ch14 wrd12e instructor_final

Statement of

Cash FlowsCash Flows

Chapter 14Chapter 14Chapter 14Chapter 14

Learning ObjectivesLearning Objectives

1.1. Describe the cash flow activities reported Describe the cash flow activities reported in the statement of cash flows.in the statement of cash flows.

2.2. Prepare a statement of cash flows, using Prepare a statement of cash flows, using the indirect method.the indirect method.

3.3. Prepare a statement of cash flows, using Prepare a statement of cash flows, using the direct method.the direct method.

4.4. Describe and illustrate the use of free Describe and illustrate the use of free cash flow in evaluating a company’s cash cash flow in evaluating a company’s cash flow.flow.

Learning Learning Objective

ObjectiveDescribe the cash flow activities

Describe the cash flow activities

reported in the statement of

reported in the statement of cash flows.cash flows.

Reporting Cash FlowsReporting Cash Flows

o The The statement of cash flows statement of cash flows reports a reports a firm’s major cash inflows and outflows for firm’s major cash inflows and outflows for a period. It provides useful information a period. It provides useful information about a company’s ability to do the about a company’s ability to do the following:following: Generate cash from operationsGenerate cash from operations

Maintain and expand its operating capacityMaintain and expand its operating capacity

Meet its financial obligationsMeet its financial obligations

Pay dividendsPay dividends

o The statement of cash flows reports cash The statement of cash flows reports cash flows from three types of activities:flows from three types of activities: Cash flows from Cash flows from operatingoperating activities activities are cash are cash

flows from transactions that affect net income.flows from transactions that affect net income.

Cash flows from Cash flows from investinginvesting activities activities are cash are cash flows from transactions that affect investments flows from transactions that affect investments in the noncurrent assets of the company.in the noncurrent assets of the company.

Cash flows from Cash flows from financingfinancing activities activities are cash are cash flows from transactions that affect the equity flows from transactions that affect the equity and debt of the company.and debt of the company.

REPORTING REPORTING CASH FLOWSCASH FLOWS

Cash Flows from Operating ActivitiesCash Flows from Operating Activities

o The The direct methoddirect method reports operating cash reports operating cash inflows (receipts) and cash outflows inflows (receipts) and cash outflows (payments) as follows:(payments) as follows:

Cash Flows from Operating ActivitiesCash Flows from Operating Activities

o The primary operating cash outflows are The primary operating cash outflows are cash payments for merchandise, operating cash payments for merchandise, operating expenses, interest, and income tax expenses, interest, and income tax payments.payments.

o The The indirect methodindirect method reports the operating reports the operating cash flows by beginning with net income cash flows by beginning with net income and adjusting it for revenues and and adjusting it for revenues and expenses that do not involve the receipt or expenses that do not involve the receipt or payment of cash as follows:payment of cash as follows:

Over 99% of companies use the indirect method.

o The primary advantage of the indirect The primary advantage of the indirect method is that it reconciles the differences method is that it reconciles the differences between net income and net cash flows between net income and net cash flows from operations. Also, the indirect method from operations. Also, the indirect method is less costly to use than the direct is less costly to use than the direct method.method.

o Whether the direct or indirect method is Whether the direct or indirect method is used, the amount of net cash flow from used, the amount of net cash flow from operating activities will be the same. This operating activities will be the same. This is illustrated in is illustrated in Exhibit 2Exhibit 2 in the next slide. in the next slide.

REPORTING REPORTING CASH FLOWSCASH FLOWS

Cash Flows from Investing ActivitiesCash Flows from Investing Activities

o Cash inflows from investing activities Cash inflows from investing activities normally arise from selling fixed assets, normally arise from selling fixed assets, investments, and intangible assets.investments, and intangible assets.

o Cash outflows from investing activities Cash outflows from investing activities normally include payments to acquire normally include payments to acquire fixed assets, investments, and intangible fixed assets, investments, and intangible assets.assets.

Cash Flows from Financing ActivitiesCash Flows from Financing Activities

o Cash inflows from financing activities Cash inflows from financing activities normally arise from issuing long-term debt normally arise from issuing long-term debt or equity securities.or equity securities.

o Cash outflows from financing activities Cash outflows from financing activities normally include paying cash dividends, normally include paying cash dividends, repaying long-term debt, and acquiring repaying long-term debt, and acquiring treasury stock. treasury stock.

Noncash Investing and Financing ActivitiesNoncash Investing and Financing Activities

o Noncash investing and financing activities Noncash investing and financing activities are transactions that do notare transactions that do not directlydirectly affect affect cash. The effect of such transactions is cash. The effect of such transactions is recorded in a separate schedule that recorded in a separate schedule that appears at the bottom of the statement of appears at the bottom of the statement of cash flows.cash flows.

No Cash Flow Per ShareNo Cash Flow Per Share

o Cash flow per shareCash flow per share should not be should not be reported on a company’s financial reported on a company’s financial statements for the following reasons:statements for the following reasons: Users may misinterpret cash flow per share as Users may misinterpret cash flow per share as

the per-share amount available for dividends.the per-share amount available for dividends.

Users may misinterpret cash flow per share as Users may misinterpret cash flow per share as equivalent to earnings per share.equivalent to earnings per share.

ObjectivePrepare a statement of cash

Prepare a statement of cash

flows, using the indirect method.

The Indirect MethodThe Indirect Method

o The indirect method of reporting cash The indirect method of reporting cash flows from operating activities uses the flows from operating activities uses the logic that a change in any balance sheet logic that a change in any balance sheet account (including cash) can be analyzed account (including cash) can be analyzed in terms of changes in other balance sheet in terms of changes in other balance sheet accounts.accounts.

o Any change in the cash account can be Any change in the cash account can be determined by analyzing changes in determined by analyzing changes in liability, stockholders’ equity, and noncash liability, stockholders’ equity, and noncash asset accounts.asset accounts.

(continued)

THE INDIRECT THE INDIRECT METHODMETHOD

(concluded)

Retained EarningsRetained Earnings

o A good starting point for determining the A good starting point for determining the cash flows from operating activities is to cash flows from operating activities is to analyze the retained earnings account.analyze the retained earnings account.

The retained earnings account for Rundell The retained earnings account for Rundell Inc. is shown below.Inc. is shown below.

Retained EarningsRetained Earnings

o The retained earnings account for 2014 The retained earnings account for 2014 indicates that the $80,000 ($108,000 – indicates that the $80,000 ($108,000 – $28,000) change resulted from net income $28,000) change resulted from net income and cash dividends. The net income of and cash dividends. The net income of $108,000 is the first amount reported in $108,000 is the first amount reported in the Cash Flows from Operating Activities the Cash Flows from Operating Activities section.section.

Adjustments to Net IncomeAdjustments to Net Income

Cash flows from operating activities:Net income $108,000Adjustments to reconcile net income

to net cash flow from operating activities:

Rundell Inc.

This phrase beginning with “Adjustments to…” is added to indicate that accrual basis net

income is being adjusted to arrive at cash flows from operations.

Step 1Step 1

o Expenses that do not affect cash are Expenses that do not affect cash are added. Such expenses decrease net added. Such expenses decrease net income, but do not involve cash payments income, but do not involve cash payments and, thus, are added to net income. and, thus, are added to net income. Examples include Examples include depreciationdepreciation of fixed of fixed assets and assets and amortizationamortization of intangible of intangible assets.assets.

Step 2Step 2

o Losses and gains on disposal of assets are Losses and gains on disposal of assets are added or deducted. The disposal (sale) of added or deducted. The disposal (sale) of assets is an investing activity, rather than assets is an investing activity, rather than an operating activity. Losses on disposal of an operating activity. Losses on disposal of assets are added back to net income. assets are added back to net income. Gains on disposal of assets are deducted Gains on disposal of assets are deducted from net income.from net income.

Step 3Step 3

o Changes in current operating assets and Changes in current operating assets and liabilities are added or deducted as follows:liabilities are added or deducted as follows: Increases in noncash current operating assets Increases in noncash current operating assets

are deducted.are deducted.

Decreases in noncash current operating assets Decreases in noncash current operating assets are added.are added.

Increases in current operating liabilities are Increases in current operating liabilities are added.added.

Decreases in current operating liabilities are Decreases in current operating liabilities are deducted.deducted.

ADJUSTMENTS ADJUSTMENTS TO NET INCOMETO NET INCOME

Rundell Inc.

Let’s start with

depreciation

Step 1:Step 1: The comparative balance sheet indicates that Accumulated Depreciation—Building increased by $7,000.

Step 1:Step 1: The account indicates that depreciation for the year was $7,000 for the building.

Rundell Inc.

Now, consider the

Next, let’s look at this

STEP 2.STEP 2. Deduct the gain on the sale of land of $12,000. The proceeds, which include the gain, are reported in the Investing section of the statement of cash flows. Thus, the gain of $12,000 is deducted from net income in determining cash flows from operating activities.

Rundell Inc.

Step 3:Step 3: Select the current operating assets and liabilities that impact cash flows and determine their increases and decreases.

(continued)

o Accounts receivable (net)Accounts receivable (net): The $9,000 : The $9,000 increase is deducted from net income. This increase is deducted from net income. This is because the $9,000 increase in is because the $9,000 increase in accounts receivable indicates that sales on accounts receivable indicates that sales on account were $9,000 more than the cash account were $9,000 more than the cash received from customers. Thus, sales (and received from customers. Thus, sales (and net income) includes $9,000 that was not net income) includes $9,000 that was not received in cash during the year.received in cash during the year.

(continued)

o InventoriesInventories: The $8,000 decrease is added to : The $8,000 decrease is added to net income. This is because the $8,000 net income. This is because the $8,000 decrease in inventories indicates that the cost decrease in inventories indicates that the cost of merchandise sold exceeds the cost of of merchandise sold exceeds the cost of merchandise purchased during the year by merchandise purchased during the year by $8,000.$8,000.

o Accounts payable (merchandise creditors)Accounts payable (merchandise creditors): The : The $3,200 decrease is deducted from net income. $3,200 decrease is deducted from net income. This is because a decrease in accounts payable This is because a decrease in accounts payable indicates that the cash payments to indicates that the cash payments to merchandise creditors exceed the merchandise merchandise creditors exceed the merchandise purchased on account by $3,200.purchased on account by $3,200.

o Accrued expenses payable (operating Accrued expenses payable (operating expenses)expenses): The $2,200 increase is added to : The $2,200 increase is added to net income. This is because an increase in net income. This is because an increase in accrued expenses payable indicates that accrued expenses payable indicates that operating expenses reported on the income operating expenses reported on the income statement exceed the cash payments for statement exceed the cash payments for operating expenses by $2,200. operating expenses by $2,200.

o Income taxes payableIncome taxes payable: The $500 decrease is : The $500 decrease is deducted from net income. This is because a deducted from net income. This is because a decrease in income taxes payable indicates decrease in income taxes payable indicates that taxes paid exceed the amount of taxes that taxes paid exceed the amount of taxes incurred during the year by $500.incurred during the year by $500.

Rundell Inc.

Transferring the previous slide to a formal statement of cash flows for Rundell, we can see that part of the statement is now complete.

DividendsDividends

o Cash dividends of $28,000 were declared Cash dividends of $28,000 were declared during 2014. during 2014.

DividendsDividends

o However, as can be seen from the However, as can be seen from the dividends payable account, only $24,000 dividends payable account, only $24,000 was paid.was paid.

Since dividend payments are a financing activity, the dividend payments totaling $24,000 are reported in the Financing Activities section.

Common StockCommon Stock

o Rundell Inc.’s common stock account Rundell Inc.’s common stock account increased by $8,000 during 2014.increased by $8,000 during 2014.

Common StockCommon Stock

o The paid-in capital in excess of par—The paid-in capital in excess of par—common stock account increased by common stock account increased by $40,000 during the year.$40,000 during the year.

Issuing company stock is a financing activity, so cash flows from financing activities increase by $48,000 ($8,000 + $40,000).

Bonds PayableBonds Payable

o Bonds Payable decreased by $50,000 Bonds Payable decreased by $50,000 during 2014, due to retiring the bonds. A during 2014, due to retiring the bonds. A check of Rundell’s income statement check of Rundell’s income statement shows that there was no gain or loss on shows that there was no gain or loss on the retirement.the retirement.

Retiring a bond payable is a financing activity, so a cash outflow of $50,000 is reported in the Financing Activities section of the statement of cash flows.

BuildingBuilding

1.1. The building account increased by The building account increased by $60,000.$60,000.

The cash outflow for this purchase is shown in the Investing Activities section of the statement.

LandLand

o The $45,000 decline in the land account The $45,000 decline in the land account was from two transactions.was from two transactions.

LandLand

o Earlier, as part of Step 2 in preparing the Earlier, as part of Step 2 in preparing the Operating Activities section, the $12,000 Operating Activities section, the $12,000 gain was deducted from net income.gain was deducted from net income.

The proceeds of $72,000 from the sale of land are reported in the Investing Activities section of the statement of cash flows.

LandLand

The October 12 transaction is the purchase The October 12 transaction is the purchase of land for cash of $15,000. This transaction of land for cash of $15,000. This transaction is reported as an outflow of cash in the is reported as an outflow of cash in the Investing Activities section.Investing Activities section.

Preparing the Statement of Cash FlowsPreparing the Statement of Cash Flows

o The completed statement of cash flows for The completed statement of cash flows for Rundell Inc. using the indirect method is Rundell Inc. using the indirect method is shown in shown in Exhibit 6 Exhibit 6 (next slide). The (next slide). The increase in cash shown on the statement increase in cash shown on the statement ($71,500) should match the increase in ($71,500) should match the increase in cash in Rundell Inc.’s cash account.cash in Rundell Inc.’s cash account.

Note that cash increased $71,500.

ObjectivePrepare a statement of cash

Prepare a statement of cash

flows, using the direct method.

The Direct MethodThe Direct Method

o The direct method reports cash flows from The direct method reports cash flows from operating activities as follows:operating activities as follows:

o The final amount reported in the Cash The final amount reported in the Cash Flows from Operating Activities section will Flows from Operating Activities section will be the same whether the direct or indirect be the same whether the direct or indirect method is used. The methods differ in how method is used. The methods differ in how the data are obtained, analyzed, and the data are obtained, analyzed, and reported. reported.

o Under the direct method, the income Under the direct method, the income statement is adjusted to cash flows from statement is adjusted to cash flows from operating activities as follows:operating activities as follows:

o Depreciation expense is Depreciation expense is notnot adjusted or adjusted or reported as part of cash flows from reported as part of cash flows from operating activities. This is because operating activities. This is because depreciation expense does not involve a depreciation expense does not involve a cash outflow.cash outflow.

o Gains and losses are also not adjusted, Gains and losses are also not adjusted, because the cash flow from operating because the cash flow from operating activities is determined directly, rather activities is determined directly, rather than by reconciling net income. Proceeds than by reconciling net income. Proceeds from the sale of land, which include any from the sale of land, which include any gains or losses, are reported as an gains or losses, are reported as an investing activity.investing activity.

Cash Received from CustomersCash Received from Customers

o Rundell Inc. reports sales of $1,180,000 for Rundell Inc. reports sales of $1,180,000 for 2014. To determine the 2014. To determine the cash received from cash received from customerscustomers, sales are adjusted by any , sales are adjusted by any increase or decrease in accounts increase or decrease in accounts receivable.receivable.

CASH CASH RECEIVED RECEIVED

FROM FROM CUSTOMERSCUSTOMERS

($9,000)($9,000)

$1,180,000 = $1,171,000

Cash Payments for MerchandiseCash Payments for Merchandise

o Rundell Inc. reports cost of merchandise Rundell Inc. reports cost of merchandise sold of $790,000. To determine the sold of $790,000. To determine the cash cash payments for merchandisepayments for merchandise, the $790,000 , the $790,000 is adjusted for any increase or decrease in is adjusted for any increase or decrease in inventories and accounts payable inventories and accounts payable (assuming the accounts payable are owed (assuming the accounts payable are owed to merchandise suppliers).to merchandise suppliers).

($8,000)

$3,200

$790,000 = $785,200

CASH CASH PAYMENTS FOR PAYMENTS FOR MERCHANDISEMERCHANDISE

Cash Payments for Operating Cash Payments for Operating ExpensesExpenses1.1. Rundell Inc. reports total operating Rundell Inc. reports total operating

expenses of $203,000, which includes expenses of $203,000, which includes depreciation expense of $7,000. To depreciation expense of $7,000. To determine determine cash payments for operating cash payments for operating expensesexpenses, the other operating expenses , the other operating expenses (excluding depreciation) of $196,000 are (excluding depreciation) of $196,000 are adjusted for any increase or decrease in adjusted for any increase or decrease in accrued expenses payable.accrued expenses payable.

$196,000 = $193,800

($2,200)

CASH CASH PAYMENTS FOR PAYMENTS FOR

OPERATING OPERATING EXPENSESEXPENSES

Interest ExpenseInterest Expense

o Rundell Inc. reports interest expense of Rundell Inc. reports interest expense of $8,000. To determine the $8,000. To determine the cash payments cash payments for interestfor interest, the $8,000 is adjusted for any , the $8,000 is adjusted for any increases or decreases in interest payable.increases or decreases in interest payable.

INTEREST INTEREST EXPENSEEXPENSE

Cash Payments for Income TaxesCash Payments for Income Taxes

o Rundell Inc. reports income tax expense of Rundell Inc. reports income tax expense of $83,000. To determine the $83,000. To determine the cash payments cash payments for income taxesfor income taxes, the $83,000 is adjusted , the $83,000 is adjusted for any increases or decreases in income for any increases or decreases in income taxes payable.taxes payable.

CASH CASH PAYMENTS FOR PAYMENTS FOR INCOME TAXESINCOME TAXES

$83,000 = $83,500

REPORTING CASH REPORTING CASH FLOWS FROM FLOWS FROM OPERATING OPERATING ACTIVITIESACTIVITIES

(continued)

REPORTING CASH REPORTING CASH FLOWS FROM FLOWS FROM OPERATING OPERATING ACTIVITIESACTIVITIES

ObjectiveDescribe and illustrate the use of

Describe and illustrate the use of

free cash flow in evaluating a

company’s cash flow.

Free Cash FlowFree Cash Flow

o Free cash flowFree cash flow measures the operating measures the operating cash flow available for a company to use cash flow available for a company to use after purchasing the property, plant, and after purchasing the property, plant, and equipment (PP&E) necessary to maintain equipment (PP&E) necessary to maintain current productive capacity.current productive capacity.

Cash flow from operating activitiesCash flow from operating activities

Less: Investments in fixed assets Less: Investments in fixed assets to maintain current to maintain current productionproduction

Free cash flowFree cash flow

o Positive free cash flow is considered Positive free cash flow is considered favorable. A company that has free cash favorable. A company that has free cash flow is able to fund internal growth, retire flow is able to fund internal growth, retire debt, pay dividends, and enjoy financial debt, pay dividends, and enjoy financial flexibility.flexibility.

o Research in Motion, Inc., maker of Research in Motion, Inc., maker of BlackBerry® smartphones, had cash flow BlackBerry® smartphones, had cash flow from operating activities of $4,009 million from operating activities of $4,009 million in a recent fiscal year. The statement of in a recent fiscal year. The statement of cash flows indicated that the cash cash flows indicated that the cash invested in property, plant, and equipment invested in property, plant, and equipment was $1,039 million. The free cash flow was $1,039 million. The free cash flow would be computed as follows (in would be computed as follows (in millions):millions):

Cash flow from operating activities $4,009Less: Investment in PP&E needed to maintain

current production 1,039Free cash flow $ 2,970

AppendixAppendix

Spreadsheet (Work

Sheet) for Statement of

Cash Flows

The Indirect MethodSpreadsheet (Work

Sheet) for Statement of

Cash Flows

The Indirect Method

Statement of

Cash FlowsCash Flows

The EndThe EndThe EndThe End

ch14 wrd12e instructor_final

cash payments

statement of cash flows

net cash flows

payment of cash

cash flow activities

reporting cash flowso

cash outflows payments

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