13–1

Chapter 13

The Statement of Cash Flows

13–2Copyright © Cengage Learning. All rights reserved.

Amazon.com

Founded in 1995, Amazon largest on-line merchandising company in the world

one of the 500 largest companies in the US

Strong cash flows to maintain growth and liquidity

Cash provided by operations more than doubled from 2006 to 2007

13–3Copyright © Cengage Learning. All rights reserved.

LO1 Statement of Cash Flows

Shows how a company’s operating, investing, and financing activities have affected cash during an accounting period

Explains the net increase or decrease in cash

Cash may include: Cash Cash equivalents Money market accounts Commercial paper U.S. Treasury bills

© Royalty Free PhotoDisc/ Getty Images

13–4Copyright © Cengage Learning. All rights reserved.

How Is the Statement of Cash Flows Used?

Pay dividends and interest

Pay its liabilities

Generate positive future cash flows

Manage cash flows

Investors and creditors assess the company’s ability to

Evaluate financing decisions

Evaluate investment decisions

Determine dividend policy

Assess liquidity

Managers

13–5Copyright © Cengage Learning. All rights reserved.

Classification of Cash Flows

The statement of cash flows classifies cash receipts and cash payments into categories

Operating Activities

Investing Activities

Financing Activities

13–6Copyright © Cengage Learning. All rights reserved.

Operating Activities

Involve the cash inflows and outflows from activities that enter into the determination of net income

Cash Inflows

collect from customers Interest and dividends

Cash OutflowsPayments for:

Purchase inventoryOther expenses interest taxes

13–7Copyright © Cengage Learning. All rights reserved.

Investing Activities

purchase and sale of property, plant, and equipment and other long-term assets, including investments (short-term and long-term), and the making and collecting of loans

Cash Inflows sell investments Sell long-term assets Collections on loans

Cash Outflows purchase assets Purchase investments lend to borrowers

13–8Copyright © Cengage Learning. All rights reserved.

Financing Activities

Sell stock and provide stockholders with a return on their investments, and obtaining resources from creditors and repaying the amounts borrowed

Cash Inflowssell stock issues

borrowing

Sale of treasury stock

Cash OutflowsRepayments of loans

(excluding interest)

cash dividends paid

Purchase of treasury stock

13–9Copyright © Cengage Learning. All rights reserved.

Noncash Investing and Financing Transactions

Significant transactions that involve only long-term assets, long-term liabilities, or stockholders’ equity

Noncash examples: Exchange long-term

asset for long-term liability

convert debt to stock

Purchase long-term asset with long-term debt

Not reflected on the statement of cash flows;

no cash inflows or outflows

Future cash flows are affected, so required to

disclose these transactions in a

separate schedule or at the bottom of the

statement

13–10Copyright © Cengage Learning. All rights reserved.

Format of the Statement of Cash Flows

Operating Activities section

Investing Activities section

Financing Activities section

Reconciliation of beg. and end. balances of cash

Indirect method starts with net income and ends with cash flows from operating activities

Cash transactions involving capital expenditures

Ties to cash balances of the balance sheet

Debt, cash stock transactions, dividends, and treasury stock transactions

1

2

3

4

13–11Copyright © Cengage Learning. All rights reserved.

Ethics and Cash Flows

How might companies misrepresent cash flows?

By classifying payments of operating expenses as investments on the statement of cash flows, a company can show an improvement in cash flows from operations

By not disclosing the financing of accounts receivables on the statement of cash flows, the company makes collections of account receivables look better than they actually are

Managers are are often tempted to manipulate the presentation of certain transactions to make cash flow look better.

13–12Copyright © Cengage Learning. All rights reserved.

Discussion: Ethics on the Job

Boxcar Industries, a small upstart company, was having cash flow difficulties. Payroll was due to employees in one week, invoices were due to vendors, and there was not enough cash to cover both. The CEO considered telling employees that payroll would be late or slowing down payments to vendors. He also considered a more aggressive collection effort on the company’s accounts receivables.

Q. What do you think of the options? Do any of the options strike you as more or less ethical than others?

13–13Copyright © Cengage Learning. All rights reserved.

Stop & Review

Q. The proceeds from trading securities should be categorized in which section of the statement of cash flows?

A. Operating activities

13–14Copyright © Cengage Learning. All rights reserved.

Stop & Review

Q. In which section of the statement of cash flows would the payment of dividends be classified?

A. Financing activities

13–15Copyright © Cengage Learning. All rights reserved.

Stop & Review

Q. What are the three classifications of cash flows?

A. Operating activities, investing activities, financing activities

13–16Copyright © Cengage Learning. All rights reserved.

LO2 Cash-Generating Efficiency (CGE)

Shows the company’s ability to generate cash from its current or continuing operations

used to calculate CGE:

Cash flow yield

Cash flows to sales Cash flows to assets

13–17Copyright © Cengage Learning. All rights reserved.

Cash Flow Yield

IncomeNet

Activities Operating from FlowsCash Net Yield FlowCash

times3.0 $476

$1,405

Shows how much of net income actually results in operating cash inflows

Amazon.com’s operating activities were generating about $3 of cash for every dollar of net income

13–18Copyright © Cengage Learning. All rights reserved.

Cash Flows to Sales

Shows how much of net sales actually results in cash inflows

Amazon.com generated positive cash flows to sales of 9.5 percent or in other words that every dollar

of sales generates 9.5 cents in cash

SalesNet

Activities Operating from FlowsCash Net Sales toFlowsCash

9.5% $14,835

$1,405 *

* Rounded

13–19Copyright © Cengage Learning. All rights reserved.

Cash Flows to Assets

2007 2006 2005

Total Assets 6,485 4,363 3,696

Amazon.com's 2007 Annual Report (in millions)

Shows how much cash is being generated by operations for each dollar of assets

Assets Total Average

Activities Operating from FlowsCash Net Assets toFlowsCash

25.9% 2 $4,363) ($6,485

$1405

*

*Rounded

13–20Copyright © Cengage Learning. All rights reserved.

Free Cash Flow

Amount of cash that remains after deducting the funds a company must commit to continue operating at its planned level

Net Cash Flows from Operating Activities– Dividends – Purchases of Plant Assets + Sales of Plant Assets Free Cash Flow

13–21Copyright © Cengage Learning. All rights reserved.

Free Cash Flow analysis

• If positive, the company– Has met all of its planned cash commitments – Has cash available to reduce debt or expand

• If negative, to continue at its planned level of operation, the company will have to– Sell investments– Borrow money – Issue stock in the short term

13–22Copyright © Cengage Learning. All rights reserved.

Stop & Review

Q. What does the cash flow yield ratio show? How is it calculated?

A. Shows how much of net income actually results in operating cash inflows. Divide net cash flows from operating activities by net income.

13–23Copyright © Cengage Learning. All rights reserved.

Stop & Apply

Q. Trentco Company demonstrated a cash flow to sales ratio of 9.4 percent. What does this mean? What amounts were needed to calculate this ratio?

A. The company generated positive cash flows to sales of 9.4 percent. Net sales and net cash flows from operating activities were needed to make the calculation.

13–24Copyright © Cengage Learning. All rights reserved.

Stop & Review

Q. Why is positive free cash flow important? A. The company has demonstrated that it can

meet all planned cash commitments and has cash available to reduce debt or to expand.

13–25Copyright © Cengage Learning. All rights reserved.

LO3 Cash Flows from Operating Activities

1. The direct method• Adjusts each item on the income statement to its

cash equivalent• More easily understood by the average reader

2. The indirect method• Lists adjustments to net income to net cash flows• Superior from an analyst’s perspective• Used by most companies

Both methods produce the same net figure

There are two methods of converting the income statement from an accrual basis to a cash basis:

13–26Copyright © Cengage Learning. All rights reserved.

Depreciation Expense

Depreciation expense appears on the income statement, but involves no outlay of cash

Adjustment: Depreciation

expense added back to net

income for the period

Cash flows from operating activities

Net income 16,000.00 Adjustments to reconcile net income to net cash flows from operating activitiesDepreciation 37,000.00

Gain on sale of investments (12,000.00)

Loss on sale of plant assets 3,000.00 Changes in current assets and current liabilities

Decrease in accounts receivable 8,000.00 Increase in inventory (34,000.00)Decrease in prepaid expenses 4,000.00 Increase in accounts payable 7,000.00 Increase in accrued liabilities 3,000.00 Decrease in income taxes payable (2,000.00) 14,000.00 Net cash flows from operating activities $30,000

13–27Copyright © Cengage Learning. All rights reserved.

Gains and Losses

Do not affect cash flows from operating activities; should be removed from net income

Adjustments: Gain/Losses

subtracted and added to net

income for the period

Cash flows from operating activities

Net income $16,000 Adjustments to reconcile net income to net cash flows from operating activitiesDepreciation $37,000

Gain on sale of investments (12,000)

Loss on sale of plant assets 3,000Changes in current assets and current liabilities

Decrease in accounts receivable 8,000Increase in inventory (34,000)Decrease in prepaid expenses 4,000Increase in accounts payable 7,000Increase in accrued liabilities 3,000Decrease in income taxes payable (2,000) 14,000Net cash flows from operating activities $30,000

13–28Copyright © Cengage Learning. All rights reserved.

Treatment of Noncash Items

Noncash Item Add to or Deduct from Net Income

Depreciation Expense Add

Amortization Expense Add

Depletion Expense Add

Losses Add

Gains Deduct

13–29Copyright © Cengage Learning. All rights reserved.

Changes in Current AssetsExample: Laguna Corporation’s Accounts Receivable

decreased by $8,000 as illustrated below.

Accounts Receivable

Beg. Bal. 55,000

End. Bal. 47,000

698,000706,000

Sales toCustomers

Cash Receipts from Customers

The $8,000 decrease in Accounts Receivable should be added to net income on the statement of cash flows.Changes Sales to collections from customers

13–30

Change net income into cash income

Decreases in current assets are

added to net income

+

Increases in current assets are

subtracted from net income

< >

Decreases in current liabilities

are subtracted from net income

< >

Increases in current liabilities are added to net income

+

13–31Copyright © Cengage Learning. All rights reserved.

Changes in Current Liabilities

Example: Laguna Corporation’s accounts payable increased by $7,000 as illustrated below.

The $7,000 increase in Accounts Payable shouldbe added to net income on the statement of cash flows

because more money was paid out than COGS.

Accounts Payable

Beg. Bal. 43,000

End. Bal. 50,000

554,000

547,000Cash Payments to Suppliers Purchases

13–32Copyright © Cengage Learning. All rights reserved.

Net Income versus Cash Flows from Operating Activities

Cash flows from operating activities

Net income $16,000 Adjustments to reconcile net income to net cash flows from operating activitiesDepreciation $37,000

Gain on sale of investments (12,000)

Loss on sale of plant assets 3,000Changes in current assets and current liabilities

Decrease in accounts receivable 8,000Increase in inventory (34,000)Decrease in prepaid expenses 4,000Increase in accounts payable 7,000Increase in accrued liabilities 3,000Decrease in income taxes payable (2,000) 14,000Net cash flows from operating activities $30,000

A net income of $16,000, after adjustments, actually yielded $30,000 in positive cash flows from operating activities

13–33Copyright © Cengage Learning. All rights reserved.

Adjustments for Changes in Current Assets and Liabilities

Add to Net Income

Deduct from Net Income

Current Assets:

Accounts receivable (net)

Decrease Increase

Inventory Decrease Increase

Prepaid expenses Decrease Increase

Current Liabilities:

Accounts payable Increase Decrease

Accrued liabilities Increase Decrease

Income taxes payable Increase Decrease

13–34Copyright © Cengage Learning. All rights reserved.

Stop & Review

Q. If New Horizons Company had a decrease in its Accounts Payable balance of $2,750, how should this amount be treated in the operating activities section of the statement of cash flows?

A. The amount should be deducted from net income.

13–35Copyright © Cengage Learning. All rights reserved.

Stop & Review

Q. Why is depreciation expense added back to net income in the operating activities section of the statement of cash flows?

A. Depreciation expense is a noncash item that has reduced net income. Thus, it must be added back to arrive at a true amount for cash flows from operating activities.

13–36Copyright © Cengage Learning. All rights reserved.

LO4 Examining Investment Transactions

To determine cash flows from investing activities, accounts involving cash receipts and cash payments from investing activities are examined individually

investments

Property, Plant & Equip

intangibles

13–37Copyright © Cengage Learning. All rights reserved.

Investment Transactions Cash Flows Illustrated

1. Laguna Corporation’s purchases of investments totaled $78,000 during 2010. These transactions, caused a $78,000 decrease in cash flows (cash paid).

2. Laguna sold investments that cost $90,000 for $102,000. This transaction resulted in a gain of $12,000 and caused an increase in cash flows of $102,000 (cash received) .

Investing activities section, statement of cash flows:

Purchase of investments ($78,000) Sale of investments 102,000

13–38Copyright © Cengage Learning. All rights reserved.

Plant Asset Transactions Cash Flows Illustrated

1. Laguna Corporation purchased plant assets totaling $1200,000. These transactions, caused a $120,000 decrease in cash flows (cash paid).

2. Laguna sold plant assets that cost $10,000 and that had accumulated depreciation of $2,000 for $5,000. This transaction resulted in a loss of $3,000 and caused an increase in cash flows of $3,000 (cash received) .

Investing activities section, statement of cash flows:

Purchase of plant assets ($120,000) Sale of plant assets 5,000

13–39Copyright © Cengage Learning. All rights reserved.

Cash Flows from Investing Activities

Cash flows from investing activitiesPurchase of investments ($78,000)Sale of investments 102,000Purchase of plant assets (120,000)Sale of plant assets 5,000Net cash flows from investing activities (91,000)

The transactions for Laguna Corporation we have examined are listed below on its statement of cash flows in the investing activities section:

13–40Copyright © Cengage Learning. All rights reserved.

Noncash Transaction Illustrated

Laguna Corporation issued bonds at face value ($100,000) for plant assets. There are no cash inflows or outflows, but it is a significant transaction.

Schedule of Noncash Investing and Financing Transactions:

Issue of bonds payable for plant assets $100,000

© Royalty Free/ Corbis

13–41Copyright © Cengage Learning. All rights reserved.

Stop & Review

Q. What types of accounts should be examined when determining the cash flows related to investments?

A. Long-term investments, short-term investments, plant assets, investment gains or losses, depreciation accounts

13–42Copyright © Cengage Learning. All rights reserved.

Stop & Apply

Q. If a company purchases a plant asset for $25,000, how will this be reflected on the statement of cash flows?

A. Investing activities section:

Purchase of plant asset ($ 25,000)

13–43Copyright © Cengage Learning. All rights reserved.

LO5 Examining Financing Transactions

To determine cash flows from financing activities, accounts involving cash receipts and cash payments from financing activities are examined individually

Short-term borrowings

Long-term liabilities

Stockholders’ equity

13–44Copyright © Cengage Learning. All rights reserved.

Bonds Payable Transactions Cash Flows Illustrated

Laguna Corporation repaid $50,000 of bonds at face value at maturity. This transaction caused a $50,000 decrease in cash flows (cash paid).

Financing activities section, statement of cash flows: Repayment of bonds ($50,000)

© Royalty Free PhotoDisc/ Getty Images

13–45Copyright © Cengage Learning. All rights reserved.

Common Stock Transactions Cash Flows Illustrated

Laguna Corporation issued 15,200 shares of $5 par value common stock for $175,000. The Common Stock account increased by $76,000, and the Additional Paid-in Capital account increased by $99,000. This transaction caused an $175,000 increase in cash flows (cash received).

Financing activities section, statement of cash flows:

Issue of common stock $175,000

13–46Copyright © Cengage Learning. All rights reserved.

Dividend Transactions Cash Flows Illustrated

Laguna Corporation paid cash dividends in the amount of $8,000. This amount decreased Retained Earnings. This transaction caused a $8,000 decrease in cash flows (cash paid).

Financing activities section, statement of cash flows: Payment of dividends ($8,000)

Only the payment of dividends appears on the statement of cash flows, not the declaration of dividends.

© Royalty Free PhotoDisc/ Getty Images

13–47Copyright © Cengage Learning. All rights reserved.

Treasury Stock Transactions Cash Flows Illustrated

Laguna Corporation purchased treasury stock for $25,000. This transaction created a cash outflow of $25,000.

Financing activities section, statement of cash flows:

Purchase of treasury stock ($25,000)

13–48Copyright © Cengage Learning. All rights reserved.

Cash Flows from Financing Activities

Cash flows from financing activitiesRepayment of bonds ($50,000)Issue of common stock 175,000Payment of dividends (8,000)Purchase of treasury stock (25,000)Net cash flows from financing activities 92,000

The transactions of Laguna Corporation that we have examined are presented in the financing section of the statement of cash flows:

13–49Copyright © Cengage Learning. All rights reserved.

Statement of Cash Flows

Laguna Corporation Statement of Cash Flows

For the Year Ended December 31, 2010

Net cash flows from operating activities $30,000 Net cash flows from investing activities (91,000)Net cash flows from financing activities 92,000Net increase (decrease) in cash $31,000 Cash at beginning of year 15,000Cash at end of year $46,000

All three sections are presented in summary form here, followed by the net increase or decrease in cash:

13–50Copyright © Cengage Learning. All rights reserved.

Stop & Review

Q. Name at least three types of transactions that would be considered financing activities.

A. Repayment of bonds payable, issuance of stock, purchase of treasury stock, payment of dividends

13–51Copyright © Cengage Learning. All rights reserved.

Chapter Review Problem

Required: Prepare the statement of cash flows using the indirect method.

Taylor Corporation had net income of $122,435 for the year ended Dec. 31, 20x7. The following data was taken from the company’s income statement: Depreciation expense, $1,400; Loss on sale of plant asset, $1,500. The general ledger reflected an increase in Accounts Payable of $4,000 and a decrease in Accounts Receivable of $1,200 during the year. Taylor sold a plant asset that cost $4,000 with accumulated depreciation of $500 for $2,000. The company also issued 5,000 shares of $5 par value common stock for $32,000. Cash and cash equivalents at the beginning of the year were $14,459.

13–52Copyright © Cengage Learning. All rights reserved.

Taylor Corporation Statement of Cash Flows for the Year Ended December 31, 20x7

Cash flows from operating activitiesNet income $122,435

Adjustments to reconcile net income to net cash flows from operating activitiesDepreciation $1,400 Loss on sale of plant asset 1,500

Changes in current assets and current liabilitiesDecrease in accounts receivable 1,200 Increase in accounts payable 4,000 8,100

Net cash flows from operating activities $130,535

Cash flows from investing activitiesSale of plant asset 2,000 Net cash flows from investing activities 2,000

Cash flows from financing activitiesIssue of common stock 32,000

Net cash flows from financing activities 32,000

Net increase (decrease) in cash $164,535 Cash at beginning of year 14,459Cash at end of year $178,994