CHAPTER 12

STATEMENT OF CASH FLOWS

PREVIEW OF CHAPTER 12

The balance sheet, income statement, and retained earnings statement do not always show the whole picture of the financial condition of a company or institution. In fact, looking at the financial statements of some well-known companies, a thoughtful investor might ask questions like these: How did Eastman Kodak finance cash dividends of $649 million in a year in which it earned only $17 million? How could United Air Lines purchase new planes that cost $1.9 billion in a year in which it reported a net loss of over $2 billion? How did the companies that spent a combined fantastic $3.4 trillion on mergers and acquisitions in a recent year finance those deals? Answers to these and similar questions can be found in this chapter, which presents the statement of cash flows.

The content and organization of this chapter are as follows.

The Statement of Cash Flows: Usefulness and Format

The balance sheet, income statement, and retained earnings statement provide only limited information about a company's cash flows (cash receipts and cash payments). For example, comparative balance sheets show the increase in property, plant, and equipment during the year. But, they do not show how the additions were financed or paid for. The income statement shows net income. But, it does not indicate the amount of cash generated by operating activities. The retained earnings statement shows cash dividends declared but not the cash dividends paid during the year. None of these statements presents a detailed summary of where cash came from and how it was used.

USEFULNESS OF THE STATEMENT OF CASH FLOWS

The statement of cash flows reports the cash receipts and cash payments from operating, investing, and financing activities during a period, in a format that reconciles the beginning and ending cash balances. The information in a statement of cash flows helps investors, creditors, and others assess:

1. The entity's ability to generate future cash flows. By examining relationships between items in the statement of cash flows, investors make predictions of the amounts, timing, and uncertainty of future cash flows better than they can from accrual-basis data.
2. The entity's ability to pay dividends and meet obligations. If a company does not have adequate cash, it cannot pay employees, settle debts, or pay dividends. Employees, creditors, and stockholders should be particularly interested in this statement because it alone shows the flows of cash in a business.

   Ethics Note Though we would discourage reliance on cash flows to the exclusion of accrual accounting, comparing net cash provided by operating activities to net income can reveal important information about the “quality” of reported net income. Such a comparison can reveal the extent to which net income provides a good measure of actual performance.

3. The reasons for the difference between net income and net cash provided (used) by operating activities. Net income provides information on the success or failure of a business enterprise. However, some financial statement users are critical of accrual-basis net income because it requires many estimates. As a result, users often challenge the reliability of the number. Such is not the case with cash. Many readers of the statement of cash flows want to know the reasons for the difference between net income and net cash provided by operating activities. Then they can assess for themselves the reliability of the income number.
4. The cash investing and financing transactions during the period. By examining a company's investing and financing transactions, a financial statement reader can better understand why assets and liabilities changed during the period.

CLASSIFICATION OF CASH FLOWS

The statement of cash flows classifies cash receipts and cash payments as operating, investing, and financing activities. Transactions and other events characteristic of each kind of activity are as follows.

1. Operating activities include the cash effects of transactions that create revenues and expenses. They thus enter into the determination of net income.
2. Investing activities include (a) cash transactions that involve the purchase or disposal of investments and property, plant, and equipment, and (b) lending money and collecting the loans.
3. Financing activities include (a) obtaining cash from issuing debt and repaying the amounts borrowed, and (b) obtaining cash from stockholders, repurchasing shares, and paying dividends.

The operating activities category is the most important. It shows the cash provided by company operations. This source of cash is generally considered to be the best measure of a company's ability to generate sufficient cash to continue as a going concern.

Illustration 12-1 (page 628) lists typical cash receipts and cash payments within each of the three classifications. Study the list carefully. It will be very useful in solving homework exercises and problems.

Note the following general guidelines:

1. Operating activities involve income statement items.
2. Investing activities involve cash flows resulting from changes in investments and long-term asset items.
3. Financing activities involve cash flows resulting from changes in long-term liability and stockholders’ equity items.

Companies classify as operating activities some cash flows related to investing or financing activities. For example, receipts of investment revenue (interest and dividends) are classified as operating activities. So are payments of interest to lenders. Why are these considered operating activities? Because companies report these items in the income statement, where results of operations are shown.

SIGNIFICANT NONCASH ACTIVITIES

Not all of a company's significant activities involve cash. Examples of significant noncash activities are:

1. Direct issuance of common stock to purchase assets.
2. Conversion of bonds into common stock.
3. Direct issuance of debt to purchase assets.
4. Exchanges of plant assets.

Companies do not report in the body of the statement of cash flows significant financing and investing activities that do not affect cash. Instead, they report these activities in either a separate schedule at the bottom of the statement of cash flows or in a separate note or supplementary schedule to the financial statements. The reporting of these noncash activities in a separate schedule satisfies the full disclosure principle.

In solving homework assignments, you should present significant noncash investing and financing activities in a separate schedule at the bottom of the statement of cash flows. (See the last entry in Illustration 12-2 for an example.)

FORMAT OF THE STATEMENT OF CASH FLOWS

The general format of the statement of cash flows presents the results of the three activities discussed previously—operating, investing, and financing—plus the significant noncash investing and financing activities. Illustration 12-2 shows a widely used form of the statement of cash flows.

The cash flows from operating activities section always appears first, followed by the investing activities section and then the financing activities section. The sum of the operating, investing, and financing activities sections equals the net increase or decrease in cash for the period. This amount is added to the beginning cash balance to arrive at the ending cash balance—the same amount reported on the balance sheet.

THE CORPORATE LIFE CYCLE

All products go through a series of phases called the product life cycle. The phases (in order of their occurrence) are introductory phase, growth phase, maturity phase, and decline phase. The introductory phase occurs at the beginning of a company's life, when it purchases fixed assets and begins to produce and sell products. During the growth phase, the company strives to expand its production and sales. In the maturity phase, sales and production level off. During the decline phase, sales of the product decline due to a weakening in consumer demand.

In the same way that products have life cycles, companies have life cycles as well. Companies generally have more than one product, and not all of a company's products are in the same phase of the product life cycle at the same time. This sometimes makes it difficult to classify a company's phase. Still, we can characterize a company as being in one of the four phases because the majority of its products are in a particular phase.

Illustration 12-3 shows that the phase a company is in affects its cash flows. In the introductory phase, we expect that the company will not generate positive cash from operations. That is, cash used in operations will exceed cash generated by operations in the introductory phase. Also, the company spends considerable amounts to purchase productive assets such as buildings and equipment. To support its asset purchases, the company issues stock or debt. Thus, during the introductory phase, we expect negative cash from operations, negative cash from investing, and positive cash from financing.

During the growth phase, we expect to see the company start to generate small amounts of cash from operations. During this phase, net cash provided by operating activities on the statement of cash flows is less than net income. One reason net income exceeds cash flow from operations during this period is explained by the difference between the cash paid for inventory and the amount expensed as cost of goods sold. Since the company projects increasing sales, the size of inventory purchases increases. Thus, in the growth phase, the company expenses less inventory on an accrual basis than it purchases on a cash basis. Also, collections on accounts receivable lag behind sales, and accrual sales during a period exceed cash collections during that period. Cash needed for asset acquisitions will continue to exceed net cash provided by operating activities. The company makes up the deficiency by issuing new stock or debt. Thus, in the growth phase, the company continues to show negative cash from investing and positive cash from financing activities.

During the maturity phase, net cash provided by operating activities and net income are approximately the same. Cash generated from operations exceeds investing needs. Thus, in the maturity phase, the company starts to pay dividends, retire debt, or buy back stock.

Finally, during the decline phase, net cash provided by operating activities decreases. Cash from investing activities might actually become positive as the company sells off excess assets. Cash from financing activities may be negative as the company buys back stock and redeems debt.

Consider Microsoft. During its early years, it had significant product development costs and little revenue. Microsoft was lucky in that its agreement with IBM to provide the operating system for IBM PCs gave it an early steady source of cash to support growth. As noted in the Feature Story, Microsoft conserved cash by paying employees with stock options rather than cash. Today, Microsoft could be characterized as being in the maturity phase. It continues to spend considerable amounts on research and development and investment in new assets. In recent years, though, its net cash provided by operating activities has exceeded its net income. Also, cash from operations over this period exceeded cash used for investing, and common stock repurchased exceeded common stock issued. For Microsoft, as for any large company, the challenge is to maintain its growth. In the software industry, where products become obsolete very quickly, the challenge is particularly great.

PREPARING THE STATEMENT OF CASH FLOWS

Companies prepare the statement of cash flows differently from the three other basic financial statements. First, it is not prepared from an adjusted trial balance. It requires detailed information concerning the changes in account balances that occurred between two points in time. An adjusted trial balance will not provide the necessary data. Second, the statement of cash flows deals with cash receipts and payments. As a result, the company adjusts the effects of the use of accrual accounting to determine cash flows.

The information to prepare this statement usually comes from three sources:

• Comparative balance sheets. Information in the comparative balance sheets indicates the amount of the changes in assets, liabilities, and stockholders' equities from the beginning to the end of the period.
• Current income statement. Information in this statement helps determine the amount of net cash provided or used by operating activities during the period.
• Additional information. Such information includes transaction data that are needed to determine how cash was provided or used during the period.

Preparing the statement of cash flows from these data sources involves three major steps, explained in Illustration 12-4 on the next page.

INDIRECT AND DIRECT METHODS

In order to perform Step 1, a company must convert net income from an accrual basis to a cash basis. This conversion may be done by either of two methods: (1) the indirect method or (2) the direct method. Both methods arrive at the same total amount for “Net cash provided by operating activities.” They differ in how they arrive at the amount.

The indirect method adjusts net income for items that do not affect cash to determine net cash provided by operating activities. A great majority of companies (98%) use this method, as shown in the chart on the left.¹ Companies favor the indirect method for two reasons. (1) It is easier and less costly to prepare, and (2) it focuses on the differences between net income and net cash flow from operating activities.

The direct method shows operating cash receipts and payments. It is prepared by adjusting each item in the income statement from the accrual basis to the cash basis. The FASB has expressed a preference for the direct method but allows the use of either method.

The next section illustrates the more popular indirect method. Appendix 12A illustrates the direct method. Appendix 12B demonstrates an approach that employs T-accounts to prepare the statement of cash flows. Many students find the T-account approach provides a useful structure. We encourage you to give it a try as you walk through the Computer Services example.

Preparation of the Statement of Cash Flows—Indirect Method

To explain how to prepare a statement of cash flows using the indirect method, we use financial information from Computer Services Company. Illustration 12-5 (page 634) presents Computer Services' current and previous-year balance sheets, its current-year income statement, and related financial information.

We now apply the three steps to the information provided for Computer Services Company.

STEP 1: OPERATING ACTIVITIES

DETERMINE NET CASH PROVIDED/USED BY OPERATING ACTIVITIES BY CONVERTING NET INCOME FROM AN ACCRUAL BASIS TO A CASH BASIS

To determine net cash provided by operating activities under the indirect method, companies adjust net income in numerous ways. A useful starting point is to understand why net income must be converted to net cash provided by operating activities.

Under generally accepted accounting principles, most companies use the accrual basis of accounting. As you have learned, this basis requires that companies record revenue when the performance obligation is satisfied and record expenses when incurred. Revenues include credit sales for which the company has not yet collected cash. Expenses incurred include some items that it has not yet paid in cash. Thus, under the accrual basis of accounting, net income is not the same as net cash provided by operating activities.

Therefore, under the indirect method, companies must adjust net income to convert certain items to the cash basis. The indirect method (or reconciliation method) starts with net income and converts it to net cash provided by operating activities. Illustration 12-6 lists the three types of adjustments.

We explain the three types of adjustments in the next three sections.

Depreciation Expense

Computer Services' income statement reports depreciation expense of $9,000. Although depreciation expense reduces net income, it does not reduce cash. In other words, depreciation expense is a noncash charge. The company must add it back to net income to arrive at net cash provided by operating activities. Computer Services reports depreciation expense as follows in the statement of cash flows.

As the first adjustment to net income in the statement of cash flows, companies frequently list depreciation and similar noncash charges such as amortization of intangible assets, depletion expense, and bad debt expense.

Loss on Disposal of Plant Assets

Illustration 12-1 states that cash received from the sale of plant assets is reported in the investing activities section. Because of this, companies eliminate from net income all gains and losses resulting from investing activities, to arrive at cash provided by operating activities.

In our example, Computer Services' income statement reports a $3,000 loss on the disposal of plant assets (book value $7,000, less cash received from sale of equipment $4,000). The company's loss of $3,000 is eliminated in the operating activities section of the statement of cash flows. Illustration 12-8 shows that the $3,000 loss is eliminated by adding $3,000 back to net income to arrive at net cash provided by operating activities.

If a gain on sale occurs, the company deducts the gain from net income in order to determine net cash provided by operating activities. In the case of either a gain or a loss, companies report the actual amount of cash received from the sale as a source of cash in the investing activities section of the statement of cash flows.

Changes to Noncash Current Asset and Current Liability Accounts

A final adjustment in reconciling net income to net cash provided by operating activities involves examining all changes in current asset and current liability accounts. The accrual-accounting process records revenues in the period in which the performance obligation is satisfied and expenses in the period incurred. For example, Accounts Receivable reflects amounts owed to the company for sales that have been made but for which cash collections have not yet been received. Prepaid Insurance reflects insurance that has been paid for but which has not yet expired and therefore has not been expensed. Similarly, Salaries and Wages Payable reflects salaries expense that has been incurred but has not been paid.

As a result, we need to adjust net income for these accruals and prepayments to determine net cash provided by operating activities. Thus, we must analyze the change in each current asset and current liability account to determine its impact on net income and cash.

CHANGES IN NONCASH CURRENT ASSETS. The adjustments required for changes in noncash current asset accounts are as follows. Deduct from net income increases in current asset accounts, and add to net income decreases in current asset accounts, to arrive at net cash provided by operating activities. We observe these relationships by analyzing the accounts of Computer Services Company.

DECREASE IN ACCOUNTS RECEIVABLE. Computer Services Company's accounts receivable decreased by $10,000 (from $30,000 to $20,000) during the period. For Computer Services, this means that cash receipts were $10,000 higher than sales revenue. The Accounts Receivable account in Illustration 12-9 shows that Computer Services Company had $507,000 in sales revenue (as reported on the income statement), but it collected $517,000 in cash.

As shown in Illustration 12-10, to adjust net income to net cash provided by operating activities, the company adds to net income the decrease of $10,000 in accounts receivable.

When the Accounts Receivable balance increases, cash receipts are lower than revenue recorded under the accrual basis. Therefore, the company deducts from net income the amount of the increase in accounts receivable, to arrive at net cash provided by operating activities.

INCREASE IN INVENTORY. Computer Services Company's inventory increased $5,000 (from $10,000 to $15,000) during the period. The change in the Inventory account reflects the difference between the amount of inventory purchased and the amount sold. For Computer Services, this means that the cost of merchandise purchased exceeded the cost of goods sold by $5,000. As a result, cost of goods sold does not reflect $5,000 of cash payments made for merchandise. The company deducts from net income this inventory increase of $5,000 during the period, to arrive at net cash provided by operating activities (see Illustration 12-10). If inventory decreases, the company adds to net income the amount of the change, to arrive at net cash provided by operating activities.

INCREASE IN PREPAID EXPENSES. Computer Services' prepaid expenses increased during the period by $4,000. This means that cash paid for expenses is higher than expenses reported on an accrual basis. In other words, the company has made cash payments in the current period but will not charge expenses to income until future periods (as charges to the income statement). To adjust net income to net cash provided by operating activities, the company deducts from net income the $4,000 increase in prepaid expenses (see Illustration 12-10).

If prepaid expenses decrease, reported expenses are higher than the expenses paid. Therefore, the company adds to net income the decrease in prepaid expense, to arrive at net cash provided by operating activities.

CHANGES IN CURRENT LIABILITIES. The adjustments required for changes in current liability accounts are as follows. Add to net income increases in current liability accounts, and deduct from net income decreases in current liability accounts, to arrive at net cash provided by operating activities.

INCREASE IN ACCOUNTS PAYABLE. For Computer Services Company, accounts payable increased by $16,000 (from $12,000 to $28,000) during the period. That means the company received $16,000 more in goods than it actually paid for. As shown in Illustration 12-11 (below), to adjust net income to determine net cash provided by operating activities, the company adds to net income the $16,000 increase in the Accounts Payable account.

DECREASE IN INCOME TAXES PAYABLE. When a company incurs income tax expense but has not yet paid its taxes, it records income taxes payable. A change in the Income Taxes Payable account reflects the difference between income tax expense incurred and income tax actually paid. Computer Services' Income Taxes Payable account decreased by $2,000. That means the $47,000 of income tax expense reported on the income statement was $2,000 less than the amount of taxes paid during the period of $49,000. As shown in Illustration 12-11, to adjust net income to a cash basis, the company must reduce net income by $2,000.

Illustration 12-11 shows that after starting with net income of $145,000, the sum of all of the adjustments to net income was $27,000. This resulted in net cash provided by operating activities of $172,000.

SUMMARY OF CONVERSION TO NET CASH PROVIDED BY OPERATING ACTIVITIES—INDIRECT METHOD

As shown in the previous illustrations, the statement of cash flows prepared by the indirect method starts with net income. Items are then added or deducted to arrive at net cash provided by operating activities. The required adjustments are of three types:

1. Noncash charges such as depreciation, amortization, and depletion.
2. Gains and losses from investing and financing transactions, such as the sale of plant assets.
3. Changes in noncash current asset and current liability accounts.

Illustration 12-12 provides a summary of these changes.

STEP 2: INVESTING AND FINANCING ACTIVITIES

ANALYZE CHANGES IN NONCURRENT ASSET AND LIABILITY ACCOUNTS AND RECORD AS INVESTING AND FINANCING ACTIVITIES, OR DISCLOSE AS NONCASH TRANSACTIONS

INCREASE IN LAND. As indicated from the change in the Land account and the additional information, Computer Services Company purchased land of $110,000 by directly exchanging bonds for land. The exchange of bonds payable for land has no effect on cash. But, it is a significant noncash investing and financing activity that merits disclosure in a separate schedule. (See Illustration 12-14.)

INCREASE IN BUILDINGS. As the additional data indicate, Computer Services Company acquired an office building for $120,000 cash. This is a cash outflow reported in the investing activities section. (See Illustration 12-14.)

INCREASE IN EQUIPMENT. The Equipment account increased $17,000. The additional information explains that this was a net increase that resulted from two transactions: (1) a purchase of equipment of $25,000, and (2) the sale for $4,000 of equipment costing $8,000. These transactions are both investing activities. The company should report each transaction separately. Thus, it reports the purchase of equipment as an outflow of cash for $25,000. It reports the sale as an inflow of cash for $4,000. The T-account below shows the reasons for the change in this account during the year.

The following entry shows the details of the equipment sale transaction.

INCREASE IN BONDS PAYABLE. The Bonds Payable account increased $110,000. As indicated in the additional information, the company acquired land by directly exchanging bonds for land. It reports this noncash transaction in a separate schedule at the bottom of the statement.

INCREASE IN COMMON STOCK. The balance sheet reports an increase in Common Stock of $20,000. The additional information section notes that this increase resulted from the issuance of new shares of stock. This is a cash inflow reported in the financing activities section.

INCREASE IN RETAINED EARNINGS. Retained earnings increased $116,000 during the year. This increase can be explained by two factors: (1) Net income of $145,000 increased retained earnings and (2) dividends of $29,000 decreased retained earnings. The company adjusts net income to net cash provided by operating activities in the operating activities section. Payment of the dividends (not the declaration) is a cash outflow that the company reports as a financing activity.

Statement of Cash Flows—2014

Using the previous information, we can now prepare a statement of cash flows for 2014 for Computer Services Company, as shown in Illustration 12-14.

STEP 3: NET CHANGE IN CASH

COMPARE THE NET CHANGE IN CASH ON THE STATEMENT OF CASH FLOWS WITH THE CHANGE IN THE CASH ACCOUNT REPORTED ON THE BALANCE SHEET TO MAKE SURE THE AMOUNTS AGREE

Illustration 12-14 indicates that the net change in cash during the period was an increase of $22,000. This agrees with the change in Cash account reported on the balance sheet in Illustration 12-5 (page 634).

Using Cash Flows to Evaluate a Company

Traditionally, investors and creditors used ratios based on accrual accounting. These days, cash-based ratios are gaining increased acceptance among analysts. In this section, we review free cash flow and introduce two new measures.

FREE CASH FLOW

In the statement of cash flows, net cash provided by operating activities is intended to indicate the cash-generating capability of the company. Analysts have noted, however, that cash provided by operating activities fails to take into account that a company must invest in new fixed assets just to maintain its current level of operations. Companies also must at least maintain dividends at current levels to satisfy investors. As we discussed in Chapter 2, the measurement of free cash flow provides additional insight regarding a company's cash-generating ability. Free cash flow describes the net cash provided by operating activities after adjustment for capital expenditures and dividends.

Consider the following example. Suppose that MPC produced and sold 10,000 personal computers this year. It reported $100,000 cash provided by operating activities. In order to maintain production at 10,000 computers, MPC invested $15,000 in equipment. It chose to pay $5,000 in dividends. Its free cash flow was $80,000 ($100,000 − $15,000 − $5,000). The company could use this $80,000 either to purchase new assets, pay off debt, or pay an $80,000 dividend. In practice, free cash flow is often calculated with the formula in Illustration 12-15. Alternative definitions also exist.

Illustration 12-16 provides basic information excerpted from the 2011 statement of cash flows of Apple (prior to the payment of its first dividends).

Apple's free cash flow is calculated as shown in Illustration 12-17 (in millions). Apple generated approximately $30 billion of free cash flow. This is a tremendous amount of cash generated in a single year. It is available for the acquisition of new assets, the buyback and retirement of stock or debt, or the payment of dividends.

Also note that Apple's cash from operations of $37.5 billion exceeds its 2011 net income of $25.9 billion by $11 billion. This lends additional credibility to Apple's income number as an indicator of potential future performance. If anything, Apple's net income might understate its actual performance. Microsoft's free cash flow for 2011 was $19.5 billion, also an incredible amount of cash.

ASSESSING LIQUIDITY AND SOLVENCY USING CASH FLOWS

Previous chapters have presented ratios used to analyze a company's liquidity and solvency. Many of those ratios used accrual-based numbers from the income statement and balance sheet. In this section, we focus on ratios that are cash-based rather than accrual-based. That is, instead of using numbers from the income statement, these ratios use numbers from the statement of cash flows.

As discussed earlier, many analysts are critical of accrual-based numbers because they feel that the adjustment process allows too much management discretion. These analysts like to supplement accrual-based analysis with measures that use the statement of cash flows. One disadvantage of these cash-based measures is that, unlike the more commonly employed accrual-based measures, there are no readily available industry averages for comparison. In the following discussion, we use cash flow-based ratios to analyze Apple. In addition to the cash flow information provided in Illustration 12-16 (page 643), we need the following information related to Apple.

Liquidity

Liquidity is the ability to pay obligations expected to become due within the next year. In Chapter 2, you learned that one measure of liquidity is the current ratio: current assets divided by current liabilities. A disadvantage of the current ratio is that it uses year-end balances of current asset and current liability accounts. These year-end balances may not be representative of the company's position during most of the year.

A ratio that partially corrects this problem is the current cash debt coverage. It is computed as net cash provided by operating activities divided by average current liabilities. Because net cash provided by operating activities involves the entire year rather than a balance at one point in time, this ratio is often considered a better representation of liquidity on the average day. In general, a value below .40 times is cause for additional investigation of a company's liquidity. Illustration 12-18 shows the current cash debt coverage for Apple, with comparative numbers for Microsoft. For comparative purposes, we have also provided each company's current ratio.

Apple's net cash provided by operating activities is 1.54 times its average current liabilities. Microsoft's ratio of .98 times is lower than that of Apple. Both companies far exceed the threshold of .40 times. Keep in mind that both Apple and Microsoft have extraordinary cash positions. For example, many large companies now have current ratios in the range of 1.0. By this standard, Apple's current ratio of 1.60:1 and Microsoft's current ratio of 2.60:1 are both strong.

Solvency

Solvency is the ability of a company to survive over the long term. A measure of solvency that uses cash figures is the cash debt coverage. It is computed as the ratio of net cash provided by operating activities to total debt as represented by average total liabilities. This ratio indicates a company's ability to repay its liabilities from cash generated from operations—that is, without having to liquidate productive assets such as property, plant, and equipment. A general rule of thumb is that a cash debt coverage below .20 times is cause for additional investigation.

Illustration 12-19 shows the cash debt coverage for Apple and Microsoft for 2011. For comparative purposes, we have also provided the debt to assets ratios for each company.

Because Apple has long-term obligations, its cash debt coverage is lower than its current cash debt coverage. Obviously, Apple is very solvent. Microsoft's cash debt coverage of .59 times is not as strong as Apple's but still far exceeds the .20 threshold. Neither the cash nor accrual measures suggest any cause for concern regarding the solvency of either company.

Summary of Learning Objectives

1. Indicate the usefulness of the statement of cash flows. The statement of cash flows provides information about the cash receipts, cash payments, and net change in cash resulting from the operating, investing, and financing activities of a company during the period.
2. Distinguish among operating, investing, and financing activities. Operating activities include the cash effects of transactions that enter into the determination of net income. Investing activities involve cash flows resulting from changes in investments and long-term asset items. Financing activities involve cash flows resulting from changes in long-term liability and stockholders' equity items.
3. Explain the impact of the product life cycle on a company's cash flows. During the introductory stage, net cash provided by operating activities and net cash from investing activities are negative, and net cash from financing activities is positive. During the growth stage, net cash provided by operating activities becomes positive but is still not sufficient to meet investing needs. During the maturity stage, net cash provided by operating activities exceeds investing needs, so the company begins to retire debt. During the decline stage, net cash provided by operating activities is reduced, net cash from investing activities becomes positive (from selling off assets), and net cash from financing activities becomes more negative.
4. Prepare a statement of cash flows using the indirect method. The preparation of a statement of cash flows involves three major steps. (1) Determine net cash provided/used by operating activities by converting net income from an accrual basis to a cash basis. (2) Analyze changes in noncurrent asset and liability accounts and record as investing and financing activities, or disclose as noncash transactions. (3) Compare the net change in cash on the statement of cash flows with the change in the Cash account reported on the balance sheet to make sure the amounts agree.
5. Use the statement of cash flows to evaluate a company. A number of measures can be derived by using information from the statement of cash flows as well as the other required financial statements. Free cash flow indicates the amount of cash a company generated during the current year that is available for the payment of dividends or for expansion. Liquidity can be measured with the current cash debt coverage (net cash provided by operating activities divided by average current liabilities). Solvency can be measured by the cash debt coverage (net cash provided by operating activities divided by average total liabilities).

Appendix 12A

Statement of Cash Flows—Direct Method

To explain and illustrate the direct method, we will use the transactions of Computer Services Company for 2014, to prepare a statement of cash flows. Illustration 12A-1 (page 650) presents information related to 2014 for Computer Services Company.

To prepare a statement of cash flows under the direct approach, we will apply the three steps outlined in Illustration 12-4 (page 633).

STEP 1: OPERATING ACTIVITIES

DETERMINE NET CASH PROVIDED/USED BY OPERATING ACTIVITIES BY CONVERTING NET INCOME FROM AN ACCRUAL BASIS TO A CASH BASIS

Under the direct method, companies compute net cash provided by operating activities by adjusting each item in the income statement from the accrual basis to the cash basis. To simplify and condense the operating activities section, companies report only major classes of operating cash receipts and cash payments. For these major classes, the difference between cash receipts and cash payments is the net cash provided by operating activities. These relationships are as shown in Illustration 12A-2.

An efficient way to apply the direct method is to analyze the items reported in the income statement in the order in which they are listed. We then determine cash receipts and cash payments related to these revenues and expenses. The following pages present the adjustments required to prepare a statement of cash flows for Computer Services Company using the direct approach.

CASH RECEIPTS FROM CUSTOMERS. The income statement for Computer Services Company reported sales revenue from customers of $507,000. How much of that was cash receipts? To answer that, companies need to consider the change in accounts receivable during the year. When accounts receivable increase during the year, revenues on an accrual basis are higher than cash receipts from customers. Operations led to revenues, but not all of these revenues resulted in cash receipts.

To determine the amount of cash receipts, the company deducts from sales revenue the increase in accounts receivable. On the other hand, there may be a decrease in accounts receivable. That would occur if cash receipts from customers exceeded sales revenue. In that case, the company adds to sales revenue the decrease in accounts receivable. For Computer Services Company, accounts receivable decreased $10,000. Thus, cash receipts from customers were $517,000, computed as shown in Illustration 12A-3.

Computer Services can also determine cash receipts from customers from an analysis of the Accounts Receivable account, as shown in Illustration 12A-4.

Illustration 12A-5 shows the relationships among cash receipts from customers, sales revenue, and changes in accounts receivable.

CASH PAYMENTS TO SUPPLIERS. Computer Services Company reported cost of goods sold of $150,000 on its income statement. How much of that was cash payments to suppliers? To answer that, it is first necessary to find purchases for the year. To find purchases, companies adjust cost of goods sold for the change in inventory. When inventory increases during the year, purchases for the year have exceeded cost of goods sold. As a result, to determine the amount of purchases, the company adds to cost of goods sold the increase in inventory.

In 2014, Computer Services Company's inventory increased $5,000. It computes purchases as follows.

After computing purchases, a company can determine cash payments to suppliers. This is done by adjusting purchases for the change in accounts payable. When accounts payable increase during the year, purchases on an accrual basis are higher than they are on a cash basis. As a result, to determine cash payments to suppliers, a company deducts from purchases the increase in accounts payable. On the other hand, if cash payments to suppliers exceed purchases, there may be a decrease in accounts payable. In that case, a company adds to purchases the decrease in accounts payable. For Computer Services Company, cash payments to suppliers were $139,000, computed as follows.

Computer Services also can determine cash payments to suppliers from an analysis of the Accounts Payable account, as shown in Illustration 12A-8.

Illustration 12A-9 shows the relationships among cash payments to suppliers, cost of goods sold, changes in inventory, and changes in accounts payable.

CASH PAYMENTS FOR OPERATING EXPENSES. Computer Services reported on its income statement operating expenses of $111,000. How much of that amount was cash paid for operating expenses? To answer that, we need to adjust this amount for any changes in prepaid expenses and accrued expenses payable. For example, if prepaid expenses increased during the year, cash paid for operating expenses is higher than operating expenses reported on the income statement. To convert operating expenses to cash payments for operating expenses, a company adds the increase in prepaid expenses to operating expenses. On the other hand, if prepaid expenses decrease during the year, it deducts the decrease from operating expenses.

Companies must also adjust operating expenses for changes in accrued expenses payable. When accrued expenses payable increase during the year, operating expenses on an accrual basis are higher than they are in a cash basis. As a result, to determine cash payments for operating expenses, a company deducts from operating expenses an increase in accrued expenses payable. On the other hand, a company adds to operating expenses a decrease in accrued expenses payable because cash payments exceed operating expenses.

Computer Services Company's cash payments for operating expenses were $115,000, computed as follows.

Illustration 12A-11 (page 654) shows the relationships among cash payments for operating expenses, changes in prepaid expenses, and changes in accrued expenses payable.

DEPRECIATION EXPENSE AND LOSS ON DISPOSAL OF PLANT ASSETS. Computer Services' depreciation expense in 2014 was $9,000. Depreciation expense is not shown on a statement of cash flows under the direct method because it is a noncash charge. If the amount for operating expenses includes depreciation expense, operating expenses must be reduced by the amount of depreciation to determine cash payments for operating expenses.

The loss on disposal of plant assets of $3,000 is also a noncash charge. The loss on disposal of plant assets reduces net income, but it does not reduce cash. Thus, the loss on disposal of plant assets is not shown on the statement of cash flows under the direct method.

Other charges to expense that do not require the use of cash, such as the amortization of intangible assets, depletion expense, and bad debt expense, are treated in the same manner as depreciation.

CASH PAYMENTS FOR INTEREST. Computer Services reported on the income statement interest expense of $42,000. Since the balance sheet did not include an accrual for interest payable for 2013 or 2014, the amount reported as expense is the same as the amount of interest paid.

CASH PAYMENTS FOR INCOME TAXES. Computer Services reported income tax expense of $47,000 on the income statement. Income taxes payable, however, decreased $2,000. This decrease means that income taxes paid were more than income taxes reported in the income statement. Cash payments for income taxes were, therefore, $49,000 as shown below.

Illustration 12A-13 shows the relationships among cash payments for income taxes, income tax expense, and changes in income taxes payable.

The operating activities section of the statement of cash flows of Computer Services Company is shown in Illustration 12A-14.

When a company uses the direct method, it must also provide in a separate schedule (not shown here) the net cash flows from operating activities as computed under the indirect method.

STEP 2: INVESTING AND FINANCING ACTIVITIES

ANALYZE CHANGES IN NONCURRENT ASSET AND LIABILITY ACCOUNTS AND RECORD AS INVESTING AND FINANCING ACTIVITIES, OR DISCLOSE AS NONCASH TRANSACTIONS

INCREASE IN LAND. As indicated from the change in the Land account and the additional information, Computer Services Company purchased land of $110,000 by directly exchanging bonds for land. The exchange of bonds payable for land has no effect on cash. But, it is a significant noncash investing and financing activity that merits disclosure in a separate schedule. (See Illustration 12A-16.)

INCREASE IN BUILDINGS. As the additional data indicate, Computer Services Company acquired an office building for $120,000 cash. This is a cash outflow reported in the investing activities section. (See Illustration 12A-16.)

INCREASE IN EQUIPMENT. The Equipment account increased $17,000. The additional information explains that this was a net increase that resulted from two transactions: (1) a purchase of equipment of $25,000, and (2) the sale for $4,000 of equipment costing $8,000. These transactions are investing activities. The company should report each transaction separately. The statement in Illustration 12A-16 reports the purchase of equipment as an outflow of cash for $25,000. It reports the sale as an inflow of cash for $4,000. The T-account below shows the reasons for the change in this account during the year.

The following entry shows the details of the equipment sale transaction.

INCREASE IN BONDS PAYABLE. The Bonds Payable account increased $110,000. As indicated in the additional information, the company acquired land by directly exchanging bonds for land. Illustration 12A-16 reports this noncash transaction in a separate schedule at the bottom of the statement.

INCREASE IN COMMON STOCK. The balance sheet reports an increase in Common Stock of $20,000. The additional information section notes that this increase resulted from the issuance of new shares of stock. This is a cash inflow reported in the financing activities section in Illustration 12A-16.

INCREASE IN RETAINED EARNINGS. Retained earnings increased $116,000 during the year. This increase can be explained by two factors: (1) Net income of $145,000 increased retained earnings and (2) dividends of $29,000 decreased retained earnings. The company adjusts net income to net cash provided by operating activities in the operating activities section. Payment of the dividends (not the declaration) is a cash outflow that the company reports as a financing activity in Illustration 12A-16.

Statement of Cash Flows—2014

Illustration 12A-16 (page 656) shows the statement of cash flows for Computer Services Company.

STEP 3: NET CHANGE IN CASH

COMPARE THE NET CHANGE IN CASH ON THE STATEMENT OF CASH FLOWS WITH THE CHANGE IN THE CASH ACCOUNT REPORTED ON THE BALANCE SHEET TO MAKE SURE THE AMOUNTS AGREE

Illustration 12A-16 indicates that the net change in cash during the period was an increase of $22,000. This agrees with the change in balances in the Cash account reported on the balance sheets in Illustration 12A-1 (page 650).

Summary of Learning Objective for Appendix 12A

  6. Prepare a statement of cash flows using the direct method. The preparation of the statement of cash flows involves three major steps: (1) Determine net cash provided/used by operating activities by converting net income from an accrual basis to a cash basis. (2) Analyze changes in noncurrent asset and liability accounts and record as investing and financing activities, or disclose as noncash transactions. (3) Compare the net change in cash on the statement of cash flows with the change in the Cash account reported on the balance sheet to make sure the amounts agree. The direct method reports cash receipts less cash payments to arrive at net cash provided by operating activities.

Appendix 12B

Statement of Cash Flows—T-Account Approach

Many people like to use T-accounts to provide structure to the preparation of a statement of cash flows. The use of T-accounts is based on the accounting equation that you learned in Chapter 1. The basic equation is:

Now, let's rewrite the left-hand side as:

Next, rewrite the equation by subtracting Noncash Assets from each side to isolate Cash on the left-hand side:

Finally, if we insert the Δ symbol (which means “change in”), we have:

What this means is that the change in cash is equal to the change in all of the other balance sheet accounts. Another way to think about this is that if we analyze the changes in all of the noncash balance sheet accounts, we will explain the change in the Cash account. This, of course, is exactly what we are trying to do with the statement of cash flows.

To implement this approach, first prepare a large Cash T-account with sections for operating, investing, and financing activities. Then, prepare smaller T-accounts for all of the other noncash balance sheet accounts. Insert the beginning and ending balances for each of these accounts. Once you have done this, then walk through the steps outlined in Illustration 12-4 (page 633). As you walk through the steps, enter debit and credit amounts into the affected accounts. When all of the changes in the T-accounts have been explained, you are done. To demonstrate, we will apply this approach to the example of Computer Services Company that is presented in the chapter. Each of the adjustments in Illustration 12B-1 is numbered so you can follow them through the T-accounts.

At this point, all of the changes in the noncash accounts have been explained. All that remains is to subtotal each section of the Cash T-account and compare the total change in cash with the change shown on the balance sheet. Once this is done, the information in the Cash T-account can be used to prepare a statement of cash flows.

Summary of Learning Objective for Appendix 12B

  7. Use the T-account approach to prepare a statement of cash flows. To use T-accounts to prepare the statement of cash flows: (1) prepare a large Cash T-account with sections for operating, investing, and financing activities; (2) prepare smaller T-accounts for all other noncash accounts; (3) insert beginning and ending balances for all accounts; and (4) follows the steps in Illustration 12-4 (page 633), entering debit and credit amounts as needed.