Ch. 11: Statement of Cash Flows

Name the 3 primary categories of cash flows.

1) Operating cash flows 2) Cash flows from investing activities 3) Cash flows from financing activities

Why are operating cash flows often higher than net income?

Because certain items, like depreciation expense, decrease net income but have no effect on operating cash flows.

Summarize the adjustments we make to convert net income to net cash flows from operating activities.

+ depreciation expense, + amortization expense (both noncash); + loss on sale of assets, - gain on sale of assets (both nonoperating items); +decrease in a current asset, - increase in a current asset, +increase in a current liability, -decrease in a current liability (all 4 are nonoperating items);

How do we adjust for a decrease in income tax payable (current liability; found in operating activities) to arrive at the operating net cash flow? Why?

-A decrease in the balance of Income Tax Payable suggests that the company paid cash to reduce its liability, but recorded no corresponding expense. To adjust for cash being lower, we subtract the decrease in Income Tax Payable from net income.

How do we adjust for an increase in interest payable (current liability; found in operating activities) to arrive at the operating net cash flow? Why?

-Add that year's increase in Interest Payable to net income. *Explanation: As interest payable increases over the year, the company correspondingly records interest expense for which it did not pay cash. An increase in interest payable reduces net income (b/c of interest expense) but has no effect on cash. To adjust for cash being greater by the amount of interest expense incurred, we add the increase in interest payable to net income.

How do we determine and report the payment of dividends when there is an increase in retained earnings?

-Determine: Retained Earnings increases with net income and decreases with dividends (b/c R.E.= Net Income - Dividends). To find amount payed in dividends, subtract retained earnings from net income. -Report: Report the payment of dividends actually paid in cash during the year (rather than just declared) as a cash outflow from financing activities.

How do we (the company) adjust for a decrease in accounts payable (current liability; found in operating activities) to arrive at the operating net cash flow? Why?

-If Accounts Payable balance decreased over the year, we subtract the balance from net income. *Explanation: A decrease in accounts payable means that a company paid cash to reduce its liability but did not report a corresponding expense during the period. The cash outflow to reduce accounts payable caused cash to decrease but net income to remain unaffected. To adjust for cash being lower, we subtract the decrease in accounts payable from net income.

How do we adjust accounts receivable, a current asset (found in operating activities), to arrive at its operating net cash flow amount? Why do we do this?

-If Accounts Receivable increased during the period, subtract it from net income. *Explanation: Accounts receivable represent sales reported as part of net income but that did not result in operating cash flows because the company has yet to collect them. -If A.R. decreased during the year, add it net income. *Explanation: A decrease in accounts receivable indicates that the company collected more cash from customers than it recorded as sales revenue.

How do we report an increase in equipment (long-term liability; found in either financing or noncash activities) on the statement of cash flows?

-If the company purchased equipment with cash (causing the Equipment account to increase) we would record a cash outflow from investing activities. -If the firm paid for equipment by issuing a note payable, the increase in equipment is classified as a noncash activity and should be disclosed either directly after the statement of cash flows or in a note to the financial statements.

How do we adjust for a decrease in the inventory (current asset; found in operating activities) balance to arrive at the operating net cash flow? Why do we do this?

-If the inventory balance decreased during the year, we add the decrease in inventory to net income. *Explanation: The amount that inventory decreases over a year is the amount of inventory a company sold but did not replace and is recorded as Cost of Goods Sold thereby reducing net income. To adjust for the increase in cash from the amount of inventory sold, we add the decrease to net income.

How do we adjust for an increase in prepaid rent (current asset; found in operating activities) to arrive at the operating net cash flow? Why do we do this?

-If the prepaid rent balance increased during the year, we subtract it from net income. *Explanation: The company pays cash to purchase this asset and yet there is no corresponding expense to reflect this decrease in cash, leaving net income unaffected. To adjust for cash being lower, we subtract the increase in prepaid rent from net income.

Give some examples of significant noncash investing and financing activities.

-Purchase of long-term assets by issuing debt (liabilities such as payables) -Purchase of long-term assets by issuing stock -Conversion of bonds payable into common stock -Exchange of long-term assets

How do we report a decrease in land (long-term asset; found in investing activities)?

-Report the cash proceeds from the sale of the land (accounting for whether the sale produced a gain or loss and factoring that into the original cost recorded for the land) as a cash inflow from investing activities.

What do the last three lines of the statement of cash flows include?

1) Amounts for the net increase or (decrease) in cash between the two years (cash inflows & outflows we identify must net this amount) 2) Cash at the beginning of the period (year 1 cash balance) 3) Cash at the end of the period (number obtained from balance sheet/year 2 cash balance)

How would a company report it on the statement of cash flows if they sold an investment in stock, originally costing $50,000, for $55,000, resulting in a $5000 gain on sale of investment?

1) As a cash outflow of 5000 from the operating activities section. -(5000) for "gain on sale of investment" 2) As a cash inflow of 55,000 in the investing activities section - 55,000 as "sale of investment"

What 4 steps are taken to prepare the statement of cash flows?

1) Calculate net cash flows from operating activities using the income statement and changes in current assets (except cash) and current liabilities from the balance sheet. 2) Determine the net cash flows from investing activities by analyzing changes in long-term asset accounts from the balance sheet. 3) Determine the net cash flows from financing activities by analyzing changes in long-term liabilities and stockholders' equity accounts from the balance sheet. 4) Combine the operating, investing, and financing activities and make sure the total from these three activities equals the amount of cash reported in the balance sheet this year versus last year (the change in cash).

What are the 3 primary sources of information used to determine the amounts necessary to prepare the statement of cash flows?

1) Income statement: Helps to determine cash flows from operating activities 2) Balance sheet: Helps to determine cash flows from operating, investing, and financing activities 3) Detailed accounting records: Helps to determine specific cash inflows and outflows from the period

What are two methods used to determine and report cash flows from operating activities?

1) Indirect method: Begin with net income and then list adjustments to net income in order to arrive at operating cash flows. 99% of US companies use this method. 2) Direct method: Adjust the items in the income statement in order to directly reflect the cash inflows/outflows from operations like cash received from customers or cash paid for inventory, salaries, rent, interest or taxes. Companies that use this method are required to report the indirect method either with the statement of cash flows or in separate note to financial statements.

What adjustments are made to net income in calculating operating cash flows?

1) Noncash items: Revenues & expenses that never affect cash, such as depreciation or amortization expense. 2) Nonoperating items: These items include gains and losses generated by the sale of long-term assets that do not affect operating cash flows, such as gains and losses on the sale of land, buildings, and equipment. 3) Changes in current assets and current liabilities: Changes that represent the noncash portion of some revenues and expenses and occur when the cash flow for the year does not equal the related amount reported in the income statement.

Sort the accounts on the income statement (revenues & expenses) and balance sheet (assets, liabilities, stockholders' equity) into their appropriate cash flow categories.

1) Operating cash flows -revenues (income statement) -expenses (income statement) -changes in current assets (balance sheet) -changes in current liabilities (balance sheet) 2) Investing cash flows -changes in long-term assets (balance sheet) 3) Financing cash flows -changes in long-term liabilities -changes in common stock -changes in retained earnings -less dividends payed

How do we report an increase in common stock (stockholders' equity; found in financing activities)?

As a cash inflow in the financing section.

How do we report an increase in retained earnings (stockholders' equity; found in financing activities)?

As a cash inflow?

How do we report an increase/purchase of investments (long-term asset; found in investing activities)?

As a cash outflow from investing activities.

How do we report an increase in notes payable (long-term liability; found in either financing or noncash activities) on the statement of cash flows?

As a noncash activity reported directly after cash flow statement or in separate note to the financial statements.

Give examples of cash flows from investing activities.

CASH INFLOWS: -sale of investments -sale of long-term assets -collection of notes-receivable CASH OUTFLOWS: -purchase of investments -purchase of long-term assets -lending with notes receivable

Give examples of cash flows from financing activities.

CASH INFLOWS: -issuance of bonds or notes payable -issuance of stock CASH OUTFLOWS: -repayment of bonds or notes payable -acquisition of treasury stock -payment of dividends

Give examples of cash flow operating activities.

CASH INFLOWS: -sale of goods/services -collection of interest & dividends CASH OUTFLOWS: -for inventory -for operating expenses -for interest -for income taxes

Investing activities

Cash transactions involving the purchase and sale of long-term assets and current investments.

What is the fourth and final step in preparing the statement of cash flows?

Combine the operating, investing, and financing activities and MAKE SURE THE TOTAL OF THESE 3 ACTIVITIES EQUALS THE NET INCREASE OR (DECREASE) IN CASH ON THE BALANCE SHEET.

How do the direct & indirect methods of reporting operating cash flows differ and how are they similar?

Different: -Differ only by presentation format of operating activities specifically Similar: -Investing, financing and noncash activities are reported identically -The total net cash flows from operating activities is the SAME in both methods.

What is the first adjustment we make to net income under the indirect method? Why do we do this?

First, add back depreciation expense and amortization expense. Explanation: Though depreciation reduces net income, it is recorded as a debit to Depreciation Expense and credit to Accumulated Depreciation and does not affect cash; Therefore it is not considered a cash outflow in the current period and should be added back to net income to compensate for its original deduction as a noncash expense from net income.

How do we adjust for changes in current assets and current liabilities (step 3 in preparing the operating cash flows section) to arrive at their operating net cash flows?

For components of net income that increase or decrease cash but BY AN AMOUNT DIFFERENT FROM THAT REPORTED IN THE INCOME STATEMENT, we adjust net income for changes in the balances of related balance sheet accounts (in order to convert the effects of those items to a cash basis).

Operating activities

Include cash receipts and cash payments for transactions relating to revenue and expense activities. These are the same activities reported in the income statement (elements of net income) but reported on a cash basis.

Financing activities.

Inflows & outflows of cash resulting from the external financing of a business (usually by stockholders and lenders). Common financing activities include borrowing & repaying debt, issuing & repurchasing stock, & paying dividends.

Why is it necessary to adjust net income when we are calculating the net cash flows from operating activities?

Net income comes from the income statement which includes all revenue and expense activities reported on an accrual basis (revenue is reported when we provide goods/services to customers & expenses are recorded at the time they are incurred, regardless of when the related cash flows occur). However, net cash flows from operating activities include all revenue & expense activities reported on a CASH BASIS. *We must reconcile net income (accrual basis) to net cash flows from operating activities (cash basis) by removing noncash activities from net income.

Is net income or operating cash flows a better estimate of a company's ongoing profitability?

Net income.

Statement of cash flows

Provides a summary of cash inflows (cash received by company) and cash outflows (cash paid by company) during the reporting period.

What is the second adjustment we make to net income under the indirect method? How do we do this?

Second, adjust for gains and losses that do not affect operating cash flows. Add back losses on sale of land and subtract gains on sale of land (Explanation: The actual sale of land is an investing activity and is not an operating inflow or outflow of cash).

Operating cash flows

The cash inflows-cash outflows related to the revenue and expense activities manipulated in net income. Amount is often higher than net income.

Net cash flows

The difference between cash inflows and cash outflows during the period.

Noncash activities

Transactions that do not increase or decrease a company's cash balance but that result in significant investing or financing activities. Are either reported directly after statement of cash flows or in a note to the financial statements.