T-Account Approach to Preparing a Statement of Cash Flows Indirect Method

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1 266 Part 1 E M Foundations of Financial Accounting With these adjustments to the income statement, we can now present the operating activities section of the statement of cash flows using either the direct or indirect methods. The indirect method would involve beginning with net income and adding or subtracting the adjustments (in the third column of the matrix) to arrive at cash flow from operations of $57,000. The direct method would simply detail the figures presented in the fourth column of the matrix. The formal cash flow statement, using the indirect method, is shown later in this section. T-Account Approach to Preparing a Statement of Cash Flows Indirect Method With a comprehensive T-account approach, special cash flow T-accounts are established. These accounts are used to summarize cash flows from operations and from investing and financing activities during the period. They provide the basis for preparing the formal cash flow statement. Individual T-accounts are also established for Cash and all other balance sheet accounts. During the process of analysis, the change in each account is explained as providing or using cash. In the three T-accounts summarizing cash flows from operating, investing, and financing activities, a debit represents an increase in cash, while a credit reflects a decrease. Once the changes in all balance sheet accounts have been reconciled and the cash flow T-accounts balanced, the formal cash flow statement can be prepared. In preparing a cash flow statement for Western Resources, Inc., we begin by determining the change in the cash balance, in this case an $8,700 decrease. All noncash accounts may now be analyzed using the T-accounts illustrated on pages 268 and 269.As noted, the cash flow statement is prepared directly from the cash flow T-accounts and is illustrated following those T-accounts. Generally, the most efficient approach to developing T-accounts for a statement of cash flows is to begin with an analysis of the change in Retained Earnings. After the change in Retained Earnings has been accounted for, the remaining noncash accounts should be reviewed in conjunction with the income statement and supplementary information to determine what additional adjustments are required. Operating income should be adjusted to determine the actual amount of cash provided or used by operations [items (e), (i), (j), and (l) (p)]. Analysis must also be made to determine all other cash flows from investing and financing activities [items (b), (c), (d), (e), (f), (h), (k), and (q)] and to reflect significant investing and financing activities that have no effect on cash [item (g)]. Explanations for individual adjustments for Western Resources, Inc., follow. The letter preceding each explanation corresponds with that used in the T-accounts, which are presented on pages 268 and 269. Entries are presented to help explain the preparation of a statement of cash flows. They are not journal entries that would be recorded in the accounting records. (a) Net income is recorded in the T-accounts as follows: Cash Flows Operating... 36,300 Retained Earnings... 36,300 (b) The cash dividends declared and deducted from retained earnings are adjusted for the change in the dividends payable balance in arriving at the amount of dividends actually paid during the year. The entry would be: Retained Earnings... 25,100 Dividends Payable... 4,400 Cash Flows Financing... 20,700 (c) The destruction of the building and the subsequent insurance reimbursement have the effect of providing cash of $10,000, the proceeds from the insurance company. The entry would be:

2 The Statement of Cash Flows E M Chapter Accumulated Depreciation Buildings... 30,000 Cash Flows Investing... 10,000 Buildings... 40,000 (d) The buildings account was increased by the cost of constructing a new building, $105,000. The cost of the new building is reported separately as an investment of cash by the following entry: Buildings ,000 Cash Flows Investing ,000 (e) The sale of long-term investments was recorded by a credit to the asset account at cost, $96,000, and a credit to a gain on sale of investment account.at the end of the period, the gain account was closed to Retained Earnings as part of income from continuing operations. Because the effect of the sale was to provide cash of $102,500, this amount is reported as cash provided by investing activities. The investments account balance is reduced, and cash provided by operations is decreased by the amount of the gain. The following adjustment is made: Cash Flows Investing ,500 Investments... 96,000 Cash Flows Operating... 6,500 (f) and (g) Land was acquired at a price of $108,500; payment was made in common stock valued at $40,000 and cash of $68,500. Two separate entries are made to segregate the cash and noncash components of this transaction: (f) Land... 68,500 Cash Flows Investing... 68,500 (g) Land... 40,000 Common Stock... 40,000 The issuance of common stock for land has no effect on cash, but it is a significant transaction that should be disclosed separately. Recall that the body of the cash flow statement reports only transactions affecting cash, in accordance with FASB Statement No. 95. (h) Machinery costing $12,000 was acquired during the year. Payment was made in cash and is reported as cash used for investing purposes. The adjustment for the acquisition of machinery is: Machinery and Equipment... 12,000 Cash Flows Investing... 12,000 (i) and (j) The changes in the accumulated depreciation accounts and in the patents account result from the recognition of depreciation and amortization expenses for the period. These noncash expenses are added in computing cash flows from operations by the following adjustments: (i) Cash Flows Operating... 20,900 Accumulated Depreciation Buildings... 5,600 Accumulated Depreciation Machinery and Equipment... 15,300 (j) Cash Flows Operating... 5,000 Patents... 5,000 (k) During the year, bonds were issued at their face value of $30,000. The entry is: Cash Flows Financing... 30,000 Bonds Payable... 30,000 (l) (p) In preparing a cash flow statement, operating income must be adjusted from an accrual basis to a cash basis, as explained earlier in the chapter. The entries (l) through (p) reflect that analysis for Western Resources, Inc.:

3 268 Part 1 E M Foundations of Financial Accounting (l) Cash Flows Operating... 10,500 Accounts Receivable... 10,500 (m) Cash Flows Operating... 1,500 Inventories... 1,500 (n) Prepaid Operating Expenses... 4,500 Cash Flows Operating... 4,500 (o) Accounts Payable... 6,700 Cash Flows Operating... 6,700 (p) Cash Flows Operating Income Taxes Payable (q) As noted earlier in the chapter, available-for-sale securities are treated differently from other current assets in preparing a cash flow statement. The adjustment to reflect the purchase of $2,000 of available-for-sale securities would be: Available-for-Sale Securities... 2,000 Cash Flows Investing... 2,000 (r) After all changes in account balances have been reconciled and the effects of the changes on cash flow have been recorded in the cash flows T-accounts, the balances of those T-accounts are determined and transferred to a Cash Flows Summary T-account as shown below. The excess of credits (decreases in cash) over debits (increases in cash) is equal to the net change in the cash balance for the period of $8,700. The following entry is made to reflect the net decrease in cash: Net Decrease in Cash... 8,700 Cash... 8,700 Cash Flows Operating (a) 36,300 (e) 6,500 (i) 20,900 (n) 4,500 (j) 5,000 (o) 6,700 (l) 10,500 (m) 1,500 (p) 500 Net cash provided by operating activities 57,000 Cash Flows Investing (c) 10,000 (d) 105,000 (e) 102,500 (f) 68,500 (h) 12,000 (q) 2,000 Net cash used in investing activities 75,000 Cash Flows Financing (k) 30,000 (b) 20,700 Net cash provided by financing activities 9,300 Net cash provided operating Net cash used investing Net cash provided financing Net decrease in cash Cash Flows Summary 57,000 9,300 (r) 8,700 75,000 75,000 75,000

4 The Statement of Cash Flows E M Chapter Cash and Cash Equivalents Beg. bal. 55,000 (r) 8,700 End. bal. 46,300 Accounts Receivable Beg. bal. 70,500 (l) 10,500 End. bal. 60,000 Available-for-Sale Securities Beg. bal. 10,000 (q) 2,000 End. bal. 12,000 Inventories Beg. bal. 76,500 (m) 1,500 End. bal. 75,000 Prepaid Operating Expenses Beg. bal. 12,000 (n) 4,500 End. bal. 16,500 Beg. bal. 75,000 (f) 68,500 (g) 40,000 End. bal. 183,500 Land Investments Beg. bal. 106,000 (e) 96,000 End. bal. 10,000 Buildings Beg. bal. 225,000 (c) 40,000 (d) 105,000 End. bal. 290,000 Accumulated Depreciation Buildings (c) 30,000 Beg. bal. 155,000 (i) 5,600 End. bal. 130,600 Beg. bal. 120,000 (h) 12,000 End. bal. 132,000 Machinery and Equipment Accumulated Depreciation Machinery and Equipment Beg. bal. 43,500 (i) 15,300 End. bal. 58,800 Patents Beg. bal. 40,000 (j) 5,000 End. bal. 35,000 Accounts Payable (o) 6,700 Beg. bal. 97,700 Dividends Payable End. bal. 91,000 Beg. bal. 0 (b) 4,400 End. bal. 4,400 Income Taxes Payable Bonds Payable Beg. bal. 9,500 (p) 500 End. bal. 10,000 Beg. bal. 0 (k) 30,000 End. bal. 30,000 Common Stock Beg. bal. 250,000 (g) 40,000 End. bal. 290,000 Retained Earnings (b) 25,100 Beg. bal. 234,300 (a) 36,300 End. bal. 245,500

5 270 Part 1 E M Foundations of Financial Accounting All T-accounts are now complete, and a statement of cash flows for Western Resources, Inc., can be prepared in an appropriate format, such as the one below. Western Resources, Inc. Statement of Cash Flows For the Year Ended December 31, 2002 Cash flows from operating activities: Net income... $ 36,300 Adjustments: Depreciation expense... 20,900 Amortization of patents... 5,000 Gain on sale of investments... (6,500) Decrease in accounts receivable... 10,500 Decrease in inventories... 1,500 Increase in prepaid operating expenses... (4,500) Decrease in accounts payable... (6,700) Increase in income taxes payable Net cash provided by operating activities... $57,000 Cash flows from investing activities: Involuntary conversion of building... $ 10,000 Construction of building... (105,000) Sale of long-term investments ,500 Purchase of land... (68,500) Purchase of machinery and equipment... (12,000) Purchase of available-for-sale securities... (2,000) Net cash used in investing activities... (75,000) Cash flows from financing activities: Issuance of bonds... $ 30,000 Payment of cash dividends... (20,700) Net cash provided by financing activities... 9,300 Net decrease in cash and cash equivalents... $ (8,700) Cash and cash equivalents at beginning of year... 55,000 Cash and cash equivalents at end of year... $46,300 Supplemental Disclosure: Cash payments for: Interest... $ 3,600 Income taxes... 23,500 Noncash transaction: Land acquired by issuing common stock... 40,000 A reader analyzing the cash flow statement for Western Resources, Inc., can readily see that $57,000 cash was provided internally from operating activities. This amount was not sufficient to satisfy the investment needs of the company, and so additional cash was generated from external financing activities involving the issuance of bonds. The cash generated from operations clearly met the need for payment of cash dividends, but when other cash needs are considered, the total cash outflow exceeded the total inflow of cash for the period, causing the cash balance to decrease by $8,700, or 15.8%. In addition to the formal statement of cash flows, supplemental disclosure is required for significant noncash investing and financing transactions. Thus, Western Resources would report the acquisition of land valued at $40,000 in exchange for common stock. When the indirect method is used to report operating activities, the amount of cash paid for interest and income taxes also must be disclosed. For Western Resources, the amount paid for interest, $3,600, is taken directly from the income statement because there is no interest payable at the beginning or end of the year.the amount paid for taxes is determined as follows:

6 The Statement of Cash Flows E M Chapter Income tax expense (reported in the income statement)... $24,000 Deduct increase in income taxes payable... (500) Amount of cash paid for income taxes... $23,500 In the Western Resources illustration, the supplemental disclosures are presented in a schedule accompanying the statement of cash flows. Alternatively, the information could be presented in the notes to the financial statements. Work Sheet Approach to Preparing a Statement of Cash Flows Indirect Method This section illustrates a work sheet approach to preparing a statement of cash flows using the indirect method. As shown, this approach produces the same results as the T- account approach; only the format is different. To highlight the similarities in the two approaches, the information and account analysis used in the T-account illustration for Western Resources, Inc., will also be used for the work sheet illustration. Using a work sheet, such as the one on page 272, facilitates the analysis of account changes when using the indirect method. The format of the work sheet is straightforward. The first amount column contains the beginning balances, then there are two columns for analysis of transactions to arrive at the ending balances in the fourth column. In preparing a work sheet, accumulated depreciation balances, instead of being reported as credit balances in the debit (asset) section, may be more conveniently listed with liability and owners equity balances in the credit section. Similarly, contra liability accounts and contra owners equity balances may be separately recognized and more conveniently listed with assets in the debit section. The lower portion of the work sheet shows the major categories of cash flows: operating, investing, and financing. A debit in the lower section means an increase in cash, while a credit is a decrease in cash. It is from the lower section of the work sheet that the formal statement of cash flows is prepared. In following the illustration, it may be helpful to refer to the detailed explanations for individual adjustments described on Once the changes in all accounts have been reconciled and the work sheet is complete, the formal cash flow statement can be prepared, as illustrated on page 270. CONCLUSION This chapter has been an overview of the statement of cash flows. Along with the balance sheet and the income statement, the statement of cash flows is one of the three primary financial statements. However, because it is relatively new (required only since 1988), it sometimes does not receive the emphasis that it deserves. Cash flow variables and ratios are only now starting to make it into the mainstream of financial statement analysis. You are now a cash flow statement expert; be patient with those who learned their accounting back in the pre-1988 days of the statement of changes in financial position. All the basic aspects of cash flow reporting and disclosure have been covered in this chapter. Additional complexities are introduced in later chapters as appropriate. An expanded illustration, incorporating these complexities, is provided in the last chapter of the text. You might start thinking now about how the cash flow statement will be affected by revenue recognition assumptions, FIFO and LIFO, capitalize or expense decisions, operating leases, bonds issued at a discount, stock splits and dividends....

7 272 Part 1 E M Foundations of Financial Accounting Western Resources, Inc. Work Sheet for Statement of Cash Flows Indirect Method For the Year Ended December 31, 2002 Balance Adjustments Balance Dec. 31, Dec. 31, Accounts 2001 Debit Credit 2002 Debits Cash and Cash Equivalents... 55,000 (r) 8,700 46,300 Available-for-Sale Securities... 10,000 (q) 2,000 12,000 Accounts Receivable... 70,500 (l) 10,500 60,000 Inventories... 76,500 (m) 1,500 75,000 Prepaid Operating Expenses... 12,000 (n) 4,500 16,500 Investments ,000 (e) 96,000 10,000 Land... 75,000 (f) 68,500 (g) 40, ,500 Buildings ,000 (d) 105,000 (c) 40, ,000 Machinery and Equipment ,000 (h) 12, ,000 Patents... 40,000 (j) 5,000 35, , ,300 Credits Accumulated Depreciation Buildings ,000 (c) 30,000 (i) 5, ,600 Accumulated Depreciation Machinery and Equipment... 43,500 (i) 15,300 58,800 Accounts Payable... 97,700 (o) 6,700 91,000 Income Taxes Payable... 9,500 (p) ,000 Dividends Payable... 0 (b) 4,400 4,400 Bonds Payable... 0 (k) 30,000 30,000 Common Stock ,000 (g) 40, ,000 Retained Earnings ,300 (b) 25,100 (a) 36, , , , , ,300 Cash flows from operating activities: Net income... (a) 36,300 Adjustments: Depreciation expense... (i) 20,900 Amortization of patents... (j) 5,000 Gain on sale of investments... (e) 6,500 Decrease in accounts receivable... (l) 10,500 Decrease in inventories... (m) 1,500 Increase in prepaid operating expenses... (n) 4,500 Decrease in accounts payable... (o) 6,700 Increase in income taxes payable... (p) 500 Cash flows from investing activities: Involuntary conversion of building... (c) 10,000 Construction of building... (d) 105,000 Sale of long-term investments... (e) 102,500 Purchase of land... (f) 68,500 Purchase of machinery and equipment... (h) 12,000 Purchase of available-for-sale securities... (q) 2,000 Cash flows from financing activities: Issuance of bonds... (k) 30,000 Payment of cash dividends... (b) 20, , ,900 Net decrease in cash... (r) 8, , ,900