Chapter 12 Important Topics
A company cannot increase its net cash provided by operating activities by increasing its depreciation expense.
Because depreciation is added back to net income on the statement of cash flows, some people erroneously conclude that a company can increase its cash flow by simply increasing its depreciation expense. This is false; a company cannot increase its net cash provided by operating activities by increasing its depreciation expense. If it increases its depreciation expense by X dollars, then net income will decline by X dollars and the amount of the adjustment in step one of this process will increase by X dollars. The decline in net income and the increase in the amount of the adjustment in step one exactly offset each other, resulting in zero impact on the net cash provided by operating activities.
Operating activities Step 3
The third step in computing the net cash provided by operating activities is to ADJUST FOR GAIN/LOSSES included in the income statement.
Financing activities
generate cash inflows and outflows related to borrowing from a repaying principal to creditors and completing transactions with the company's owners, such as selling or repurchasing shares of common stock and paying dividends. The most common types of cash inflows and outflows resulting from these three activities are summarized in Exhibit 12-1.^3
Under the Direct Method
the income statement is reconstructed on a cash basis from top to bottom. For example, cash collected from customers is listed instead of revenue, and payments to suppliers is listed instead of cost of goods sold. In essence, cash receipts are counted as revenues and cash disbursements pertaining to operating activities are counted as expenses. The difference between the cash receipts and cash disbursements is the net cash provided by operating activities.
if BONDS PAYABLE (liabilities and stockholders' equity): INCREASE in account balance
then you ADD to ...
if COMMON STOCK (liabilities and stockholders' equity): INCREASES in account balance
then you ADD to ...
If ACCOUNTS RECEIVABLE (current asset): DECREASE in account balance
then you ADD to net income
If ACCRUED LIABILITIES (current liabilities): INCREASE in account balance
then you ADD to net income
If INVENTORY (current asset): DECREASE in account balance
then you ADD to net income
if ACCOUNTS PAYABLE (current liabilities): INCREASE in account balance
then you ADD to net income
if ACCRUED LIABILITIES (current liabilities): DECREASE in account balance
then you SUBTRACT from net income
if INCOME TAXES PAYABLE (current liabilities): DECREASE in account balance
then you SUBTRACT from net income
The third key concept is
that the indirect method requires three steps to compute net cash provided by operating activities. The first step is to add back depreciation to net income. The second step is to analyze net changes in noncash balance sheet accounts that impact net income. The third step is to adjust gross cash inflows and outflows in the investing and financing activities sections of the statement of cash flows.
The first key concept is
that the statement of cash flows is divided into three sections: operating activities, investing activities, and financing activities. The net cash used or provided by these three types of activities is combined to derive the net increase/decrease in cash and cash equivalents, which explains the change in the cash balance.
if INCOME TAXES PAYABLE (current liabilities): INCREASE in account balance
then you ADD to net income
if BONDS PAYABLE (liabilities and stockholders' equity): DECREASE in account balance
then you SUBTRACT from ...
if COMMON STOCK (liabilities and stockholders' equity): DECREASE
then you SUBTRACT from ...
if ACCOUNTS PAYABLE (current liabilities): DECREASE in account balance
then you SUBTRACT from net income
if ACCOUNTS RECEIVABLE (current asset): INCREASE in account balance
then you SUBTRACT from net income
if INVENTORY (current asset): INCREASE in account balance
then you SUBTRACT from net income.
Managers generally perceive that earnings are of higher quality, or more indicative of operational performance, when the earnings
1. are not unduly influenced by inflation 2. are computed using conservative accounting principles and estimates and 3. are correlated with net cash provided by operating activities.
99% of companies use indirect method
Although both methods result in the same amount of net cash provided by operating activities, only about 1% of companies use the direct method and the remaining 99% use the indirect method. If a company uses the direct method to prepare its statement of cash flows, then it must also provide a supplementary report that uses the indirect method.
Basic Equation for Asset Accounts
Beginning balance + Debits - Credits = Ending balance
Basic Equation of Contra Asset, Liability, and Stockholders' Equity Accounts
Beginning balance - Debits + Credits = Ending balance
Step 1 in the indirect method
Step I The first step is to add depreciation charges to net income. Depreciation charges are the credits to the Accumulated Depreciation account during the period-the sum total of the entries that have increased Accumulated Depreciation. Why do we do this? Because Accumulated Depreciation is a noncash balance sheet account and we must adjust net income for all of the changes in the noncash balance sheet accounts that have occurred during the period.
Operating Activities Step 1
The first step in computing Apparel's net cash provided by operating activities is to ADD DEPRECIATION to net income. Beginning balance - Debits + Credits = Ending balance
Operating Activities Step 2
The second step in computing net cash provided by operating activities is to ANALYZE NET CHANGES IN NONCHASH BALANCE SHEET ACCOUNTS that impact net income.
The statement of cash flows
The statement of cash flows highlights the major activities that impact cash flows and, hence, affect the overall cash balance. Managers focus on cash for a very good reason - without sufficient cash at the right times, a company may miss golden investment opportunities or may even go bankrupt. The statement of cash flows answers questions that cannot be easily answered by looking at the income statement and balance sheet.
Investing activities
generate cash inflows and outflows related to acquiring or disposing of noncurrent assets such as property, plant, and equipment, long-term investments, and loans to another entity.
Operating activities
generate cash inflows and outflows related to revenue and expense transactions that affect net income.
When a company's net income and net cash provided by operating activities move in tandem with one another (in other words, are correlated with one another)
it suggest that earnings result from changes in sales and operating expenses.
If a company's net income is steadily increasing and its net cash provided by operating activities is declining
it suggests that net income is being influenced by factors unrelated to operational performance, such as nonrecurring transactions or aggressive accounting principles and estimates.
Free Cash flow
measures a company's ability to fund its capital expenditures for property, plant, and equipment and its dividends from its net cash provided by operating activities.
Free cash flow =
net cash provided by operating activities -capital expenditures - Dividends
Under the Indirect method
net income is adjusted to a cash basis. That is, rather than directly computing cash sales, cash expenses, and so forth, these amounts are derived indirectly by removing from net income any items that do not affect cash flows.
In the matter of gains and losses on sale of assets
no adjustments are needed under the direct method These gains and losses are simply ignored because they are not part of sales, cost of goods sold, selling and administrative expense, or income taxes.
The second key concept is
that the operating activities section of the statement of cash flows can be prepared using the direct or indirect method. The direct method translates sales, cost of goods sold, selling ad administrative expense, and income tax expense to a cash basis. The indirect method begins with accrual-based net income and adjust it to cash basis.