The Income Statement and Statement of Cash Flows

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1 THE STATEMENT OF CASH FLOWS Purpose of the Statement of Cash Flows The purpose of the statement of cash flows is to identify the sources and uses of cash and the change in cash from the beginning to the end of the accounting period. The sources (cash receipts) and uses (cash disbursements) are classified into three categories. 1. Operating Activities: Cash receipts from sales and cash disbursements for cost of goods sold and operating expenses that are incurred to generate the sales. For financial accounting purposes operating activities include the receipt of dividends and interest and the payment of interest. 2. Investing Activities: Cash paid for the acquisition of fixed assets and investments and cash received from their disposition. 3. Financing Activities: Cash received from the issuance of debt or equity financing and cash paid for the retirement of financing as well as the payment of dividends. Content and Format of the Statement of Cash Flows The basic format of the statement of cash flows is as follows: Cash flows from operating activities $ Cash flows from investing activities $ Cash flows from financing activitie $ Net increase (decrease in cash for the year) $ Beginning cash balance $ Ending cash balance $ Preparation of the Statement of Cash Flows There are two approaches to preparing the statement of cash flows. In the direct method operating activities are presented as total cash receipts from sales and cash disbursements for cost of sales and other operating activities. In the indirect method operating activities are a reconciliation of net income. In this course we will be using the indirect method. Cash flows from operating activities: Net income $ Add: Noncash charges $ Increases in current liabilities $ Decreases in current assets $ Less: Increases in current assets $ Decreases in current liabilities $ Add: Losses from investing or financing activities $ Less: Gains from investing or financing activities $ $ Net cash provided by (used by) operating activities $ E:\Teaching\3321\web\module2\c4\tnotes\c4b.doc 1/31/2007 1

2 Use of the Cash Flows Worksheet Using the cash flows worksheet simplifies the process of preparing a statement of cash flows. We will be using a cash flows worksheet to complete the exercises assigned in this lesson. The worksheet starts with a listing of the beginning and ending balances of each account on the balance sheet. We then examine changes in each account and enter those amounts in a multi-column worksheet. For example, had a cash balance of $70,000 at the beginning of 2002 and a cash balance of $100,000 at the end of the year. The change in cash of $30,000 needs to be separated into operating activities, investing activities and financing activities. The work sheet is our starting point to complete this task. Changes in Cash Increase Decrease Cash 100,000 70,000 30,000 Accounts receivable 50,000 60,000 10,000 Investments 30,000 60,000 30,000 Equipment 300, ,000 50,000 Less: Accumulated depreciation (110,000) (90,000) 20,000 Current liabilities (50,000) (60,000) 10,000 Capital stock (160,000) (160,000) Retained earnings (160,000) (130,000) 30, ,000 60,000 In analyzing the changes in cash we can see from the work sheet the increases in current assets result in decreases in cash. If we make sales on credit the amounts are included in net income but are not reflected in the cash account. Likewise when we pay down our current liabilities this uses cash which is not reflected in the net income amount. Once we have reconciled the increases and decreases in cash as a result of changes in the account balances we are ready to examine the income statement. In this case the company had net income of $60,000. Also included in the income statement was a loss on the sale of investments. The change in the investments account reflects the original cost of the investment that was sold. In analyzing the accounts we also discover that dividends were declared and paid in the amount of $30,000 during the E:\Teaching\3321\web\module2\c4\tnotes\c4b.doc 1/31/2007 2

3 year. With this information on hand we can now extend the work sheet. The following shows the extensions to the Operating Activities columns (items shaded in green). Changes in Cash Operating Increase Decrease Increase Decrease Cash 30,000 Accounts receivable 10,000 10,000 Investments 30,000 Equipment 50,000 Less: Accumulated depreciation 20,000 20,000 Current liabilities 10,000 10,000 Capital stock Retained earnings 30,000 90,000 60,000 Analysis of retained earnings: Net income 60,000 Dividends paid Loss on sale of investments 10, ,000 10,000 Changes in cash flow 30,000 90,000 10,000 10,000 The extension to operating activities includes the extension of changes in current assets and current liabilities as well as non-cash charges to net income such as depreciation expense. We were not given any information regarding the disposition of fixed assets with accumulated depreciation so therefore the change in accumulated depreciation is the depreciation expense charged to net income for the year. Rather than analyzing the changes in the retained earnings account on a single line we have expanded the analysis in the section below the balance sheet accounts (items shaded in pink). We start with net income which is the starting point for the operating activities and add back the loss on sale of investments. The amount is included in net income on the income statement but belongs in the investing activities section of the cash flow statement. We can think of this as just a transfer from one section to another. E:\Teaching\3321\web\module2\c4\tnotes\c4b.doc 1/31/2007 3

4 After extending all of the information to the operating activities portion of the work sheet we foot the columns and calculate a cash inflow of $100,000 and a cash outflow of $10,000 to give us a net cash inflow for the year of $90,000 (items shaded in yellow). This information will be transcribed to the statement of cash flows. We repeat the process for the investing activities section of the cash flow statement (items shaded in blue). The following is the extension for. Changes in Cash Investing Increase Decrease Increase Decrease Cash 30,000 Accounts receivable 10,000 Investments 30,000 30,000 Equipment 50,000 50,000 Less: Accumulated depreciation 20,000 Current liabilities 10,000 Capital stock Retained earnings 30,000 90,000 60,000 Analysis of retained earnings: Net income Dividends paid Loss on sale of investments 10,000 30,000 60,000 Changes in cash flow 30,000 30,000 30,000 30,000 The disposition of the investment resulted in a loss. If we combine this loss with the original basis in the investment we will be able to derive the cash received from the disposition of the investment. In this case we received $20,000 in cash from the sale of the investment. Selling price $20,000 Original cost 30,000 Loss on disposition $10,000 E:\Teaching\3321\web\module2\c4\tnotes\c4b.doc 1/31/2007 4

5 The other transaction that will be reported in the cash flow statement is the purchase of equipment in the amount of $50,000. By footing the columns of the investing activities we see that there was $30,000 in cash outflow for the accounting period. Once the amounts are extended to the financing columns of the work sheet we can conduct an analysis of cash flow from financing activities (items shaded in orange). The following is an excerpt from the original work sheet for. Changes in Cash Financing Increase Decrease Increase Decrease Cash 30,000 Accounts receivable 10,000 Investments 30,000 Equipment 50,000 Less: Accumulated depreciation 20,000 Current liabilities 10,000 Capital stock Retained earnings 30,000 90,000 60,000 Analysis of retained earnings: Net income Dividends paid 30,000 Loss on sale of investments - 30,000 Changes in cash flow 30,000 30, In this example the only financing activity is the declaration and payment of dividends. Therefore the cash outflow from financing activities was $30,000 for the year. Using Excel a cash flow statement can be prepared by linking the items on the cash flow work sheet to a separate page where the cash flow statement is formatted. The following is the completed cash flow statement for. E:\Teaching\3321\web\module2\c4\tnotes\c4b.doc 1/31/2007 5

6 Statement of Cash Flows Cash flows from operating activties Net income $60,000 Adjustments to reconcile net income to net cash provided by operating activities Depreciation $20,000 Decrease in accounts receivable 10,000 Decrease in accrued liabilities (10,000) Loss on sale of investments 10,000 30,000 Net cash provided by operating activities 90,000 Cash flows from investing activities Sale of investments 20,000 Purchase of equipment (50,000) Net cash used in investing activities (30,000) Cash flows from financing activities Dividends paid (30,000) Net cash used in financing activities (30,000) Net increase increase in cash 30,000 Cash at beginning of year 70,000 Cash at end of year $100,000 Noncash Investing and Financing Activities A separate disclosure is made at the bottom of the cash flow statement identifying any significant investing or financing activities that were executed without any cash changing hands. We will explore how this is handled on the cash flow work sheet and as well as the disclosure in the statement when we reexamine this subject in Chapter 22. E:\Teaching\3321\web\module2\c4\tnotes\c4b.doc 1/31/2007 6