Statement of Cash Flows Notes

Statement of Cash Flows

Learning Objectives

• Describe the usefulness and format of the statement of cash flows.

• Prepare a statement of cash flows.

• Contrast the direct and indirect methods of calculating net cash flow from operating activities.

• Discuss special problems in preparing a statement of cash flows.

• Explain the use of a worksheet in preparing a statement of cash flows.

Usefulness of the Statement of Cash Flows

• Primary purpose: To provide information about a company’s cash receipts and cash payments during a period.

• Secondary objective: To provide cash-basis information about the company’s operating, investing, and financing activities.

It provides information to help assess:

1. Entity’s ability to generate future cash flows.

2. Entity’s ability to pay dividends and meet obligations.

3. Reasons for the difference between net income and net cash flow from operating activities.

4. Cash and non-cash investing and financing transactions during the period.

Classification of Cash Flows

• Operating Activities: Income Statement Items

• Investing Activities: Changes in Investments and Other Non-Current Asset Items

• Financing Activities: Changes in Equity and Non-Current Liability Items

Investing Activities

• Cash inflows:

  • From sale of property, plant, and equipment.

  • From sale of 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 debt or equity securities of other entities.

  • To make loans to other entities.

Financing Activities

• Cash inflows:

  • From sale of equity securities.

  • From issuance of debt (bonds and notes).

• Cash outflows:

  • To stockholders as dividends.

  • To redeem long-term debt or reacquire capital stock.

Cash and Cash Equivalents

• The basis recommended by the IASB for the statement of cash flows is “cash and cash equivalents.”

• Cash equivalents are short-term, highly liquid investments that are both:

  • Readily convertible to known amounts of cash, and

  • So near their maturity that they present insignificant risk of changes value (e.g., due to changes in interest rates).

• Generally, only investments with original maturities of three months or less qualify under this definition.

Format of the Statement of Cash Flows

• Presentation:

  1. Operating activities.

  2. Investing activities.

  3. Financing activities.

• Report inflows and outflows from investing and financing activities separately.

• Two methods for operating activities:

  • Direct Method

  • Indirect Method

Statement of Cash Flows Format

• Cash flows from operating activities

  • Net income

  • Adjustments to reconcile net income to net cash provided (used) by 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)

  • Net cash provided (used) by financing activities

• Net increase (decrease) in cash

• Cash at beginning of period

• Cash at end of period

Preparing the Statement of Cash Flows

• Three Sources of Information:

  1. Comparative statements of financial position.

  2. Current income statement data.

  3. Selected transaction data.

• Three Major Steps:

  • Step 1. Determine change in cash.

  • Step 2. Determine net cash flow from operating activities.

  • Step 3. Determine net cash flows from investing and financing activities.

Determining Net Cash Flow from Operating Activities

• Company must determine revenues and expenses on a cash basis.

• Eliminate the effects of income statement transactions that do not result in an increase or decrease in cash.

• Convert net income to net cash flow from operating activities through either a direct method or an indirect method.

Accounts Receivable and Net Cash Flow (Indirect Method)

• When the Accounts Receivable balance increases, cash receipts are lower than revenue earned under the accrual basis.

• The increase in accounts receivable is subtracted from net income to arrive at net cash provided by operating activities.

Accounts Payable and Net Cash Flow (Indirect Method)

• When accounts payable increase during the year, expenses on an accrual basis exceed those on a cash basis.

Tax Consultants Inc. Example (Year 1)

• Started on January 1, 2019, when it issued 60,000 shares of $1 par value common stock for $60,000 cash.

• The company rented its office space, furniture, and equipment, and performed tax consulting services throughout the first year.

Statement of Cash Flows for Tax Consultants Inc. (Year 1)

• Net income: $34,000$

• Increase in accounts receivable: $(36,000)

• Increase in accounts payable: $5,000$

• Net cash provided by operating activities: $3,000$

• Issuance of ordinary shares: $60,000$

• Payment of cash dividends: $(14,000)

• Net cash provided by financing activities: $46,000$

• Net increase in cash: $49,000$

• Cash, January 1, 2019: $0$

• Cash, December 31, 2019: $49,000$

Tax Consultants Inc. Example (Year 2)

Step 1: Determine the Change in Cash

Assets:

• Land: Increase by $70,000$

• Buildings: Increase by $200,000$

• Accumulated depreciation-buildings: Increase by $11,000$

• Equipment: Increase by $68,000$

• Accumulated depreciation-equipment: Increase by $10,000$

• Accounts receivable: Decrease by $10,000$

• Prepaid expenses: Increase by $6,000$

• Cash: Decrease by $12,000$

Equity and Liabilities:

• Retained earnings: Increase by $116,000$

• Bonds payable: Increase by $150,000$

• Accounts payable: Increase by $35,000$

Step 2: Determine Net Cash Flow from Operating Activities—Indirect Method

• Accounts receivable decreased during the period because cash receipts (cash-basis revenues) are higher than revenues reported on an accrual basis.

• To convert net income to net cash flow from operating activities, the decrease of $10,000$ in accounts receivable must be added to net income.

• When prepaid expenses (assets) increase during a period, expenses on an accrual-basis income statement are lower than they are on a cash-basis income statement.

• To convert net income to net cash flow from operating activities, the increase of $6,000$ must be deduct from net income.

• When accounts payable increase, the company incurred a greater amount of expense than the amount of cash it disbursed.

• Tax Consultants must add the 2020 increase of $35,000$ in accounts payable to net income, to convert to net cash flow from operating activities.

• Depreciation expense of $21,000$ (also represented by the increase in accumulated depreciation) is a non-cash charge.

• Tax Consultants adds depreciation expense back to net income, to arrive at net cash flow from operating activities.

Step 3: Determine Net Cash Flow from Investing and Financing Activities

• The company purchased land of $70,000$ during the period.

• Tax Consultants acquired an office building using $200,000$ cash.

• Tax Consultants acquired equipment using $68,000$ cash.

• Tax Consultants acquired received $150,000$ from the issuance of bonds.

• Two factors explain the increase in retained earnings: (1) net income of $134,000$ increased retained earnings, and (2) dividends of $18,000$ decreased retained earnings.

Statement of Cash Flows for Tax Consultants Inc. (Year 2)

• Net income: $134,000$

• Depreciation expense: $21,000$

• Decrease in accounts receivable: $10,000$

• Increase in prepaid expenses: $(6,000)$

• Increase in accounts payable: $35,000$

• Net cash provided by operating activities: $194,000$

• Purchase of land: $(70,000)$

• Purchase of building: $(200,000)$

• Purchase of equipment: $(68,000)$

• Net cash used by investing activities: $(338,000)$

• Issuance of bonds: $150,000$

• Payment of cash dividends: $(18,000)$

• Net cash provided by financing activities: $132,000$

• Net decrease in cash: $(12,000)$

• Cash, January 1, 2020: $49,000$

• Cash, December 31, 2020: $37,000$

Sources of Information

1. Comparative statements of financial position.

2. An analysis of the Retained Earnings account.

3. All changes that have passed through cash or have resulted in an increase or decrease in cash.

4. Write-downs, amortization charges, and similar “book” entries, such as depreciation, because they have no effect on cash.

Net Cash Flow Operating Activities—Direct Method

Major Classes of Cash Receipts and Payments

Direct Method Example: Drogba SA

• Dividends of €70,000 were declared and paid in cash.

• The accounts payable increase resulted from the purchase of merchandise.

• Prepaid expenses and accrued expenses payable relate to operating expenses.

Accounts receivable

Accounts receivable increased €15,000. Thus, cash receipts from customers are computed as follows.

• Beginning Balance: $0$

• Sales revenue: $780,000$

• Receipts from customers: $765,000$

• Ending Balance: $15,000$

Accounts Payable and Inventory

Drogba SA reported cost of goods sold on its income statement of €450,000. In 2019, Drogba’s inventory increased €160,000. The company computes purchases as follows.

• Cost of goods sold €450,000

• Add: Increase in inventory 160,000

• Purchases €610,000

Cash Payments to Suppliers

Drogba determines cash payments to suppliers by adjusting purchases for the change in accounts payable.

• Payments to suppliers 550,000

Cash Payments for Operating Expenses

Drogba reported operating expenses of €160,000 on its income statement. To determine the cash paid for operating expenses, it must adjust this amount for any changes in

• prepaid expenses and

• accrued expenses payable.

Prepaid Expenses

• Beginning Balance 0

• Ending Balance 8,000

Accrued Expenses Payable

• Beginning Balance 0

• Ending Balance 20,000

• Operating expenses €160,000

• Add: Increase in prepaid expenses 8,000

• Deduct: Increase in accrued expenses payable 20,000

• Cash payments for operating expenses €148,000

Cash paid for income taxes

The income statement for Drogba shows income tax expense of €48,000.
Cash paid for income taxes is computed by taking the expense and adjusting by the change in the payable.

Operating Activities Section-Direct Method, 2020

• Cash received from customers €765,000

• Cash payments:

  • To suppliers €550,000

  • For operating expenses 148,000

  • For income taxes 48,000

• Net cash provided by operating activities € 19,000

Accrual Basis to Cash Basis

Sales revenue

• Accrual Basis: €780,000

• Increase in accounts receivable: € (15,000)

• Cash Basis: €765,000

Cost of goods sold

• Accrual Basis: 450,000

• Increase in inventory: 160,000

• Increase in accounts payable: (60,000)

• Cash Basis: 550,000

Operating expenses

• Accrual Basis: 160,000

• Increase in prepaid expenses: 8,000

• Increase in accrued expenses payable: (20,000)

• Cash Basis: 148,000

Income tax expense

• Accrual Basis: 48,000

• Depreciation expense: (10,000)

• Cash Basis: 48,000

Total expense

• Accrual Basis: 668,000

Net income

• Accrual Basis: €112,000

Net cash provided by operating activities

• Cash Basis: € 19,000

Special Problems in Statement Preparation

Adjustments to Net Income

• Amortization of limited-life intangible assets.

• Amortization of bond discount or premium.

• Depreciation and Amortization

• Postretirement Benefit Costs

• Company must adjust net income by the difference between cash paid and the expense reported.

Adjustments to Net Income

• Affect net income but have no effect on cash.

Equity Method of Accounting

• Net increase in the investment account does not affect cash flows.

• Company must deduct the net increase from net income to arrive at net cash flow from operating activities.

Loss and Gains

• A loss is added to net income to compute net cash flow from operating activities because the loss is a noncash charge in the income statement.

• Company reports a gain in the statement of cash flows as part of the cash proceeds from the sale of equipment under investing activities, thus it deducts the gain from net income to avoid double-counting—once as part of net income and again as part of the cash proceeds from the sale.

Share-Based Compensation

• Cash is not affected by recording the expense.

• The company must increase net income by the amount of compensation expense from share options in computing net cash flow from operating activities.