The Statement of Cash Flows Chapter 16 © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. Learning Objectives Identify the purposes of the statement of cash flows and distinguish among operating, investing, and financing cash flows Prepare the statement of cash flows by the indirect method © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. Learning Objectives Use free cash flow to evaluate business performance Prepare the statement of cash flows by the direct method (Appendix 16A) Prepare the statement of cash flows by the indirect method using a spreadsheet (Appendix 16B) © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. Learning Objective 1 Identify the purposes of the statement of cash flows and distinguish among operating, investing, and financing cash flows © 2015 Pearson Education, Limited.

Purpose of the Statement of Cash Flows Reports on the cash flows of a business. Reports why cash increased or decreased during the period. Covers the same period of time as the income statement. Can be used to: Predict future cash flows. Evaluate management decisions. Predict ability of the company to pay debts and dividends. The Statement of Cash Flows was developed to provide users of the financial statements information regarding the sources and uses of cash during the fiscal period. The statement allows the user to determine why cash increased or decreased during a period (Did we sell a lot of product? Did we borrow money? Did we sell off equipment?). The statement helps to predict future cash flows and helps with the planning of future cash flows. © 2015 Pearson Education, Limited.

Classification of Cash Flows Cash Flows From: Operating Activities Investing Activities Financing Activities All cash flows can be assigned to one of three categories: Cash Flows from Operating Activities Cash Flows from Investing Activities Cash Flows from Financing Activities © 2015 Pearson Education, Limited.

Classification of Cash Flows Cash Flows From: Operating Activities Investing Activities Financing Activities Cash receipts and disbursements related to revenue or expense activities. Includes cash flows related to: interest income and expense dividend revenue income tax expense Cash Flows from Operating Activities include cash inflows and outflows related to revenue and expense activities. Items such as cash received from customers, wages that were paid, interest payments, income tax payments, and cash paid for advertising would appear in this category. © 2015 Pearson Education, Limited.

Classification of Cash Flows Cash Flows From: Operating Activities Investing Activities Financing Activities Cash receipts and disbursements related to increases and decreases in long-term assets, including: PP&E Notes Receivable Investments Cash Flows from Investing Activities include cash flows related to changes in long-term assets. For example, if we purchase a building, or new equipment, we would record cash outflows related to investing activities. Also, if we buy equity investments in other companies, that would be considered an investing activity cash outflow. On the other hand, when we sell land or equipment, or sell off an investment in another company’s stock, we would record cash inflows related to investing activities. © 2015 Pearson Education, Limited.

Classification of Cash Flows Cash Flows From: Operating Activities Investing Activities Financing Activities Cash receipts and disbursements related to increases and decreases in long-term liabilities and equity. Includes: Borrowing Issuing stock Paying dividends Cash Flows from Financing Activities include cash receipts and disbursements that are related to increases and decreases in long-term liabilities and equity. For example, financing cash flow activities would include borrowing money from the bank (though, the interest related to the borrowing would be considered an Operating Cash Flow), paying a dividend to shareholders, and raising capital by issuing new stock. © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. Exhibit 16-2 in the text summarizes the various types of cash flows. © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. Table 16-2 in the text summarizes the various types of cash flows. © 2015 Pearson Education, Limited.

Two Formats for Operating Activities Indirect Method Starts with accrual net income. Adjusts net income to net cash from operations using known relationships. Direct Method Restates the Income Statement in terms of cash Shows actual cash receipts and cash disbursements. There are two formats for preparing the Statement of Cash Flows that are allowed under GAAP; the Indirect Method and the Direct Method. Although the FASB considers the Direct Method to be a more theoretically sound approach, the Indirect Method provides the same net results, but is much easier to prepare. Under the Indirect Method, start with the accrual net income. Then make adjustments to the net income to arrive at a “cash income” number. Under the Direct Method, we will restate the income statement as cash receipts and disbursements. This method will show actual cash receipts and cash disbursements related to the income generating process. © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. >TRY IT! Match the accounting terms below to the proper definitions. © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. >TRY IT! Match the accounting terms below to the proper definitions. © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. >TRY IT! Match the accounting terms below to the proper definitions. © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. >TRY IT! Match the accounting terms below to the proper definitions. © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. >TRY IT! Match the accounting terms below to the proper definitions. © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. >TRY IT! Match the accounting terms below to the proper definitions. © 2015 Pearson Education, Limited.

Prepare the statement of cash flows by the indirect method Learning Objective 2 Prepare the statement of cash flows by the indirect method © 2015 Pearson Education, Limited.

Preparing a Statement of Cash Flows with the Indirect Method Information Needed: Current Income Statement Current Balance Sheet Immediate past Balance Sheet Changes in long-term assets and long-term liabilities Changes in equity To compute Cash Flows from Operations, we need: Net Income Non-cash expenses Gains/Losses Changes in current assets and current liabilities The FASB allows two different approaches to be used for the preparation of the Statement of Cash Flows; the Direct Method and the Indirect Method. The Direct Method is the FASB’s preferred approach, but the Indirect Method is used by over 90% of companies that prepare GAAP-based financial statements. The only difference between the Direct Method and the Indirect Method is the way in which Cash Flows from Operating Activities is determined. To prepare the Statement of Cash Flows using the Indirect Method, you will need five pieces of information: The Income Statement for the current period. The Balance Sheet for the beginning of the current period The Balance Sheet for the end of the current period. All of the changes in long-term assets during the period. All the changes in long-term liabilities and equity during the period. The actual computation of Cash Flows from Operating Activities will be: Net Income + Non-Cash Expenses + Accounting Losses – Accounting Gains +/- changes in Current Assets and Current Liabilities © 2015 Pearson Education, Limited.

Computing Cash Flows from Operating Activities Exhibit 16-6 shows how changes different items impact the Cash Flows from Operating Activities. As stated earlier, we always start with Net Income (or Loss). Add back all non-cash expenses to the net income. Expenses such as Depreciation Expense, Amortization Expense, or Depletion Expense represent expenses that are not related to current cash flows. Subtract accounting gains from net income. These gains (such as Gain on Sale of Land) are not cash flows that are related to operating activities, so their effect should be eliminated from net income. Add accounting losses back to net income. These losses (such as Loss on Sale of Equipment) are not cash flows that are related to operating activities, so their effect should be eliminated from net income. When current assets increase, we will treat that as a “use” of cash and subtract it from net income. When current assets decrease, we will treat that as a “source” of cash, and add it to net income. When current liabilities increase, we will treat that as a “source” of cash, and add the increase to net income. When current liabilities decrease, we will treat that as a “use” of cash, and we will subtract the decrease from net income. © 2015 Pearson Education, Limited.

Computing Cash Flows from Operating Activities Smart Touch Learning’s Net Income for 2015 is $40,000 If we want to see how Cash Flows from Operating Activities works with numbers, let’s look at Smart Touch Learning. Assume that Smart Touch Learning’s net income for the period was $40,000. We will put that in our starting “slot” for this computation. © 2015 Pearson Education, Limited.

Computing Cash Flows from Operating Activities Non-cash expense include Depreciation, Depletion and Amortization. Depreciation is $20,000. If Smart Touch Learning has Depreciation Expense of $20,000, we will treat that as a Non-Cash Expense and simply add that to net income. © 2015 Pearson Education, Limited.

Computing Cash Flows from Operating Activities Smart Touch Learning has no Losses, but has a $10,000 Gain on Disposal of Plant Assets. Smart Touch Learning has no losses during the period, but they do have a $10,000 gain from selling plant assets. The $10,000 will be subtracted from net income. © 2015 Pearson Education, Limited.

Computing Cash Flows from Operating Activities Smart Touch Learning’s Inventory decreased by $2,000 during 2015, and A/R increased by $17,000. Smart Touch Learning’s inventory decreased during the year by $2,000. The change will need to be added to net income. In addition, since Accounts Receivable increased by $17,000 during the year, that change will have to be subtracted from net income, since it does represent an increase in non-cash sales. © 2015 Pearson Education, Limited.

Computing Cash Flows from Operating Activities Smart Touch Learning’s Accounts Payable increased by $40,000 during 2015. Smart Touch Learning’s Accounts Payable increased during the year by $40,000. The change will need to be added to net income. © 2015 Pearson Education, Limited.

Computing Cash Flows from Operating Activities Smart Touch Learning’s Accrued Liabilities decreased by $5,000 during 2015. Accrued Liabilities decreased by $5,000 during the year. The change will have to be subtracted from net income. © 2015 Pearson Education, Limited.

Reporting Cash Flows from Operating Activities When all of the adjustments have been made to Net Income, you will be able to compute Net Cash Flow from Operating Activities. Exhibit 16-5 shows how the Cash Flows from Operating Activities section might appear on Smart Touch Learning’s Statement of Cash Flows. © 2015 Pearson Education, Limited.

Computing Cash Flows from Investing Activities Smart Touch Learning’s records indicate: $310,000 in plant assets were purchased with cash during 2015. The $10,000 gain resulted from selling plant assets with a cost of $55,000 and accumulated depreciation of $15,000 for $50,000. With respect to Investing Activities, Smart Touch Learning’s records show that $310,000 in cash was spent on new plant assets during 2015. The $10,000 gain on the Income Statement resulted from selling fixed assets originally costing $55,000 and having accumulated depreciation of $15,000, for $50,000. © 2015 Pearson Education, Limited.

Reporting Cash Flows from Investing Activities Exhibit 16-5 shows the Cash Flows from Investing Activities section. Smart Touch Learning shows cash outflows from Investing Activities of $310,000 and cash inflows from Investing Activities of $50,000. © 2015 Pearson Education, Limited.

Computing Cash Flows from Financing Activities Smart Touch Learning’s records indicate: $90,000 was borrowed on a note payable. $10,000 was paid to retire old notes. $120,000 was received from issuing shares of common stock. $20,000 was paid to acquire treasury stock. $10,000 in dividends were paid. With respect to Financing Activities, Smart Touch Learning’s records show inflows from Investing Activities of $90,000 borrowed on a note payable and $120,000 received from the issuance of common stock. Cash outflows from Investing Activities included $10,000 paid to retire old notes, $20,000 was paid to acquire treasury stock, and $10,000 in dividends were paid. © 2015 Pearson Education, Limited.

Reporting Cash Flows from Financing Activities Exhibit 16-5 shows Cash Flows from Financing Activities of $170,000. © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. Smart Touch Learning’s net decrease in cash for the year is $20,000. We arrive at this by combining the Net Cash Provided by Operating Activities of $70,000, the Net Cash Used by Investing Activities of $260,000, and Net Cash Provided by Financing Activities of $170,000. When we add the balance in Cash at December 31, 2014 of $42,000, we have a Cash balance at December 31, 2015 of $22,000, which matches the Cash balance on the December 31, 2015 balance sheet. © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. >TRY IT! Using the amounts shown for Owl Inc. at December 31, 2015, prepare Owl’s Statement of Cash Flows using the indirect method. Assume that Cash at December 31, 2014 was $12,000 and Cash at December 31, 2015 is $75,000. © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. >TRY IT! Cash Flows from Operating Activities starts with Net Income of $30,000. Add back Depreciation Expense of $12,000, the decrease in Current Assets of $8,000, and the increase in Current Liabilities of $10,000. Cash Flows from Investing Activities shows a $20,000 increase in cash provided by the disposal of equipment and a $25,000 decrease in cash resulting from the acquisition of Land. Cash Flows from Financing Activities shows a $12,000 increase in cash resulting from the issuance of Common Stock and a $4,000 decrease in cash resulting from the payment of dividends. The resulting Net Increase in Cash of $63,000 is added to the beginning Cash balance of $12,000 to arrive at the ending Cash balance of $75,000. © 2015 Pearson Education, Limited.

Use free cash flow to evaluate business performance Learning Objective 3 Use free cash flow to evaluate business performance © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. Free Cash Flow Measures the amount of cash flow available for unexpected opportunities. Free Cash Flow is a measure used to assess the amount of cash available for unexpected opportunities. The amount is determined by starting with Net Cash from Operating Activities and deducting cash payments planned for investments in long-term assets and dividends. © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. Free Cash Flow Smart Touch Learning expects operating cash flow of $200,000. They plan to spend $160,000 to modernize its production facilities, and to pay $15,000 in cash dividends. Smart Touch Learning expects $200,000 in operating cash flow. Their plans are to spend $160,000 to modernize their production facilities and to pay $15,000 in dividends. $200,000 - $160,000 - $15,000 = $25,000 of Free Cash Flow. © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. >TRY IT! Kalapono Company expects the net cash from operating activities in 2014 of $100,000. Net cash used for Investing Activities is expected to be $20,000 and cash dividends for 2014 will be $2,000. How much free cash flow does Kalapono expect in 2014? © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. >TRY IT! Free Cash Flow = $100,000 - $20,000 - $2,000 = $78,000 © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. Learning Objective 4 Prepare the statement of cash flows by the direct method (Appendix 16A) © 2015 Pearson Education, Limited.

Cash Flows from Operating Activities Each item on the income statement will be converted from the accrual basis to cash basis. Most of the amounts will be adjusted based on changes in current asset amounts and current liability amounts. Non-cash expenses and gains and losses will be ignored. Cash Flows from Operating Activities can also be computed using the direct method. Each item on the income statement is converted from an accrual number to a cash basis number. Most of the amounts will be adjusted based on changes in current assets and current liability amounts. Non-cash expenses, losses, and gains will be ignored. The most difficult characteristic of this approach is that the numbers needed for the direct method are not actually directly available in an accrual accounting system. © 2015 Pearson Education, Limited.

Cash Flows from Operating Activities Cash Collections from Customers Cash Receipts of Interest Cash Collections from Customer is computed by starting with Sales Revenue. Add back beginning accounts receivable and subtract ending accounts receivable. Cash Receipts of Interest can be determined by starting with Interest Revenue and adding beginning interest receivable and subtracting ending interest receivable. © 2015 Pearson Education, Limited.

Cash Flows from Operating Activities Cash Receipts of Dividends Payments to Suppliers Cash Receipts of Dividends can be determined by starting with Dividend Revenue and adding beginning dividends receivable and subtracting ending dividends receivable. Cash Payments to Suppliers can be determined by starting with Cost of Goods Sold. Add ending merchandise inventory and beginning accounts payable. Then subtract beginning merchandise inventory and ending accounts payable. © 2015 Pearson Education, Limited.

Cash Flows from Operating Activities Payments to Employees Payments for Interest Expense and Tax Expense Cash Payments to Employees can be determined by starting with Salaries & Wages Expense and adding beginning salaries and wages payable and subtracting ending salaries and wages payable. Cash Payments for Taxes and Interest can be determined by starting with Taxes/Interest Expense and adding the related beginning payable balance and subtracting the related ending payable balance. © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. Practice Questions © 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited.

© 2015 Pearson Education, Limited. End of Chapter 16 © 2015 Pearson Education, Limited.