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13
Statement of
Cash Flows
Chapter
STUDY
OBJECTIVES
After studying this chapter, you should be
able to:
1 Indicate the usefulness of the statement
of cash flows.
2 Distinguish among operating, investing,
and financing activities.
3 Prepare a statement of cash flows using
the indirect method.
4 Analyze the statement of cash flows.
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✓ The Navigator
Scan Study Objectives
■
Read Feature Story
■
Read Preview
■
Read text and answer
p. 617
■
p. 625
■
Work Comprehensive
Do it!
p. 628
Do it!
■
p. 632
p. 634
■
■
Review Summary of Study Objectives
■
Work Comprehensive
■
Do it!
p. 648
Answer Self-Study Questions
■
Complete Assignments
■
Feature Story
GOT CASH?
In today’s environment, companies must be ready to respond to changes
quickly in order to survive and thrive. They need to produce new products
and expand into new markets continually. To do this takes cash—lots and
lots of cash. Keeping lots of cash available is a real challenge for a young
company. It requires careful cash management and attention to cash flow.
One company that managed cash successfully in its early years was
Microsoft (www.microsoft.com). During those years the company paid much
of its payroll with stock options (rights to purchase company stock in the
future at a given price) instead of cash. This strategy conserved cash, and
turned more than a thousand of its employees into millionaires during the
company’s first 20 years of business.
612
In recent years Microsoft has had a different kind of cash problem. Now that
it has reached a more “mature” stage in life, it generates so much cash—
roughly $1 billion per month—that it cannot always figure out what to do
with it. By 2004 Microsoft had accumulated $60 billion.
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The company said it was accumulating cash to invest in new opportunities, buy other companies, and
pay off pending lawsuits. But for
years, the federal government has
blocked attempts by Microsoft to
buy anything other than small firms
because it feared that purchase of
a large firm would only increase
Microsoft’s monopolistic position.
In addition, even the largest estimates of Microsoft’s legal obligations
related to pending lawsuits would use up only about $6 billion in cash.
Microsoft’s stockholders have complained for years that holding all this cash
was putting a drag on the company’s profitability. Why? Because Microsoft
had the cash invested in very low-yielding government securities. Stockholders felt that the company either should find new investment projects that
would bring higher returns, or return some of the cash to stockholders.
Finally, in July 2004 Microsoft announced a plan to return cash to stockholders, by paying a special one-time $32 billion dividend in December 2004.
This special dividend was so large that, according to the U.S. Commerce
Department, it caused total personal income in the United States to rise
by 3.7% in one month—the largest monthly increase ever recorded by the
agency. (It also made the holiday season brighter, especially for retailers in
the Seattle area.) Microsoft also doubled its regular annual dividend to $3.50
per share. Further, it announced that it would spend another $30 billion over
the next four years buying treasury stock. In addition, in 2008 Microsoft
offered to buy Yahoo! for $44.6 billion (Yahoo! declined the offer). These
actions will help to deplete some of its massive cash horde, but as you will
see in this chapter, for a cash-generating machine like Microsoft, the company
will be anything but cash-starved.
Source: “Business: An End to Growth? Microsoft’s Cash Bonanza,” The Economist, July 23,
2005, p. 61.
✓
The Navigator
Inside Chapter 13…
• Net What?
(p. 617)
• Cash Flow Isn’t Always What It Seems
• GM Must Sell More Cars
(p. 619)
(p. 626)
• All About You: Where Does the Money Go?
(p. 633)
613
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Preview of Chapter 13
The balance sheet, income statement, and retained earnings statement do not always show the whole
picture of the financial condition of a company or institution. In fact, looking at the financial statements of
some well-known companies, a thoughtful investor might ask questions like these: How did Eastman Kodak
finance cash dividends of $649 million in a year in which it earned only $17 million? How could United
Airlines purchase new planes that cost $1.9 billion in a year in which it reported a net loss of over $2 billion?
How did the companies that spent a combined fantastic $3.4 trillion on mergers and acquisitions in a recent
year finance those deals? Answers to these and similar questions can be found in this chapter, which
presents the statement of cash flows.
The content and organization of this chapter are as follows.
Statement of Cash Flows
The Statement of Cash Flows:
Usefulness and Format
•
•
•
•
•
•
Usefulness
Classifications
Significant noncash activities
Format
Preparation
Indirect and direct methods
Preparing the Statement of
Cash Flows—Indirect Method
• Step 1: Operating activities
• Step 2: Investing and financing
activities
• Step 3: Net change in cash
Using Cash Flows to Evaluate
a Company
• Free cash flow
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THE STATEMENT OF CASH FLOWS: USEFULNESS AND FORMAT
The balance sheet, income statement, and retained earnings statement provide
only limited information about a company’s cash flows (cash receipts and cash payments). For example, comparative balance sheets show the increase in property,
plant, and equipment during the year. But they do not show how the additions were
financed or paid for. The income statement shows net income. But it does not indicate the amount of cash generated by operating activities. The retained earnings
statement shows cash dividends declared but not the cash dividends paid during
the year. None of these statements presents a detailed summary of where cash
came from and how it was used.
Usefulness of the Statement of Cash Flows
STUDY OBJECTIVE 1
Indicate the usefulness of the
statement of cash flows.
The statement of cash flows reports the cash receipts, cash payments, and
net change in cash resulting from operating, investing, and financing activities during a period. The information in a statement of cash flows should
help investors, creditors, and others assess:
1. The entity’s ability to generate future cash flows. By examining relationships
between items in the statement of cash flows, investors can make predictions of
the amounts, timing, and uncertainty of future cash flows better than they can
from accrual basis data.
614
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The Statement of Cash Flows: Usefulness and Format
615
2. The entity’s ability to pay dividends and meet obligations. If a company does
not have adequate cash, it cannot pay employees, settle debts, or pay dividends.
Employees, creditors, and stockholders should be particularly interested in this
statement, because it alone shows the flows of cash in a business.
3. The reasons for the difference between net income and net cash provided
(used) by operating activities. Net income provides information on the success
or failure of a business enterprise. However, some financial statement
ETHICS NOTE
users are critical of accrual-basis net income because it requires many
Though we would discourestimates.As a result, users often challenge the reliability of the number.
age reliance on cash flows to
Such is not the case with cash. Many readers of the statement of cash
the exclusion of accrual accountflows want to know the reasons for the difference between net income ing, comparing cash from operaand net cash provided by operating activities. Then they can assess for tions to net income can reveal
themselves the reliability of the income number.
important information about
4. The cash investing and financing transactions during the period. By the “quality” of reported net
examining a company’s investing and financing transactions, a finan- income. Such a comparison can
cial statement reader can better understand why assets and liabilities reveal the extent to which net
income provides a good meachanged during the period.
sure of actual performance.
Classification of Cash Flows
The statement of cash flows classifies cash receipts and cash payments as
operating, investing, and financing activities.Transactions and other events
characteristic of each kind of activity are as follows.
STUDY OBJECTIVE 2
Distinguish among operating,
investing, and financing
activities.
1. Operating activities include the cash effects of transactions that create
revenues and expenses. They thus enter into the determination of net
income.
2. Investing activities include (a) acquiring and disposing of investments and
property, plant, and equipment, and (b) lending money and collecting the
loans.
3. Financing activities include (a) obtaining cash from issuing debt and repaying
the amounts borrowed, and (b) obtaining cash from stockholders, repurchasing
shares, and paying dividends.
The operating activities category is the most important. It shows the cash provided by company operations. This source of cash is generally considered to be the
best measure of a company’s ability to generate sufficient cash to continue as a
going concern.
Illustration 13-1 (page 616) lists typical cash receipts and cash payments within
each of the three classifications. Study the list carefully. It will prove very useful in
solving homework exercises and problems.
Note the following general guidelines:
1. Operating activities involve income statement items.
2. Investing activities involve cash flows resulting from changes in investments
and long-term asset items.
3. Financing activities involve cash flows resulting from changes in long-term liability and stockholders’ equity items.
Companies classify as operating activities some cash flows related to investing or financing activities. For example, receipts of investment revenue (interest
and dividends) are classified as operating activities. So are payments of interest
to lenders. Why are these considered operating activities? Because companies
report these items in the income statement, where results of operations are
shown.
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Chapter 13 Statement of Cash Flows
Illustration 13-1
Typical receipt and payment
classifications
Operating
activities
J AVA
J AVA
TIME
TIME
Investing activities
S T O CK
BOND
Financing
activities
TYPES OF CASH INFLOWS AND OUTFLOWS
Operating activities—Income statement items
Cash inflows:
From sale of goods or services.
From interest received and dividends received.
Cash outflows:
To suppliers for inventory.
To employees for services.
To government for taxes.
To lenders for interest.
To others for expenses.
Investing activities—Changes in investments and long-term assets
Cash inflows:
From sale of property, plant, and equipment.
From sale of investments in debt or equity securities of other entities.
From collection of principal on loans to other entities.
Cash outflows:
To purchase property, plant, and equipment.
To purchase investments in debt or equity securities of other entities.
To make loans to other entities.
Financing activities—Changes in long-term liabilities and stockholders’ equity
Cash inflows:
From sale of common stock.
From issuance of long-term debt (bonds and notes).
Cash outflows:
To stockholders as dividends.
To redeem long-term debt or reacquire capital stock (treasury stock).
Significant Noncash Activities
Not all of a company’s significant activities involve cash. Examples of significant
noncash activities are:
1.
2.
3.
4.
Direct issuance of common stock to purchase assets.
Conversion of bonds into common stock.
Direct issuance of debt to purchase assets.
Exchanges of plant assets.
INTERNATIONAL NOTE
The statement of cash flows
is very similar under GAAP and
IFRS. One difference is that,
under IFRS, noncash investing
and financing activities are not
reported in the statement of cash
flows but instead are reported in
the notes to the financial
statements.
Companies do not report in the body of the statement of cash flows
significant financing and investing activities that do not affect cash.
Instead, they report these activities in either a separate schedule at the
bottom of the statement of cash flows or in a separate note or supplementary schedule to the financial statements. The reporting of these noncash
activities in a separate schedule satisfies the full disclosure principle.
In solving homework assignments you should present significant noncash investing and financing activities in a separate schedule at the bottom
of the statement of cash flows. (See the last entry in Illustration 13-2, on
page 617, for an example.)
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The Statement of Cash Flows: Usefulness and Format
617
ACCOUNTING ACROSS THE ORGANIZATION
Net What?
Net income is not the same as net cash provided by operating activities. Below
are some results from recent annual reports (dollars in millions). Note the wide
disparity among these companies, all of which engaged in retail merchandising.
Company
Net Income
Kohl’s Corporation
Wal-Mart Stores, Inc.
J. C. Penney Company, Inc.
Costco Wholesale Corp.
Target Corporation
$ 1,083
11,284
1,153
1,082
2,849
Net Cash Provided by
Operating Activities
$ 1,234
20,164
1,255
2,076
4,125
In general, why do differences exist between net income and net cash provided by
operating activities?
Format of the Statement of Cash Flows
The general format of the statement of cash flows presents the results of the three
activities discussed previously—operating, investing, and financing—plus the significant noncash investing and financing activities. Illustration 13-2 shows a widely
used form of the statement of cash flows.
Illustration 13-2
Format of statement of cash
flows
COMPANY NAME
Statement of Cash Flows
Period Covered
Cash flows from operating activities
(List of individual items)
Net cash provided (used) by operating activities
Cash flows from investing activities
(List of individual inflows and outflows)
Net cash provided (used) by investing activities
Cash flows from financing activities
(List of individual inflows and outflows)
XX
XXX
XX
XXX
XX
Net cash provided (used) by financing activities
XXX
Net increase (decrease) in cash
Cash at beginning of period
XXX
XXX
Cash at end of period
XXX
Noncash investing and financing activities
(List of individual noncash transactions)
XXX
The cash flows from operating activities section always appears first, followed by
the investing activities section and then the financing activities section.
before you go on...
Do it!
During its first week, Duffy & Stevenson Company had these transactions.
1. Issued 100,000 shares of $5 par value common stock for $800,000 cash.
2. Borrowed $200,000 from Castle Bank, signing a 5-year note bearing 8% interest.
Classification of Cash Flows
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Chapter 13 Statement of Cash Flows
Action Plan
• Identify the three types of
activities used to report all
cash inflows and outflows.
• Report as operating activities
the cash effects of transactions
that create revenues and
expenses and enter into the
determination of net income.
• Report as investing activities
transactions that (a) acquire
and dispose of investments and
long-term assets and (b) lend
money and collect loans.
• Report as financing activities
transactions that (a) obtain
cash from issuing debt and
repay the amounts borrowed
and (b) obtain cash from stockholders and pay them dividends.
3. Purchased two semi-trailer trucks for $170,000 cash.
4. Paid employees $12,000 for salaries and wages.
5. Collected $20,000 cash for services provided.
Classify each of these transactions by type of cash flow activity.
Solution
1. Financing activity
2. Financing activity
3. Investing activity
4. Operating activity
5. Operating activity
Related exercise material: BE13-1, BE13-2, BE13-3, E13-1, E13-2, E13-3, and Do it! 13-1.
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Preparing the Statement of Cash Flows
Companies prepare the statement of cash flows differently from the three
other basic financial statements. First, it is not prepared from an adjusted
trial balance. It requires detailed information concerning the changes in
account balances that occurred between two points in time.An adjusted trial
balance will not provide the necessary data. Second, the statement of cash
flows deals with cash receipts and payments. As a result, the company must
adjust the effects of the use of accrual accounting to determine cash flows.
The information to prepare this statement usually comes from three sources:
• Comparative balance sheets. Information in the comparative balance sheets
indicates the amount of the changes in assets, liabilities, and stockholders’ equities from the beginning to the end of the period.
• Current income statement. Information in this statement helps determine the
amount of cash provided or used by operations during the period.
• Additional information. Such information includes transaction data that are
needed to determine how cash was provided or used during the period.
Preparing the statement of cash flows from these data sources involves three
major steps, as explained in Illustration 13-3 on the next page.
INTERNATIONAL NOTE
Companies preparing financial statements under IFRS must
prepare a statement of cash
flows as an integral part of the
financial statements.
Usage of Methods
99%
Indirect Method
1% Direct Method
Indirect and Direct Methods
In order to perform step 1, a company must convert net income from an accrual
basis to a cash basis. This conversion may be done by either of two methods: (1) the
indirect method or (2) the direct method. Both methods arrive at the same total
amount for “Net cash provided by operating activities.” They differ in how they
arrive at the amount.
The indirect method adjusts net income for items that do not affect cash. A
great majority of companies (98.8%) use this method, as shown in the nearby
chart.1 Companies favor the indirect method for two reasons: (1) It is easier and
1
Accounting Trends and Techniques—2007 (New York: American Institute of Certified Public
Accountants, 2007).
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The Statement of Cash Flows: Usefulness and Format
Step 1: Determine net cash provided/used by operating activities by converting
net income from an accrual basis to a cash basis.
This step involves analyzing not only
the current year's income statement
but also comparative balance sheets
and selected additional data.
Buying & selling
goods
Step 2: Analyze changes in noncurrent asset and liability accounts and record as
investing and financing activities, or disclose as noncash transactions.
Inve
g
ncin
stin
g
Fina
This step involves analyzing comparative
balance sheet data and selected additional
information for their effects on cash.
Step 3: Compare the net change in cash on the statement of cash flows with the
change in the cash account reported on the balance sheet to make sure
the amounts agree.
+
or
–
The difference between the beginning
and ending cash balances can be easily
computed from comparative balance
sheets.
less costly to prepare, and (2) it focuses on the differences between net income and
net cash flow from operating activities.
The direct method shows operating cash receipts and payments, making it
more consistent with the objective of a statement of cash flows. The FASB has
expressed a preference for the direct method, but allows the use of either method.
The next section illustrates the more popular indirect method. Appendix 13B
illustrates the direct method.
I N V E S T O R
I N S I G H T
Cash Flow Isn’t Always What It Seems
Some managers have taken actions that artificially increase cash flow from operating
activities. They do this by moving negative amounts out of the operating section and into the
investing or financing section.
For example, WorldCom, Inc. disclosed that it had improperly capitalized expenses: It had
moved $3.8 billion of cash outflows from the “Cash from operating activities” section of the cash
flow statement to the “Investing activities” section, thereby greatly enhancing cash provided by
operating activities. Similarly, Dynegy, Inc. restated its cash flow statement because it had improperly included in operating activities, instead of in financing activities, $300 million from natural gas
trading. The restatement resulted in a drop of 37% in cash flow from operating activities.
Source: Henny Sender, “Sadly, These Days Even Cash Flow Isn’t Always What It Seems to Be,” Wall Street Journal,
May 8, 2002.
For what reasons might managers at WorldCom and at Dynegy take the actions noted
above?
619
Illustration 13-3
Three major steps in
preparing the statement
of cash flows
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Chapter 13 Statement of Cash Flows
PREPARING THE STATEMENT OF CASH
FLOWS—INDIRECT METHOD
To explain how to prepare a statement of cash flows using the indirect
method, we use financial information from Computer Services Company.
Illustration 13-4 presents Computer Services’ current and previous-year
balance sheets, its current-year income statement, and related financial information for the current year.
STUDY OBJECTIVE 3
Prepare a statement of cash
flows using the indirect method.
Illustration 13-4
Comparative balance
sheets, income statement,
and additional information
for Computer Services
Company
COMPUTER SERVICES COMPANY
Comparative Balance Sheets
December 31
Assets
Current assets
Cash
Accounts receivable
Merchandise inventory
Prepaid expenses
Property, plant, and equipment
Land
Building
Accumulated depreciation—building
Equipment
Accumulated depreciation—equipment
Total assets
2011
2010
$ 55,000
20,000
15,000
5,000
$ 33,000
30,000
10,000
1,000
130,000
160,000
(11,000)
27,000
(3,000)
20,000
40,000
(5,000)
10,000
(1,000)
Change in
Account Balance
Increase/Decrease
$ 22,000
10,000
5,000
4,000
Increase
Decrease
Increase
Increase
110,000
120,000
6,000
17,000
2,000
Increase
Increase
Increase
Increase
Increase
$398,000
$138,000
$ 28,000
6,000
$ 12,000
8,000
130,000
20,000
110,000 Increase
70,000
164,000
50,000
48,000
20,000 Increase
116,000 Increase
$398,000
$138,000
Liabilities and Stockholders’ Equity
Current liabilities
Accounts payable
Income tax payable
Long-term liabilities
Bonds payable
Stockholders’ equity
Common stock
Retained earnings
Total liabilities and stockholders’ equity
$ 16,000 Increase
2,000 Decrease
COMPUTER SERVICES COMPANY
Income Statement
For the Year Ended December 31, 2011
Revenues
Cost of goods sold
Operating expenses (excluding depreciation)
Depreciation expense
Loss on sale of equipment
Interest expense
Income before income tax
Income tax expense
Net income
$507,000
$150,000
111,000
9,000
3,000
42,000
315,000
192,000
47,000
$145,000
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Preparing the Statement of Cash Flows—Indirect Method
Additional information for 2011:
1. The company declared and paid a $29,000 cash dividend.
2. Issued $110,000 of long-term bonds in direct exchange for land.
3. A building costing $120,000 was purchased for cash. Equipment costing $25,000 was also
purchased for cash.
4. The company sold equipment with a book value of $7,000 (cost $8,000, less accumulated
depreciation $1,000) for $4,000 cash.
5. Issued common stock for $20,000 cash.
6. Depreciation expense was comprised of $6,000 for building and $3,000 for equipment.
621
Illustration 13-4
(continued)
We will now apply the three steps to the information provided for Computer
Services Company.
Step 1: Operating Activities
DETERMINE NET CASH PROVIDED/USED BY OPERATING ACTIVITIES BY
CONVERTING NET INCOME FROM AN ACCRUAL BASIS TO A CASH BASIS
To determine net cash provided by operating activities under the indirect method,
companies adjust net income in numerous ways. A useful starting point is to understand why net income must be converted to net cash provided by operating activities.
Under generally accepted accounting principles, most companies use the accrual basis of accounting. This basis requires that companies record revenue when
earned and record expenses when incurred. Earned revenues may include credit
sales for which the company has not yet collected cash. Expenses incurred may include some items that it has not yet paid in cash. Thus, under the accrual basis, net
income is not the same as net cash provided by operating activities.
Therefore, under the indirect method, companies must adjust net income to
convert certain items to the cash basis. The indirect method (or reconciliation
method) starts with net income and converts it to net cash provided by operating
activities. Illustration 13-5 lists the three types of adjustments.
Net Income
ⴙⲐⴚ
Adjustments
ⴝ
Net Cash Provided/
Used by Operating
Activities
• Add back noncash
expenses, such as
depreciation, amortization,
or depletion.
Illustration 13-5
Three types of adjustments
to convert net income to
net cash provided by
operating activities
• Deduct gains and add
losses that resulted from
investing and financing
activities.
• Analyze changes to noncash
current asset and current
liability accounts.
DEPRECIATION EXPENSE
Computer Services’ income statement reports depreciation expense of $9,000.
Although depreciation expense reduces net income, it does not reduce cash. In other
words, depreciation expense is a noncash charge. The company must add it back to
net income to arrive at net cash provided by operating activities. Computer Services
reports depreciation expense in the statement of cash flows as shown on page 622.
HELPFUL HINT
Depreciation is similar
to any other expense
in that it reduces net
income. It differs in that
it does not involve a
current cash outflow; that
is why it must be added
back to net income to
arrive at cash provided
by operating activities.
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Chapter 13 Statement of Cash Flows
Illustration 13-6
Adjustment for depreciation
Cash flows from operating activities
Net income
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation expense
Net cash provided by operating activities
$145,000
9,000
$154,000
As the first adjustment to net income in the statement of cash flows, companies
frequently list depreciation and similar noncash charges such as amortization of
intangible assets, depletion expense, and bad debt expense.
LOSS ON SALE OF EQUIPMENT
Illustration 13-1 (page 616) states that the investing activities section should report
cash received from the sale of plant assets. Because of this, companies must eliminate
from net income all gains and losses related to the disposal of plant assets, to arrive
at cash provided by operating activities.
In our example, Computer Services’ income statement reports a $3,000 loss on
the sale of equipment (book value $7,000, less $4,000 cash received from sale of
equipment). The company’s loss of $3,000 should not be included in the operating
activities section of the statement of cash flows. Illustration 13-7 shows that the
$3,000 loss is eliminated by adding $3,000 back to net income to arrive at net cash
provided by operating activities.
Illustration 13-7
Adjustment for loss on sale
of equipment
Cash flows from operating activities
Net income
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation expense
Loss on sale of equipment
Net cash provided by operating activities
$145,000
$9,000
3,000
12,000
$157,000
If a gain on sale occurs, the company deducts the gain from its net income in
order to determine net cash provided by operating activities. In the case of either
a gain or a loss, companies report as a source of cash in the investing activities
section of the statement of cash flows the actual amount of cash received from
the sale.
CHANGES TO NONCASH CURRENT ASSET AND CURRENT
LIABILITY ACCOUNTS
A final adjustment in reconciling net income to net cash provided by operating
activities involves examining all changes in current asset and current liability
accounts. The accrual accounting process records revenues in the period earned
and expenses in the period incurred. For example, companies use Accounts
Receivable to record amounts owed to the company for sales that have been
made but for which cash collections have not yet been received. They use the
Prepaid Insurance account to reflect insurance that has been paid for, but which
has not yet expired, and therefore has not been expensed. Similarly, the Salaries
Payable account reflects salaries expense that has been incurred by the company
but has not been paid.
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Preparing the Statement of Cash Flows—Indirect Method
As a result, we need to adjust net income for these accruals and prepayments
to determine net cash provided by operating activities. Thus we must analyze the
change in each current asset and current liability account to determine its impact
on net income and cash.
CHANGES IN NONCASH CURRENT ASSETS. The adjustments required for changes
in noncash current asset accounts are as follows: Deduct from net income increases
in current asset accounts, and add to net income decreases in current asset accounts, to arrive at net cash provided by operating activities. We can observe these
relationships by analyzing the accounts of Computer Services Company.
Decrease in Accounts Receivable. Computer Services Company’s accounts
receivable decreased by $10,000 (from $30,000 to $20,000) during the period. For
Computer Services this means that cash receipts were $10,000 higher than revenues. The Accounts Receivable account in Illustration 13-8 shows that Computer
Services Company had $507,000 in revenues (as reported on the income statement),
but it collected $517,000 in cash.
Accounts Receivable
1/1/11
12/31/11
Balance
Revenues
Balance
30,000
507,000
Receipts from customers
517,000
20,000
To adjust net income to net cash provided by operating activities, the company
adds to net income the decrease of $10,000 in accounts receivable (see Illustration 13-9, page 624). If the Accounts Receivable balance increases, cash receipts are
lower than revenue earned under the accrual basis.Therefore, the company deducts
from net income the amount of the increase in accounts receivable, to arrive at net
cash provided by operating activities.
Increase in Merchandise Inventory. Computer Services Company’s
Merchandise Inventory balance increased $5,000 (from $10,000 to $15,000) during
the period. The change in the Merchandise Inventory account reflects the difference between the amount of inventory purchased and the amount sold. For
Computer Services this means that the cost of merchandise purchased exceeded
the cost of goods sold by $5,000. As a result, cost of goods sold does not reflect
$5,000 of cash payments made for merchandise. The company deducts from net
income this inventory increase of $5,000 during the period, to arrive at net cash
provided by operating activities (see Illustration 13-9, page 624). If inventory decreases, the company adds to net income the amount of the change, to arrive at net
cash provided by operating activities.
Increase in Prepaid Expenses. Computer Services’ prepaid expenses increased during the period by $4,000. This means that cash paid for expenses is
higher than expenses reported on an accrual basis. In other words, the company
has made cash payments in the current period, but will not charge expenses
to income until future periods (as charges to the income statement). To adjust
net income to net cash provided by operating activities, the company deducts
from net income the $4,000 increase in prepaid expenses (see Illustration 13-9,
page 624).
If prepaid expenses decrease, reported expenses are higher than the expenses
paid. Therefore, the company adds to net income the decrease in prepaid expenses,
to arrive at net cash provided by operating activities.
Illustration 13-8
Analysis of accounts
receivable
623
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Chapter 13 Statement of Cash Flows
Illustration 13-9
Adjustments for changes
in current asset accounts
Cash flows from operating activities
Net income
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation expense
Loss on sale of equipment
Decrease in accounts receivable
Increase in merchandise inventory
Increase in prepaid expenses
$145,000
$ 9,000
3,000
10,000
(5,000)
(4,000)
Net cash provided by operating activities
13,000
$158,000
CHANGES IN CURRENT LIABILITIES. The adjustments required for changes in current
liability accounts are as follows: Add to net income increases in current liability
accounts, and deduct from net income decreases in current liability accounts, to
arrive at net cash provided by operating activities.
Increase in Accounts Payable. For Computer Services Company, Accounts
Payable increased by $16,000 (from $12,000 to $28,000) during the period. That
means the company received $16,000 more in goods than it actually paid for. As
shown in Illustration 13-10 (below), to adjust net income to determine net cash
provided by operating activities, the company adds to net income the $16,000
increase in Accounts Payable.
Decrease in Income Tax Payable. When a company incurs income tax expense
but has not yet paid its taxes, it records income tax payable.A change in the Income
Tax Payable account reflects the difference between income tax expense incurred
and income tax actually paid. Computer Services’ Income Tax Payable account decreased by $2,000. That means the $47,000 of income tax expense reported on the
income statement was $2,000 less than the amount of taxes paid during the period
of $49,000. As shown in Illustration 13-10, to adjust net income to a cash basis, the
company must reduce net income by $2,000.
Illustration 13-10
Adjustments for changes in
current liability accounts
Cash flows from operating activities
Net income
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation expense
Loss on sale of equipment
Decrease in accounts receivable
Increase in merchandise inventory
Increase in prepaid expenses
Increase in accounts payable
Decrease in income tax payable
Net cash provided by operating activities
$145,000
$ 9,000
3,000
10,000
(5,000)
(4,000)
16,000
(2,000)
27,000
$172,000
Illustration 13-10 shows that, after starting with net income of $145,000, the
sum of all of the adjustments to net income was $27,000. This resulted in net cash
provided by operating activities of $172,000.
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625
Summary of Conversion to Net Cash Provided
by Operating Activities—Indirect Method
As shown in the previous illustrations, the statement of cash flows prepared by the indirect method starts with net income. It then adds or deducts items to arrive at net
cash provided by operating activities. The required adjustments are of three types:
1. Noncash charges such as depreciation, amortization, and depletion.
2. Gains and losses on the sale of plant assets.
3. Changes in noncash current asset and current liability accounts.
Illustration 13-11 provides a summary of these changes.
Adjustment Required
to Convert Net Income
to Net Cash Provided
by Operating Activities
Loss on sale of plant asset
Gain on sale of plant asset
Add
Deduct
⎫
⎬
⎭
Changes in
Current Assets
and
Current Liabilities
Depreciation expense
Patent amortization expense
Depletion expense
⎫
⎬
⎭
Gains
and Losses
⎫
⎬
⎭
Noncash
Charges
Increase in current asset account
Decrease in current asset account
Increase in current liability account
Decrease in current liability account
Deduct
Add
Add
Deduct
Illustration 13-11
Adjustments required to
convert net income to net
cash provided by operating
activities
Add
Add
Add
before you go on...
Do it!
Josh’s PhotoPlus reported net income of $73,000 for 2011. Included in the income statement were depreciation expense of $7,000 and a gain on sale of equipment of $2,500.
Josh’s comparative balance sheets show the following balances.
Accounts receivable
Accounts payable
12/31/10
12/31/11
$17,000
6,000
$21,000
2,200
Calculate net cash provided by operating activities for Josh’s PhotoPlus.
Solution
Cash flows from operating activities
Net income
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation expense
Gain on sale of equipment
Increase in accounts receivable
Decrease in accounts payable
Net cash provided by operating activities
$73,000
$7,000
(2,500)
(4,000)
(3,800)
(3,300)
$69,700
Related exercise material: BE13-4, BE13-5, BE13-6, BE13-7, E13-4, E13-5, E13-6, E13-7, E13-8, and Do it!
13-2.
Cash from Operating
Activities
Action Plan
• Add noncash charges such as
depreciation back to net income
to compute net cash provided
by operating activities.
• Deduct from net income gains
on the sale of plant assets, or
add losses back to net income,
to compute net cash provided
by operating activities.
• Use changes in noncash current
asset and current liability
accounts to compute net cash
provided by operating activities.
✓
The Navigator
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ACCOUNTING ACROSS THE ORGANIZATION
GM Must Sell More Cars
Market share matters—and it shows up in the accounting numbers. Just ask
General Motors. In recent years GM has seen its market share erode until, at
25.6% of the market, the company reached the point where it actually consumed more cash
than it generated. It isn’t time to panic yet—GM has about $20 billion in cash on hand—but it
is time to come up with a plan.
To address immediate cash needs, GM management reduced its annual dividend and sold
off some assets and businesses. Even these measures were not enough to avoid bankruptcy.
GM is now in the process of shrinking its operations to fit its sales figures. The following table
shows net income and cash provided by operating activities at various market-share levels.
$3.0
Cash flow*
Net income*
$1.5
$0
⫺$1.5
25%
24%
23%
22%
21%
20%
28%
27%
26%
U.S. market share
⫺$3.0
⫺$4.5
GM'S current U.S.
market share = 25.6%
Data: Merrill Lynch & Co.
*Net income and cash flow figures in billions of dollars, including GMAC.
Source: David Welch and Dan Beucke, “Why GM’s Plan Won’t Work,” Business Week, May 9, 2005, pp. 85–93.
Why does GM’s cash provided by operating activities drop so precipitously when the
company’s sales figures decline?
Step 2: Investing and Financing Activities
ANALYZE CHANGES IN NONCURRENT ASSET
AND LIABILITY ACCOUNTS AND RECORD AS INVESTING
AND FINANCING ACTIVITIES, OR AS NONCASH INVESTING
AND FINANCING ACTIVITIES
Increase in Land. As indicated from the change in the Land account and the
additional information, the company purchased land of $110,000 through the
issuance of long-term bonds. The issuance of bonds payable for land has no effect
on cash. But it is a significant noncash investing and financing activity that merits
disclosure in a separate schedule. (See Illustration 13-13 on page 628.)
Increase in Building. As the additional data indicate, Computer Services
Company acquired an office building for $120,000 cash. This is a cash outflow
reported in the investing section. (See Illustration 13-13 on page 628.)
Increase in Equipment. The Equipment account increased $17,000. The additional information explains that this was a net increase that resulted from two
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627
transactions: (1) a purchase of equipment of $25,000, and (2) the sale for $4,000 of
equipment costing $8,000. These transactions are investing activities. The company should report each transaction separately. Thus it reports the purchase of
equipment as an outflow of cash for $25,000. It reports the sale as an inflow of cash
for $4,000. The T account below shows the reasons for the change in this account
during the year.
Illustration 13-12
Analysis of equipment
Equipment
1/1/11 Balance
Purchase of equipment
12/31/11 Balance
10,000
25,000
Cost of equipment sold
8,000
27,000
The following entry shows the details of the equipment sale transaction.
A
Cash
Accumulated Depreciation
Loss on Sale of Equipment
Equipment
⫽
L
⫹
SE
⫹4,000
⫹1,000
4,000
1,000
3,000
⫺3,000 Exp
8,000
⫺8,000
Cash Flows
⫹4,000
Increase in Bonds Payable. The Bonds Payable account increased $110,000. As
indicated in the additional information, the company acquired land from the
issuance of these bonds. It reports this noncash transaction in a separate schedule
at the bottom of the statement.
Increase in Common Stock. The balance sheet reports an increase in Common
Stock of $20,000. The additional information section notes that this increase resulted from the issuance of new shares of stock. This is a cash inflow reported in the
financing section.
Increase in Retained Earnings. Retained earnings increased $116,000
during the year. This increase can be explained by two factors: (1) Net income
of $145,000 increased retained earnings. (2) Dividends of $29,000 decreased
retained earnings. The company adjusts net income to net cash provided by operating activities in the operating activities section. Payment of the dividends
(not the declaration) is a cash outflow that the company reports as a financing
activity.
STATEMENT OF CASH FLOWS—2011
Using the previous information, we can now prepare a statement of cash flows for
2011 for Computer Services Company as shown in Illustration 13-13 (page 628).
Step 3: Net Change in Cash
COMPARE THE NET CHANGE IN CASH ON THE STATEMENT OF CASH
FLOWS WITH THE CHANGE IN THE CASH ACCOUNT REPORTED ON
THE BALANCE SHEET TO MAKE SURE THE AMOUNTS AGREE
Illustration 13-13 indicates that the net change in cash during the period was an
increase of $22,000. This agrees with the change in Cash account reported on the
balance sheet in Illustration 13-4 (page 620).
HELPFUL HINT
When companies issue
stocks or bonds for cash,
the actual proceeds will
appear in the statement
of cash flows as a
financing inflow (rather
than the par value of the
stocks or face value of
bonds).
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Chapter 13 Statement of Cash Flows
Illustration 13-13
Statement of cash flows,
2011—indirect method
HELPFUL HINT
Note that in the investing and financing activities sections, positive
numbers indicate cash
inflows (receipts), and
negative numbers
indicate cash outflows
(payments).
COMPUTER SERVICES COMPANY
Statement of Cash Flows—Indirect Method
For the Year Ended December 31, 2011
Cash flows from operating activities
Net income
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation expense
Loss on sale of equipment
Decrease in accounts receivable
Increase in merchandise inventory
Increase in prepaid expenses
Increase in accounts payable
Decrease in income tax payable
$145,000
$
Net cash provided by operating activities
Cash flows from investing activities
Purchase of building
Purchase of equipment
Sale of equipment
Net cash used by investing activities
Cash flows from financing activities
Issuance of common stock
Payment of cash dividends
9,000
3,000
10,000
(5,000)
(4,000)
16,000
(2,000)
27,000
172,000
(120,000)
(25,000)
4,000
(141,000)
20,000
(29,000)
Net cash used by financing activities
(9,000)
Net increase in cash
Cash at beginning of period
22,000
33,000
Cash at end of period
$ 55,000
Noncash investing and financing activities
Issuance of bonds payable to purchase land
$110,000
before you go on...
Indirect Method
Action Plan
• Determine net cash provided/
used by operating activities by
adjusting net income for items
that did not affect cash.
• Determine net cash
provided/used by investing
activities and financing activities.
• Determine the net increase/
decrease in cash.
Do it!
Use the information below and on the next page to prepare a statement of
cash flows using the indirect method.
REYNOLDS COMPANY
Comparative Balance Sheets
December 31
Assets
Cash
Accounts receivable
Inventories
Prepaid expenses
Land
Buildings
Accumulated depreciation—buildings
Equipment
Accumulated depreciation—equipment
Totals
2011
2010
Change
Increase/Decrease
$ 54,000
68,000
54,000
4,000
45,000
200,000
(21,000)
193,000
(28,000)
$ 37,000
26,000
–0–
6,000
70,000
200,000
(11,000)
68,000
(10,000)
$ 17,000 Increase
42,000 Increase
54,000 Increase
2,000 Decrease
25,000 Decrease
–0–
10,000 Increase
125,000 Increase
18,000 Increase
$569,000
$386,000
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Preparing the Statement of Cash Flows—Indirect Method
629
Liabilities and Stockholders’ Equity
Accounts payable
Accrued expenses payable
Bonds payable
Common stock ($1 par)
Retained earnings
Totals
$ 23,000
10,000
110,000
220,000
206,000
$ 40,000
–0–
150,000
60,000
136,000
$569,000
$386,000
$ 17,000
10,000
40,000
160,000
70,000
Decrease
Increase
Decrease
Increase
Increase
REYNOLDS COMPANY
Income Statement
For the Year Ended December 31, 2011
Revenues
Cost of goods sold
Operating expenses
Interest expense
Loss on sale of equipment
$890,000
$465,000
221,000
12,000
2,000
700,000
Income before income taxes
Income tax expense
190,000
65,000
Net income
$125,000
Additional information:
1. Operating expenses include depreciation expense of $33,000 and charges from prepaid
expenses of $2,000.
2. Land was sold at its book value for cash.
3. Cash dividends of $55,000 were declared and paid in 2011.
4. Interest expense of $12,000 was paid in cash.
5. Equipment with a cost of $166,000 was purchased for cash. Equipment with a cost of
$41,000 and a book value of $36,000 was sold for $34,000 cash.
6. Bonds of $10,000 were redeemed at their face value for cash. Bonds of $30,000 were
converted into common stock.
7. Common stock ($1 par) of $130,000 was issued for cash.
8. Accounts payable pertain to merchandise suppliers.
Solution
REYNOLDS COMPANY
Statement of Cash Flows—Indirect Method
For the Year Ended December 31, 2011
Cash flows from operating activities
Net income
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation expense
Loss on sale of equipment
Increase in accounts receivable
Increase in inventories
Decrease in prepaid expenses
Decrease in accounts payable
Increase in accrued expenses payable
Net cash provided by operating activities
$125,000
$ 33,000
2,000
(42,000)
(54,000)
2,000
(17,000)
10,000
(66,000)
59,000
HELPFUL HINT
1. Determine net cash
provided/used by
operating activities,
recognizing that
operating activities
generally relate to
changes in current
assets and current
liabilities.
2. Determine net cash
provided/used by
investing activities,
recognizing that
investing activities
generally relate to
changes in noncurrent
assets.
3. Determine net cash
provided/used by
financing activities,
recognizing that
financing activities
generally relate to
changes in long-term
liabilities and stockholders’ equity
accounts.
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Chapter 13 Statement of Cash Flows
Cash flows from investing activities
Sale of land
Sale of equipment
Purchase of equipment
Net cash used by investing activities
Cash flows from financing activities
Redemption of bonds
Sale of common stock
Payment of dividends
25,000
34,000
(166,000)
(107,000)
(10,000)
130,000
(55,000)
Net cash provided by financing activities
65,000
Net increase in cash
Cash at beginning of period
17,000
37,000
Cash at end of period
$ 54,000
Noncash investing and financing activities
Conversion of bonds into common stock
$ 30,000
Related exercise material: BE13-4, BE13-5, BE13-6, BE13-7, E13-4, E13-5, E13-6, E13-7, E13-8, and E13-9.
✓
The Navigator
USING CASH FLOWS TO EVALUATE A COMPANY
STUDY OBJECTIVE 4
Analyze the statement of cash
flows.
Traditionally, investors and creditors have most commonly used ratios
based on accrual accounting. These days, cash-based ratios are gaining increased acceptance among analysts.
Free Cash Flow
In the statement of cash flows, cash provided by operating activities is intended
to indicate the cash-generating capability of the company. Analysts have noted,
however, that cash provided by operating activities fails to take into account that
a company must invest in new fixed assets just to maintain its current level of
operations. Companies also must at least maintain dividends at current levels to
satisfy investors. The measurement of free cash flow provides additional insight
regarding a company’s cash-generating ability. Free cash flow describes the
cash remaining from operations after adjustment for capital expenditures and
dividends.
Consider the following example: Suppose that MPC produced and sold
10,000 personal computers this year. It reported $100,000 cash provided by operating activities. In order to maintain production at 10,000 computers, MPC
invested $15,000 in equipment. It chose to pay $5,000 in dividends. Its free cash
flow was $80,000 ($100,000 ⫺ $15,000 ⫺ $5,000). The company could use this
$80,000 either to purchase new assets to expand the business or to pay an $80,000
dividend and continue to produce 10,000 computers. In practice, free cash flow is
often calculated with the formula in Illustration 13-14. (Alternative definitions
also exist.)
Illustration 13-14
Free cash flow
Free Cash
Cash Provided by
Capital
Cash
ⴝ
ⴚ
ⴚ
Flow
Operating Activities
Expenditures
Dividends
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631
Illustration 13-15 provides basic information (in millions) excerpted from the
2008 statement of cash flows of Microsoft Corporation.
Illustration 13-15
Microsoft cash flow
information ($ in millions)
MICROSOFT CORPORATION
Statement of Cash Flows (partial)
2008
Cash provided by operating activities
Cash flows from investing activities
Additions to property and equipment
Purchases of investments
Sales of investments
Acquisitions of companies
Maturities of investments
Other
$21,612
$ (3,182)
(20,954)
25,132
(8,053)
2,597
(127)
Cash used by investing activities
Cash paid for dividends
(4,587)
(4,015)
Microsoft’s free cash flow is calculated as shown in Illustration 13-16.
Cash provided by operating activities
Less: Expenditures on property and equipment
Dividends paid
$21,612
3,182
4,015
Free cash flow
$14,415
This is a tremendous amount of cash generated in a single year. It is available
for the acquisition of new assets, the retirement of stock or debt, or the payment of
dividends. As indicated in the Feature Story, for example, Microsoft is attempting
to buy Yahoo! for over $44 billion as part of its acquisition strategey.
Oracle Corporation is one of the world’s largest sellers of database software and
information management services. Like Microsoft, its success depends on continuing
to improve its existing products while developing new products to keep pace with
rapid changes in technology. Oracle’s free cash flow for 2008 was $7,159 million. This
is impressive, but significantly less than Microsoft’s amazing ability to generate cash.
Be sure to read
all about Y U
*
Where Does
the Money Go?
on page 633 for
information on how topics
in this chapter apply
to you.
Illustration 13-16
Calculation of Microsoft’s
free cash flow ($ in millions)
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Chapter 13 Statement of Cash Flows
before you go on...
Free Cash Flow
Do it!
Chicago Corporation issued the following statement of cash flows for 2011.
CHICAGO CORPORATION
Statement of Cash Flows—Indirect Method
For the Year Ended December 31, 2011
Cash flows from operating activities
Net income
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation expense
Loss on sale of equipment
Decrease in accounts receivable
Increase in inventory
Decrease in accounts payable
Net cash provided by operating activities
Cash flows from investing activities
Sale of investments
Purchase of equipment
$19,000
$ 8,100
1,300
6,900
(4,000)
(2,000)
1,100
(19,000)
Net cash used by investing activities
Cash flows from financing activities
Issuance of stock
Payment on long-term note payable
Payment for dividends
(17,900)
10,000
(5,000)
(9,000)
Net cash used by financing activities
(4,000)
Net increase in cash
Cash at beginning of year
7,400
10,000
Cash at end of year
Action Plan
• Compute free cash flow as:
Cash provided by operating
activities ⫺ Capital
expenditures ⫺ Cash dividends.
10,300
29,300
$17,400
(a) Compute free cash flow for Chicago Corporation. (b) Explain why free cash flow often
provides better information than “Net cash provided by operating activities.”
Solution
(a) Free cash flow ⫽ $29,300 ⫺ $19,000 ⫺ $9,000 ⫽ $1,300
(b) Cash provided by operating activities fails to take into account that a company must invest
in new plant assets just to maintain the current level of operations. Companies must also
maintain dividends at current levels to satisfy investors. The measurement of free cash flow
provides additional insight regarding a company’s cash-generating ability.
Related exercise material: BE13-8, BE13-9, BE13-10, BE13-11, E13-7, E13-9, and Do it! 13-3.
✓
The Navigator
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all about Y U
*
Where Does the Money Go?
W
When a company’s cash flow from operating
activities does not cover its cash needs, it must
borrow money. In the short term this is OK, but in
the long-term it can spell disaster. Sooner or later the
company needs to increase its cash from operations
or cut back on its expenditures, or it will go broke.
Guess what? The same is true for you and me.
Where do you spend your cash? Most of us know
how much we spend each month on rent and car
payments. But how much do you spend each month
on soda, coffee, pizza, video rentals, music downloads,
and your cell phone service? Don’t think it matters?
Suppose you spend an average of only $4 per day on
unneeded “incidentals.” That’s $120 a month, or
almost $1,500 per year.
*About the Numbers
College students spend an average of $287 per month on discretionary items
(defined as anything other than tuition, room/board, rent, books, and school fees).
A large chunk of that—more than $11 billion—is spent on beverages and snack
foods. Maybe this would be a good place to start cutting your expenditures.
Annual Spending by College Students on Beverages and Snacks
Sports drinks
Chip snacks
Coffee
Bottled water
Bottled juice
Soda
$0
$1,000
$2,000
$3,000
Dollars in millions
$4,000
Source: “College Students Spend $200 Billion per Year,” HarrisInteractive,
www.harrisinteractive.com/news/allnewsbydate.asp?NewsID⫽480 (accessed May 2006).
*
Some Facts
* College students spend about $200 billion per year
on consumer products. Of that amount, $41 billion
is “discretionary” in nature.
* More than 70% of college students own a cell phone,
and 71% own a car.
* College students spend more than $8 billion per
year purchasing DVDs, CDs, music downloads, and
video games.
* Annual spending on travel by college students is
about $4.6 billion.
* 78% of college students work, earning an average
of $821 per month.
*What Do You Think?
Let’s say that you live on campus and own a car. You use the car for pleasure
and to drive to a job that is three miles away. Suppose your annual cash flow
statement includes the following items.
Cash inflows:
Wages
Student loans
Credit card debt
Cash outflows:
Tuition, books, room, and board
Vehicle costs
Vacation
Cell phone service
Snacks and beverages
$ 9,000
5,000
4,000
13,000
2,000
2,000
500
500
Should you get rid of your car and cell phone, quit eating snacks, and give up
the idea of a vacation?
YES: At this rate you will accumulate nearly $40,000 in debts by the time
you graduate. It is not fun to spend most of the paycheck of your postgraduation job paying off the debts you accumulated while in school.
NO: Give me a break. A person has to have some fun. Life wouldn’t be
worth living if I couldn’t be drinking a Starbucks while cruising down the
road talking on my cell phone.
Sources: Becky Ebenkamp, “College Communications 101,” Brandweek, August 22-29, 2005, p. 16.
*
The authors’ comments on this situation appear on page 672.
633
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Chapter 13 Statement of Cash Flows
Comprehensive Do it!
The income statement for the year ended December 31, 2011, for Kosinski Manufacturing
Company contains the following condensed information.
KOSINSKI MANUFACTURING COMPANY
Income Statement
For the Year Ended December 31, 2011
Revenues
Operating expenses (excluding depreciation)
Depreciation expense
$6,583,000
$4,920,000
880,000
Income before income taxes
Income tax expense
5,800,000
783,000
353,000
Net income
$ 430,000
Included in operating expenses is a $24,000 loss resulting from the sale of machinery for $270,000
cash. Machinery was purchased at a cost of $750,000.
The following balances are reported on Kosinski’s comparative balance sheets at December 31.
KOSINSKI MANUFACTURING COMPANY
Comparative Balance Sheets (partial)
Cash
Accounts receivable
Inventories
Accounts payable
2011
2010
$672,000
775,000
834,000
521,000
$130,000
610,000
867,000
501,000
Income tax expense of $353,000 represents the amount paid in 2011. Dividends declared
and paid in 2011 totaled $200,000.
Instructions
Action Plan
• Determine net cash from operating activities. Operating
activities generally relate to
changes in current assets and
current liabilities.
• Determine net cash from investing activities. Investing activities
generally relate to changes in
noncurrent assets.
• Determine net cash from
financing activities. Financing
activities generally relate to
changes in long-term liabilities
and stockholders’ equity
accounts.
Prepare the statement of cash flows using the indirect method.
Solution to Comprehensive
Do it!
KOSINSKI MANUFACTURING COMPANY
Statement of Cash Flows—Indirect Method
For the Year Ended December 31, 2011
Cash flows from operating activities
Net income
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation expense
$ 880,000
Loss on sale of machinery
24,000
Increase in accounts receivable
(165,000)
Decrease in inventories
33,000
Increase in accounts payable
20,000
Net cash provided by operating activities
Cash flows from investing activities
Sale of machinery
Purchase of machinery
$ 430,000
792,000
1,222,000
270,000
(750,000)
Net cash used by investing activities
Cash flows from financing activities
Payment of cash dividends
(480,000)
(200,000)
Net increase in cash
Cash at beginning of period
Cash at end of period
542,000
130,000
$ 672,000
✓
The Navigator
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635
SUMMARY OF STUDY OBJECTIVES
1 Indicate the usefulness of the statement of cash flows.
The statement of cash flows provides information about
the cash receipts, cash payments, and net change in cash
resulting from the operating, investing, and financing activities of a company during the period.
2 Distinguish among operating, investing, and financing
activities. Operating activities include the cash effects of
transactions that enter into the determination of net income. Investing activities involve cash flows resulting from
changes in investments and long-term asset items. Financing
activities involve cash flows resulting from changes in longterm liability and stockholders’ equity items.
provided/used by operating activities by converting net
income from an accrual basis to a cash basis. (2) Analyze
changes in noncurrent asset and liability accounts and
record as investing and financing activities, or disclose as
noncash transactions. (3) Compare the net change in cash
on the statement of cash flows with the change in the cash
account reported on the balance sheet to make sure the
amounts agree.
4 Analyze the statement of cash flows. Free cash flow
indicates the amount of cash a company generated during
the current year that is available for the payment of additional dividends or for expansion.
3 Prepare a statement of cash flows using the indirect
method. The preparation of a statement of cash flows
involves three major steps: (1) Determine net cash
✓
The Navigator
GLOSSARY
Direct method A method of determining net cash provided
by operating activities by adjusting each item in the income
statement from the accrual basis to the cash basis and
which shows operating cash recipts and payments. (p. 619).
Financing activities Cash flow activities that include (a) obtaining cash from issuing debt and repaying the amounts
borrowed and (b) obtaining cash from stockholders, repurchasing shares, and paying dividends. (p. 615).
Free cash flow Cash provided by operating activities
adjusted for capital expenditures and dividends paid.
(p. 630).
Indirect method A method of preparing a statement of
cash flows in which net income is adjusted for items that do
not affect cash, to determine net cash provided by operating activities. (pp. 618, 621).
Investing activities Cash flow activities that include
(a) purchasing and disposing of investments and property,
plant, and equipment using cash and (b) lending money
and collecting the loans. (p. 615).
Operating activities Cash flow activities that include the
cash effects of transactions that create revenues and expenses
and thus enter into the determination of net income. (p. 615).
Statement of cash flows A basic financial statement that
provides information about the cash receipts, cash payments, and net change in cash during a period, resulting
from operating, investing, and financing activities. (p. 614).
Using a Worksheet to Prepare the
Statement of Cash Flows—Indirect Method
APPENDIX 13A
When preparing a statement of cash flows, companies may need to
make numerous adjustments of net income. In such cases, they often use a
worksheet to assemble and classify the data that will appear on the statement. The worksheet is merely an aid in preparing the statement. Its use is
optional. Illustration 13A-1 (page 636) shows the skeleton format of the
worksheet for preparation of the statement of cash flows.
The following guidelines are important in preparing a worksheet.
STUDY OBJECTIVE 5
Explain how to use a worksheet
to prepare the statement of cash
flows using the indirect method.
1. In the balance sheet accounts section, list accounts with debit balances separately
from those with credit balances. This means, for example, that Accumulated
Depreciation appears under credit balances and not as a contra account under
debit balances. Enter the beginning and ending balances of each account in the
appropriate columns. Enter as reconciling items in the two middle columns the
transactions that caused the change in the account balance during the year.
After all reconciling items have been entered, each line pertaining to a
balance sheet account should “foot across.” That is, the beginning balance plus
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Illustration 13A-1
Format of worksheet
XYZ Company.xls
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XYZ COMPANY
Worksheet
Statement of Cash Flows For the Year Ended . . .
Balance Sheet Accounts
Debit balance accounts
Totals
Credit balance accounts
Totals
Statement of Cash
Flows Effects
Operating activities
Net income
Adjustments to net income
Investing activities
Receipts and payments
Financing activities
Receipts and payments
Totals
Increase (decrease) in cash
Totals
End of
Last Year
Balances
XX
XX
XXX
XX
XX
XXX
Reconciling Items
Debit
Credit
XX
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(XX)
XXX
End of
Current Year
Balances
XX
XX
XXX
XX
XX
XXX
XX
XXX
XX
XXX
or minus the reconciling item(s) must equal the ending balance. When this
agreement exists for all balance sheet accounts, all changes in account balances
have been reconciled.
2. The bottom portion of the worksheet consists of the operating, investing, and
financing activities sections. It provides the information necessary to prepare
the formal statement of cash flows. Enter inflows of cash as debits in the reconciling columns. Enter outflows of cash as credits in the reconciling columns.
Thus, in this section, the sale of equipment for cash at book value appears as a
debit under investing activities. Similarly, the purchase of land for cash appears
as a credit under investing activities.
3. The reconciling items shown in the worksheet are not entered in any journal or
posted to any account. They do not represent either adjustments or corrections
of the balance sheet accounts. They are used only to facilitate the preparation
of the statement of cash flows.
Preparing the Worksheet
As in the case of worksheets illustrated in earlier chapters, preparing a worksheet
involves a series of prescribed steps. The steps in this case are:
1. Enter in the balance sheet accounts section the balance sheet accounts and
their beginning and ending balances.
2. Enter in the reconciling columns of the worksheet the data that explain the
changes in the balance sheet accounts other than cash and their effects on the
statement of cash flows.
3. Enter on the cash line and at the bottom of the worksheet the increase or
decrease in cash. This entry should enable the totals of the reconciling columns
to be in agreement.
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637
To illustrate the preparation of a worksheet, we will use the 2011 data for
Computer Services Company. Your familiarity with these data (from the chapter)
should help you understand the use of a worksheet. For ease of reference, the
comparative balance sheets, income statement, and selected data for 2011 are
presented in Illustration 13A-2 (on page 638).
DETERMINING THE RECONCILING ITEMS
Companies can use one of several approaches to determine the reconciling items.
For example, they can first complete the changes affecting net cash provided by
operating activities, and then can determine the effects of financing and investing
transactions. Or, they can analyze the balance sheet accounts in the order in which
they are listed on the worksheet. We will follow this latter approach for Computer
Services, except for cash. As indicated in step 3, cash is handled last.
Accounts Receivable. The decrease of $10,000 in accounts receivable means
that cash collections from revenues are higher than the revenues reported in the
income statement.To convert net income to net cash provided by operating activities,
we add the decrease of $10,000 to net income. The entry in the reconciling columns
of the worksheet is:
(a)
Operating—Decrease in Accounts Receivable
Accounts Receivable
10,000
10,000
Merchandise Inventory. Computer Services Company’s Merchandise Inventory
balance increases $5,000 during the period. The Merchandise Inventory account
reflects the difference between the amount of inventory that the company purchased
and the amount that it sold. For Computer Services this means that the cost of merchandise purchased exceeds the cost of goods sold by $5,000. As a result, cost of
goods sold does not reflect $5,000 of cash payments made for merchandise. We
deduct this inventory increase of $5,000 during the period from net income to
arrive at net cash provided by operating activities. The worksheet entry is:
(b)
Merchandise Inventory
Operating—Increase in Merchandise
Inventory
5,000
5,000
Prepaid Expenses. An increase of $4,000 in prepaid expenses means that expenses deducted in determining net income are less than expenses that were paid
in cash. We deduct the increase of $4,000 from net income in determining net cash
provided by operating activities. The worksheet entry is:
(c)
Prepaid Expenses
Operating—Increase in Prepaid Expenses
4,000
4,000
Land. The increase in land of $110,000 resulted from a purchase through the
issuance of long-term bonds. The company should report this transaction as a significant noncash investing and financing activity. The worksheet entry is:
(d)
Land
Bonds Payable
110,000
110,000
Building. The cash purchase of a building for $120,000 is an investing activity
cash outflow. The entry in the reconciling columns of the worksheet is:
(e)
Building
Investing—Purchase of Building
120,000
120,000
Equipment. The increase in equipment of $17,000 resulted from a cash purchase
of $25,000 and the sale of equipment costing $8,000.The book value of the equipment
HELPFUL HINT
These amounts are
asterisked in the
worksheet to indicate
that they result from a
significant noncash
transaction.
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Chapter 13 Statement of Cash Flows
Illustration 13A-2
Comparative balance
sheets, income statement,
and additional information
for Computer Services
Company
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COMPUTER SERVICES COMPANY
Comparative Balance Sheets
December 31
Assets
Current assets
Cash
Accounts receivable
Merchandise inventory
Prepaid expenses
Property, plant, and equipment
Land
Building
Accumulated depreciation—building
Equipment
Accumulated depreciation—equipment
Total
Liabilities and Stockholders’ Equity
Current liabilities
Accounts payable
Income tax payable
Long-term liabilities
Bonds payable
Stockholders’ equity
Common stock
Retained earnings
Total liabilities and stockholders’ equity
2011
2010
Change in
Account Balance
Increase/Decrease
$ 55,000
20,000
15,000
5,000
$ 33,000
30,000
10,000
1,000
$ 22,000 Increase
10,000 Decrease
5,000 Increase
4,000 Increase
130,000
160,000
(11,000)
27,000
(3,000)
$398,000
20,000
40,000
(5,000)
10,000
(1,000)
$138,000
$ 28,000
6,000
$ 12,000
8,000
130,000
20,000
110,000 Increase
70,000
164,000
$398,000
50,000
48,000
$138,000
20,000 Increase
116,000 Increase
110,000
120,000
6,000
17,000
2,000
Increase
Increase
Increase
Increase
Increase
$ 16,000 Increase
2,000 Decrease
Sheet 1 Sheet 2
Computer Services Company.xls
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COMPUTER SERVICES COMPANY
Income Statement
For the Year Ended December 31, 2011
Revenues
Cost of goods sold
Operating expenses (excluding depreciation)
Depreciation expense
Loss on sale of equipment
Interest expense
Income before income tax
Income tax expense
Net income
$507,000
$150,000
111,000
9,000
3,000
42,000
315,000
192,000
47,000
$145,000
Sheet 1 Sheet 2
Additional information for 2011:
1. The company declared and paid a $29,000 cash dividend.
2. Issued $110,000 of long-term bonds in direct exchange for land.
3. A building costing $120,000 was purchased for cash. Equipment costing $25,000 was also
purchased for cash.
4. The company sold equipment with a book value of $7,000 (cost $8,000, less accumulated
depreciation $1,000) for $4,000 cash.
5. Issued common stock for $20,000 cash.
6. Depreciation expense was comprised of $6,000 for building and $3,000 for equipment.
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was $7,000, the cash proceeds were $4,000, and a loss of $3,000 was recorded. The
worksheet entries are:
(f)
(g)
Equipment
Investing—Purchase of Equipment
Investing—Sale of Equipment
Operating—Loss on Sale of Equipment
Accumulated Depreciation—Equipment
Equipment
25,000
25,000
4,000
3,000
1,000
8,000
Accounts Payable. We must add the increase of $16,000 in accounts payable to net
income to determine net cash provided by operating activities.The worksheet entry is:
(h)
Operating—Increase in Accounts Payable
Accounts Payable
16,000
16,000
Income Tax Payable. When a company incurs income tax expense but has not
yet paid its taxes, it records income tax payable. A change in the Income Tax
Payable account reflects the difference between income tax expense incurred
and income tax actually paid. Computer Services’ Income Tax Payable account
decreases by $2,000.That means the $47,000 of income tax expense reported on the
income statement was $2,000 less than the amount of taxes paid during the period
of $49,000. To adjust net income to a cash basis, we must reduce net income by
$2,000. The worksheet entry is:
(i)
Income Tax Payable
Operating—Decrease in Income Taxes
Payable
2,000
2,000
Bonds Payable. The increase of $110,000 in this account resulted from the issuance of bonds for land. This is a significant noncash investing and financing activity. Worksheet entry (d) above is the only entry necessary.
Common Stock. The balance sheet reports an increase in Common Stock of
$20,000. The additional information section notes that this increase resulted from
the issuance of new shares of stock. This is a cash inflow reported in the financing
section. The worksheet entry is:
(j)
Financing—Issuance of Common Stock
Common Stock
20,000
20,000
Accumulated Depreciation—Building, and Accumulated Depreciation—
Equipment. Increases in these accounts of $6,000 and $3,000, respectively,
resulted from depreciation expense. Depreciation expense is a noncash charge that
we must add to net income to determine net cash provided by operating activities.
The worksheet entries are:
(k)
(l)
Operating—Depreciation Expense—Building
Accumulated Depreciation—Building
6,000
Operating—Depreciation Expense—Equipment
Accumulated Depreciation—Equipment
3,000
6,000
3,000
Retained Earnings. The $116,000 increase in retained earnings resulted from
net income of $145,000 and the declaration and payment of a $29,000 cash dividend. Net income is included in net cash provided by operating activities, and the
dividends are a financing activity cash outflow. The entries in the reconciling
columns of the worksheet are:
(m)
(n)
Operating—Net Income
Retained Earnings
Retained Earnings
Financing—Payment of Dividends
145,000
145,000
29,000
29,000
639
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Chapter 13 Statement of Cash Flows
Disposition of Change in Cash. The firm’s cash increased $22,000 in 2011. The
final entry on the worksheet, therefore, is:
(o)
Cash
Increase in Cash
22,000
22,000
As shown in the worksheet, we enter the increase in cash in the reconciling credit
column as a balancing amount. This entry should complete the reconciliation of the
changes in the balance sheet accounts. Also, it should permit the totals of the reconciling columns to be in agreement. When all changes have been explained and
the reconciling columns are in agreement, the reconciling columns are ruled to
complete the worksheet. The completed worksheet for Computer Services
Company is shown in Illustration 13A-3.
Illustration 13A-3
Completed worksheet—
indirect method
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COMPUTER SERVICES COMPANY
Worksheet
Statement of Cash Flows For the Year Ended December 31, 2011
Balance Sheet Accounts
Debits
Cash
Accounts receivable
Merchandise inventory
Prepaid expenses
Land
Building
Equipment
Total
Credits
Accounts payable
Income tax payable
Bonds payable
Accumulated depreciation—building
Accumulated depreciation—equipment
Common stock
Retained earnings
Total
Statement of Cash Flows Effects
Operating activities
Net income
Decrease in accounts receivable
Increase in merchandise inventory
Increase in prepaid expenses
Increase in accounts payable
Decrease in income tax payable
Depreciation expense—building
Depreciation expense—equipment
Loss on sale of equipment
Investing activities
Purchase of building
Purchase of equipment
Sale of equipment
Financing activities
Issuance of common stock
Payment of dividends
Totals
Increase in cash
Totals
Reconciling Items
Debit
Credit
Balance
12/31/10
33,000
30,000
10,000
1,000
20,000
40,000
10,000
144,000
12,000
8,000
20,000
5,000
1,000
50,000
48,000
144,000
* Significant noncash investing and financing activity.
(o)
22,000
(b)
5,000
(c)
4,000
(d) 110,000*
(e) 120,000
(f) 25,000
(i)
(a)
10,000
(g)
8,000
(h)
16,000
2,000
(g)
1,000
(n)
29,000
(d) 110,000*
(k)
6,000
(l)
3,000
(j) 20,000
(m) 145,000
(m) 145,000
(a) 10,000
(h)
16,000
(k)
(l)
(g)
6,000
3,000
3,000
(b)
(c)
5,000
4,000
(i)
2,000
(e) 120,000
(f) 25,000
(g)
4,000
(j)
20,000
(n)
525,000
525,000
29,000
503,000
(o) 22,000
525,000
Balance
12/31/11
55,000
20,000
15,000
5,000
130,000
160,000
27,000
412,000
28,000
6,000
130,000
11,000
3,000
70,000
164,000
412,000
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641
SUMMARY OF STUDY OBJECTIVE FOR APPENDIX 13A
5 Explain how to use a worksheet to prepare the statement of cash flows using the indirect method. When
there are numerous adjustments, a worksheet can be a
helpful tool in preparing the statement of cash flows. Key
guidelines for using a worksheet are: (1) List accounts with
debit balances separately from those with credit balances.
(2) In the reconciling columns in the bottom portion of the
worksheet, show cash inflows as debits and cash outflows as
APPENDIX 13B
credits. (3) Do not enter reconciling items in any journal or
account, but use them only to help prepare the statement of
cash flows.
The steps in preparing the worksheet are: (1) Enter beginning and ending balances of balance sheet accounts.
(2) Enter debits and credits in reconciling columns. (3) Enter
the increase or decrease in cash in two places as a balancing
amount.
Statement of Cash Flows—Direct Method
To explain and illustrate the direct method, we will use the transactions of
Juarez Company for 2011, to prepare a statement of cash flows. Illustration
13B-1 presents information related to 2011 for Juarez Company.
STUDY OBJECTIVE 6
Prepare a statement of cash
flows using the direct method.
JUAREZ COMPANY
Comparative Balance Sheets
December 31
Assets
Cash
Accounts receivable
Inventory
Prepaid expenses
Land
Equipment
Accumulated depreciation—equipment
Total
2011
2010
Change
Increase/Decrease
$191,000
12,000
170,000
6,000
140,000
160,000
(16,000)
$159,000
15,000
160,000
8,000
80,000
–0–
–0–
$ 32,000 Increase
3,000 Decrease
10,000 Increase
2,000 Decrease
60,000 Increase
160,000 Increase
16,000 Increase
$663,000
$422,000
$ 52,000
15,000
12,000
130,000
360,000
94,000
$ 60,000
20,000
–0–
–0–
300,000
42,000
$663,000
$422,000
Liabilities and Stockholders’ Equity
Accounts payable
Accrued expenses payable
Income tax payable
Bonds payable
Common stock
Retained earnings
Total
$ 8,000 Decrease
5,000 Decrease
12,000 Increase
130,000 Increase
60,000 Increase
52,000 Increase
JUAREZ COMPANY
Income Statement
For the Year Ended December 31, 2011
Revenues
Cost of goods sold
Operating expenses (excluding depreciation)
Depreciation expense
Loss on sale of store equipment
Income before income taxes
Income tax expense
Net income
$975,000
$660,000
176,000
18,000
1,000
855,000
120,000
36,000
$ 84,000
Illustration 13B-1
Comparative balance
sheets, income statement,
and additional information
for Juarez Company
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Chapter 13 Statement of Cash Flows
Illustration 13B-1
(continued)
Additional information:
1. In 2011, the company declared and paid a $32,000 cash dividend.
2. Bonds were issued at face value for $130,000 in cash.
3. Equipment costing $180,000 was purchased for cash.
4. Equipment costing $20,000 was sold for $17,000 cash when the book value of the equipment
was $18,000.
5. Common stock of $60,000 was issued to acquire land.
To prepare a statement of cash flows under the direct approach, we will apply
the three steps outlined in Illustration 13-3 (page 619).
Step 1: Operating Activities
Illustration 13B-2
Major classes of cash
receipts and payments
Cash Receipts
DETERMINE NET CASH PROVIDED/USED BY OPERATING ACTIVITIES BY
CONVERTING NET INCOME FROM AN ACCRUAL BASIS TO A CASH BASIS
Under the direct method, companies compute net cash provided by operating activities by adjusting each item in the income statement from the accrual basis to the cash
basis.To simplify and condense the operating activities section, companies report only
major classes of operating cash receipts and cash payments. For these major classes,
the difference between cash receipts and cash payments is the net cash provided by
operating activities. These relationships are as shown in Illustration 13B-2.
–
Cash Payments
=
Net Cash Provided
by Operating Activities
To suppliers
From sales of
goods and services
to customers
To employees
For operating
expenses
Net cash
provided by
operating activities
For interest
From receipts
of interest and
dividends on loans
and investments
For taxes
An efficient way to apply the direct method is to analyze the items reported in
the income statement in the order in which they are listed. We then determine cash
receipts and cash payments related to these revenues and expenses. The following
pages present the adjustments required to prepare a statement of cash flows for
Juarez Company using the direct approach.
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Appendix 13B Statement of Cash Flows—Direct Method
643
Cash Receipts from Customers. The income statement for Juarez Company reported revenues from customers of $975,000. How much of that was cash receipts?
To answer that, companies need to consider the change in accounts receivable
during the year. When accounts receivable increase during the year, revenues on an
accrual basis are higher than cash receipts from customers. Operations led to
revenues, but not all of these revenues resulted in cash receipts.
To determine the amount of cash receipts, the company deducts from sales
revenues the increase in accounts receivable. On the other hand, there may be a
decrease in accounts receivable. That would occur if cash receipts from customers
exceeded sales revenues. In that case, the company adds to sales revenues the
decrease in accounts receivable.
For Juarez Company, accounts receivable decreased $3,000. Thus, cash receipts
from customers were $978,000, computed as shown in Illustration 13B-3.
Revenues from sales
Add: Decrease in accounts receivable
$975,000
3,000
Cash receipts from customers
$978,000
Illustration 13B-3
Computation of cash
receipts from customers
Juarez can also determine cash receipts from customers from an analysis of the
Accounts Receivable account, as shown in Illustration 13B-4.
Accounts Receivable
1/1/11 Balance
Revenues from sales
12/31/11 Balance
15,000
975,000
Receipts from customers
978,000
12,000
Illustration 13B-5 shows the relationships among cash receipts from customers,
revenues from sales, and changes in accounts receivable.
ⴝ
Revenues
from
Sales
⎫⎪
⎬
⎭⎪
Cash Receipts
from
Customers
ⴙ Decrease in Accounts Receivable
or
ⴚ Increase in Accounts Receivable
Illustration 13B-4
Analysis of accounts
receivable
HELPFUL HINT
The T account shows that
revenue plus decrease in
receivables equals cash
receipts.
Illustration 13B-5
Formula to compute cash
receipts from customers—
direct method
Cash Payments to Suppliers. Juarez Company reported cost of goods sold of
$660,000 on its income statement. How much of that was cash payments to suppliers?
To answer that, it is first necessary to find purchases for the year. To find purchases,
companies adjust cost of goods sold for the change in inventory. When inventory
increases during the year, purchases for the year have exceeded cost of goods sold.
As a result, to determine the amount of purchases, the company adds to cost of
goods sold the increase in inventory.
In 2011, Juarez Company’s inventory increased $10,000. It computes purchases
as follows.
Cost of goods sold
Add: Increase in inventory
$660,000
10,000
Purchases
$670,000
Illustration 13B-6
Computation of purchases
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Chapter 13 Statement of Cash Flows
After computing purchases, a company can determine cash payments to suppliers.
This is done by adjusting purchases for the change in accounts payable. When accounts payable increase during the year, purchases on an accrual basis are higher than
they are on a cash basis. As a result, to determine cash payments to suppliers, a company deducts from purchases the increase in accounts payable. On the other hand, if
cash payments to suppliers exceed purchases, there will be a decrease in accounts
payable. In that case, a company adds to purchases the decrease in accounts payable.
For Juarez Company, cash payments to suppliers were $678,000, computed as
follows.
Illustration 13B-7
Computation of cash
payments to suppliers
Purchases
Add: Decrease in accounts payable
Cash payments to suppliers
$670,000
8,000
$678,000
Juarez also can determine cash payments to suppliers from an analysis of the
Accounts Payable account, as shown in Illustration 13B-8.
Illustration 13B-9
Formula to compute cash
payments to suppliers—
direct method
Payments to suppliers
678,000
1/1/11 Balance
Purchases
12/31/11 Balance
60,000
670,000
52,000
Illustration 13B-9 shows the relationships among cash payments to suppliers, cost
of goods sold, changes in inventory, and changes in accounts payable.
Cash
Cost
Payments
of
ⴝ Goods
to
Suppliers
Sold
⎫
⎪
⎪
⎬
⎪
⎪
⎭
HELPFUL HINT
The T account shows
that purchases plus
decrease in accounts
payable equals payments
to suppliers.
Accounts Payable
ⴙ Increase in Inventory
or
ⴚ Decrease in Inventory
⎫
⎪
⎪
⎬
⎪
⎪
⎭
Illustration 13B-8
Analysis of accounts
payable
ⴙ Decrease in
Accounts Payable
or
ⴚ Increase in Accounts
Payable
Cash Payments for Operating Expenses. Juarez reported on its income statement operating expenses of $176,000. How much of that amount was cash paid for
operating expenses? To answer that, we need to adjust this amount for any changes
in prepaid expenses and accrued expenses payable. For example, if prepaid expenses increased during the year, cash paid for operating expenses is higher than
operating expenses reported on the income statement. To convert operating expenses to cash payments for operating expenses, a company adds the increase to
operating expenses. On the other hand, if prepaid expenses decrease during the
year, it deducts the decrease from operating expenses.
Companies must also adjust operating expenses for changes in accrued expenses payable. When accrued expenses payable increase during the year, operating expenses on an accrual basis are higher than they are in a cash basis. As a result,
to determine cash payments for operating expenses, a company deducts from operating expenses an increase in accrued expenses payable. On the other hand, a company adds to operating expenses a decrease in accrued expenses payable because
cash payments exceed operating expenses.
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Appendix 13B Statement of Cash Flows—Direct Method
645
Juarez Company’s cash payments for operating expenses were $179,000,
computed as follows.
Operating expenses
Deduct: Decrease in prepaid expenses
Add: Decrease in accrued expenses payable
$176,000
2,000
5,000
Cash payments for operating expenses
$179,000
Illustration 13B-10
Computation of cash
payments for operating
expenses
Illustration 13B-11 shows the relationships among cash payments for operating
expenses, changes in prepaid expenses, and changes in accrued expenses payable.
ⴙ Increase in
Prepaid Expense
or
ⴚ Decrease in
Prepaid Expense
⎫
⎪
⎪
⎬
⎪
⎪
⎭
⎫
⎪
⎪
⎬
⎪
⎪
⎭
Cash
Payments
Operating
for
ⴝ Expenses
Operating
Expenses
ⴙ Decrease in Accrued
Expenses Payable
or
ⴚ Increase in Accrued
Expenses Payable
Illustration 13B-11
Formula to compute cash
payments for operating
expenses—direct method
Depreciation Expense and Loss on Sale of Equipment. Companies show
operating expenses exclusive of depreciation. Juarez’s depreciation expense in
2011 was $18,000. Depreciation expense is not shown on a statement of cash flows
because it is a noncash charge. If the amount for operating expenses includes
depreciation expense, the company must reduce operating expenses by the amount
of depreciation to determine cash payments for operating expenses.
The loss on sale of equipment of $1,000 is also a noncash charge. The loss on
sale of equipment reduces net income, but it does not reduce cash. Thus, companies
do not report on a statement of cash flows the loss on sale of equipment.
Other charges to expense that do not require the use of cash, such as the amortization of intangible assets, depletion expense, and bad debt expense, are treated
in the same manner as depreciation.
Cash Payments for Income Taxes. Juarez reported income tax expense of
$36,000 on the income statement. Income tax payable, however, increased $12,000.
This increase means that the company has not yet paid $12,000 of the income
taxes. As a result, income taxes paid were less than income taxes reported in the income statement. Cash payments for income taxes were, therefore, $24,000 as shown
below.
Income tax expense
Deduct: Increase in income tax payable
$36,000
12,000
Cash payments for income taxes
$24,000
Illustration 13B-12
Computation of cash
payments for income taxes
Illustration 13B-13 shows the relationships among cash payments for income taxes,
income tax expense, and changes in income tax payable.
ⴝ
Income Tax
Expense
⎪⎫
⎬
⎭⎪
Cash
Payments for
Income Taxes
ⴙ Decrease in Income Tax Payable
or
ⴚ Increase in Income Tax Payable
Illustration 13B-13
Formula to compute cash
payments for income
taxes—direct method
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Chapter 13 Statement of Cash Flows
The operating activities section of the statement of cash flows of Juarez
Company is shown in Illustration 13B-14.
Illustration 13B-14
Operating activities section
of the statement of cash
flows
Cash flows from operating activities
Cash receipts from customers
Less: Cash payments:
To suppliers
For operating expenses
For income taxes
$978,000
$678,000
179,000
24,000
Net cash provided by operating activities
881,000
$ 97,000
When a company uses the direct method, it must also provide in a separate schedule
(not shown here) the net cash flows from operating activities as computed under
the indirect method.
Step 2: Investing and Financing Activities
ANALYZE CHANGES IN NONCURRENT ASSET AND LIABILITY
ACCOUNTS AND RECORD AS INVESTING AND FINANCING
ACTIVITIES, OR AS SIGNIFICANT NONCASH TRANSACTIONS
Increase in Land. Juarez’s land increased $60,000. The additional information
section indicates that the company issued common stock to purchase the land. The
issuance of common stock for land has no effect on cash. But it is a significant
noncash investing and financing transaction. This transaction requires disclosure in
a separate schedule at the bottom of the statement of cash flows.
Increase in Equipment. The comparative balance sheets show that equipment
increased $160,000 in 2011. The additional information in Illustration 13B-1
indicated that the increase resulted from two investing transactions: (1) Juarez
purchased for cash equipment costing $180,000. And (2) it sold for $17,000 cash
equipment costing $20,000, whose book value was $18,000. The relevant data for
the statement of cash flows is the cash paid for the purchase and the cash proceeds
from the sale. For Juarez Company, the investing activities section will show the
following: The $180,000 purchase of equipment as an outflow of cash, and the
$17,000 sale of equipment as an inflow of cash.The company should not net the two
amounts. Both individual outflows and inflows of cash should be shown.
The analysis of the changes in equipment should include the related
Accumulated Depreciation account. These two accounts for Juarez Company are
shown in Illustration 13B-15.
Illustration 13B-15
Analysis of equipment
and related accumulated
depreciation
Equipment
1/1/11
12/31/11
Balance
Cash purchase
–0–
180,000
Balance
160,000
Cost of equipment sold
20,000
Accumulated Depreciation—Equipment
Sale of equipment
2,000
1/1/11
12/31/11
Balance
Depreciation expense
–0–
18,000
Balance
16,000
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647
Increase in Bonds Payable. Bonds Payable increased $130,000. The additional
information in Illustration 13B-1 indicated that Juarez issued, for $130,000 cash,
bonds with a face value of $130,000.The issuance of bonds is a financing activity. For
Juarez Company, there is an inflow of cash of $130,000 from the issuance of bonds.
Increase in Common Stock. The Common Stock account increased $60,000.
The additional information indicated that Juarez acquired land from the issuance
of common stock. This transaction is a significant noncash investing and financing
transaction which the company should report separately at the bottom of the statement.
Increase in Retained Earnings. The $52,000 net increase in Retained Earnings
resulted from net income of $84,000 and the declaration and payment of a cash
dividend of $32,000. Companies do not report net income in the statement of cash
flows under the direct method. Cash dividends paid of $32,000 are reported in the
financing activities section as an outflow of cash.
STATEMENT OF CASH FLOWS—2011
Illustration 13B-16 shows the statement of cash flows for Juarez.
Illustration 13B-16
Statement of cash flows,
2011—direct method
JUAREZ COMPANY
Statement of Cash Flows—Direct Method
For the Year Ended December 31, 2011
Cash flows from operating activities
Cash receipts from customers
Less: Cash payments:
To suppliers
For operating expenses
For income taxes
Net cash provided by operating activities
Cash flows from investing activities
Purchase of equipment
Sale of equipment
Net cash used by investing activities
Cash flows from financing activities
Issuance of bonds payable
Payment of cash dividends
Net cash provided by financing activities
Net increase in cash
Cash at beginning of period
$ 978,000
$ 678,000
179,000
24,000
881,000
97,000
(180,000)
17,000
(163,000)
130,000
(32,000)
98,000
32,000
159,000
Cash at end of period
$ 191,000
Noncash investing and financing activities
Issuance of common stock to purchase land
$ 60,000
Step 3: Net Change in Cash
COMPARE THE NET CHANGE IN CASH ON THE STATEMENT OF CASH
FLOWS WITH THE CHANGE IN THE CASH ACCOUNT REPORTED ON
THE BALANCE SHEET TO MAKE SURE THE AMOUNTS AGREE
Illustration 13B-16 indicates that the net change in cash during the period was an
increase of $32,000. This agrees with the change in balances in the cash account
reported on the balance sheets in Illustration 13B-1 (page 641).
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Chapter 13 Statement of Cash Flows
SUMMARY OF STUDY OBJECTIVE FOR APPENDIX 13B
6 Prepare a statement of cash flows using the direct
method. The preparation of the statement of cash flows
involves three major steps: (1) Determine net cash provided/
used by operating activities by converting net income from
an accrual basis to a cash basis. (2) Analyze changes in noncurrent asset and liability accounts and record as investing
and financing activities, or disclose as noncash transactions.
(3) Compare the net change in cash on the statement of
cash flows with the change in the cash account reported on
the balance sheet to make sure the amounts agree. The
direct method reports cash receipts less cash payments to
arrive at net cash provided by operating activities.
GLOSSARY FOR APPENDIX 13B
Direct method A method of determining net cash provided by operating activities by adjusting each item in the
income statement from the accrual basis to the cash basis.
(pp. 619, 642)
Comprehensive Do it!
The income statement for Kosinski Manufacturing Company contains the following condensed
information.
KOSINSKI MANUFACTURING COMPANY
Income Statement
For the Year Ended December 31, 2011
Revenues
Operating expenses, excluding depreciation
Depreciation expense
$6,583,000
$4,920,000
880,000
Income before income taxes
Income tax expense
5,800,000
783,000
353,000
Net income
$ 430,000
Included in operating expenses is a $24,000 loss resulting from the sale of machinery for $270,000
cash. Machinery was purchased at a cost of $750,000. The following balances are reported on
Kosinski’s comparative balance sheet at December 31.
KOSINSKI MANUFACTURING COMPANY
Comparative Balance Sheets (partial)
Cash
Accounts receivable
Inventories
Accounts payable
2011
2010
$672,000
775,000
834,000
521,000
$130,000
610,000
867,000
501,000
Income tax expense of $353,000 represents the amount paid in 2011. Dividends declared and
paid in 2011 totaled $200,000.
Instructions
Prepare the statement of cash flows using the direct method.
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Self-Study Questions
Solution to Comprehensive
Do it!
KOSINSKI MANUFACTURING COMPANY
Statement of Cash Flows—Direct Method
For the Year Ended December 31, 2011
Cash flows from operating activities
Cash collections from customers
Cash payments:
For operating expenses
For income taxes
$6,418,000*
$4,843,000**
353,000
Net cash provided by operating activities
Cash flows from investing activities
Sale of machinery
Purchase of machinery
270,000
(750,000)
Net cash used by investing activities
Cash flows from financing activities
Payment of cash dividends
5,196,000
1,222,000
(480,000)
649
Action Plan
• Determine net cash from
operating activities. Each item
in the income statement must
be adjusted to the cash basis.
• Determine net cash from
investing activities. Investing
activities generally relate to
changes in noncurrent assets.
• Determine net cash from
financing activities. Financing
activities generally relate to
changes in long-term liabilities
and stockholders’ equity
accounts.
(200,000)
Net cash used by financing activities
Net increase in cash
Cash at beginning of period
Cash at end of period
(200,000)
542,000
130,000
$ 672,000
Direct-Method Computations:
*Computation of cash collections from customers:
Revenues per the income statement
...
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