Cash Flow

1-1
Statement of Cash Flows

Are cash flows sufficient to support ongoing operations? Can we meet our obligations to creditors? Why is there a difference between net income and net cash flow? Can we pay dividends?
How Well Am I Doing? Statement of Cash Flows
Will the company have to borrow money to make needed investments?
Learning Objective
LO1
Definition of Cash
The term cash on the statement of cash flows refers broadly to both currency and cash equivalents.
To classify changes in noncash balance sheet accounts as sources or uses of cash.
Currency and Bank Accounts
T-bills
Cash
Money Market Funds Commercial Paper
Constructing the Statement of Cash Flows Using Changes in Noncash Balance Sheet Accounts
Constructing the Statement of Cash Flows

Sources Always Decreases Increases Uses Always Increases Decreases
Changes in Capital Stock Net Cash Flows for a Period
Changes in Liabilities
Dividends Paid to Stockholders
Changes in Noncash Assets
Net Income Net Loss Changes in noncash assets Changes in liabilities* Changes in capital stock accounts Dividends paid to stockholders
Increases Decreases Always Total sources - Total uses = Net cash flow
* Contra asset accounts, such as the Accumulated Depreciation and Amortization account, follow the rules for liabilities.
Net Income
1-2

Increases in noncash asset accounts imply uses of cash.
Example: Inventory is purchased on credit from a supplier. It is implied that cash was used to acquire the inventory.

Increases in liability accounts imply sources of cash.
Example: Inventory is purchased on credit from a supplier. It is implied that an increase in a payable has the effect of increasing cash available for other uses.

Decreases in noncash assets accounts imply sources of cash.
Example: Accounts receivable decreases when a customer pays their bill. When the customer pays the bill, the companys cash increases.

Decreases in liability accounts imply uses of cash.
Example: A company pays a note payable held by a creditor. When the payment is made, cash decreases.
A Simplified Statement of Cash Flows: An Example

Ed's Pizza Hut Comparative Balance Sheet Account Balances 3/31/2007 DR (CR) $ 71,000 23,000 350,000 68,000 84,000 (45,000) (38,000) (9,000) (500,000) (4,000) $ 3/31/2006 Change DR (CR) Incr. (Decr.) $ 90,000 $ (19,000) 40,000 (17,000) 300,000 50,000 100,000 (32,000) 84,000 (39,000) 6,000 (27,000) 11,000 (14,000) (5,000) (50,000) (50,000) (450,000) 50,000 (34,000) (30,000) $ -

Additional Information:

Cash Accounts Receivable Inventory Land Equipment Accumulated Depr. Accounts Payable Salaries Payable Note Payable - Joe Doe Common Stock Retained Earnings
There was a net loss for the year of $27,000. Depreciation charges for the year were $6,000. During the year, Ed sold land originally costing $32,000 for $32,000. During the year, Ed paid dividends of $3,000 to the stockholders. Ed issued $50,000 of common stock to settle the note due to Joe Doe.
1-3

Here is a summary of the sources of cash for Eds Pizza Hut.
Ed's Pizza Hut Sources of Cash Decrease in A/R $ Decrease in Land Increase in A/P Depreciation charges Total sources of cash $

Here is a summary of the uses of cash for Eds Pizza Hut.
Ed's Pizza Hut Uses of Cash
17,000 32,000 11,000 6,000 66,000
Net loss $ Increase in Inventory Decrease in Salaries Payable Dividends paid Total uses of cash $
27,000 50,000 5,000 3,000 85,000
The net cash flow for Eds Pizza Hut is ($19,000): $66,000 in sources minus $85,000 in uses.
A Simplified Statement of Cash Flows

Learning Objective
LO2
17,000 32,000 11,000 6,000 66,000
Ed's Pizza Hut Uses of Cash Net loss $ Increase in Inventory Decrease in Salaries Payable Dividends paid Total uses of cash $
27,000 50,000 5,000 3,000 85,000
This simplified approach does not follow the format required for external reporting purposes. It is for illustrative purposes only.
To classify transactions as operating activities, investing activities, or financing activities.
The Full-Fledged Statement of Cash Flows: Operating Activities

Operating activities are those activities that enter into the determination of net income.
Transactions affecting current assets Transactions affecting current liabilities Changes in noncurrent balance sheet accounts that directly affect net income
The Full-Fledged Statement of Cash Flows: Investing Activities

Investing activities relate to transactions involving the acquiring or disposing of noncurrent assets.
Acquiring or selling property, plant and equipment Lending money to another entity and subsequently collecting on the loan
Acquiring or selling investment securities
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The Full-Fledged Statement of CashCash The Full-Fledged Statement of Flows: Financing Activities Flows: Financing Activities
Financing activities relate to transactions involving borrowing from creditors or repaying creditors and engaging in transactions with the companys owners.
Organization of the Full-Fledged Statement of Cash Flows

Operating Activities: Net income XYZ Company Changes in current assets Cash Flow Statement Changes in noncurrent assets that affect net income (e.g., depreciation) For the Period Ending MM/DD/YY Changes in current liabilities (except for debts to lenders and dividends Cash flows I. Operating Activities $ XXX payable) are divided Changes in noncurrent liabilities that affect net income II. Investing Activities XXX
III. Financing Activities XXX Investing Activities: categories. Changes in noncurrent assets that are Flows for the net income Net Cash not included in
into three
Interest on debt is classified as an operating activity
Period $ XXX Financing Activities: Add: Beg. Cash Balance XXX Changes in the current liabilities that are debts to lenders rather than obligations to suppliers, employees, Cash Balance or the government Ending $ XXX Changes in noncurrent liabilities that are not included in net income Changes in capital stock accounts Dividends
Organization of the Full-Fledged Statement of Cash Flows

Operating Activities Investing Activities Financing Activities
Reconciliation of the Net Increase or Decrease in Cash with the Change in the Balance of the Cash Account
Add:
Operating Activities
Net Income (Loss) Decr. in Current Noncash Assets Incr. in Current Liabilities Depreciation Charges Losses Less: Incr. in Current Noncash Assets Decr. in Current Liabilities Gains Net Cash Flows from Operating Activities $ XXX XXX XXX XXX XXX (XXX) (XXX) (XXX) $ XXX
Noncash Investing and Financing Activities
Includes those activities that enter into the determination of net income.
Sources of cash are added to net income and uses of cash are subtracted from net income.
Impact on Net Income Sources Uses Current Noncash Assets Current Liabilities Decreases Increases Increases Decreases
Current Noncash Assets Current Liabilities
Net Income (Loss) Add: Decr. in Current Noncash Assets Incr. in Current Liabilities Depreciation Charges Losses Less: Incr. in Current Noncash Assets Decr. in Current Liabilities Gains Net Cash Flows from Operating Activities
Impact on Net Income Sources Uses Decreases Increases Increases Decreases
$ XXX XXX XXX XXX XXX (XXX) (XXX) (XXX) $ XXX
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Impact on Net Income Sources Uses Current Noncash Assets Current Liabilities Decreases Increases Increases Decreases
$ XXX XXX XXX XXX XXX (XXX) (XXX) (XXX) $ XXX Net Income (Loss) Add: Decr. in Current Noncash Assets Incr. in Current Liabilities Depreciation Charges Losses Less: Incr. in Current Noncash Assets Decr. in Current Liabilities Gains Net Cash Flows from Operating Activities $ XXX XXX XXX XXX XXX (XXX) (XXX) (XXX) $ XXX
Depreciation and Amortization charges are added back to net income because they are decreases in noncash assets.
Gains are subtracted from net income.
Investing Activities
$ XXX XXX XXX XXX XXX (XXX) (XXX) (XXX) $ XXX
Add: Proceeds from sale of land, buildings, equipment, or other noncurrent assets Receipt of principal from investments Less: Payments to acquire land, buildings, equipment, or other noncurrent assets Payments to acquire investments Net Cash Flows from Investing Activities $ XXX XXX
(XXX) (XXX) $ XXX
Losses are added back to net income.
Includes transactions that involve the acquisition or disposal of noncurrent assets.
Financing Activities
Add: Proceeds from borrowings Proceeds from issuing capital stock Proceeds from sale of bonds Less: Principal payments on borrowed funds Payments related to bond maturities Dividend payments Net Cash Flows from Financing Activities $ XXX XXX XXX (XXX) (XXX) (XXX) $ XXX
Other Issues: Gross or Net?

For investing and financing activities, items on the statement of cash flows should be presented in gross amounts rather than in net amounts.
Example:
Assume Macys purchases $50 million in property during the year and sells other property for $30 million. Instead of showing the net change of $20 million, the company must report the gross amounts of both transactions.
Includes transactions involving receipts from or payments to creditors and owners.
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Operating Activities: Direct or Indirect Method?

Two Formats for Reporting Operating Activities
Learning Objective
LO3
To prepare a statement of cash flows using the indirect method to determine the net cash provided by operating activities.
Direct Method Reports the cash effects of each operating activity
Indirect Method Starts with accrual net income and converts to cash basis
Note that no matter which format is used, the same amount of net cash flows from operating activities is generated.
A Full-Fledged Statement of Cash Flows: An Example

A Full-Fledged Statement of Cash Flows: An Example

Lets also refresh our memory regarding the following additional information.
Lets revisit the comparative balance sheet account balances for Eds Pizza Hut.
Preparing the Statement of Cash Flows: Step 1

Ed's Pizza Hut Statement of Cash Flows Worksheet Source Cash Flow AdjustChange or Use? Effect ments Assets (except cash and Current assets Accounts receivable Inventory Noncurrent assets Land Equipment Contra Assets, Liabilities, Contra assets Accumulated depreciation Current liabilities Accounts payable Salaries payable Noncurrent liabilities Notes payable Stockholders' equity Common stock Retained earnings Net loss Dividends Total (net cash flow) Adjusted Effect Classification

(17,000) 50,000 (32,000) -
List each account appearing on the comparative balance sheets except for cash and cash equivalents and retained earnings.
6,000 11,000 (5,000) (50,000) 50,000 (27,000) 3,000
Compute the change from the beginning balance to the ending balance for each account.
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(17,000) Source 50,000 Use (32,000) Source -
6,000
Source
Code each entry on the worksheet as a source or use of cash.
17,000 (50,000) 32,000 -
6,000
Source
6,000 11,000 (5,000) (50,000) 50,000 (27,000) (3,000) (19,000)
11,000 Source (5,000) Use (50,000) 50,000 (27,000) 3,000 Use Source Use Use
11,000 Source (5,000) Use (50,000) 50,000 (27,000) 3,000 Use Source Use Use $
Recall that the transaction involving the Notes Payable and Common Stock was noncash.
Code sources of cash as positive numbers and uses of cash as negative numbers.


17,000 (50,000) 32,000 -
17,000 (50,000) 32,000 -
6,000
Source
6,000 11,000 (5,000) (50,000) 50,000 (27,000) (3,000) (19,000) $
50,000
6,000 11,000 (5,000)
(50,000) -
{
$
Make any necessary adjustments, including adjustments for gains and losses. The net effect of these should equal zero.
17,000 (50,000) 32,000 -
17,000 (50,000) 32,000 -
Operating Operating Investing
6,000
Source
6,000 11,000 (5,000) (50,000) 50,000 (27,000) (3,000) (19,000) $
50,000 (50,000) -
6,000 11,000 (5,000) (27,000) (3,000) (19,000)
Operating Operating Operating
We -need
to make an adjustment for the noncash transaction relating to Notes Payable and (27,000) Common Stock.
(3,000) (19,000)
Classify each entry as operating, investing or financing activity.
Operating Financing

Ed's Pizza Hut Statement of Cash Flows For the Period Ending 3/31/2007 Operating Activities Net loss $ Add: Decrease in accounts receivable Increase in accounts payable Increase in depreciation charges Less: Increase in inventory Decrease in salaries payable Net cash flow from operations Investing Activities Proceeds from sale of land Financing Activities Dividends paid Net change in cash

Ed's Pizza Hut Statement of Cash Flows For the Period Ending 3/31/2007 Operating Activities Net loss $ Add: Decrease in accounts receivable Increase in accounts payable Increase in depreciation charges Less: Increase in inventory Decrease in salaries payable Net cash flow from operations Investing Activities Proceeds from sale of land Financing Activities Dividends paid Net change in cash Cash, beginning Cash, ending $
(27,000) 17,000 11,000 6,000 (50,000) (5,000) (48,000) 32,000 (3,000) (19,000)
Copy the data from the worksheet into the Statement of Cash Flows section by section.
(27,000) 17,000 11,000 6,000 (50,000) (5,000) (48,000) 32,000 (3,000) (19,000) 90,000 71,000
Prepare a cash reconciliation at the bottom of the statement.
1-8
Preparing the Statement of Cash Flows

Interpretation of the Statement of Cash Flows
(27,000) 17,000 11,000 6,000 (50,000) (5,000) (48,000) 32,000 (3,000) (19,000) 90,000 71,000
In addition, on the face of the statement or in a supplemental schedule, disclose the issuance of $50,000 of stock to a creditor, a noncash financing activity.
Examine the operating activities section carefully.

Eds Pizza Hut generated a negative cash flow from operations of $48,000. This is usually a sign of fundamental difficulties. Ultimately, a positive cash flow is necessary to avoid liquidating assets or borrowing money to pay for day-to-day activities.
Learning Objective
LO4
To use the direct method to determine the net cash provided by operating activities. (Appendix A)
Appendix A
The Direct Method of Determining the Net Cash Provided by Operating Activities
Computing Net Cash Provided by Operating Activities

The direct method computes net cash provided by operating activities by reconstructing the income statement on a cash basis from top to bottom.
Similarities and Differences in Handling Data

Revenue or Expense Item Sales revenue (as reported) Adjustments to a cash basis: 1 Increases in accounts receivable 2 Decreases in accounts receivable Cost of goods sold (as reported) Adjustments to a cash basis: 3 Increase in merchandise inventory 4 Decrease in merchandise inventory 5 Increase in accounts payable 6 Decrease in accounts payable Operating expenses (as reported) Adjustments to a cash basis: 7 Increase in prepaid expenses 8 Decrease in prepaid expenses 9 Increase in accrued liabilities 10 Decrease in accrued liabilities 11 Period's depreciation, depletion and amortization charges Income tax expense (as reported) Adjustments to a cash basis: 12 Increase in accrued taxes payable 13 Decrease in accrued taxes payable 14 Increase in deferred income taxes 15 Decrease in deferred income taxes Add (+) or Deduct (-) to Adjust to a Cash Basis +
+ +
Adjustments for accounts that affect revenue are the same in the direct method and indirect methods.
Cash provided by operating activities under the direct method will always agree with the amount computed using the indirect method.
+ + -
Adjustments for accounts that affect expenses are handled in opposite ways for the direct and indirect methods.
+ +
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Direct Method: Gains and Losses

Regarding gains and losses on sale of assets, no adjustments are needed at all under the direct method.
The Direct Method: An Example

Lets revisit the comparative balance sheet account balances for Eds Pizza Hut.

Step 1: Translate sales revenue into cash collected from customers.
Ed's Pizza Hut Income Statement For the Year Ended 3/31/2007 Sales $ 1,000,000 Cost of goods sold 750,000 Gross margin 250,000 Operating expenses 277,000 Net loss $ (27,000)
Lets assume that Eds Pizza Hut prepared this income statement.
Sales (as reported) Add: Decrease in accounts receivable Cash collected from customers
$ $
1,000,000 17,000 1,017,000

Step 2: Translate cost of goods sold into cash disbursements for purchases.
Cost of goods sold (as reported) $ Add: Increase in inventory Less: Increase in accounts payable Cash paid for purchases $ 750,000 50,000 (11,000) 789,000

Step 3: Translate operating expenses into cash paid for operating expenses.
Operating expenses (as reported) Add: Decrease in salaries payable Less: Increase in depreciation Cash paid for operating expenses $ 277,000 5,000 (6,000) 276,000
There is not an adjustment needed for income taxes because Eds Pizza Hut has a net loss of $27,000.
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Ed's Pizza Hut Statement of Cash Flows For the Period Ending 3/31/2007 Operating Activities Cash received from customers $ 1,017,000 Cash paid for purchases (789,000) Cash paid for operating expenses (276,000) Net cash flow from operations (48,000) Investing Activities Proceeds from sale of land 32,000 Financing Activities Dividends paid (3,000) Net change in cash (19,000) Cash, beginning 90,000 Cash, ending $ 71,000
Learning Objective
LO5
Notice that the net cash provided by operating activities agrees with that computed using the indirect method.
To prepare a statement of cash flows using the T-account approach. (Appendix B)
T-Account Approach
Appendix B
The T-Account Approach to Preparing the Statement of Cash Flows
T-Account Approach

T-Account Approach
Here is a summary of the sources of cash for Eds Pizza Hut.
17,000 32,000 11,000 6,000 66,000
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T-Account Approach
Here is a summary of the uses of cash for Eds Pizza Hut.
Ed's Pizza Hut Uses of Cash Net loss $ Increase in Inventory Decrease in Salaries Payable Dividends paid Total uses of cash $ 27,000 50,000 5,000 3,000 85,000
T-Account Approach
Cash Provided 27,000 Net loss Used
3,000 Cash dividends paid
The net cash flow for Eds Pizza Hut is ($19,000): $66,000 in sources minus $85,000 in uses.
T-Account Approach
Cash Provided Decrease in accounts receivable 17,000 Used 27,000 Net loss 50,000 Increase in inventory
T-Account Approach
Cash Provided Decrease in accounts receivable Depreciation charges 17,000 6,000 Used 27,000 Net loss 50,000 Increase in inventory
Proceeds from sale of land
32,000
T-Account Approach
Cash Provided Decrease in accounts receivable Depreciation charges Increase in accounts payable Proceeds from sale of land 17,000 6,000 11,000 32,000 27,000 50,000 5,000 48,000 3,000 Used Net loss Increase in inventory Decrease in salaries payable Net cash used by operating activities Cash dividends paid
T-Account Approach
Cash Provided Decrease in accounts receivable Depreciation charges Increase in accounts payable Proceeds from sale of land 17,000 6,000 11,000 32,000 27,000 50,000 5,000 48,000 3,000 Used Net loss Increase in inventory Decrease in salaries payable Net cash used by operating activities Cash dividends paid
No Effect in the Cash account.
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T-Account Approach
Cash Provided Decrease in accounts receivable Depreciation charges Increase in accounts payable Proceeds from sale of land 17,000 6,000 11,000 32,000 27,000 50,000 5,000 48,000 3,000 19,000 Used Net loss Increase in inventory Decrease in salaries payable Net cash used by operating activities Cash dividends paid Net decrease in cash and cash equivalents
Preparing the Statement of Cash Flows

The net effect of these transactions on the cash account is as shown. Notice, the net decrease in cash is $19,000.
(27,000) 17,000 11,000 6,000 (50,000) (5,000) (48,000) 32,000 (3,000) (19,000) 90,000 71,000
In addition, on the face of the statement or in a supplemental schedule, disclose the issuance of $50,000 of stock to a creditor, a noncash financing activity.
End of Chapter

Cash Flow

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Cash Flow

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1-1

Statement of Cash Flows

How Well Am I Doing? Statement of Cash Flows

Will the company have to borrow money to make needed investments?

To classify changes in noncash balance sheet accounts as sources or uses of cash.

Currency and Bank Accounts

Constructing the Statement of Cash Flows

Changes in Capital Stock Net Cash Flows for a Period

Dividends Paid to Stockholders

Changes in Noncash Assets

Constructing the Statement of Cash Flows

Constructing the Statement of Cash Flows

Constructing the Statement of Cash Flows

Constructing the Statement of Cash Flows

A Simplified Statement of Cash Flows: An Example

A Simplified Statement of Cash Flows: An Example

A Simplified Statement of Cash Flows: An Example

A Simplified Statement of Cash Flows: An Example

17,000 32,000 11,000 6,000 66,000

27,000 50,000 5,000 3,000 85,000

A Simplified Statement of Cash Flows

17,000 32,000 11,000 6,000 66,000

27,000 50,000 5,000 3,000 85,000

To classify transactions as operating activities, investing activities, or financing activities.

The Full-Fledged Statement of Cash Flows: Operating Activities

The Full-Fledged Statement of Cash Flows: Investing Activities

Acquiring or selling investment securities

Organization of the Full-Fledged Statement of Cash Flows

Interest on debt is classified as an operating activity

Organization of the Full-Fledged Statement of Cash Flows

Noncash Investing and Financing Activities

$ XXX XXX XXX XXX XXX (XXX) (XXX) (XXX) $ XXX

(XXX) (XXX) $ XXX

Losses are added back to net income.

Includes transactions that involve the acquisition or disposal of noncurrent assets.

Other Issues: Gross or Net?

Includes transactions involving receipts from or payments to creditors and owners.

Operating Activities: Direct or Indirect Method?

Direct Method Reports the cash effects of each operating activity

A Full-Fledged Statement of Cash Flows: An Example

A Full-Fledged Statement of Cash Flows: An Example

Preparing the Statement of Cash Flows: Step 1

Preparing the Statement of Cash Flows: Step 2

(17,000) 50,000 (32,000) -

6,000 11,000 (5,000) (50,000) 50,000 (27,000) 3,000

Preparing the Statement of Cash Flows: Step 3

Preparing the Statement of Cash Flows: Step 4

(17,000) Source 50,000 Use (32,000) Source -

Code each entry on the worksheet as a source or use of cash.

(17,000) Source 50,000 Use (32,000) Source -

17,000 (50,000) 32,000 -

6,000 11,000 (5,000) (50,000) 50,000 (27,000) (3,000) (19,000)

Preparing the Statement of Cash Flows: Step 5

Preparing the Statement of Cash Flows: Step 6

(17,000) Source 50,000 Use (32,000) Source -

17,000 (50,000) 32,000 -

17,000 (50,000) 32,000 -

6,000 11,000 (5,000) (50,000) 50,000 (27,000) (3,000) (19,000) $

6,000 11,000 (5,000)

(17,000) Source 50,000 Use (32,000) Source -

17,000 (50,000) 32,000 -

17,000 (50,000) 32,000 -

Operating Operating Investing