Chapter 12: Statement of Cash Flows

Cash Equivalents

Cash equivalents are short-term, highly liquid investments purchased within three months of maturity. They are considered equivalent to cash because they are both: 1.) Readily convertible to known amounts of cash 2.) So near to maturity their value is unlikely to change. - Restricted cash is money that is legally or contractually required to be set aside such that it is not available for use in day-to-day operations.

Increase in Accounts Payable

Cash flow from operations must reflect cash purchases, but not all purchases are for cash. Purchases on account increase Accounts Payable and cash paid to suppliers decreases Accounts Payable. Accounts Payable increased by $15 million, which means that purchases on account were greater than cash payments to suppliers. Thus, to show the lower cash outflow, the increase in Accounts Payable must be added back in Exhibit 12.4. (A decrease would be subtracted.)

Financing Activities

Financing activities are transactions that include owner's equity, long-term liabilities, and changes in short-term loans. Financing activities include the movement of cash and cash equivalents among the organization and its sources of cash.

Noncash Transactions and Other Supplemental Disclosures

In addition to cash flows, all companies are required to report material investing and financing transactions that did not have cash flow effects (called noncash investing and financing activities). For example, the purchase or lease of a $10,000 piece of equipment with a $10,000 note payable to the equipment supplier does not cause either an inflow or an outflow of cash. As a result, these activities are not listed in the three main sections of the statement of cash flows. This important information is normally presented for users in a supplementary schedule to the statement of cash flows or in the financial statement notes. Companies using the indirect method also must disclose the amount of cash paid for interest and for income taxes. Examples of these supplemental disclosures are shown at the bottom of Exhibit 12.7.

Investing Activities

Investing activities include purchases of physical assets, investments in securities, or the sale of securities or assets. Negative cash flow from investing activities might not be a bad sign if management is investing in the long-term health of the company.

The Statement of Cash Flows

Shows the major types of business activity that caused a company's cash to increase or decrease during the accounting period. For purposes of this statement, cash is defined to include cash, cash equivalents, and restricted cash.

Operating Activities

The daily activities of a company involved in producing and selling its product, generating revenues, as well as general administrative and maintenance activities. Key operating activities for a company include manufacturing, sales, advertising, and marketing activities. Cash inflows and outflows that directly relate to revenues and expenses reported on the income statement. Operating activities involve day-to-day business activities with customers, suppliers, employees, landlords, and others.

Reporting Operating Cash Flows with the Direct Method

The direct method presents a summary of all operating transactions that result in either a debit or a credit to cash. It is prepared by adjusting each revenue and expense on the income statement from the accrual basis to the cash basis.

Relationship to Other Financial Statements

To prepare a statement of cash flows, you need the following: 1.) Comparative balance sheets, showing beginning and ending balances, used in calculating the cash flows from all activities (operating, investing, and financing). 2.) A complete income statement, used primarily in calculating cash flows from operating activities. 3/4.) Additional data concerning selected accounts that increase and decrease as a result of investing and/or financing activities.

Reporting Investing Cash Flow Calculations

To prepare the investing section of the statement of cash flows, you must analyze accounts related to long-lived tangible and intangible assets. Unlike the analysis of operating activities, where you were concerned only with the net change in selected balance sheet accounts, an analysis of investing (and financing) activities requires that you identify and separately report the causes of both increases and decreases in account balances. The following relationships are the ones you will encounter most: Dave & Buster's balance sheet (Exhibit 12.3) shows two investing assets (noted with an I) that changed during the year: Property and Equipment, and Intangible and Other Assets.

Cash Flows from Operating Activities (Cash Flows from Operations)

Typical cash flows from operating activities include: The difference between these cash inflows and outflows is reported on the statement of cash flows as a subtotal, Net Cash Provided by (Used for) Operating Activities.

Evaluating Cash Flows from Financing Activities

Unlike the operating and investing activities sections, where a healthy company typically shows positive and negative cash flows, respectively, the financing activities section does not have an obvious expected direction for cash flows. For example, a healthy company that is growing rapidly could need financing cash inflows to fund its expansion. In this case, the company could take out new loans or issue new shares, both of which would result in positive net cash flows from financing activities. Alternatively, a healthy company could use its cash resources to repay existing loans, pay dividends, or repurchase shares, all of which would result in negative net cash flows from financing activities. Thus, it's not possible to evaluate the company's financing cash flows by simply determining whether they are positive or negative on an overall basis. Rather, you will need to consider detailed line items within this section to assess the company's overall financing strategy (is the company moving toward greater reliance on risky debt financing?)

Indirect Method - Relationships to the Balance Sheet and the Income Statement

Use this table when adjusting net income to operating cash flows using the indirect method.

Accrual-Based Net Income

When accurately reported, accrual-based net income is the best measure of a company's profitability during the period.

Indirect Method - Net Income

When determining operating cash flows using the indirect method, start with net income as reported on the last line of the company's income statement. By starting with net income, it's as if we are assuming all revenues resulted in cash inflows and all expenses resulted in cash outflows. But we know this is not true, so we add and subtract various amounts to convert that net income number into cash flows from operating activities.

Indirect Method - Add (+) Depreciation

When initially recording depreciation in the accounting system, we increase Depreciation Expense (with a debit) and increase Accumulated Depreciation (with a credit). Notice that this entry for depreciation does not involve cash. To eliminate the effect of having deducted Depreciation Expense from Net Income in the income statement, we add it back in the statement of cash flows.

Intangible and Other Assets

A similar approach is used to determine cash flows associated with intangible assets. For our example, analysis of Dave & Buster's additional data indicates the company did not have any reductions in its intangible assets as a result of disposals, impairments, or amortization during the year. However, Dave & Buster's did purchase intangible assets for $2 million cash, as noted in the additional data in Exhibit 12.3. This cash outflow is subtracted in the schedule of investing activities in Exhibit 12.5.

Decrease in Accounts Receivable

Accounts Receivable increases when sales are made on account and it decreases when cash is collected from customers. An overall decrease in this account, then, implies sales on account were less than cash collections. To convert from the lower sales number that is included in net income to the higher cash collected from customers, we add the difference ($9 million).

Indirect Method - Add (+) Decreases in Current Assets

Adding decreases in current assets serves two purposes. 1.) First, it eliminates the effects of some transactions that decreased net income but did not affect cash in the current period. - For example, when Supplies are used, net income decreases, but cash is not affected. To eliminate these noncash effects from our cash flow computations, we must add back decreases in Supplies and other current assets. 2.) Second, adding decreases in current assets allows us to include the cash effects of other transactions that did not affect net income in the current period but did increase cash. - For example, Cash increases when Accounts Receivable are collected. These cash inflows are captured by adding the amount by which this current asset had decreased.

Indirect Method - Add (+) Increases in Current Liabilities

Adding increases in current liabilities serves two purposes. 1.) First, it eliminates the effects of transactions that decreased net income but did not affect cash. - For example, when interest is accrued on a bank loan, a company decreases net income, but its cash is not affected. To eliminate these noncash effects, we add back increases in current liabilities. 2.) Second, adding increases in current liabilities allows us to include the cash effects of other transactions that did not affect net income in the current period but did increase cash. - For example, Cash and Deferred Revenue increase when the company receives cash in advance of providing services. Adding the increase in current liabilities captures these cash inflows.

Evaluating Cash Flows from Operating Activities

All other things being equal, when net income and operating cash flows are similar, there is a high likelihood that revenues are realized in cash and that expenses are associated with cash outflows. Any major deviations should be investigated. In some cases, a deviation may be nothing to worry about, but in others, it could be the first sign of big problems to come. Four potential causes of deviations to consider include: 1.) Seasonality 2.) The corporate life cycle (growth in sales) 3.) Changes in revenue and expense recognition 4.) Changes in working capital management

Evaluating Cash Flows from Investing Activities

Although it might seem counterintuitive at first, healthy companies tend to show negative cash flows in the investing section of the statement of cash flows. A NEGATIVE total for this section means the company is spending more to acquire new long-term assets than it is taking in from selling its existing long-term assets. If you see a POSITIVE total cash flow in the investing activities section, you should be concerned because it could mean the company is selling off its long-term assets just to generate cash inflows. If a company sells off too many long-term assets, it may not have a sufficient base to continue running its business effectively, which would likely lead to further decline in the future.

Information for Preparing a Statement of Cash Flows

Another way to remember whether to add or subtract the difference is to think about whether the overall change in the account balance is explained by a debit or credit. If the change in the account is explained by a credit, the adjustment in the cash flow schedule is reported like a corresponding debit to cash (added). In Dave & Buster's case, the decrease in Accounts Receivable is explained by a credit, so the adjustment in the cash flow schedule is reported like a debit to cash (added), as follows:

Steps to Preparing the Statement of Cash Flows

Based on the idea that the change in cash equals the sum of the changes in all other balance sheet accounts, we use the following steps to prepare the statement of cash flows: 1.) Determine the change in each balance sheet account. From this year's ending balance, subtract this year's beginning balance (i.e., last year's ending balance). 2.) Identify the cash flow category or categories to which each account relates. 3.) Create schedules that summarize operating, investing, and financing cash flows. Let's start with operating cash flows.

Cash Flows from Financing Activities

Cash flows from financing activities include exchanges of cash with stockholders and cash exchanges with lenders (for principal on loans). Common cash flows from financing activities include: The difference between these cash inflows and outflows is reported on the statement of cash flows as a subtotal, Net Cash Provided by (Used in) Financing Activities.

Cash Flows from Investing Activities

Cash flows from investing activities are the cash inflows and outflows related to the purchase and disposal of investments and long-lived assets. Typical cash flows from investing activities include: The difference between these cash inflows and outflows is reported on the statement of cash flows as a subtotal, Net Cash Provided by (Used in) Investing Activities.

Converting Cost of Goods Sold to Cash Paid to Suppliers

Cost of Goods Sold represents the cost of merchandise sold during the accounting period, which may be more or less than the amount of cash paid to suppliers during the period. In Dave & Buster's case, Inventory decreased during the year, implying the company bought less merchandise than it sold. If the company paid cash to suppliers of inventory, it would have paid less cash to suppliers than the amount of Cost of Goods Sold. So, the decrease in Inventory must be subtracted from Cost of Goods Sold to compute cash paid to suppliers. Typically, companies buy inventory on account from suppliers (as indicated by an Accounts Payable balance on the balance sheet). Consequently, we need to consider more than just the change in Inventory to convert Cost of Goods Sold to cash paid to suppliers. The credit purchases and payments that are recorded in Accounts Payable also must be considered. Credit purchases increase Accounts Payable and cash payments decrease it. The overall increase in Accounts Payable reported by Dave & Buster's in Exhibit 12.3 indicates that cash payments were less than credit purchases, so the difference must be subtracted in the computation of total cash payments to suppliers. In summary, to fully convert Cost of Goods Sold to a cash basis, you must consider changes in both Inventory and Accounts Payable as follows: Using information from Exhibit 12.3, we compute cash paid to suppliers as follows

Example: Dave & Busters Condensed Statement of Cash Flows

Dave & Buster's cash flows suggest the company is financially healthy. The company generated enough cash from its day-to-day operations ($305 million) to pay for investments in store upgrades ($185 million) and to return some cash to stockholders through stock repurchases ($149 million) and dividends ($11 million). To learn more about these cash flows, you would consider the details of each category, as we will do now.

Net Income

Despite its importance, net income is not what companies use when they pay wages, dividends, or loans. These activities require cash, so financial statement users need information about changes in a company's cash. Neither the balance sheet nor the income statement provides this information. The balance sheet shows a company's cash balance at a point in time, but it doesn't explain the activities that caused changes in its cash. Cash may have been generated by the company's day-to-day operations, by the sale of the company's buildings, or by advances on loans. The income statement doesn't explain changes in cash because it focuses on just the operating results of the business, excluding cash that is received or paid when taking out or paying down loans, issuing or acquiring the company's own stock, and selling or investing in long-lived assets.

Retained Earnings

Net income increases Retained Earnings and any declared dividends decrease Retained Earnings. Net income has already been accounted for as an operating cash flow. The declared dividends were $11 million (see the additional data in Exhibit 12.3), which decreased Retained Earnings as shown in the following T-account. Because the balance sheet does not report Dividends Payable, we assume all of these declared dividends were paid in cash. This cash outflow is reported in the financing section of the statement of cash flows, as summarized in Exhibit 12.6.

Relationships between Classified Balance Sheet & Statement of Cash Flows

One way to classify cash flows into operating, investing, and financing categories is to think about the balance sheet accounts to which the cash flows relate. Although exceptions exist, a general rule is that operating cash flows cause changes in current assets and current liabilities, investing cash flows affect noncurrent assets, and financing cash flows affect noncurrent liabilities or stockholders' equity accounts. This image shows how this general rule relates the three sections of the statement of cash flows (SCF) to each of the main sections of a classified balance sheet.

Indirect Method - Subtract (-) Decreases in Current Liabilities

Subtracting decreases in current liabilities serves two purposes. 1.) First, it eliminates the effects of transactions that increased net income but did not affect cash. - For example, a company decreases Deferred Revenue and increases net income in the current period when it fulfills prior obligations to provide services, but cash is not affected. To eliminate these noncash effects, we subtract decreases in current liabilities. 2.) Second, subtracting decreases in current liabilities allows us to include the cash effects of other transactions that did not affect net income in the current period but did decrease cash. - For example, Cash decreases when a company pays wages that were incurred and expensed in a previous period. These cash outflows are captured by subtracting decreases in current liabilities.

Indirect Method - Subtract (-) Increases in Current Assets

Subtracting increases in current assets similarly serves two purposes. 1.) First, it eliminates the effects of transactions that increased net income but did not affect cash in the current period. - For example, net income increases when a company provides services on account to its customers, but cash is not affected. We eliminate these noncash effects by subtracting increases in current assets. 2.) Second, subtracting increases in current assets allows us to include the cash effects of other transactions that did not affect net income in the current period but did decrease cash. - For example, Cash decreases when a company prepays its insurance or rent, but net income isn't affected until these assets are used up. The cash outflows can be captured by subtracting the increase in these current assets.

Common Stock and Treasury Stock

The additional data in Exhibit 12.3 indicate Dave & Buster's issued $10 million of common stock and repurchased treasury stock for $149 million cash. * These stock transactions fully account for the change in Common Stock and Treasury Stock, as shown in the following T-accounts. These cash flows are listed in the schedule of financing activities in Exhibit 12.6.

Notes Payable

The additional data in Exhibit 12.3 indicate Notes Payable (long-term) was affected by both cash inflows and outflows, as shown in the T-account below. These cash flows are reported separately in the schedule of financing activities shown in Exhibit 12.6.

Preparing the Cash Flow Statement (CFS)

The approach to preparing the cash flow statement focuses on changes in the balance sheet accounts. It relies on a simple rearrangement of the balance sheet equation:

Increase in Accrued Liabilities

The income statement reports all accrued expenses, but the cash flow statement must reflect only the actual cash payments for expenses. Recording accrued expenses increases the balance in Accrued Liabilities and cash payments for the expenses decreases Accrued Liabilities. Dave & Buster's Accrued Liabilities increased by $60 million, which indicates that more expenses were accrued than paid. To convert to the smaller cash outflow, this difference must be added in Exhibit 12.4. (A decrease would be subtracted.) By scanning Exhibit 12.3 you can see that you have now considered the changes in all balance sheet accounts that relate to operating activities (marked by the letter O). The last step in determining the net cash flow provided by (used in) operating activities is to calculate a total. As shown in Exhibit 12.4, the combined effects of all operating cash flows is a net inflow of $305 million.

Increase in Prepaid Expenses

The income statement reports expenses of the period, but cash flow from operating activities must reflect the cash payments. Cash prepayments increase the balance in prepaid expenses, and recording of expenses decreases the balance in prepaid expenses. Dave & Buster's $2 million increase in Prepaid Expenses means cash prepayments this period were more than expenses. These extra cash prepayments must be subtracted in Exhibit 12.4. (A decrease would be added.)

Decrease in Inventory

The income statement reports the cost of goods sold during the period, but cash flow from operating activities must report cash purchases of inventory. As shown in the T-account on the left, purchases of goods increase the balance in inventory, and recording the cost of goods sold decreases the balance in inventory The above T-account on the right shows a $1 million inventory decrease, which means that the cost of goods sold deducted on the income statement was more than the cash outflow for inventory purchases. This difference must be added back to net income to convert it to cash flow from operating activities in Exhibit 12.4. (An increase would be subtracted.)

Indirect Method of Recording Cash Flows

The indirect method starts with net income from the income statement and adjusts it by eliminating the effects of items that do not involve cash (for example, depreciation) and including items that do have cash effects. Adjusting net income for these items yields the Net Cash Provided by (Used in) Operating Activities.

Classifying Cash Flows

The statement of cash flows requires all cash inflows and outflows to be classified as relating to the companies operating, investing, or financing activities. The first thing Jordan and Ty needed to get their idea off the ground was financing, which the company could then use to invest in assets that later would be needed to operate the business.

Converting Operating Expenses to a Cash Outflow

The total amount of an expense on the income statement may differ from the cash outflow associated with that activity. Some amounts, like prepaid rent, are paid before they are recognized as expenses. When prepayments are made, the balance in the asset Prepaid Expenses increases. When expenses are recorded, Prepaid Expenses decreases. When we see Dave & Buster's prepaids increase by $2 million during the year, it means the company paid more cash than it recorded as operating expenses. This amount must be added in computing cash paid to service suppliers for operating expenses. **More information in chapter 12, page 24.

Reporting Financing Cash Flow Calculations

This section of the cash flow statement includes changes in liabilities owed to owners (Dividends Payable) and financial institutions (Notes Payable and other types of debt), as well as changes in stockholders' equity accounts. Interest is considered an operating activity so it is excluded from financing cash flows. The following relationships are the ones you will encounter most often: To compute cash flows from financing activities, you should review changes in all debt and stockholders' equity accounts. Increases and decreases must be identified and reported separately. Dave & Buster's balance sheet in Exhibit 12.3 indicates that Notes Payable, Common Stock, Retained Earnings, and Treasury Stock changed during the period as a result of financing cash flows (noted with an F).

Property and Equipment

To determine the cause of the change in the Property and Equipment account, accountants would examine the detailed accounting records for purchases (increases) and disposals (decreases). The additional data in Exhibit 12.3 indicate Dave & Buster's purchased equipment for $ 185 million cash. This purchase is a cash outflow, which we subtract in the schedule of investing activities in Exhibit 12.5. In our example, this purchase fully accounts for the change in the Property and Equipment balance, as shown in the following T-account. Note 3 of the additional data in Exhibit 12.3 confirms there were no disposals or impairments during the year.

Example: Recording Disposals of PPE (Indirect Method)

To illustrate, assume Dave & Buster's sold equipment for $7 million. The equipment originally cost $15 million and had $10 million of accumulated depreciation at the time of disposal. The disposal would have been analyzed and recorded as follows (in millions): The $7 million inflow of cash would be reported as an investing activity. The $10 million and $15 million are taken into account Page 578 when considering changes in the Accumulated Depreciation and Equipment account balances. Lastly, the $2 million Gain on Disposal was included in net income, so we must remove (subtract) it in the operating activities section of the statement. Thus, the disposal would affect two parts of the statement of cash flows:

Converting Sales Revenues to Cash Inflows

When sales are recorded, Accounts Receivable increases, and when cash is collected, Accounts Receivable decreases. This means that if Accounts Receivable decreases by $9 million, then cash collections were $9 million more than sales on account. To convert sales revenue to the cash collected, we need to add $9 million to Sales Revenue. The following flowchart shows this visually: Using information from Dave & Buster's income statement and balance sheet presented in from customers as follows:

Determining Operating Cash Flows Using the Indirect Method

When using the indirect method, operating cash flows are calculated as follows. We explain each of these items below and then we demonstrate how to use Dave & Buster's financial information to create such a schedule.

Recording Disposals of PPE (Indirect Method)

Whenever a company sells property, plant, and equipment (PPE), it records three things: 1.) Decreases in the PPE accounts for the assets sold 2.) An increase in the Cash account for the cash received on disposal 3.) A gain if the cash received is more than the book value of the assets sold (or a loss if the cash received is less than the book value of the assets sold). The only part of this transaction that qualifies for the statement of cash flows is the cash received on disposal. This cash inflow is classified as an investing activity, just like the original equipment purchase.