horngren introduction to financial accounting 9e ch_05

© 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick

Statement of Cash Flows

CHAPTER

5


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Learning Objectives

After studying this chapter, you should be able to

1. Identify the purposes of the statement of cash flows

2. Classify activities affecting cash as operating, investing, or financing activities

3. Compute and interpret cash flows from financing activities

4. Compute and interpret cash flows from investing activities

5. Use the direct method to calculate cash flows from operations


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Learning Objectives

After studying this chapter, you should be able to

6. Use the indirect method to explain the difference between net income and net cash provided by (used for) operating activities

7. Understand why depreciation is added to net income when using the indirect method for computing cash flow from operating activities

8. Show how the balance sheet equation provides a conceptual framework for the statement of cash flows


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Overview

• The purpose of the statement of cash flows is to

– Report cash receipts and cash payments of an entity over a period of time

– Classify the cash flows as operating, investing, and financing activities

– Detail the changes in the cash account on the balance sheet


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Overview

Balance Sheet December 31,

20X0


20X0


20X1


20X1

Statement of IncomeStatement of Income

Statement of Cash FlowsStatement of Cash Flows


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Purpose of the Cash Flow Statement

• A statement of cash flows

– Shows the relationship of net income to changes in cash balances

– Helps to predict future cash flows– Evaluates how management generates and uses

cash– Determines a company’s ability to pay interest,

dividends, and debts when they are due– Identifies specific increases and decreases in a firm’s

productive assets


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Purpose of the Cash Flow Statement

• The term “cash” also refers to cash equivalents

• Cash equivalents are highly liquid short-term investments that a company can easily and quickly convert into cash

– Money market funds– Treasury bills


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Typical Activities Affecting Cash

• Managers affect cash by three types of decisions:

– Operating decisions– Financing decisions– Investing decisions

• Operating decisions are concerned with the major day-to-day activities that generate revenues and expenses


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• Operating activities are transactions that affect the purchase, processing, and selling of a company’s products and services– Making sales– Collecting accounts receivable– Purchasing inventory– Paying accounts payable

• The first major section of the statement of cash flows is labeled cash flows from operating activities


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• Financing decisions are concerned with how to obtain or repay cash

• Financing activities are a company’s transactions that obtain resources from debt and equity transactions– Issuance of additional stock– Borrowing money from the bank– Repaying previous loans

• The financing section on the statement is labeled cash flows from financing activities


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• Investing decisions include the choices to acquire or dispose of long-term productive assets or long-term investments

• Investing activities are transactions that acquire or dispose of assets that are expected to provide services for more than one year

– Purchasing or disposing of equipment

• The investing section on the statement is labeled cash flows from investing activities


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Cash Inflows Cash Outflows Operating Activities: Collections from customers Cash payments to suppliers Interest and dividends collected Cash payments to employees Other operating receipts Interest and taxes paid Other operating cash payments Investing Activities: Sale of property, plant, and equipment Purchase of property, plant, and equipment Sale of securities that are not Purchase of securities that are not cash equivalents cash equivalents Receipt of loan repayments Making loans Financing: Borrowing cash from creditors Repayment of amounts borrowed Issuing equity securities Repurchase of equity shares (including the Issuing debt securities purchase of treasury stock) Payment of dividends

Cash Inflows Cash Outflows Operating Activities: Collections from customers Cash payments to suppliers Interest and dividends collected Cash payments to employees Other operating receipts Interest and taxes paid Other operating cash payments Investing Activities: Sale of property, plant, and equipment Purchase of property, plant, and equipment Sale of securities that are not Purchase of securities that are not cash equivalents cash equivalents Receipt of loan repayments Making loans Financing: Borrowing cash from creditors Repayment of amounts borrowed Issuing equity securities Repurchase of equity shares (including the Issuing debt securities purchase of treasury stock) Payment of dividends


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Preparing the Statement of Cash Flows

• The following two slides for Biwheels Company show the:

– Changes in the balance sheet equation (transactions) during the first month of operations

– Income statement for the first month of operations and the January 31 balance sheet

• Notice that the cash balance increased from $0 to $351,000 during the month


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Assets = Liabilities + Stockholders' Equity

Description of Transactions Cash +Accounts Receivable +

Merchandise Inventory +

Prepaid Rent +

Store Equipment =

Note Payable +

Accounts Payable +

Paid-in Capital +

Retained Earnings

(1) Initial investment +400,000 = +400,000

(2) Loan from bank +100,000 = +100,000(3) Acquire store equipment for cash -15,000 +15,000 =

(4) Acquire inventory for cash -120,000 +120,000 =

(5) Acquire inventory on credit +10,000 = +10,000(6) Acquire inventory for cash plus credit -10,000 +30,000 = +20,000

(7) Sales of equipment +1,000 -1,000 =(8) Return of inventory acquired on January 5 -800 = -800

(9) Payments to creditors -4,000 = -4,000

(10a) Sales on open account +160,000 = +160,000(10b) Cost of merchandise inventory sold -100,000 = -100,000(11) Collect accounts receibable +5,000 -5,000 =

(12) Pay rent in advance -6,000 +6,000 =(13) Recognize expiration of rental services -2,000 = -2,000

(14) Depreciation -100 = -100Balance January 31, 20X2 351,000 +155,000 +59,200 +4,000 +13,900 = 100,000 +25,200 +400,000 +57,900

Assets = Liabilities + Stockholders' Equity

Description of Transactions Cash +Accounts Receivable +

Merchandise Inventory +

Prepaid Rent +

Store Equipment =

Note Payable +

Accounts Payable +

Paid-in Capital +

Retained Earnings

(1) Initial investment +400,000 = +400,000

(2) Loan from bank +100,000 = +100,000(3) Acquire store equipment for cash -15,000 +15,000 =

(4) Acquire inventory for cash -120,000 +120,000 =

(5) Acquire inventory on credit +10,000 = +10,000(6) Acquire inventory for cash plus credit -10,000 +30,000 = +20,000

(7) Sales of equipment +1,000 -1,000 =(8) Return of inventory acquired on January 5 -800 = -800

(9) Payments to creditors -4,000 = -4,000

(10a) Sales on open account +160,000 = +160,000(10b) Cost of merchandise inventory sold -100,000 = -100,000(11) Collect accounts receibable +5,000 -5,000 =

(12) Pay rent in advance -6,000 +6,000 =(13) Recognize expiration of rental services -2,000 = -2,000

(14) Depreciation -100 = -100Balance January 31, 20X2 351,000 +155,000 +59,200 +4,000 +13,900 = 100,000 +25,200 +400,000 +57,900

583,100 583,100


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Biwheels Company Income Statement

For the Month Ended January 31, 20X2 Sales (revenues) $160,000 Deduct expenses: Cost of goods sold $100,000 Rent 2,000 Depreciation 100 Total expenses 102,100 Net income $ 57,900

Balance Sheet, January 31, 20X2 Assets Liabilities and Stockholders’ Equity Cash $351,000 Liabilities Accounts receivable 155,000 Note payable $100,000 Merchandise inventory 59,200 Accounts payable 25,200 Prepaid rent 4,000 Total liabilities $125,000 Store equipment 13,900 Stockholders’ equity Paid-in capital $400,000 Retained earnings 57,900 Total stockholders’ equity 457,900 Total liabilities and Total assets $583.100 stockholders’ equity $583,100

Biwheels Company Income Statement

For the Month Ended January 31, 20X2 Sales (revenues) $160,000 Deduct expenses: Cost of goods sold $100,000 Rent 2,000 Depreciation 100 Total expenses 102,100 Net income $ 57,900

Balance Sheet, January 31, 20X2 Assets Liabilities and Stockholders’ Equity Cash $351,000 Liabilities Accounts receivable 155,000 Note payable $100,000 Merchandise inventory 59,200 Accounts payable 25,200 Prepaid rent 4,000 Total liabilities $125,000 Store equipment 13,900 Stockholders’ equity Paid-in capital $400,000 Retained earnings 57,900 Total stockholders’ equity 457,900 Total liabilities and Total assets $583.100 stockholders’ equity $583,100


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Cash Flows from Financing Activities

• Two general rules apply for identifying financing activities:

– Increases in cash (cash inflows) stem from increases in long-term liabilities or paid-in capital

– Decreases in cash (cash outflows) stem from decreases in long-term liabilities or paid-in capital

• Biwheels had two such transactions in January:

– Transaction 1: Initial investment, $400,000– Transaction 2: Loan from bank, $500,000


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Cash Flows from Investing Activities

• Two general rules apply for identifying investing activities:– Increases in cash (cash inflows) from decreases in

long-lived assets, loans, and investments– Decreases in cash (cash outflows) stem from

increases in long-lived assets, loans, and investments

• There were two such transactions relating to store equipment in January:

– Transaction 3: Acquire store equipment for cash, $15,000

– Transaction 7: Sale of store equipment for cash, $1,000


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Noncash Investing and Financing Activities

• Sometimes financing and investing activities do not affect cash

• Example: If Biwheels acquires $8,000 of store equipment by issuing common stock

– The purchase of store equipment is an investing activity

– The issuance of common stock is a financing activity

• Companies must report such items in a schedule of noncash investing and financing activities


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Cash Flow from Operating Activities

• Direct method:

– Subtracts operating cash disbursements from operating cash collections

– Is preferred by the FASB

• Indirect method:

– Adjusts accrual-based net income from the income statement to reflect only cash receipts and disbursements

– Is used by most U.S. companies

Two approaches may be used:


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The Direct Method

• Examining the cash column of Biwheels balance sheet equation, transactions 1, 2, 3, and 7 are financing and investing activities

• The remaining transactions must be operating activities:

Biwheels Company Cash Flows from Operating Activities—Direct Method

For the Month of January 20X2 Cash payments for inventory (transactions 4 and 6) $(130,000) Cash payments to creditors for accounts payable (transaction 9) (4,000) Cash collections on accounts receivable (transaction 11) 5,000 Cash payments for rent (transaction 12) 6,000 Net cash used by operating activities $(135,000)

Biwheels Company Cash Flows from Operating Activities—Direct Method

For the Month of January 20X2 Cash payments for inventory (transactions 4 and 6) $(130,000) Cash payments to creditors for accounts payable (transaction 9) (4,000) Cash collections on accounts receivable (transaction 11) 5,000 Cash payments for rent (transaction 12) 6,000 Net cash used by operating activities $(135,000)


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The Indirect Method

• When the cash flow from a sale or outflow from an expense occurs in one accounting period and the revenue or expense occurs in another, net income differs from cash flows from operations

• The indirect method highlights these differences by starting with net income, and adjusts it to cash flows from operating activities

• Example: Depreciation is added back to net income because it is a noncash expense


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The Indirect Method

• Net income

– Adjust for revenues and expenses not requiring cash• Add back depreciation• Other adjustments

– Adjust for changes in noncash assets and liabilities relating to operating activities

• Add decreases in assets• Deduct increases in assets• Add increases in liabilities• Deduct decreases in liabilities


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The Indirect Method

Biwheels Company Cash Flows from operating Activities—Indirect Method

For the Month of January 20X2 Net income $ 57,900 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 100 Net increase in accounts receivable (155,000) Net increase in inventory (59,200) Net increase in accounts payable 25,200 Net increase in rent payable (4,000) Net cash provided by operating activities $(135,000)

Biwheels Company Cash Flows from operating Activities—Indirect Method

For the Month of January 20X2 Net income $ 57,900 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 100 Net increase in accounts receivable (155,000) Net increase in inventory (59,200) Net increase in accounts payable 25,200 Net increase in rent payable (4,000) Net cash provided by operating activities $(135,000)


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Reconciliation Statement

• The FASB requires direct-method statements to include a supplementary schedule reconciling net income to net cash provided by operations

• In other words, companies that use the direct method must also prepare a report using the indirect method (reconciliation schedule)

• As a result, most companies use the indirect method


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Example of Statement of Cash Flows

Biwheels Company Statement of Cash Flows

For the Month of January 20X2 Cash flows from operating activities: Net income $ 57,900 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 100 Net increase in accounts receivable (155,000) Net increase in inventory (59,200) Net increase in accounts payable 25,200 Net increase in rent payable (4,000) Net cash provided by operating activities $(135,000) Cash flows from investing activities: Purchase of store equipment $ (15,000) Proceeds from sale of store equipment 1,000 Net cash provided by investing activities (14,000) Cash flows from financing activities: Proceeds from initial investment $ 400,000 Proceeds from issuance of common stock 100,000 Net cash provided by financing activities 500,000 Net increase in cash 351,000 Cash, January 2, 20X2 0 Cash, January 31, 20X2 $351,000

Biwheels Company Statement of Cash Flows

For the Month of January 20X2 Cash flows from operating activities: Net income $ 57,900 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 100 Net increase in accounts receivable (155,000) Net increase in inventory (59,200) Net increase in accounts payable 25,200 Net increase in rent payable (4,000) Net cash provided by operating activities $(135,000) Cash flows from investing activities: Purchase of store equipment $ (15,000) Proceeds from sale of store equipment 1,000 Net cash provided by investing activities (14,000) Cash flows from financing activities: Proceeds from initial investment $ 400,000 Proceeds from issuance of common stock 100,000 Net cash provided by financing activities 500,000 Net increase in cash 351,000 Cash, January 2, 20X2 0 Cash, January 31, 20X2 $351,000


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The Importance of Cash Flow

• The income statement matches revenues and expenses using accrual concepts and provides a measure of economic performance

• The statement of cash flows explains changes in the cash account rather than owners’ equity

• Free cash flow

– Is a measure of cash management performance– Refers to cash flows from operations less capital

expenditures (and sometimes less dividends)

horngren introduction to financial accounting 9e ch_05

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