22–1 McQuaig Bille 1 College Accounting 10 th Edition McQuaig Bille Nobles © 2011 Cengage Learning PowerPoint presented by Douglas Cloud Professor Emeritus of Accounting, Pepperdine University Chapter 22 Statement of Cash Flows—Indirect Method

22–2 Accounting Language  The income statement shows the results of operations.  The statement of retained earnings shows additional investments by owners and payments to owners.  The balance sheet portrays a company’s financial condition.  The statement of cash flows was developed to explain the reasons for the inflows and outflows of cash.

22–3 Definitions  The statement of cash flows is a financial statement that explains in detail how the balance of cash and cash equivalents has changed between the beginning and the end of the fiscal period.  On the statement of cash flows, cash is defined to include both cash, as you think of it, and cash equivalents.  Cash equivalents are short-term, highly liquid investments, including money market accounts.

22–4 Purpose  The main purpose of the statement of cash flows is to provide a summary of information concerning a company’s cash receipts and payments during a fiscal period.  A secondary purpose is to provide information about a firm’s operating, investing, and financing activities during a fiscal period.  The statement of cash flows also serves to reconcile the beginning and ending cash balance for the period.

22–5 Uses of the Statement of Cash Flows  Management uses the statement of cash flows to determine the liquidity of the business, to determine dividend policy, and to evaluate possible investments and means of financing.  Liquidity is generating enough cash to enable the company to pay the bills.  Dividend policy is to be sure enough cash is being generated to establish a regular cash dividend policy.  Investment and financing to determine if the firm has a sound strategy so that if it borrows to buy an asset, there is enough cash being generated to make the payments.

22–6 Operating Activities  Operating activities is the first category on the statement of cash flows, and this category lists and classifies cash inflows and outflows from a variety of sources.  Cash inflows include cash receipts from customers for the sale of merchandise and services and cash receipts in the form of interest and dividend income.  Cash outflows include cash payments for merchandise purchases and operating expenses.

22–7 Investing Activities  Investing activities is the second category on the statement of cash flows.  Investing activities include: 1.Buying and selling property and equipment 2.Acquiring and selling investments other than cash equivalents 3.Making and collecting loans  Cash inflows include the cash received from selling investments, and from collecting loans.  Cash outflows include cash paid to purchase property and equipment, cash invested in another corporation’s stocks or bonds, and cash loaned to borrowers.

22–8 Financing Activities  Financing activities, the last category listed on the statement of cash flows, includes: 1.Cash transactions that involve borrowing from or repaying creditors 2.Additional cash investments from owners 3.Transactions that reduce owners’ investments  Cash inflows include proceeds received from short- or long-term borrowing and those from issuing stock for cash.  Cash outflows include repayments of loans (issuing notes or bonds) and payments to owners, including personal withdrawals and cash dividends.

22–9

22–10 Developing the Statement of Cash Flows STEP 1. Determine the change in cash. STEP 2.Determine the net cash flows from operating activities. STEP 3.Determine the net cash flows from investing activities. STEP 4.Determine the net cash flows from financing activities.

Illustration 1 Jenny’s Paintings, a one-owner merchandising business operates on the accrual basis.

22–12 Illustration 1

22–13 Illustration 1 (concluded)

22–14 Illustration 1 STEP 1. Determine the change in cash. Jenny’s Paintings had a $3,600 ($31,400 ‒ $35,000) decrease in cash for the year. This change in cash will be verified on the statement of cash flows at the bottom of the statement.

22–15 Illustration 1 STEP 2.Determine the net cash flows from operating activities. The net income for Jenny’s Paintings is $146,000 as found on the income statement. This amount is listed first in the Operating Activities. Next, we will add or subtract noncash operating income and expense items. We need to convert net income to a cash-only basis.

Illustration 1  Depreciation Expense. Jenny’s Paintings had $22,000 recorded as Depreciation Expense, Equipment on the income statement for the current year. Depreciation decreases net income but represents a noncash amount that was deducted from net income. So, we need to add it back. To convert net income from an accrual basis to a cash basis, we will adjust net income for the change in current assets (other than Cash) and current liabilities that are found on the balance sheet.

22–17 Illustration 1 Increase in Accounts Receivable. Accounts Receivable increased by $12,600 ($45,600 – $33,000). The $12,600 increase in accounts receivable, representing noncash sales, will need to be subtracted from net income.

22–18 Illustration 1  Increase in Merchandise Inventory. In order to analyze Merchandise Inventory, it will help if we review of the T accounts related to cost of Goods sold— Cash, Merchandise Inventory, Accounts Payable, and Cost of Goods Sold.  As you analyze the T accounts and the journal entries, notice that cash payments for inventory sold during the year are $8,500 ($518,500 – $510,000) higher than what is represented by Cost of Goods Sold on the income statement.

22–19 Illustration 1

22–20 Illustration 1

 The difference in Cost of Goods Sold is comprised of two parts: the change in inventory, $4,000 ($130,000 – $126,000), and the change in Accounts Payable, $(4,500) ($51,500 – $56,000).  The increase in inventory of $4,000 will need to be subtracted from net income to eliminate the noncash portion of cost of goods sold.

22–22 Illustration 1 Increase in Prepaid Insurance. The Prepaid Insurance account for Jenny’s Paintings increased by $900 during the year. This means that $900 more in cash than the $400 listed as Insurance Expense on the income statement was paid out. Below is a summary journal entry:

22–23 (continued) Illustration 1

 Decrease in Accounts Payable. Jenny’s Paintings Accounts Payable decreased by $4,500. The reduction in Accounts Payable means that the company paid cash of $4,500 to suppliers that was not reflected in the cost of goods sold shown on the income statement.  The additional cash outflow of $4,500 needs to be subtracted from net income to reflect operating activities on a cash basis.

22–25 Illustration 1 Increase in Salaries Payable. The Salaries Payable account increased by $400 during the year. As depicted in the following summary journal entry, Jenny’s Paintings’ Salary Expense. Salary Expense

22–26 Illustration 1 (continued)

22–27 Illustration 1 (continued) Let’s total the Operating Activities.

22–28 Converting from Accrual to Cash Basis

22–29 Illustration 1 STEP 3.Determine the net cash flows from investing activities.  Investing activities are concerned with changes in property and equipment (long-term assets). There were no changes in the Equipment account balance.  Accumulated Depreciation, Equipment increased from $40,000 to $62,000. This $22,000 change is accounted for by reporting $22,000 as Depreciation Expense.  Because there are no other changes in long-term assets, we can say that there have been no cash transactions involving investing activities.

22–30 Illustration 1 STEP 4.Determine the net cash flows from financing activities. Financing activities include additions to or reductions in owner’s equity. On the statement of owner’s equity, we note $150,000 in personal withdrawals. We record $150,000 as an outflow of cash in the Financing Activities section.

Illustration 1 Putting these cash conversions all together, we have the complete statement of cash flows for Jenny’s Paintings.

Illustration 2 Bryan Corporation is a merchandising business operating on an accrual basis. In this example, you will learn how to handle sale of equipment, issuance on note payable, and issuance of stock.

22–33 Illustration 2

22–34 Illustration 2

22–35 Illustration 2

22–36 Illustration 2 STEP 1. Determine the change in cash. Bryan Corporation had a $14,400 ($47,800 – $33,400) increase in cash for the year. This change in cash will be verified on the statement of cash flows at the bottom of the following statement:

22–37 Illustration 2 STEP 2.Determine the net cash flows from operating activities. Bryan Corporation had net income of $2,500 during the year. This is listed first in the Operating Activities section of the statement of cash flows.

22–38 Illustration 2 Depreciation Expense. Depreciation Expense is treated as an addition to cash flows. Depreciation Expense is a noncash expense that we need to add back to determine net income on a cash basis. Bryan Corporation had $24,000 recorded as Depreciation Expense on the income statement for the current year. The adjustment is added to net income.

Illustration 2 Gain (or Loss) on Disposal of Property and Equipment. Gain (or Loss) on Disposal of Property and Equipment is a noncash net income item. The cash received when disposing of the equipment is reported in the Investing Activities section. Bryan Corporation’s income statement shows a $5,000 gain on sale of property and equipment. An adjustment is necessary to remove the gain from Cash Flows from Operating Activities.

22–40 Illustration 2 Loss on Disposal of Property and Equipment is treated in the opposite manner. A loss is an addition to cash flows and is added to net income in the Operating activities section. As we did in Illustration 1, we need to convert net income from an accrual basis to a cash basis. We must adjust net income for the changes in current assets (other than Cash) and current liabilities that are found n the balance sheet.

22–41 Illustration 2 Decrease in Accounts Receivable. Bryan Corporation experienced a decrease of $2,600 ($66,400 – $69,000) it its Accounts Receivable account. This means less was recorded as revenue than was received in cash. Therefore, $2,600 needs to added to net income.

22–42 Illustration 2 Increase in Merchandise Inventory. Let’s look at the T accounts related to cost of goods. (a) The cost of goods that were sold (b) Purchases of inventory for year (c) Cash payments for inventory for the year

Illustration 2 Increase in Prepaid Insurance. If a prepaid expense increases, cash payments for the item(s) are more than the amount listed as an expense and will need to be subtracted from net income. Because Bryan Corporation’s Prepaid Insurance increased by $1,100 during the year, net income will need to be reduced by that amount.

Illustration 2 Decrease in Accounts Payable. Bryan Corporation’s Accounts Payable account decreased by $11,100. This means that the company paid cash of $11,100 to suppliers that was not reflected in the Cost of Goods Sold shown on the income statement. Therefore, the $11,100 should be subtracted from net income.

Illustration 2 Decrease in Wages Payable. Bryan Corporation’s Wages Payable account decreased by $300 during the year. When Wages Payable decreases, more wages were paid than were actually recorded in net income, so we to decrease net income.

22–46 Illustration 2 Increase in Property Tax Payable and Interest Payable. Bryan Corporation’s Property Tax Payable account increased by $200 during the year, while Interest Payable increased by $600. Less property taxes and interest was paid for than actually used or expired, so we increase net income for Bryan Corporation by $200 and $600, respectively.

22–47 Illustration 2

Note that there are no adjustments for the change in Notes Payable and Dividends Payable. These are reported in the Financing Activities section. Now, the complete Operating Activities.

22–49 Illustration 2 Record Cash Receipts from the Sale of Equip-ment.  Investing activities include changes in property and equipment (long-term assets).  During 2011, Equipment decreased from $143,000 to $114,000.  Gain on Disposal of Property and Equipment of $5,000 is listed as Other Income. STEP 3.Determine the net cash flows from investing activities.

22–50  Accumulated Depreciation increased only $12,000 even though there was $24,000 reported in Depreciation Expense on the income statement. Illustration 2

22–51 Illustration 2

22–52 Illustration 2 Notice that there is no adjustment for Depreciation Expense because this adjustment was already made in the Operating Activities section.

Illustration 2 Convert Notes Payable to Cash Receipts from the Issuance of a Note. Notes Payable increased from $0 to $24,000. STEP 4.Determine the net cash flows from financing activities.

Illustration 2 Convert Common Stock to Cash Receipts from the Issuance of Common Stock. During 2011, Common Stock increased from $297,500 to $306,500.

22–55 Illustration 2 Convert Dividends to Cash Payments of Dividends. On the statement of retained earnings, we note $16,000 listed as cash dividends. Dividends Payable decreased from $3,000 to $2,000. Cash Dividends Declared$16,000 +Beginning Dividends Payable 3,000 =Total$19,000 –Ending Dividends Payable 2,000 =Cash Payments of Dividends$17,000

22–56 Illustration 2

22–57 Noncash Investing and Financing Transactions  A significant transaction sometimes does not affect cash directly. For example, issuing a long-term mortgage for the purchase of land, or issuing common stock for the land and building.  The Financial Accounting Standards Board determined that these noncash transactions should be presented in a separate schedule at the bottom of the statement of cash flows.

22–58 Benefits to Users  Anyone who uses financial statements can gather a great deal of information from the statement of cash flows.  Managers, investors, and creditors use the statement of cash flows to judge how a company is doing.