Lecture Issues in financial accounting – Lecture 26: Statement of cash flows revisited

The contents of this chapter include all of the following: Indicate the primary purpose of the statement of cash flows; distinguish among operating, investing, and financing activities; explain the impact of the product life cycle on a company’s cash flows;…

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1 Describe the purpose of the statement of cash flows.

2 Identify the major classifications of cash flows.

3 Differentiate between net income and net cash flow from operating

activities.

4 Contrast the direct and indirect methods of calculating net cash flow

from operating activities.

5 Determine net cash flows from investing and financing activities.

6 Prepare a statement of cash flows.

7 Identify sources of information for a statement of cash flows.

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

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

Learning Objectives

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Accounts receivable (net)

Other working capital changes

Net losses Significant noncash transactions

Preparation of worksheet Analysis of transactions Preparation of final statement

Statement of Cash Flows

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4 LO 1 Describe the purpose 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

Section 1 - Preparation of the

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5 LO 1 Describe the purpose of the statement of cash flows.

1 Entity’s ability to generate future cash flows

2 Entity’s ability to pay dividends and meet obligations

3 Reasons for difference between net income and net

cash flow from operating activities

4 Cash and noncash investing and financing transactions

Usefulness of the Statement of Cash Flows

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Income Statement

Transactions

Operating

Activities

Changes in Investments and Long-Term Asset Items

Investing

Activities

Changes in Long-Term Liabilities and Stockholders’

Equity

Financing

Activities

Classification of Cash Flows

LO 2 Identify the major classifications of cash flows.

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The basis recommended by the FASB for the statement of

cash flows is actually “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 in value (e.g., due to changes in interest rates)

Generally, only investments with original maturities of three

months or less qualify under this definition

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Format of the Statement of Cash Flows

Report inflows and outflows from investing and financing

activities separately.

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Format of the Statement of Cash Flows

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Three Sources of Information:

1 Comparative balance sheets

2 Current income statement

3 Selected transaction data

Steps in Preparation

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.LO 2 Identify the major classifications of cash flows.

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First Example - 2011

Illustration: Tax Consultants Inc started on January 1, 2011,

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

The comparative statements of financial position at the

beginning and end of the year 2011 appear in Illustration 23-3

Illustration 23-4 shows the income statement and additional

information for Tax Consultants

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Step 1: Determine the Change in Cash

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 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

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Deducts operating cash disbursements from operating cash

receipts.

LO 4 Contrast the direct and indirect methods of calculating net

cash flow from operating activities.

“Net cash provided by operating activities” is the equivalent of cash

basis net income.

Direct Method

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Common adjustments to Net Income (Loss):

 Depreciation and amortization expense.

 Gain or loss on disposition of long-term assets.

 Change in current assets and current liabilities.

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Step 3: Determine Net Cash Flows from Investing

and Financing Activities

No long-term assets, thus no investing activities.

LO 5 Determine net cash flows from investing and financing activities.

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Step 3: Determine Net Cash Flows from Investing

and Financing Activities

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

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Statement of Cash Flows - 2011

LO 6 Prepare a statement of cash flows.

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Norman Company’s financial statements for the year ended December

31, 2012, contained the following condensed information.

Operating Activities — Indirect Method

2012 2011 Change Service revenue $ 840,000

Operating expenses 624,000

Depreciation expense 60,000

Loss on sale of equipment 26,000

Income before income tax 130,000

Income tax 40,000

Net income $ 90,000

Accounts receivable $ 37,000 $ 59,000 $ (22,000) Accounts payable 46,000 31,000 15,000 Income taxes payable 4,000 8,500 (4,500)

LO 4

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Cash flows from operating activities

Adjustment to reconcile net income

to net cash provided by operating activities:

Decrease in accounts receivable 22,000

Increase in accounts payable 15,000

Decrease in income taxes payable (4,500)

Net cash provided by operating activities 208,500

Prepare the operating activities section of the statement of cash flows

using the indirect method (Step 2).

Operating Activities — Indirect Method

LO 4

Advance slide to uncover solution

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2012 2011 Change Service revenue $ 840,000

Operating expenses 624,000

Income before income tax 130,000

Income tax 40,000

Net income $ 90,000

Accounts receivable $ 37,000 $ 59,000 $ (22,000) Accounts payable 46,000 31,000 15,000 Income taxes payable 4,000 8,500 (4,500)

Norman Company’s financial statements for the year ended

December 31, 2012, contained the following condensed information.

Operating Activities — Direct Method

Assume accounts payable relates to operating expenses.

LO 4

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Prepare the operating activities section of the statement of cash

flows using the Direct method (Step 2).

LO 4 Contrast the direct and indirect methods of calculating

net cash flow from operating activities.

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Payments to suppliers 609,000

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Payments for income tax 44,500

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Cash flows from operating activities

Cash receipts from customers $ 862,000 Cash paid for operating expenses (609,000) Cash paid for income taxes (44,500)

Net cash provided by operating activities $ 208,500

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Illustration (a): Plant assets that had cost $25,000 6 years

before and were being depreciated on a straight-line basis

over 10 years with no estimated scrap value were sold for

$5,300

Step 3: Determine Net Cash Flow from

Investing and Financing Activities

Step 3: Determine Net Cash Flow from

Investing and Financing Activities

Accumulated depreciation ([$25,000 / 10] x 6) 15,000

Book value at date of sale 10,000

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Cash flow from operating activities

Adjustment to reconcile net income to cash:

Cash flow from investing activities

Sale of plant assets 5,300

Cash from investing activities 44,300

Cash flow from financing activities

Purchase of company stock (47,000) Cash from financing activities 283,000

Net Change in Cash $ 293,000

Statement of Cash Flows (a,b,d,h)

O

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F

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Illustration (b): During the year, 10,000 shares of common

stock with a stated value of $10 a share were issued for $33 a

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F

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Illustration (d): The company sustained a net loss for the

year of $50,000 Depreciation amounted to $22,000, and a

gain of $9,000 was realized on the sale of land for $39,000

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O

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F

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Net Change in Cash $ 293,000.0

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F

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42 LO 7 Identify sources of information for a statement of cash flows.

Sources of Information for the

1 Comparative balance sheets

2 An analysis of the Retained Earnings account

3 Writedowns, amortization charges, and similar “book”

entries, such as depreciation, because they have no

effect on cash

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43 LO 7

Net Cash Flow from Operating Activities—

Indirect Versus Direct Method

Adjustments Needed to Determine Net Cash Flow from Operating Activities.

Indirect Method

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Companies adjust each item in the income statement from the accrual basis to the cash basis.

Direct Method

LO 7

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In Favor of the Direct Method

 Shows operating cash receipts and payments.

 Information about cash receipts and payments is more

revealing of a company’s ability

1 to generate sufficient cash from operating activities to pay

its debts,

2 to reinvest in its operations, and

3 to make distributions to its owners.

Direct Versus Indirect Controversy

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Direct Versus Indirect Controversy

In Favor of the Indirect Method

 Focuses on the differences between net income and net

cash flow from operating activities.

 Provides link between the statement of cash flows and the

income statement and statement of financial position.

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Adjustments to Net Income

LO 8 Discuss special problems in preparing a statement of cash flows.

 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

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 Affect net income but have no effect on cash

Changes in Deferred Income Taxes

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

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 A loss is added to net income to compute net cash flow

from operating activities because the loss is a non-cash 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

Loss and Gains

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