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Accounting Principles, 6e Weygand t, K ieso , & K immel
Prepared by
Marianne Bradford, Ph. D.
Bryant College
John Wiley & Sons , Inc .
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After studying this chapter, you should be able to:
1 Indicate the primary purpose of the statement
of cash flows.
2 Distinguish among operating, investing, and
financing activities.
3 Prepare a statement of cash flows using the
indirect method.
4 Prepare a statement of cash flows using the
direct method.
5 Analyze the statement of cash flows.
CHAPTER 18 THE STATEMENT OF CASH FLOWS
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PREVIEW OF CHAPTER 18
THE STATEMENT OF CASH FLOWS
The Statement of Cash Flows: Purpose and Format
Purpose
Meaning of ―cash flows‖
Classifications
Significant noncash activities
Format
Usefulness
Preparation
Indirect & direct methods
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PREVIEW OF CHAPTER 18
ORSection 1:
Indirect Method
Determining net increase/decrease in
cash
Determining net cash provided/used
by operating activities
Determining net cash provided/used
by investing and financing activities
Section 2:
Direct Method
Determining net increase/decrease in
cash
Determining net cash provided/used
by operating activities
Determining net cash provided/used
by investing and financing activities
THE STATEMENT OF CASH FLOWS
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PREVIEW OF CHAPTER 18
Analysis of the Statement of Cash Flows
Current cash debt coverage ratio
Cash return on sales ratio
Cash debt coverage ratio
THE STATEMENT OF CASH FLOWS
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STUDY OBJECTIVE 1
Indicate the primary purpose
of the statement of cash flows.
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PURPOSE OF
THE STATEMENT OF CASH FLOWS
The primary purpose of the statement of cash flows
(SCF) is to provide information about an entity’s cash
receipts and cash payments during a period.
A secondary objective is to provide information about its 1) operating, 2) investing, and 3) financing activities
of an entity during a period.
It provides answers to the following simple, but
important, questions about an enterprise:1 Where did the cash come from during the period?
2 What was the cash used for during the period?
3 What was the change in the cash balance during the
period?
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MEANING OF
CASH FLOWS The SCF is usually prepared using cash and cash
equivalents as its basis.
Cash equivalents are short-term, highly liquid
investments that are both:1 readily convertible to known amounts of cash,
and
2 so near to their maturity that their market value
is relatively insensitive to changes in interest
rates.
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STUDY OBJECTIVE 2
Distinguish among operating,
investing, and financing activities.
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CLASSIFICATION OF
CASH FLOWSTransactions and other events characteristic of each
kind of activity are as follows:
1 Operating activities include the cash effects of
transactions that create revenues and expenses. Theythus enter into the determination of net income.
2 Investing activities include a) acquiring and disposing
of investments and productive long-lived assets, and
b) lending money and collecting the loans.
3 Financing activities include a) obtaining cash from
issuing debt and repaying the amounts borrowed,
and b) obtaining cash from stockholders and
providing them with a return on their investment.
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CLASSIFICATION OF
CASH FLOWS The category of operating activities is the mostimportant because it shows the cash provided bycompany operations.
Note the following general guidelines:1) Operating activities involve income determination
(income statement) items,
2) Investing activities involve cash flows resultingfrom changes in investments and long-term assetitems.
3) Financing activities involve cash flows resultingfrom changes in long-term liability andstockholders’ equity items.
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ILLUSTRATION 18-1
BUSINESS ACTIVITIES SHOWN ON
THE STATEMENT OF CASH FLOWS
Operating
Activities
Investing
Activities
Financing
Activities
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ILLUSTRATION 18-1
TYPICAL RECEIPTS AND PAYMENTS
CLASSIFIED BY ACTIVITY
Types of Cash Inflows and Outflows
Operating activities
Cash inflows:
From sale of goods or services
From returns on loans (interest received) and on equity securities (dividends received) Cash outflows:
To suppliers for inventory
To employees for services
To government for taxes
To lenders for interest
To others for expenses
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ILLUSTRATION 18-1
TYPICAL RECEIPTS AND PAYMENTS
CLASSIFIED BY ACTIVITY
Investing activities
Cash inflows:
From sale of property, plant, and equipment
From sale of debt or equity securities of other entities From collection of principal on loans to other entities
Cash outflows:
To purchase property, plant, and equipment
To purchase debt or equity securities of other entities
To make loans to other entities
Financing activities Cash inflows:
From sale of equity securities (company’s own stock)
From issuance of debt (bonds and notes)
Cash outflows:
To stockholders as dividends
To redeem long-term debt or reacquire capital stock
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COMPANY NAME
Statement of Cash Flows
Period Covered
Cash flows from operating activities
(List of individual items) XX Net cash provided (used) by operating activities XXX
Cash flows from investing activities
(List of individual inflows and outflows) XX
Net cash provided (used) by investing activities XXX
Cash flows from financing activities
(List of individual inflows and outflows) XX
Net cash provided (used) by financing activities XXX
Net increase (decrease) in cash XXX
Cash at beginning of period XXX
Cash at end of period XXX
Noncash investing and financing activities
(List of individual noncash transactions) XXX
The general
format of the SCF
Is the 3 activities
previouslydiscussed –
operating,
investing, and
financing – plus
the significant
noncash investing
and financing
activities.
ILLUSTRATION 18-2 FORMAT OF STATEMENT OF CASH FLOWS
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FORMAT OF
THE STATEMENT OF CASH FLOWS
Net Cash
Company Net Income from Operations
Kmart Corporation $ 518 $ 1237
Wal-Mart Stores, Inc. 4430 7580
The GAP, Inc. 1127 1478J. C. Penney Company, Inc. 594 1058
Sears, Roebuck and Co. 1948 3090
The May Department Stores Company 849 1505
Differences between net income and net cash provided by operating
activities are illustrated by the following results from recent annual
reports for the same fiscal year (all data are in millions of dollars).
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USEFULNESS OF
THE STATEMENT OF CASH FLOWS
The information in the SCF should help investors,
creditors and others assess the following aspects of
the firm’s financial position:
1 The entity’s ability to generate future cash flows.
2 The entity’s ability to pay dividends and meet
obligations.
3 The reasons for the difference between net incomeand net cash provided (used) by operating
activities.
4 The cash investing and financing transactions
during the period.
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PREPARING
THE STATEMENT OF CASH FLOWS
The SCF is prepared differently from the 3 other
basic financial statements.
1 It is not prepared from the adjusted trial balance.
2 The SCF deals with cash receipts and payments, so
the accrual concept is not used in the preparation
of the SCF.
The information to prepare this statement usuallycomes from 3 sources:
1 Comparative balance sheet.
2 Current income statement.
3 Additional information.
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ILLUSTRATION 18-3
THREE MAJOR STEPS IN PREPARING
THE STATEMENT OF CASH FLOWS
+ or -The difference between the
beginning and ending cash
balances can be easily computed
from comparative balance sheets.
This step involves analyzing not only the current
year’s income statement but also comparative
balance sheets and selected additional data.
XYZ
Goods
This step involves analyzing
comparative balance sheet data
and selected additional informationfor their effects on cash.
For
Sale Investing Financing
Step 1: Determine the net increase/decrease in cash.
Step 2: Determine net cash provided/used by operating activities.
Step 3: Determine net cash provided/used by investing and financing activities.
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USAGE OF INDIRECT AND
DIRECT METHODS
98.3%
Indirect
Method
1.7% Direct Method
In order to determine net cash provided/used by operating activities, the
operating activities section must be converted from accrual basis to cash
basis. This conversion may be accomplished by 1) the indirect method or
2) the direct method. The indirect method is used extensively in practice,
as shown below. The indirect is favored by companies for 2 reasons: 1) it
is easier to prepare and 2) it focuses on the differences between net income
and net cash flow from operating activities.
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STUDY OBJECTIVE 3
Prepare a statement of cash
flows using the indirect method.
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SECTION 1
STATEMENT OF CASH FLOWS
INDIRECT METHOD
The transactions of the Computer Services
Company for 2002 and 2003 are used to illustrate
and explain the indirect method of preparing the
SCF.
First Year of Operations – 2002
1 Computer Services Company started on
January 1, 2002, when it issued 50,000 shares of$1 par value common stock for $50,000 cash.
2 The company rented its office space and
furniture and rendered consulting services
throughout the first year.
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ILLUSTRATION 18-4COMPARATIVE BALANCE SHEET, 2002,
WITH INCREASES AND DECREASES
COMPUTER SERVICES COMPANY
Comparative Balance Sheets
Change
Assets Dec. 31, 2002 Jan. 1, 2002 Increase/Decrease
Cash $ 34,000 $ – 0 – $ 34,000 Increase
Accounts receivable 30,000 – 0 – 30,000 Increase
Equipment 10,000 – 0 – 10,000 Increase
Total $ 74,000 $ – 0 –
Liabilities and
Stockholders’ Equity
Accounts payable $ 4,000 $ – 0 – $ 4,000 Increase
Common stock 50,000 – 0 – 50,000 Increase
Retained earnings 20,000 – 0 – 20,000 Increase
Total $ 74,000 $ – 0 –
The comparative balance sheets at the beginning and end of2002 – showing increases and decreases – are shown below.
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ILLUSTRATION 18-5
INCOME STATEMENT AND
ADDITIONAL INFORMATION, 2002
The income statement and additional information
for Computer Services Company are shown below.
COMPUTER SERVICES COMPANY
Income Statement
For the Year Ended December 31, 2002
Revenues $ 85,000
Operating expenses 40,000
Income before income taxes 45,000
Income tax expense 10,000
Net income $ 35,000
Additional information:
(1) Examination of selected data indicates
that a dividend of $15,000 was declared
and paid during the year.
(2) The equipment was purchased at the
end of 2002. No depreciation was takenin 2002.
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ILLUSTRATION 18-6
NET INCOME VERSUS NET CASH
PROVIDED BY OPERATING ACTIVITIESThe indirect method starts with net income and converts it to net cash provided by
operating activities. In other words, the indirect method adjusts net income for
items that affect reported net income but do not affect cash. Noncash charges in
the income statement are added back to net income. Likewise, noncash credits are
deducted. The result is to calculate net cash provided by operating activities.
Earned
Revenues
Net Income
Incurred
Expenses
Accrual Basis of Accounting Cash Basis of Accounting
Adjustments to
Reconcile Net
Income to Net
Cash Provided
by Operations
Net Cash Provided
by Operating
Activities
Eliminate noncash revenues
Eliminate noncash expenses
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ILLUSTRATION 18-7ANALYSIS OF ACCOUNTS RECEIVABLE
ACCOUNTS RECEIVABLE
1/1/02 Balance – 0 – Receipts from customers 55,000
Revenues 85,000
12/31/02 Balance 30,000
When accounts receivable increase during the year, revenues on an accrualbasis are higher than are revenues on a cash basis.
In other words, operations of the period caused revenues to increase, but notall of these revenues resulted in an increase in cash.
Some of increase in revenues had to result in an increase in accountsreceivable.
As shown below, Computer Services Company had $85,000 in revenues, butcollected only $55,000 in cash.
Therefore, to convert net income into net cash provided by operatingactivities, the increase of $30,000 in accounts receivable must be deductedfrom net income.
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ILLUSTRATION 18-8ANALYSIS OF ACCOUNTS PAYABLE
ACCOUNTS PAYABLE
Payments to creditors 36,000 1/1/02 Balance – 0 –
Operating expenses 40,000
12/31/02 Balance 4,000
When accounts payable increase during the year, operating
expenses on an accrual basis are higher than they are on a cash
basis.
For Computer Services Company, operating expenses reported inthe income statement were $40,000.
Since Accounts Payable increased $4,000, only $36,000 ($40,000
– $4,000) of the expenses were paid in cash.
To adjust net income to net cash provided by operating activities,
the increase of $4,000 must be added to net income.
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COMPUTER SERVICES COMPANYPartial Statement of Cash Flows— Indirect Method
For the Year Ended December 31, 2002
Cash flows from operating activities
Net income $ 35,000
Adjustments to reconcile net income to net cash provided by operating
activities:
Increase in accounts receivable $ ( 30,000)
Increase in accounts payable 4,000 ( 26,000)
Net cash provided by operating activities $ 9,000
ILLUSTRATION 18-9PRESENTATION OF NET CASH PROVIDED BY
OPERATING ACTIVITIES, 2002 — INDIRECT METHOD
The changes in accounts receivable and accounts payable were the only changes
in current assets and current liabilities during the year for Computer Services
Company.
Therefore, any other revenues or expenses reported in the income statement
were received or paid in cash.
The operating activities section of the SCF for Computer Services Company is
shown below.
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ILLUSTRATION 18-10ANALYSIS OF RETAINED EARNINGS
RETAINED EARNINGS
12/31/02 Cash dividend 15,000 1/1/02 Balance – 0 –
12/31/02 Net income 35,000 12/31/02 Balance 20,000
The reasons for the net increase of $20,000 in Retained Earnings aredetermined by analysis.
1 Net income increased Retained Earnings by $35,000.
2 The additional information below the income statement in
Illustration 18-5 indicates that a cash dividend of $15,000 wasdeclared and paid.
The increase due to net income is reported in the operating activitiessection while the cash dividend paid is reported in the financingactivities section. This analysis can also be made directly from theRetained Earnings account as shown below.
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ILLUSTRATION 18-11
STATEMENT OF CASH FLOWS, 2002
— INDIRECT METHOD
COMPUTER SERVICES COMPANY
Statement of Cash Flows— Indirect Method
For the Year Ended December 31, 2002
Cash flows from operating activities
Net income $ 35,000
Adjustments to reconcile net income to net cash provided by operating
activities:
Increase in accounts receivable $ ( 30,000)
Increase in accounts payable 4,000 ( 26,000)
Net cash provided by operating activities 9,000
Cash flows from investing activities
Purchase of equipment ( 10,000)Net cash used by investing activities ( 10,000)
Cash flows from financing activities
Issuance of common stock 50,000
Payment of cash dividends ( 15,000) 35,000
Net increase in cash 34,000
Cash at beginning of period – 0 –
Cash at end of period $ 34,000
Operating
activities provided
$9,000 cash,
investing activities
used $10,000 cash,
while financing
activities provided
$35,000 cash.
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ILLUSTRATION 18-12COMPARATIVE BALANCE SHEET, 2003,
WITH INCREASES AND DECREASES
The
comparative
balance
sheets at thebeginning
and end of
2003 –
showing
increases
and
decreases –
are shown to
the right.
COMPUTER SERVICES COMPANY
Comparative Balance Sheets
December 31
Change
Assets 2003 2002 Increase/Decrease
Cash $ 56,000 $ 34,000 $ 22,000 Increase
Accounts receivable 20,000 30,000 10,000 Decrease
Prepaid expenses 4,000 – 0 – 4,000 Increase
Land 130,000 – 0 – 130,000 Increase
Building 160,000 – 0 – 160,000 Increase
Accumulated depreciation – building ( 11,000) – 0 – 11,000 Increase
Equipment 27,000 10,000 17,000 Increase
Accumulated depreciation – equipment ( 3,000) – 0 – 3,000 Increase
Total $ 383,000 $ 74,000
Liabilities and
Stockholders’ Equity
Accounts payable $ 59,000 $ 4,000 $ 55,000 Increase
Bonds payable 130,000 – 0 – 130,000 Increase
Common stock 50,000 50,000 – 0 –
Retained earnings 144,000 20,000 124,000 IncreaseTotal $ 383,000 $ – 0 –
S O
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ILLUSTRATION 18-13
INCOME STATEMENT AND
ADDITIONAL INFORMATION, 2003
COMPUTER SERVICES COMPANY
Income Statement
For the Year Ended December 31, 2003
Revenues $ 507,000
Operating expenses (excluding depreciation) $ 261,000Depreciation expense 15,000
Loss on sale of equipment 3,000 279,000
Income from operations 228,000
Income tax expense 89,000
Net income $ 139,000
Additional information:
(1) In 2003, the company declared and paid a $15,000 cash dividend.
(2) The company obtained land through the issuance of $130,000 of long-term bonds.
(3) A building costing $160,000 was purchased for cash; equipment costing $25,000
was also purchased for cash.
(4) During 2003, the company sold equipment with a book value of $7,000 (cost
$8,000, less accumulated depreciation of $1,000) for $4,000 cash.
The incomestatement
andadditionalinformationfor 2003 forComputerServicesCompanyare shownto the right.
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ILLUSTRATION 18-14ANALYSIS OF ACCUMULATED
DEPRECIATION — EQUIPMENT
ACCUMULATED DEPRECIATION— EQUIPMENT
Accumulated depreciation on 1/1/03 Balance – 0 –
equipment sold 1,000 Depreciation expense 4,000
12/31/03 Balance 3,000
The increase in Accumulated Depreciation – Equipment was$3,000, which does not represent depreciation expense for theyear since the account was debited $1,000 as a result a sale ofsome equipment.
Depreciation expense for 2003 was $4,000 ($3,000 + $1,000).
This amount is added to net income to determine net cashprovided by operating activities.
The T-account below provides information about the changes
that occurred in this account in 2003.
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ILLUSTRATION 18-15PRESENTATION OF NET CASH PROVIDED BY
OPERATING ACTIVITIES, 2003 — INDIRECT METHOD
COMPUTER SERVICES COMPANY
Partial Statement of Cash Flows— Indirect MethodFor the Year Ended December 31, 2003
Cash flows from operating activities
Net income $ 139,000
Adjustments to reconcile net income to net cash provided by operatingactivities:
Depreciation expense $ 15,000
Loss on sale of equipment 3,000
Decrease in accounts receivable 10,000
Increase in prepaid expenses ( 4,000)
Increase in accounts payable 55,000 79,000
Net cash provided by operating activities $ 218,000
Net cash provided by operating activities
for 2003 is $218,000 as calculated below.
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ILLUSTRATION 18-16
ANALYSIS OF EQUIPMENT
Equipment increased $17,000, which was a net increase thatresulted from 2 transactions:
1) a purchase of equipment of $25,000 and
2) the sale of equipment costing $8,000 for $4,000.
These transactions are classified as investing activities and eachshould be reported separately. The purchase of equipment
should therefore be reported as an outflow of cash for $25,000 andthe sale should be reported as an inflow of cash for $4,000. The
T-account below shows the reasons for the change in this accountduring the year.
EQUIPMENT
1/1/03 Balance 10,000 Cost of old equipment 8,000
Purchase of equipment 25,00012/31/03 Balance 27,000
ILLUSTRATION 18 17
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ILLUSTRATION 18-17
STATEMENT OF CASH FLOWS, 2003
— INDIRECT METHOD
COMPUTER SERVICES COMPANY
Statement of Cash Flows
For the Year Ended December 31, 2003
Cash flows from operating activities
Net income $ 139,000Adjustments to reconcile net income to net cash provided by operating
activities:
Depreciation expense $ 15,000
Loss on sale of equipment 3,000
Decrease in accounts receivable 10,000
Increase in prepaid expenses ( 4,000)
Increase in accounts payable 55,000 79,000
Net cash provided by operating activities 218,000
ILLUSTRATION 18 17
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ILLUSTRATION 18-17
STATEMENT OF CASH FLOWS, 2003
— INDIRECT METHOD
Cash flows from investing activities
Purchase of building $(160,000) Purchase of equipment ( 25,000)
Sale of equipment 4,000
Net cash used by investing activities (181,000)
Cash flows from financing activities
Payment of cash dividends ( 15,000)
Net cash used by financing activities ( 15,000)Net increase in cash 22,000
Cash at beginning of period 34,000
Cash at end of period $ 56,000
Noncash investing and financing activities
Issuance of bonds payable to purchase land $ 130,000
ILLUSTRATION 18 18
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Adjustments to Convert Net
Income to Net Cash Provided
by Operating Activities
Current Assets and Add to Deduct from
Current Liabilities Net Income Net Income
Accounts receivable Decrease Increase
Inventory Decrease Increase
Prepaid expenses Decrease Increase
Accounts payable Increase DecreaseAccrued expenses payable Increase Decrease
The SCF prepared by the indirect method starts with net income. Itthen adds or deducts items not affecting cash to arrive at net cashprovided by operating activities. The additions and deductions consistof:
1) changes in specific current assets and current liabilities and2) noncash charges reported in the income statement.
A summary of the adjustments for current assets and current liabilitiesis provided in Illustration 18-18.
ILLUSTRATION 18-18
ADJUSTMENTS FOR CURRENT
ASSETS AND CURRENT LIABILITIES
ILLUSTRATION 18 19
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ILLUSTRATION 18-19
ADJUSTMENTS FOR
NONCASH CHARGES
Adjustments to Convert Net
Income to Net Cash ProvidedNoncash Charges by Operating Activities
Depreciation expense Add
Patent amortization expense Add
Depletion expense Add
Loss on sale of asset Add
Adjustments for the noncashcharges reported in the
income statement are made asshown in Illustration 18-19.
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STUDY OBJECTIVE 4
Prepare a statement of cash
flows using the direct method.
SECTION 2
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SECTION 2
STATEMENT OF CASH FLOWS
DIRECT METHOD
The transactions of Juarez Company for 2002
and 2003 are used to illustrate and explain the
indirect method of preparing the SCF.
First Year of Operations – 2002 1 Juarez Company started on January 1, 2002,
when it issued 300,000 shares of $1 par value
common stock for $300,000 cash.
2 The company rented its office, sales space, and
equipment.
ILLUSTRATION 18 20
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ILLUSTRATION 18-20COMPARATIVE BALANCE SHEET, 2002,
WITH INCREASES AND DECREASES
JUAREZ COMPANY
Comparative Balance Sheet
Change
Assets Dec. 31, 2002 Jan. 1, 2002 Increase/Decrease
Cash $ 159,000 $ – 0 – $ 159,000 Increase
Accounts receivable 15,000 – 0 – 15,000 Increase
Inventory 160,000 – 0 – 160,000 Increase
Prepaid expenses 8,000 – 0 – 8,000 Increase
Land 80,000 – 0 – 80,000 Increase
Total $ 422,000 $ – 0 –
Liabilities andStockholders’ Equity
Accounts payable $ 60,000 $ – 0 – $ 60,000 Increase
Accrued expenses payable 20,000 – 0 – 20,000 Increase
Common stock 300,000 – 0 – 300,000 Increase
Retained earnings 42,000 – 0 – 42,000 Increase
Total $ 422,000 $ – 0 –
The
comparative
balance
sheets at thebeginning
and end of
2002 –
showing
increases
and
decreases –
are shown to
the right.
ILLUSTRATION 18 21
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ILLUSTRATION 18-21
INCOME STATEMENT AND
ADDITIONAL INFORMATION, 2002
JUAREZ COMPANY
Income Statement
For the Year Ended December 31, 2002
Revenues from sales $ 780,000
Cost of goods sold 450,000
Gross profit 330,000
Operating expenses 170,000
Income before income taxes 160,000
Income tax expense 48,000
Net income $ 112,000
Additional information:
(1) Dividends of $70,000 were declared and paid in cash.
(2) The accounts payable increase resulted from the purchase of merchandise.
The income statement and additional information
for Juarez Company are shown below.
ILLUSTRATION 18 22
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ILLUSTRATION 18-22
MAJOR CLASSES OF CASH
RECEIPTS AND PAYMENTS
From sales of
goods and services
to customers
From receipts of
interest and
dividends on loans
and investments
Net cash provided
by operating
activities
For interest
and dividends
For taxes
For operating
expenses
To suppliers
To employees
Cash Receipts – Cash Payments = Net Cash Provided
by Operating Activities
CASH RECEIPTS
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CASH RECEIPTS
FROM CUSTOMERS The income statement for Juarez Company
reported revenues from customers of $780,000.
To determine the amount of cash receipts, the
increase in accounts receivable is deducted fromsales revenues.
Conversely, a decrease in accounts receivable is
added to sales revenues, since cash receipts from
customers exceed sales revenues.
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ILLUSTRATION 18-23
COMPUTATION OF CASH
RECEIPTS FROM CUSTOMERS
Revenues from sales $ 780,000
Deduct: Increase in accounts receivable 15,000
Cash receipts from customers $ 765,000
For Juarez Company, accountsreceivable increased $15,000, so
that cash receipts from customerswere $765,000, calculated as shownin Illustration 18-23.
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ILLUSTRATION 18-24
ANALYSIS OF
ACCOUNTS RECEIVABLE
ACCOUNTS RECEIVABLE1/1/02 Balance – 0 – Receipts from customers 765,000
Revenues from sales 780,000
12/31/02 Balance 15,000
Cash receipts from customers mayalso be determined from an analysis
of Accounts Receivable as shown inIllustration 18-24.
ILLUSTRATION 18 25
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ILLUSTRATION 18-25FORMULA TO COMPUTE CASH RECEIPTS
FROM CUSTOMERS — DIRECT METHOD
The relationships among cashreceipts from customers, revenues
from sales, and changes in accountsreceivable are shown in Illustration18-25.
Cash
receipts from
customers
Revenues
from sales{+ Decrease in accounts receivable
or
– Increase in accounts receivable=
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ILLUSTRATION 18-26
COMPUTATION OF PURCHASES
Juarez Company reported cost of goods sold on its
income statement of $450,000. To determine
purchases, cost of goods sold must be adjusted for
the change in inventory. An increase (decrease) ininventory is added to (deducted from) cost of
goods sold to arrive at purchases. In 2002, Juarez
Company’s inventory increased $160,000.
Purchases are calculated in Illustration 18-26.
Cost of goods sold $ 450,000
Add: Increase in inventory 160,000
Purchases $ 610,000
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Cash payments to suppliers are then
determined by adjusting purchases for the
change in accounts payable. An accounts
payable increase (decrease) is deducted from
(added to) purchases. Cash payments to
suppliers are calculated in Illustration 18-27.
Purchases $ 610,000
Deduct: Increase in accounts payable 60,000
Cash payments to suppliers $ 550,000
ILLUSTRATION 18-27
COMPUTATION OF CASH PAYMENTS
TO SUPPLIERS
ILLUSTRATION 18-28
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ACCOUNTS PAYABLE
Payments to creditors 550,000 1/1/02 Balance – 0 –
Purchases 610,000
12/31/02 Balance 60,000
Cash payments to suppliers mayalso be determined from an analysisof Accounts Payable as shown inIllustration 18-28.
ILLUSTRATION 18-28
ANALYSIS OF
ACCOUNTS PAYABLE
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ILLUSTRATION 18-29FORMULA TO COMPUTE CASH PAYMENTS
TO SUPPLIERS — DIRECT METHOD
Cash
payments
to suppliers
=
Cost of
goods sold
{
+ Increase in inventory
or
– Decrease in inventory
{
+ Decrease in accounts payable
or
– Increase in accounts payable
The relationship among cash payments to
suppliers, cost of goods sold, changes in inventory,
and changes in accounts payable is shown in
Illustration 18-29.
ILLUSTRATION 18-30
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Operating expenses $ 170,000
Add: Increase in prepaid expenses 8,000
Deduct: Increase in accrued expenses payable ( 20,000)
Cash payments for operating expenses $ 158,000
Operating expenses of $170,000 were reported on Juarez’sincome statement. To convert operating expenses to cashpayments for operating expenses, the increase in prepaidexpenses of $8,000 must be added to operating expenses. A
decrease in prepaid expenses would be deducted from operatingexpenses. The increase in accrued expenses of $20,000 must bededucted, while a decrease would be added. Juarez Company’scash payments for operating expenses are calculated inIllustration 18-30.
ILLUSTRATION 18-30
COMPUTATION OF CASH PAYMENTS
FOR OPERATING EXPENSES
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ILLUSTRATION 18-31FORMULA TO COMPUTE CASH PAYMENTS FOR
OPERATING EXPENSES — DIRECT METHOD
Cash payments
for operating
expenses=
Operating expenses
+ Increase in prepaid expenses
or
- Decrease in prepaid expenses
+ Decrease in accrued expenses payable
or
- Increase in accrued expenses payable
ILLUSTRATION 18-32
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ILLUSTRATION 18-32
OPERATING ACTIVITIES SECTION
— DIRECT METHOD
All of the revenues and expenses in the 2002 incomestatement have now been adjusted to cash basis.
The operating activities section of the SCF is shown
below.
JUAREZ COMPANY
Partial Statement of Cash Flows— Direct Method
For the Year Ended December 31, 2002
Cash flows from operating activitiesCash receipts from customers $ 765,000
Cash payments:
To suppliers $ 550,000
For operating expenses 158,000
For income taxes 48,000 756,000
Net cash provided by operating activities $ 9,000
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ILLUSTRATION 18-33ANALYSIS OF RETAINED EARNINGS
RETAINED EARNINGS
12/31/02 Cash dividend 70,000 1/1/02 Balance – 0 –
12/31/02 Net income 112,000
12/31/02 Balance 42,000
The reasons for the net increase of $42,000 in Retained Earnings aredetermined by analysis.
1 Net income increased Retained Earnings by $112,000.
2 The additional information below the income statement in
Illustration 18-21 indicates that a cash dividend of $70,000 wasdeclared and paid.
The increase due to net income is reported in the operating activitiessection while the cash dividend paid is reported in the financingactivities section. This analysis can also be made directly from the
Retained Earnings account as shown below.
ILLUSTRATION 18-34
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ILLUSTRATION 18 34
STATEMENT OF CASH FLOWS, 2002
— DIRECT METHODJUAREZ COMPANY
Statement of Cash Flows— Direct Method
For the Year Ended December 31, 2002
Cash flows from operating activities
Cash receipts from customers $ 765,000
Cash payments:To suppliers $ 550,000
For operating expenses 158,000
For income taxes 48,000 (756,000)
Net cash provided by operating activities 9,000
Cash flows from investing activities
Purchase of land ( 80,000)
Net cash used by investing activities ( 80,000)Cash flows from financing activities
Issuance of common stock 300,000
Payment of cash dividend ( 70,000)
Net cash provided by financing activities 230,000
Net increase in cash 159,000
Cash at beginning of period – 0 –
Cash at end of period $ 159,000
The SCF for 2002
for Juarez
Company shows
that operating
activities provided
$9,000 cash,
investing activities
used $80,000 cash,
while financing
activities provided
$230,000 cash.
ILLUSTRATION 18-35
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ILLUSTRATION 18 35COMPARATIVE BALANCE SHEET, 2003,
WITH INCREASES AND DECREASES
JUAREZ COMPANY
Comparative Balance SheetDecember 31
Change
Assets 2003 2002 Increase/Decrease
Cash $ 191,000 $ 159,000 $ 32,000 Increase
Accounts receivable 12,000 15,000 3,000 DecreaseInventory 130,000 160,000 30,000 Decrease
Prepaid expenses 6,000 8,0000 2,000 Decrease
Land 180,000 80,000 100,000 Increase
Equipment 160,000 – 0 – 160,000 Increase
Accumulated depreciation – equipment ( 16,000) – 0 – 16,000 Increase
Total $ 663,000 $ 422,000
The comparative balance sheets at the beginning and end of 2003
– showing increases and decreases – are shown below.
ILLUSTRATION 18-35
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ILLUSTRATION 18 35COMPARATIVE BALANCE SHEET, 2003,
WITH INCREASES AND DECREASES
Liabilities and
Stockholders’ Equity
Accounts payable $ 52,000 $ 60,000 $ 8,000 Decrease
Accrued expenses payable 15,000 20,000 5,000 Decrease
Income taxes payable 12,000 –0– 12,000 Increase
Bonds payable 90,000 –0– 90,000 Increase
Common stock 400,000 300,000 100,000 Increase
Retained earnings 94,000 42,000 52,000 Increase
Total $ 663,000 $ 422,000
ILLUSTRATION 18-36
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ILLUSTRATION 18 36
INCOME STATEMENT AND
ADDITIONAL INFORMATION, 2003JUAREZ COMPANY
Income Statement
For the Year Ended December 31, 2003
Revenues from sales $ 975,000
Cost of goods sold $ 660,000
Operating expenses (excluding depreciation) 176,000Depreciation expense 18,000
Loss on sale of store equipment 1,000 855,000
Income before income taxes 120,000
Income tax expense 36,000
Net income $ 84,000
Additional information:
(1) In 2003, the company declared and paid a $32,000 cash dividend.
(2) Bonds were issued at face value for $90,000 in cash.
(3) Equipment costing $180,000 was purchased for cash.
(4) Equipment costing $20,000 was sold for $17,000 cash when the book value of the
Equipment was $18,000.
(5) Common stock of $100,000 was issued to acquire land.
The income statement and
additional information for 2003
for Juarez Company are shown.
ILLUSTRATION 18-37
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Revenues from sales $ 975,000
Add: Decrease in accounts receivable 3,000
Cash receipts from customers $ 978,000
Revenues from sales were $975,000. Cash receipts
from customers were greater than sales revenues since
accounts receivable decreased $3,000. Cash receiptsfrom customers were $978,000, as calculated below.
ILLUSTRATION 18 37
COMPUTATION OF CASH
RECEIPTS FROM CUSTOMERS
ILLUSTRATION 18-38
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Cost of goods sold $ 660,000
Deduct: Decrease in inventory 30,000
Purchases 630,000
Add: Decrease in accounts payable 8,000
Cash payments to suppliers $ 638,000
Purchases are calculated using cost of goods sold of
$660,000. The inventory decrease of $30,000 is deducted
from cost of goods sold. Purchases are then adjusted by
the accounts payable decrease of $8,000. Cash paymentsto suppliers are calculated in Illustration 18-38.
ILLUSTRATION 18 38
COMPUTATION OF CASH
PAYMENTS TO SUPPLIERS
ILLUSTRATION 18-39
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ILLUSTRATION 18 39COMPUTATION OF CASH PAYMENTS
FOR OPERATING EXPENSES
Operating expenses, exclusive of depreciation $ 176,000Deduct: Decrease in prepaid expenses ( 2,000)
Add: Decrease in accrued expenses payable 5,000
Cash payments for operating expenses $ 179,000
Operating expenses (exclusive of depreciation expense)
was $176,000 for 2000. The $2,000 decrease in prepaid
expenses is deducted and the $5,000 decrease in accruedexpenses payable is added in determining cash payments
for operating expenses, as shown in Illustration 18-39.
ILLUSTRATION 18-40
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Income tax expense $ 36,000
Deduct: Increase in income taxes payable 12,000
Cash payments for income taxes $ 24,000
Income tax expense reported on the incomestatement was $36,000. The $12,000increase in income taxes payable must be
deducted from income tax expense todetermine cash payments for income taxes.Cash payments for income taxes were$24,000 as shown in Illustration 18-40.
ILLUSTRATION 18 40COMPUTATION OF CASH PAYMENTS
FOR INCOME TAXES
ILLUSTRATION 18-41
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ILLUSTRATION 18 41FORMULA TO COMPUTE CASH PAYMENTS
FOR INCOME TAXES — DIRECT METHOD
Cash
payments for
income
taxes
Income
tax
expense{+ Decrease in income taxes payable
or
– Increase in income taxes payable
=
The relationships among cash payments forincome taxes, income tax expense, andchanges in income taxes payable are shown inthe formula in Illustration 18-41.
ILLUSTRATION 18-42
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ILLUSTRATION 18 42ANALYSIS OF EQUIPMENT AND RELATED
ACCUMULATED DEPRECIATION
EQUIPMENT
1/1/03 Balance – 0 – Cost of equipment sold 20,000
Cash purchase 180,000
12/31/03 Balance 160,000
The comparative balance sheet shows that Equipment increased
$160,000 in 2003. The additional information in Illustration 18-
36 that the increase resulted from 2 investing transactions: 1)
equipment costing $180,000 was purchased for cash and 2)
equipment costing $20,000 was sold for $17,000 cash when its
book value was $18,000. For Juarez Company, the investing
activities section will show: 1) the $180,000 purchase of
equipment as an outflow of cash and 2) the $17,000 sale of
equipment as an inflow of cash.
ILLUSTRATION 18-42
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ILLUSTRATION 18 42ANALYSIS OF EQUIPMENT AND RELATED
ACCUMULATED DEPRECIATION
ACCUMULATED DEPRECIATION— EQUIPMENT
Sale of equipment 2,000 1/1/03 Balance – 0 –
Depreciation expense 18,000
12/31/03 Balance 16,000
ILLUSTRATION 18-43
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STATEMENT OF CASH FLOWS, 2003
— DIRECT METHOD
JUAREZ COMPANY
Statement of Cash Flows— Direct Method
For the Year Ended December 31, 2003
Cash flows from operating activities
Cash receipts from customers $ 978,000Cash payments:
To suppliers $ 638,000
For operating expenses 179,000
For income taxes 24,000 (841,000)
Net cash provided by operating activities 137,000
ILLUSTRATION 18-43
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STATEMENT OF CASH FLOWS, 2003
— DIRECT METHOD
Cash flows from investing activities
Purchase of equipment (180,000)
Sale of equipment 17,000
Net cash used by investing activities (163,000)
Cash flows from financing activities
Issuance of bonds payable 90,000
Payment of cash dividend ( 32,000)
Net cash provided by financing activities 58,000
Net increase in cash 32,000Cash at beginning of period 159,000
Cash at end of period $ 191,000
Noncash investing and financing activities
Issuance of common stock to purchase land $ 100,000
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STUDY OBJECTIVE 5
Analyze the statement of cash flows.
ILLUSTRATION 18-45
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THE GAP, INC. DATA USED IN CASH
FLOW ANALYSIS
The GAP, Inc. reported the following
information in its 2000 annual report:
Gap, Inc.
($ in millions) Fiscal 2000 Fiscal 1999
Current Liabilities $1,753 $1,553
Total Liabilities 2,956 2,390
Net Sales 11,635 9,054
Net Cash provided by operating activities 1,478 1,394
ILLUSTRATION 18-45
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CURRENT CASH DEBT
COVERAGE RATIO
Net CashProvided by
Operating
Activities
Average Current
Liabilities
Current Cash Debt
Coverage Ratio
A disadvantage of the current ratio is that it employs year-end
balances of current asset and current liability accounts. Such
year-end balances may not be representative of the company’s
current position during most of the year. The current cash debt
coverage ratio partially corrects this problem and is calculatedby dividing average current liabilities into net cash provided by
operating activities. The current cash debt coverage ratio for
The GAP, Inc. for 2000 is calculated below.
$1,753 + $1,553
$1,478 ÷ ———————— = .89:12
ILLUSTRATION 18-46
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ILLUSTRATION 18-46
CASH RETURN ON SALES RATIO
The cash return on sales ratio is the cash based ratio that
is the counterpart of the profit margin percentage. This
ratio is calculated by dividing net sales into net cash
provided by operating activities. The current return on
sales ratio for The GAP, Inc. for 2000 is calculated below.
Net CashProvided by
Operating
Activities
Cash Return on
Sales RatioNet Sales
$1,478 ÷ $11,635 = 13%
ILLUSTRATION 18-47
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ILLUSTRATION 18-47
CASH DEBT COVERAGE RATIO
The cash basis measure of solvency is the cash debt coverage
ratio – the ratio of net cash provided by operating activities
to average total liabilities. This ratio demonstrates a
company’s ability to repay its liabilities from net cash
provided by operating activities, without having to liquidate
the assets it employs. The cash debt coverage ratio for The
GAP, Inc. for 2000 is calculated below.
Net CashProvided by
Operating
Activities
Cash Debt
Coverage RatioAverage Total
Liabilities
$2,956 + $2,390
$1,478 ÷ ———————— = .55:12
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COPYRIGHT
Copyright © 2002 John Wiley & Sons, Inc. All rights reserved. Reproduction or
translation of this work beyond that permitted in Section 117 of the 1976 United
States Copyright Act without the express written consent of the copyright owner is
unlawful. Request for further information should be addressed to the Permissions
Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for
his/her own use only and not for distribution or resale. The Publisher assumes no
responsibility for errors, omissions, or damages, caused by the use of theseprograms or from the use of the information contained herein.
CHAPTER 18