Cash Flows and Accrual Accounting in Predicting Future Cash Flows
Ch_05 Statement of Cash Flows
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Transcript of Ch_05 Statement of Cash Flows
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2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick
Statement of
Cash Flows
CHAPTER
5
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Learning Objectives
After studying this chapter, you should be able to
1. Identify the purposes of the statement of cash flows
2. Classify activities affecting cash as operating,
investing, or financing activities3. Compute and interpret cash flows from financing
activities
4. Compute and interpret cash flows from investing
activities5. Use the direct method to calculate cash flows from
operations
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Learning Objectives
After studying this chapter, you should be able to
6. Use the indirect method to explain the differencebetween net income and net cash provided by
(used for) operating activities7. Understand why depreciation is added to net
income when using the indirect method forcomputing cash flow from operating activities
8. Show how the balance sheet equation provides aconceptual framework for the statement of cashflows
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Overview
The purpose of the statement of cash flowsisto
Report cash receipts and cash payments of an entity
over a period of time Classify the cash flows as operating, investing, and
financing activities
Detail the changes in the cash account on the
balance sheet
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Overview
Balance Sheet
December 31,
20X0
Balance Sheet
December 31,
20X1
Statement of Income
Statement of Cash Flows
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Purpose of the Cash Flow Statement
A statement of cash flows
Shows the relationship of net income to changes incash balances
Helps to predict future cash flows Evaluates how management generates and uses
cash
Determines a companys ability to pay interest,
dividends, and debts when they are due Identifies specific increases and decreases in a firms
productive assets
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Purpose of the Cash Flow Statement
The term cash also refers to cash equivalents
Cash equivalentsare highly liquid short-terminvestments that a company can easily and
quickly convert into cash
Money market funds
Treasury bills
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Typical Activities Affecting Cash
Managers affect cash by three types ofdecisions:
Operating decisions
Financing decisions Investing decisions
Operating decisionsare concerned with the
major day-to-day activities that generaterevenues and expenses
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Typical Activities Affecting Cash
Operating activitiesare transactions that affectthe purchase, processing, and selling of acompanys products and services
Making sales Collecting accounts receivable
Purchasing inventory
Paying accounts payable
The first major section of the statement of cashflows is labeled cash flows from operatingactivities
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Typical Activities Affecting Cash
Financing decisionsare concerned with how toobtain or repay cash
Financing activitiesare a companys
transactions that obtain resources from debt andequity transactions
Issuance of additional stock
Borrowing money from the bank
Repaying previous loans The financing section on the statement is
labeled cash flows from financing activities
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Typical Activities Affecting Cash
Investing decisionsinclude the choices toacquire or dispose of long-term productiveassets or long-term investments
Investing activitiesare transactions thatacquire or dispose of assets that are expected toprovide services for more than one year
Purchasing or disposing of equipment The investing section on the statement is labeled
cash flows from investing activities
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Typical Activities Affecting Cash
Cash Inflows Cash Outflows
Operating Activities:Collections from customers Cash payments to suppliersInterest and dividends collected Cash payments to employeesOther operating receipts Interest and taxes paid
Other operating cash payments
Investing Activities:Sale of property, plant, and equipment Purchase of property, plant, and equipmentSale of securities that are not Purchase of securities that are not
cash equivalents cash equivalentsReceipt of loan repayments Making loans
Financing:Borrowing cash from creditors Repayment of amounts borrowedIssuing equity securities Repurchase of equity shares (including theIssuing debt securities purchase of treasury stock)
Payment of dividends
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Preparing the
Statement of Cash Flows
The following two slides for Biwheels Companyshow the:
Changes in the balance sheet equation (transactions)
during the first month of operations Income statement for the first month of operations
and the January 31 balance sheet
Notice that the cash balance increased from $0
to $351,000 during the month
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Preparing the
Statement of Cash FlowsAssets = Liabili ties + Stockholders' Equity
Description of Transactions Cash +
Accounts
Receivable +
Merchandise
Inventory +
Prepaid
Rent +
Store
Equipment =
Note
Payable +
Accounts
Payable +
Paid-in
Capital +
Retained
Earnings
(1) Initial investment +400,000 = +400,000
(2) Loan from bank +100,000 = +100,000
(3) Acquire s tore equipment
for cash -15,000 +15,000 =
(4) Acquire inventory for cash -120,000 +120,000 =
(5) Acquire inventory on credit +10,000 = +10,000
(6) Acquire inventory for cashplus credit -10,000 +30,000 = +20,000
(7) Sales of equipment +1,000 -1,000 =
(8) Return of inventory
acquired on January 5 -800 = -800
(9) Payments to creditors -4,000 = -4,000
(10a) Sales on open account +160,000 = +160,000
(10b) Cost of merchandise
inventory sold -100,000 = -100,000
(11) Collect accounts
receibable +5,000 -5,000 =
(12) Pay rent in advance -6,000 +6,000 =
(13) Recognize expiration of
rental services -2,000 = -2,000
(14) Depreciation -100 = -100
Balance January 31, 20X2 351,000 +155,000 +59,200 +4,000 +13,900 = 100,000 +25,200 +400,000 +57,900
583,100 583,100
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Preparing the
Statement of Cash Flows
Biwheels CompanyIncome Statement
For the Month Ended January 31, 20X2
Sales (revenues) $160,000Deduct expenses:
Cost of goods sold $100,000Rent 2,000
Depreciation 100Total expenses 102,100
Net income $ 57,900
Balance Sheet, January 31, 20X2
Assets Liabilities and Stockholders EquityCash $351,000 Liabilities
Accounts receivable 155,000 Note payable $100,000Merchandise inventory 59,200 Accounts payable 25,200
Prepaid rent 4,000 Total liabilities $125,000Store equipment 13,900 Stockholders equity
Paid-in capital $400,000Retained earnings 57,900Total stockholders equity 457,900
Total liabilities andTotal assets $583.100 stockholders equity $583,100
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Cash Flows from
Financing Activities
Two general rules apply for identifying financingactivities:
Increases in cash (cash inflows) stem from increases
in long-term liabilities or paid-in capital Decreases in cash (cash outflows) stem from
decreases in long-term liabilities or paid-in capital
Biwheels had two such transactions in January:
Transaction 1: Initial investment, $400,000
Transaction 2: Loan from bank, $500,000
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Cash Flows from
Investing Activities
Two general rules apply for identifying investingactivities:
Increases in cash (cash inflows) from decreases in
long-lived assets, loans, and investments Decreases in cash (cash outflows) stem fromincreases in long-lived assets, loans, and investments
There were two such transactions relating tostore equipment in January:
Transaction 3: Acquire store equipment for cash,$15,000
Transaction 7: Sale of store equipment for cash,$1,000
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Noncash Investing and
Financing Activities
Sometimes financing and investing activities donot affect cash
Example: If Biwheels acquires $8,000 of store
equipment by issuing common stock
The purchase of store equipment is an investingactivity
The issuance of common stock is a financing activity Companies must report such items in a schedule
of noncash investing and financing activities
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Cash Flow from Operating Activities
Direct method:
Subtracts operating cashdisbursements fromoperating cash collections
Is preferred by the FASB
Indirect method:
Adjusts accrual-based netincome from the incomestatement to reflect onlycash receipts anddisbursements
Is used by most U.S.companies
Two approaches may be used:
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The Direct Method
Examining the cash column of Biwheels balancesheet equation, transactions 1, 2, 3, and 7 arefinancing and investing activities
The remaining transactions must be operating
activities:
Biwheels CompanyCash Flows from Operating ActivitiesDirect Method
For the Month of January 20X2
Cash payments for inventory (transactions 4 and 6) $(130,000)Cash payments to creditors for accounts payable (transaction 9) (4,000)Cash collections on accounts receivable (transaction 11) 5,000Cash payments for rent (transaction 12) 6,000Net cash used by operating activities $(135,000)
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The Indirect Method
When the cash flow from a sale or outflow froman expense occurs in one accounting period andthe revenue or expense occurs in another, net
income differs from cash flows from operations The indirect method highlights these differences
by starting with net income, and adjusts it tocash flows from operating activities
Example: Depreciation is added back to netincome because it is a noncash expense
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The Indirect Method
Net income
Adjust for revenues and expenses not requiring cash
Add back depreciation
Other adjustments Adjust for changes in noncash assets and liabilities
relating to operating activities
Add decreases in assets
Deduct increases in assets
Add increases in liabilities
Deduct decreases in liabilities
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The Indirect Method
Biwheels CompanyCash Flows from operating ActivitiesIndirect Method
For the Month of January 20X2
Net income $ 57,900
Adjustments to reconcile net income tonet cash provided by operating activities:Depreciation 100Net increase in accounts receivable (155,000)Net increase in inventory (59,200)Net increase in accounts payable 25,200Net increase in rent payable (4,000)
Net cash provided by operating activities $(135,000)
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Reconciliation Statement
The FASB requires direct-method statements toinclude a supplementary schedule reconcilingnet income to net cash provided by operations
In other words, companies that use the directmethod must also prepare a report using theindirect method (reconciliation schedule)
As a result, most companies use the indirectmethod
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Example of Statement of Cash Flows
Biwheels CompanyStatement of Cash Flows
For the Month of January 20X2
Cash flows from operating activities:Net income $ 57,900Adjustments to reconcile net income to
net cash provided by operating activities:Depreciation 100Net increase in accounts receivable (155,000)Net increase in inventory (59,200)Net increase in accounts payable 25,200Net increase in rent payable (4,000)
Net cash provided by operating activities $(135,000)
Cash flows from investing activities:Purchase of store equipment $ (15,000)Proceeds from sale of store equipment 1,000Net cash provided by investing activities (14,000)
Cash flows from financing activities:Proceeds from initial investment $ 400,000Proceeds from issuance of common stock 100,000Net cash provided by financing activities 500,000
Net increase in cash 351,000Cash, January 2, 20X2 0Cash, January 31, 20X2 $351,000
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The Importance of Cash Flow
The income statement matches revenues andexpenses using accrual concepts and provides ameasure of economic performance
The statement of cash flows explains changes inthe cash account rather than owners equity
Free cash flow
Is a measure of cash management performance Refers to cash flows from operations less capital
expenditures (and sometimes less dividends)