: 20062005 Bonds payable (face) $28,000 $28,400 Note that the bonds declined by a total of $400. If the bonds payable were issued at face value, there is no premium or discount amortization; the entire change (decrease) is due to a payment on the bonds. Cash paid to reduce bonds = $400 CF from Financing Activities

  39. The only other change in P14-19 financing activities was for retained earnings; the financing section includes Cash Dividends Paid. (1)To find dividends declared, use the Retained Earnings formula: REB + NI - Dividends = REE 17,100 + 11,200 - Div. = 25,200 Div. = 3,100 (2)Then check for any dividends payable, to see if the amount declared and the amount paid are different: Div. Pay.B + Dividends - Div. Pay.E = Cash Paid 0 + 3,100 - 0 = $3,100 CF from Financing Activities

  40. Since the only financing changes related to bonds and retained earning, the cash flow from financing activities would be: Cash paid to reduce bonds $ ( 400) Cash paid for dividends (3,100) Cash used for financing activities $(3,500) Statement of Cash Flows

  41. For Problem 14-19, the SCF activities for 2006 may be summarized as follows (note - the full financial statement would include details for all three categories): Cash from operating activities $ 20,500 Cash used for investing activities $(16,400) Cash used for financing activities $( 3,500) Net increase in cash $ 600 Check against the change in cash in the balance sheet( from $5,400 to $6,000 = increase of $600) SCF - Summary

  42. 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. Additional Issues - SCF