Transcript Chapter 14 Instructor - Texas Tech University

Appendix B:
Statement of Cash Flows
1
General Information on 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.
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Content of Statement of Cash Flows

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:
A. Cash flow from operating activities.
B. Cash flow from investing activities.
C. Cash flow from financing activities.
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A. 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.
– indirect method: this technique starts
with net income and makes adjustments
to net income to convert it to a cash
basis.

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A. Cash Flows from Operating Activities
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.

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B. 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, 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.
– Note that the change in equity method
investments held during the period is classified in
the operating section of SCF, because the change
deals with income, and will adjust income from
equity to cash basis.
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C. 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 treasury stock.
– cash paid for dividends.
Note: use RE formula to find dividends:
BRE + NI - Dividends = ERE
Note that cash paid for dividends is classified as a
financing activity. However, cash paid for interest is
classified as an operating activity. Also, cash
received for dividends and cash received for interest
are both classified as operating activities.
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A. Cash Flow from Operations:
Components of Indirect method


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.
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(1) Indirect Method - Noncash Items
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.
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(1) Indirect Method - Noncash Items
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
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(1) Indirect Method - Noncash Items

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.
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(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.
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(2)Indirect Method - Double Counted Items

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.
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(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.

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(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.

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(3) Indirect Method Change in Related Assets and Liabilities
Accounts Receivable
Beginning
Balance
Sales
Ending
Balance
Cash
Collection
on A/R
First assume that all
sales are on account.
Now note that the
relationship can be
expressed in a
formula involving A/R
and Sales:
A/RBeginning + Sales - Cash Collections = A/REnding
Or:
A/RBeginning + Sales - A/REnding = Cash Collections
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(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.
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(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 AOLS
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.).
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(3) Indirect Method Change in Related Assets and Liabilities
Examples of related assets are:
Accounts Receivable.
Dividends Receivable (relates to dividend income).
Inventories.
Prepaid Expenses.
Deferred Tax Assets (because this relates to
income tax expense).
Examples of related liabilities include:
Accounts Payable.
Interest Payable.
Income Tax Payable.
Other Current Liabilities.
Unearned Revenues (short and long term).
Deferred Tax Liabilities (because this relates to
income tax expense).
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Class Problem, Operating Section
Indirect Method
Given the following I/S for Company S:
Revenues
COGS
Wage Exp.
Rent Exp.
Int. Exp.
Depr. Exp.
Loss on Sale
Inc. Tax Exp.
Net Income
$109,100
(56,000)
(15,200)
(9,000)
(2,900)
(6,200)
(4,200)
(4,400)
$ 11,200
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Class Problem, Operating Section
Selected Balance Sheet accounts, Company S
Part 3 (indirect method): find the change in the related assets
and liabilities (ignore the change in cash, as that is the amount
we are trying to explain):
2006
2005
Incr.(Decr)
A/R
$11,200
$ 9,000
2,200
Inventory
15,000
Prepaid Rent 1,200
A/P
11,200
15,600
1,800
14,600
( 600)
( 600)
(3,400)
Wages Pay.
9,000
Interest Pay.
1,500
Unearned Rev. 6,500
6,800
2,200
4,700
2,200
( 700)
1,800
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Class Problem
Cash Flows From Operations:
Net income
Add: Depreciation expense (Part 1)
Add: Loss on sale of equipment (Part 2)
Changes in related assets and liabilities (part 3):
Incr. in Accounts Receivable
Decr. In Inventory
Decr. In Prepaid Rent
Incr. in Wages Payable
Incr. in Unearned Revenue
Decr. In Accounts Payable
Decr. In Interest Payable
Cash flows from operating activities
$ 11,200
6,200
4,200
(2,200)
600
600
2,200
1,800
(3,400)
( 700)
$ 20,500
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CF from Operations - Direct Method
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.

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CF from Operations - Direct Method
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.

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CF from Operations - Direct Method

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 22. 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.
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Class Problem - Direct Method
Worksheet for calculations:
Income Statement
Revenues 109,100
Adjustments
Cash
-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
-0Loss on Sale(4,200) +4,200 noncash
-0Inc. Tax Exp.(4,400) no adjustment
(4,400)
Cash flow from operating activity
$20,500
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Class Problem -Direct Method
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).
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CF from Investing Activities
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.

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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.

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