©The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin

Chapter Twelve

Statement ofCash Flows

Reporting Format for the Statement of Cash Flows

The Statement of Cash Flows must include the following three sections, as defined in FASB Statement 95:

The Statement of Cash Flows must include the following three sections, as defined in FASB Statement 95:

Operating Activities

Investing Activities

Financing Activities

Cash Flows from

Operating

Activities

Cash Flows from

Operating

Activities

Cash Flows from Operating Activities

Inflows Receipts from sales. Commissions and fees. Interest and dividends

received.

Inflows Receipts from sales. Commissions and fees. Interest and dividends

received.

Outflows Payments for inventory. Salaries and wages. Operating expenses Interest on liabilities. Taxes.

Outflows Payments for inventory. Salaries and wages. Operating expenses Interest on liabilities. Taxes.

Cash Flows from

Investing Activities

Cash Flows from

Investing Activities

Cash Flows from InvestingActivities

InflowsSelling property, plant, and

equipment.Selling investment

securities.Collecting loans.

InflowsSelling property, plant, and

equipment.Selling investment

securities.Collecting loans.

Outflows Purchasing property, plant, and

equipment. Purchasing investment

securities. Lending to others.

Outflows Purchasing property, plant, and

equipment. Purchasing investment

securities. Lending to others.

Cash Flows from

Financing Activities

Cash Flows from

Financing Activities

Cash Flows from Financing Activities

InflowsBorrowing. Issuing stock.

InflowsBorrowing. Issuing stock.

Outflows Repaying debt (excluding

interest). Purchasing treasury stock. Paying dividends.

Outflows Repaying debt (excluding

interest). Purchasing treasury stock. Paying dividends.

Significant noncash investing and financing transactions must be reported separately.

Example: issuing common stock in exchange for land.

Significant noncash investing and financing transactions must be reported separately.

Example: issuing common stock in exchange for land.

Noncash Investing and Financing Transactions

Cash flows from operating

activities can be prepared using either the direct method or the

indirect method.

Cash flows from operating

activities can be prepared using either the direct method or the

indirect method.Let’s look at the direct method

first.

Let’s look at the direct method

first.

Cash Flows from Operating Activities

Accrual basis revenue includes sales that did not result in cash inflows.

Cash received from customers can be computed as follows:

Cash received from customers

Cash received from customers

Decrease in receivablesDecrease in receivables

Increase in receivablesIncrease in receivables

+

–

=

=

Net salesNet sales

Converting from Accrual to Cash-Basis Accounting

Converting from Accrual to Cash-Basis Accounting

We will use T-accounts toanalyze changes in accounts.

Let’s look at an example.

We will use T-accounts toanalyze changes in accounts.

Let’s look at an example.

The Accounts Receivable balance was The Accounts Receivable balance was $27,000 on 12/31/04 and $35,000 on $27,000 on 12/31/04 and $35,000 on

12/31/05. If accrual Sales Revenue for 12/31/05. If accrual Sales Revenue for 2005 was $800,000, what were cash 2005 was $800,000, what were cash

receipts from sales?receipts from sales?

The Accounts Receivable balance was The Accounts Receivable balance was $27,000 on 12/31/04 and $35,000 on $27,000 on 12/31/04 and $35,000 on

12/31/05. If accrual Sales Revenue for 12/31/05. If accrual Sales Revenue for 2005 was $800,000, what were cash 2005 was $800,000, what were cash

receipts from sales?receipts from sales?

Converting from Accrual to Cash-Basis Accounting

27,000

800,000

35,000

12/31/04 Balance

12/31/05 Balance

Accrual Sales Revenue

Accounts Receivable

Cash receipts =

The Accounts Receivable balance was The Accounts Receivable balance was $27,000 on 12/31/04 and $35,000 on $27,000 on 12/31/04 and $35,000 on

12/31/05. If accrual Sales Revenue for 12/31/05. If accrual Sales Revenue for 2005 was $800,000, what were cash 2005 was $800,000, what were cash

receipts from sales?receipts from sales?

The Accounts Receivable balance was The Accounts Receivable balance was $27,000 on 12/31/04 and $35,000 on $27,000 on 12/31/04 and $35,000 on

12/31/05. If accrual Sales Revenue for 12/31/05. If accrual Sales Revenue for 2005 was $800,000, what were cash 2005 was $800,000, what were cash

receipts from sales?receipts from sales?

$792,000

$27,000 + $800,000 - $35,000$27,000 + $800,000 - $35,000

Converting from Accrual to Cash-Basis Accounting

The Salaries Payable balance was $7,000 on 12/31/04 and $5,000 on 12/31/05. If accrued Salaries Expense for 2005 was $80,000, what amount of cash was paid

for salaries?

The Salaries Payable balance was $7,000 on 12/31/04 and $5,000 on 12/31/05. If accrued Salaries Expense for 2005 was $80,000, what amount of cash was paid

for salaries?

Now let’s use T-account analysis for a liability account with anaccrued expense.

Now let’s use T-account analysis for a liability account with anaccrued expense.

Converting from Accrual to Cash-Basis Accounting

The Salaries Payable balance was $7,000 on 12/31/04 and $5,000 on 12/31/05. If accrual Salaries Expense for 2005 was

$80,000, what amount of cash was paid for salaries?

The Salaries Payable balance was $7,000 on 12/31/04 and $5,000 on 12/31/05. If accrual Salaries Expense for 2005 was

$80,000, what amount of cash was paid for salaries?

12/31/04 Balance

12/31/05 Balance

Accrued Salaries Expense

Salaries Payable

Cash payments =

7,000

80,000

5,000

$82,000

$7,000 + $80,000 - $5,000$7,000 + $80,000 - $5,000

Direct MethodNow that we have

seen the T-account method of analysis,

let’s use it to prepare a Direct Method

Statement of Cash Flows for Batson

Company.

We will begin with by analyzing changes in

balance sheet accounts.

Batson Company.

Comparative Balance Sheets - Assets

December 31,

2004 2005Cash 60,000$ 70,000$ Accounts Receivable, net 27,000 35,000 Inventory 230,000 200,000 Land 95,000 167,000 Buildings, net 300,000 325,000 Equipment, net 200,000 126,000

Total Assets 912,000$ 923,000$

Batson Company

Comparative Balance Sheets - Liabilities and Equity

December 31,

2004 2005

Liabilities Accounts Payable 15,000$ 12,000$ Salaries Payable 7,000 5,000 Interest Payable 11,950 14,450 Income Tax Payable 20,000 17,000 Notes Payable 70,000 60,000 Bonds Payable 250,000 150,000 Stockholders' Equity Common Stock 450,000 500,000 Retained Earnings 88,050 164,550 Total Liabilities and Equity 912,000$ 923,000$

Batson CompanyIncome Statement

For the Year Ending December 31, 2005

Sales Revenues 800,000$ Cost of Goods Sold 460,000 Gross Margin 340,000 Depreciation Expense 10,000$ Interest Expense 24,500 Salary Expense 80,000 Other Expenses 71,000 185,500 Operating Income 154,500 Gain on Sale of Equipment 3,000 Loss Due to Flood (30,000) Income Before Tax 127,500 Income Tax Expense 51,000 Net Income 76,500$

Direct MethodAdditional Information

Depreciation on buildings was $6,000 in 2005. Depreciation on equipment was $4,000 in 2005.

A building addition in 2005 cost $31,000, paid in cash.

Equipment with a book value of $40,000 was sold during the year for $43,000.

Equipment with a book value of $30,000 was destroyed during a flood in 2005. There was no insurance.

Batson had no noncash financing and investing activities.

Additional Information Depreciation on buildings was $6,000 in

2005. Depreciation on equipment was $4,000 in 2005.

A building addition in 2005 cost $31,000, paid in cash.

Equipment with a book value of $40,000 was sold during the year for $43,000.

Equipment with a book value of $30,000 was destroyed during a flood in 2005. There was no insurance.

Batson had no noncash financing and investing activities.

Direct MethodAdditional Information

Batson’s tax rate is 40%. Interest Expense on Notes Payable was $6,500. Interest Expense on Bonds Payable was $18,000. Issued Common Stock during 2005 for $50,000. Other Expenses of $71,000 were paid in cash.

Additional Information Batson’s tax rate is 40%. Interest Expense on Notes Payable was $6,500. Interest Expense on Bonds Payable was $18,000. Issued Common Stock during 2005 for $50,000. Other Expenses of $71,000 were paid in cash.

Let’s get started analyzing the accounts. First, we willreview the T-account analysis that we completed earlier.

Then we will analyze the remaining balance sheet accounts starting with the current accounts.

12/31/04 Balance

12/31/05 Balance

Accrual sales revenue

Accounts Receivable

Cash receipts = $792,000

27,000

800,000

35,000

12/31/04 Balance

12/31/05 Balance

Accrued salaries expense

Salaries Payable

Cash Payments = $82,000

7,000

80,000

5,000

12/31/04 Balance

12/31/05 Balance

Cost of Goods Sold

Inventory

Purchases =

230,000

460,000

200,000

12/31/04 Balance

12/31/05 Balance

Purchases

Accounts Payable

Cash Payments =

15,000

430,000

12,000

$430,000

$433,000

12/31/04 Balance

12/31/05 Balance

Interest Expense

Interest Payable

Cash payments =

11,950

24,500

14,450

12/31/04 Balance

12/31/05 Balance

Income Tax Expense

Income Taxes Payable

Cash payment =

20,000

51,000

17,000

$22,000

$54,000

Direct MethodNow, that we have

analyzed the current accounts and found

the cash receipts and cash payments related to operations, we are ready to prepare the

Cash Flows from Operating Activities

portion of the Statement of Cash

Flows.

Cash Flow from Operating Activities

Now, Let’s continue to use the T-account analysis for the

remaining noncurrent balance sheet

accounts.

Direct Method

12/31/04 Balance

12/31/05 Balance

Depreciation

Buildings, Net

Cash paid for addition =

300,000

6,000

325,000

12/31/04 Balance

12/31/05 Balance

Depreciation

Equipment, Net40,000

200,000 30,000

4,000

126,000

Flood loss

Equipment sale

$31,000

12/31/04 Balance

12/31/05 Balance

Land

Cash paid for land purchase =

95,000

167,000

After completing the analysis of noncurrent assets,we are ready to prepare the Cash Flow from

Investing portion of the Statement of Cash flows.

$72,000

Cash Flow from Investing Activities

Next, we will analyze noncurrent liabilities and equity so that we can

prepare the Cash Flow from Financing portion of the Statement

of Cash flows.

12/31/04 Balance

12/31/05 Balance

Notes Payable

Cash paid to retire notes =

70,000

60,000

12/31/04 Balance

12/31/05 Balance

Bonds Payable

Cash paid to retire bonds =

250,000

150,000

$10,000

$100,000

12/31/04 Balance

12/31/05 Balance

Common Stock

Cash received from stocksale =

450,000

50,000

After completing the analysis of noncurrent liabilitiesand equity, we are ready to prepare the Cash Flow

from Financing portion of the Statement of Cash flows.

$50,000

Cash Flow from Financing Activities

Next, we will put the three sections together to completethe Statement of Cash Flows.

Batson Company.Statement of Cash Flows

For the Period Ending December 31, 2005

Cash Fows from Operating Activities 130,000$

Cash flows from Investing Activities (60,000)

Cash flows from Financing Activities (60,000)

Net Cash Flows for the Period 10,000$

Add: Beginning Cash Balance 60,000

Ending Cash Balance 70,000$

Notice that the Ending Cash Balance on the Statement of Cash Flows agrees with

the 12/31/05 Cash balance on the Balance Sheet.

Notice that the Ending Cash Balance on the Statement of Cash Flows agrees with

the 12/31/05 Cash balance on the Balance Sheet.

Now let’s look at the Indirect Method that is used by over 95% of all

companies.

Indirect Method

A Comparison of the Direct and Indirect Methods

Net cash flow is the same for both methods. The Direct Method provides more detail

about cash from operating activities. The investing and financing sections for the

two methods are identical.

Net cash flow is the same for both methods. The Direct Method provides more detail

about cash from operating activities. The investing and financing sections for the

two methods are identical.

Net Income

Net Income

Cash Flows from

Operating Activities

Cash Flows from

Operating Activities

Indirect Method

Changes in current assets and current liabilities as shown on the following table.

Changes in current assets and current liabilities as shown on the following table.

+ Losses and - Gains

+ Losses and - Gains

+ Noncash expenses such as depreciation and

amortization.

+ Noncash expenses such as depreciation and

amortization.

Use this table when adjusting Net Income

to Cash Flow form Operations.

Use this table when adjusting Net Income

to Cash Flow form Operations.

Indirect Method

We will use the Indirect Method to prepare the

Cash Flows from Operating Activities for the Batson Company.

First, we will review the Balance Sheet and

Income Statement for Batson Company.

Indirect Method

Batson Company.

Comparative Balance Sheets - Assets

December 31,

2004 2005Cash 60,000$ 70,000$ Accounts Receivable, net 27,000 35,000 Inventory 230,000 200,000 Land 95,000 167,000 Buildings, net 300,000 325,000 Equipment, net 200,000 126,000

Total Assets 912,000$ 923,000$

Batson Company

Comparative Balance Sheets - Liabilities and Equity

December 31,

2004 2005

Liabilities Accounts Payable 15,000$ 12,000$ Salaries Payable 7,000 5,000 Interest Payable 11,950 14,450 Income Tax Payable 20,000 17,000 Notes Payable 70,000 60,000 Bonds Payable 250,000 150,000 Stockholders' Equity Common Stock 450,000 500,000 Retained Earnings 88,050 164,550 Total Liabilities and Equity 912,000$ 923,000$

Batson CompanyIncome Statement

For the Year Ending December 31, 2005

Sales Revenues 800,000$ Cost of Goods Sold 460,000 Gross Margin 340,000 Depreciation Expense 10,000$ Interest Expense 24,500 Salary Expense 80,000 Other Expenses 71,000 185,500 Operating Income 154,500 Gain on Sale of Equipment 3,000 Loss Due to Flood (30,000) Income Before Tax 127,500 Income Tax Expense 51,000 Net Income 76,500$

The Indirect Method begins with Net Income, which is then adjusted for the non-cash items

included in net income.

For Batson, the only non-cash items are depreciation, and gains and losses.

The Indirect Method begins with Net Income, which is then adjusted for the non-cash items

included in net income.

For Batson, the only non-cash items are depreciation, and gains and losses.

(Remember, we showed the balance sheets a few slides earlier.)

To complete the Cash flows from operating activities section, we must examine comparative balance sheets

to determine the changes in current assets and current liabilities from the beginning of the period to

the end of the period.

To complete the Cash flows from operating activities section, we must examine comparative balance sheets

to determine the changes in current assets and current liabilities from the beginning of the period to

the end of the period.

Statement of Cash Flows Indirect Method Example

Remember that when we prepared the operating section using the Direct Method, we also arrived at

Net Cash flows from Operating Activities of $130,000.

Remember that when we prepared the operating section using the Direct Method, we also arrived at

Net Cash flows from Operating Activities of $130,000.

Because the investingand financing sections

are identical with eithermethod of preparation,

we will not repeatthose sections of the

statement.

Indirect Method

The Financial Analyst

The statement focusesattention on:

Ability to generate cashfrom its operations.

Management of currentassets and current liabilities.

Expenditures forlong-term assets.

Amount received fromexternal financing.

End of Chapter Twelve