JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 612 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. ✓ The Navigator ✓ 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. JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 613 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 JWCL165_c13_612-673.qxd 8/14/09 7:59 AM Page 614 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 ✓ The Navigator 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 JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 615 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. JWCL165_c13_612-673.qxd 616 8/13/09 11:15 AM Page 616 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.) JWCL165_c13_612-673.qxd 8/14/09 7:59 AM Page 617 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 JWCL165_c13_612-673.qxd 618 8/13/09 11:15 AM Page 618 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. ✓ The Navigator 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). JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 619 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 JWCL165_c13_612-673.qxd 620 8/13/09 11:15 AM Page 620 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 JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 621 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. JWCL165_c13_612-673.qxd 622 8/13/09 11:15 AM Page 622 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. JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 623 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 JWCL165_c13_612-673.qxd 624 8/13/09 11:15 AM Page 624 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. JWCL165_c13_612-673.qxd 8/14/09 7:59 AM Page 625 Preparing the Statement of Cash Flows—Indirect Method 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 JWCL165_c13_612-673.qxd 626 8/13/09 11:15 AM Page 626 Chapter 13 Statement of Cash Flows 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 JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 627 Preparing the Statement of Cash Flows—Indirect Method 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). JWCL165_c13_612-673.qxd 628 8/14/09 7:59 AM Page 628 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 JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 629 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. JWCL165_c13_612-673.qxd 630 8/13/09 11:15 AM Page 630 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 $80,000 dividend and continue to produce 10,000 computers. In practice, free cash flow is often calculated with the formula in Illustration 13-14. (Alternative definitions also exist.) Illustration 13-14 Free cash flow Free Cash Cash Provided by Capital Cash ⴝ ⴚ ⴚ Flow Operating Activities Expenditures Dividends JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 631 Using Cash Flows to Evaluate a Company 631 Illustration 13-15 provides basic information (in millions) excerpted from the 2008 statement of cash flows of Microsoft Corporation. Illustration 13-15 Microsoft cash flow information ($ 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) JWCL165_c13_612-673.qxd 632 8/13/09 6:15 PM Page 632 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 JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 633 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 JWCL165_c13_612-673.qxd 634 8/13/09 11:15 AM Page 634 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 JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 635 Appendix 13A Using a Worksheet to Prepare the Statement of Cash Flows—Indirect Method 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 JWCL165_c13_612-673.qxd 636 8/13/09 11:15 AM Page 636 Chapter 13 Statement of Cash Flows Illustration 13A-1 Format of worksheet XYZ Company.xls File Edit View Insert A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 Format Tools Data B Window C Help D E 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 XX XX XX XX XX XX XX XX XX XX XX XX XX XXX (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. JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 637 Appendix 13A Using a Worksheet to Prepare the Statement of Cash Flows—Indirect Method 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. JWCL165_c13_612-673.qxd 638 8/13/09 11:15 AM Page 638 Chapter 13 Statement of Cash Flows Illustration 13A-2 Comparative balance sheets, income statement, and additional information for Computer Services Company Computer Services Company.xls File Edit View Insert Format Tools A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 Data Window B Help C D 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 File Edit View Insert Format Tools A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Data B Window Help C D 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. JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 639 Appendix 13A Using a Worksheet to Prepare the Statement of Cash Flows—Indirect Method 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 JWCL165_c13_612-673.qxd 640 8/13/09 11:15 AM Page 640 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 Computer Services Company.xls File Edit View Insert Format A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 Tools Data B Window Help C D E 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 JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 641 Appendix 13B Statement of Cash Flows—Direct Method 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 JWCL165_c13_612-673.qxd 642 8/13/09 11:15 AM Page 642 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. JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 643 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 JWCL165_c13_612-673.qxd 644 8/13/09 11:15 AM Page 644 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. JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 645 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 JWCL165_c13_612-673.qxd 646 8/13/09 11:15 AM Page 646 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 JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 647 Appendix 13B Statement of Cash Flows—Direct Method 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). JWCL165_c13_612-673.qxd 648 8/13/09 11:15 AM Page 648 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. JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 649 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 ...
Purchase answer to see full attachment