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Homework answers / question archive / Statement of Cash Flows C HAPT ER PREVIEW 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

Statement of Cash Flows C HAPT ER PREVIEW 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

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Statement of Cash Flows C HAPT ER PREVIEW 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. CHAPTER OUTLINE LEARNING OBJECTIVES 2 Prepare a statement of cash flows using the indirect method. ? Discuss the usefulness and format of the statement of cash flows. • Indirect and direct methods • Indirect method—Computer Services Company • Step 1: Operating activities • Summary of conversion to net cash provided by operating activities • Step 2: Investing and financing activities • Step 3: Net change in cash ? 1 PRACTICE • Usefulness of the statement of cash flows • Classification of cash flows • Significant noncash activities • Format of the statement of cash flows DO IT! 1 Cash Flow Activities DO IT! 2 2a Net Cash Provided by Operating Activities 2b Indirect Method DO IT! Use the statement of cash flows to evaluate a company. • The corporate life cycle • Free cash flow ? 3 3 Free Cash Flow Go tto Go o th the e RE REVIEW REVI VIEW VI EW A AND ND P PRACTICE RACT RA CTIC CT ICE IC CE section sec ecti tion ti on at at the the end end of the the chapter cha hapt p er ffor pt or a ttargeted arge ar gete ge ted te d su summ summary mmar mm aryy an ar and d ex exer exercises erci cise ise sess wi with ith th ssolutions. ollut uti tions ions.. Visi sit it Visit for ad for fo addi additional dditi tion ionall ttutorials utor ut oriia or ials ial ls a and nd dp practice ract cti tic ice op ice oppo opportunities. port rtun tun unit itiies it ies. TonyV3112/Shutterstock F EAT URE STORY Companies must be ready to respond to changes quickly in order to survive and thrive. This requires careful management of cash. One company that managed cash successfully in its early years was Microsoft. During those years, the company paid much of its payroll by giving employees stock options (rights to purchase company stock in the future at a given price) instead of cash. This conserved cash and turned more than a thousand of its employees into millionaires. Finally, Microsoft announced a plan to return cash to stockholders by paying a special one-time $32 billion dividend. This special dividend was so large that, according to the U.S. Commerce Department, it caused total personal income in the United States to rise by 3.7% in one month—the largest increase ever recorded by the agency. (It also made the holiday season brighter, especially for retailers in the Seattle area.) Microsoft also doubled its regular annual dividend to $3.50 per share. Further, it announced that it would spend another $30 billion buying treasury stock. Apple has also encountered this cash “problem.” Apple recently had nearly $100 billion in liquid assets (cash, cash equivalents, and investment securities). It was generating $37 billion of cash per year from its operating activities but spending only about $7 billion on plant assets and purchases of patents. In response to shareholder pressure, Apple announced that it would begin to pay a quarterly dividend of $2.65 per share and buy back up to $10 billion of its stock. Analysts noted that the dividend consumes only $10 billion of cash per year. This leaves Apple wallowing in cash. The rest of us should have such problems. Got Cash? In recent years, Microsoft has had a different kind of cash problem. Now that it has reached a more “mature” stage in life, it generates so much cash— roughly $1 billion per month—that it cannot always figure out what to do with it. At one time, Microsoft had accumulated $60 billion. The company said it was accumulating cash to invest in new opportunities, buy other companies, and pay off pending lawsuits. Microsoft’s stockholders complained that holding all this cash was putting a drag on the company’s profitability. Why? Because Microsoft had the cash invested in very low-yielding government securities. Stockholders felt that the company either should find new investment projects that would bring higher returns, or return some of the cash to stockholders. Source: “Business: An End to Growth? Microsoft’s Cash Bonanza,” The Economist (July 23, 2005), p. 61. LEARNING OBJECTIVE Statement of Cash Flows 1 ? 592 12 Discuss the usefulness and format of the statement of cash flows. 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 the following. ? 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. 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. 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. Usefulness and Format of the Statement of Cash Flows 593 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 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. Types of Cash Inflows and Outflows Operating activities—Income statement items Cash inflows: From sale of goods or services. From interest received and dividends received. Cash outflows: To suppliers for inventory. To employees for wages. To government for taxes. To lenders for interest. To others for expenses. Investing activities—Changes in investments and long-term assets Cash inflows: From sale of property, plant, and equipment. From sale of investments in debt or equity securities of other entities. From collection of principal on loans to other entities. Cash outflows: To purchase property, plant, and equipment. To purchase investments in debt or equity securities of other entities. To make loans to other entities. Financing activities—Changes in long-term liabilities and stockholders’ equity Cash inflows: From sale of common stock. From issuance of debt (bonds and notes). Cash outflows: To stockholders as dividends. To redeem long-term debt or reacquire capital stock (treasury stock). Note the following general guidelines: ILLUSTRATION 12-1 Typical receipt and payment classifications Operating activities CANDY TIME CANDY TIME Investing activities S TO C K BOND Financing activities 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. 2. 3. 4. Direct issuance of common stock to purchase assets. Conversion of bonds into common stock. Direct issuance of debt to purchase assets. Exchanges of plant assets. INTERNATIONAL NOTE The statement of cash flows is very similar under GAAP and IFRS. One difference is that, under IFRS, noncash investing and financing activities are not reported in the statement of cash flows but instead are reported in the notes to the financial statements. 594 12 Statement of Cash Flows ? HELPFUL HINT Do not include noncash investing and financing activities in the body of the statement of cash flows. Report this information in a separate schedule below the statement of cash flows. 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.) ACCOUNTING ACROSS THE ORGANIZATION Target Corporation Net What? Net income is not the same as net cash provided by operating activities. Below are some results from recent annual reports (dollars in millions), including Target Corporation. Note how the numbers differ greatly across the list even though all these companies engage in retail merchandising. Company Darren McCollester/Getty Images, Inc. Kohl’s Corporation Wal-Mart Stores, Inc. J. C. Penney Company, Inc. Costco Wholesale Corp. Target Corporation Net Income $ Net Cash Provided by Operating Activities 889 16,669 (1,388) 20,391 1,971 $ 1,884 25,591 (1,814) 3,437 6,520 In general, why do differences exist between net income and net cash provided by operating activities? (Go to WileyPLUS for this answer and additional questions.) 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. ILLUSTRATION 12-2 Format of statement of cash flows COMPANY NAME Statement of Cash Flows For the Period Covered Cash flows from operating activities (List of individual items) Net cash provided (used) by operating activities Cash flows from investing activities (List of individual inflows and outflows) Net cash provided (used) by investing activities Cash flows from financing activities (List of individual inflows and outflows) XX XXX XX XXX XX Net cash provided (used) by financing activities Net increase (decrease) in cash Cash at beginning of period XXX XXX XXX Cash at end of period XXX Noncash investing and financing activities (List of individual noncash transactions) XXX Preparing a Statement of Cash Flows—Indirect Method 595 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. 1 ? DO IT! Cash Flow Activities During its first week, Duffy & Stevenson Company had these transactions. 1. Issued 100,000 shares of $5 par value common stock for $800,000 cash. 2. Borrowed $200,000 from Castle Bank, signing a 5-year note bearing 8% interest. 3. Purchased two semi-trailer trucks for $170,000 cash. 4. Paid employees $12,000 for salaries and wages. 5. Collected $20,000 cash for services performed. Classify each of these transactions by type of cash flow activity. (Hint: Refer to Illustration 12-1.) SOLUTION 1. Financing activity 4. Operating activity 2. Financing activity 5. Operating activity 3. Investing activity Related exercise material: BE12-1, BE12-2, BE12-3, 2 ? LEARNING OBJECTIVE DO IT! 12-1, E12-1, and E12-2. Action Plan ? Identify the three types of activities used to report all cash inflows and outflows. ? Report as operating activities the cash effects of transactions that create revenues and expenses and enter into the determination of net income. ? Report as investing activities transactions that (a) acquire and dispose of investments and productive long-lived assets and (b) lend money and collect loans. ? Report as financing activities transactions that (a) obtain cash from issuing debt and repay the amounts borrowed and (b) obtain cash from stockholders and pay them dividends. Prepare a statement of cash flows using the indirect method. 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 asset, liability, and stockholders’ equity accounts 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. 596 12 Statement of Cash Flows Preparing the statement of cash flows from these data sources involves three major steps, explained in Illustration 12-3. ILLUSTRATION 12-3 Three major steps in preparing the statement of cash flows STEP 1: Determine net cash provided/used by operating activities by converting net income from an accrual basis to a cash basis. This step involves analyzing not only the current year's income statement but also comparative balance sheets and selected additional data. Buying & selling goods XY GooZ ds STEP 2: Analyze changes in noncurrent asset and liability accounts and record as investing and financing activities, or disclose as noncash transactions. BANK E XYZ Corp. AL S OR F Inve g ncin stin g Fina This step involves analyzing comparative balance sheet data and selected additional information for their effects on cash. STEP 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. Year 1 Year 2 – Difference = The difference between the beginning and ending cash balances can be easily computed from comparative balance sheets. 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. 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. INDIRECT METHOD—COMPUTER SERVICES COMPANY To explain how to prepare a statement of cash flows using the indirect method, we use financial information from Computer Services Company. Illustration 12-4 presents Computer Services’ current- and previous-year balance sheets, its current-year income statement, and related financial information. Preparing a Statement of Cash Flows—Indirect Method ILLUSTRATION 12-4 Comparative balance sheets, income statement, and additional information for Computer Services Company COMPUTER SERVICES COMPANY Comparative Balance Sheets December 31 Assets 2017 Current assets Cash Accounts receivable Inventory Prepaid expenses Property, plant, and equipment Land Buildings Accumulated depreciation—buildings Equipment Accumulated depreciation—equipment Total assets 2016 $ 55,000 $ 33,000 20,000 30,000 15,000 10,000 5,000 1,000 130,000 160,000 (11,000) 27,000 (3,000) 20,000 40,000 (5,000) 10,000 (1,000) Change in Account Balance Increase/Decrease $ 22,000 10,000 5,000 4,000 Increase Decrease Increase Increase 110,000 120,000 6,000 17,000 2,000 Increase Increase Increase Increase Increase $398,000 $138,000 Liabilities and Stockholders’ Equity Current liabilities Accounts payable Income taxes payable Long-term liabilities Bonds payable Stockholders’ equity Common stock Retained earnings Total liabilities and stockholders’ equity $ 28,000 6,000 $ 12,000 8,000 $ 16,000 Increase 2,000 Decrease 130,000 20,000 110,000 Increase 70,000 164,000 50,000 48,000 20,000 Increase 116,000 Increase $398,000 $138,000 COMPUTER SERVICES COMPANY Income Statement For the Year Ended December 31, 2017 Sales revenue Cost of goods sold Operating expenses (excluding depreciation) Depreciation expense Loss on disposal of plant assets Interest expense Income before income tax Income tax expense Net income $507,000 $150,000 111,000 9,000 3,000 42,000 597 315,000 192,000 47,000 $145,000 Additional information for 2017: 1. Depreciation expense was comprised of $6,000 for building and $3,000 for equipment. 2. The company sold equipment with a book value of $7,000 (cost $8,000, less accumulated depreciation $1,000) for $4,000 cash. 3. Issued $110,000 of long-term bonds in direct exchange for land. 4. A building costing $120,000 was purchased for cash. Equipment costing $25,000 was also purchased for cash. 5. Issued common stock for $20,000 cash. 6. The company declared and paid a $29,000 cash dividend. 598 12 Statement of Cash Flows We now apply the three steps to the information provided for Computer Services. 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 a company 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 12-5 lists the three types of adjustments. ILLUSTRATION 12-5 Three types of adjustments to convert net income to net cash provided by operating activities Net Income +/− Adjustments = Net Cash Provided/ Used by Operating Activities • Add back noncash expenses, such as depreciation expense and amortization expense. • Deduct gains and add losses that resulted from investing and financing activities. • Analyze changes to noncash current asset and current liability accounts. We explain the three types of adjustments in the next three sections. ? HELPFUL HINT Depreciation Expense Depreciation is similar to any other expense in that it reduces net income. It differs in that it does not involve a current cash outflow. That is why it must be added back to net income to arrive at net cash provided by operating activities. 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. ILLUSTRATION 12-6 Adjustment for depreciation Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense Net cash provided by operating activities $145,000 9,000 $154,000 Preparing a Statement of Cash Flows—Indirect Method 599 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 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 net 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 12-7 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. Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense Loss on disposal of plant assets $145,000 $9,000 3,000 Net cash provided by operating activities 12,000 $157,000 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, in this case $4,000, 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 step to reconcile 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. ILLUSTRATION 12-7 Adjustment for loss on disposal of plant assets 600 12 Statement of Cash Flows DECREASE IN ACCOUNTS RECEIVABLE Computer Services’ accounts receivable decreased by $10,000 (from $30,000 to $20,000) during the period. This means that cash receipts were $10,000 higher than sales revenue. The analysis of the Accounts Receivable account in Illustration 12-8 reveals this $10,000 difference. Computer Services had $507,000 in sales revenue (as reported on the income statement), but it collected $517,000 in cash. ILLUSTRATION 12-8 Analysis of accounts receivable Accounts Receivable 1/1/17 12/31/17 Balance Sales revenue Balance 30,000 507,000 Receipts from customers 517,000 20,000 As shown in Illustration 12-9, 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. ILLUSTRATION 12-9 Adjustments for changes in current asset accounts Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense Loss on disposal of plant assets Decrease in accounts receivable Increase in inventory Increase in prepaid expenses Net cash provided by operating activities $145,000 $ 9,000 3,000 10,000 (5,000) (4,000) 13,000 $158,000 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’ 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 12-9). 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 Preparing a Statement of Cash Flows—Indirect Method net cash provided by operating activities, the company deducts from net income the $4,000 increase in prepaid expenses (see Illustration 12-9). 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 cur- rent 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, 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 12-10, 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 taxes 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 12-10, to adjust net income to a cash basis, the company must reduce net income by $2,000. Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense Loss on disposal of plant assets Decrease in accounts receivable Increase in inventory Increase in prepaid expenses Increase in accounts payable Decrease in income taxes payable $145,000 $ 9,000 3,000 10,000 (5,000) (4,000) 16,000 (2,000) Net cash provided by operating activities 27,000 $172,000 Illustration 12-10 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 and amortization. ILLUSTRATION 12-10 Adjustments for changes in current liability accounts 601 602 12 Statement of Cash Flows 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 12-11 provides a summary of these changes. ILLUSTRATION 12-11 Adjustments required to convert net income to net cash provided by operating activities Adjustment Required to Convert Net Income to Net Cash Provided by Operating Activities Noncash charges Gains and losses Changes in current assets and current liabilities Depreciation expense Amortization expense Add Add Loss on disposal of plant assets Gain on disposal of plant assets Add Deduct Increase in current asset account Decrease in current asset account Increase in current liability account Decrease in current liability account Deduct Add Add Deduct ANATOMY OF A FRAUD For more than a decade, the top executives at the Italian dairy products company Parmalat engaged in multiple frauds that overstated cash and other assets by more than $1 billion while understating liabilities by between $8 and $12 billion. Much of the fraud involved creating fictitious sources and uses of cash. Some of these activities incorporated sophisticated financial transactions with subsidiaries created with the help of large international financial institutions. However, much of the fraud employed very basic, even sloppy, forgery of documents. For example, when outside auditors requested confirmation of bank accounts (such as a fake $4.8 billion account in the Cayman Islands), documents were created on scanners, with signatures that were cut and pasted from other documents. These were then passed through a fax machine numerous times to make them look real (if difficult to read). Similarly, fictitious bills were created in order to divert funds to other businesses owned by the Tanzi family (who controlled Parmalat). Total take: Billions of dollars THE MISSING CONTROL Independent internal verification. Internal auditors at the company should have independently verified bank accounts and major transfers of cash to outside companies that were controlled by the Tanzi family. 2a ? DO IT! Net Cash Provided by Operating Activities Josh’s PhotoPlus reported net income of $73,000 for 2017. Included in the income statement were depreciation expense of $7,000 and a gain on disposal of plant assets of $2,500. Josh’s comparative balance sheets show the following balances. Accounts Receivable Accounts Payable 12/31/17 12/31/16 $21,000 2,200 $17,000 6,000 Calculate net cash provided by operating activities for Josh’s PhotoPlus. Preparing a Statement of Cash Flows—Indirect Method Action Plan ? Add noncash charges such as depreciation back to net income to compute net cash provided by operating activities. ? Deduct gains and add back losses from the disposal of plant assets to compute net cash provided by operating activities. ? Use changes in noncash current asset and current liability accounts to compute net cash provided by operating activities. SOLUTION Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense Gain on disposal of plant assets Increase in accounts receivable Decrease in accounts payable $73,000 $ 7,000 (2,500) (4,000) (3,800) Net cash provided by operating activities Related exercise material: BE12-4, BE12-5, BE12-6, DO IT! 603 (3,300) $69,700 12-2a, E12-3, and E12-4. 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 investing and financing activities are measured and reported the same under both the direct and indirect methods. ETHICS NOTE ? the additional information, Computer Services 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 12–13, page 604.) ? HELPFUL HINT INCREASE IN BUILDINGS As the additional data indicate, Computer Services acquired an office building for $120,000 cash. This is a cash outflow reported in the investing activities section. (See Illustration 12–13.) 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. ILLUSTRATION 12-12 Analysis of equipment Equipment 1/1/17 Balance 10,000 Purchase of equipment 25,000 12/31/17 Balance Because investors and management bonus contracts often focus on cash flow from operations, some managers have taken unethical actions to artificially increase cash flow from operations. For example, Dynegy restated its statement of cash flows because it had improperly included in operating activities $300 million that should have been reported as financing activities. This error increased cash from operating activities by 37%. Cost of equipment sold 8,000 27,000 The following entry shows the details of the equipment sale transaction. Cash Accumulated Depreciation—Equipment Loss on Disposal of Plant Assets Equipment 4,000 1,000 3,000 A = L + SE +4,000 +1,000 −3,000 Exp 8,000 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. −8,000 Cash Flows +4,000 604 12 Statement of Cash Flows ? HELPFUL HINT When companies issue stocks or bonds for cash, the actual proceeds will appear in the statement of cash flows as a financing inflow (rather than the par value of the stocks or face value of bonds). 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—2017 Using the previous information, we can now prepare a statement of cash flows for 2017 for Computer Services Company, as shown in Illustration 12-13. ILLUSTRATION 12-13 Statement of cash flows, 2017—indirect method ? HELPFUL HINT Note that in the investing and financing activities sections, positive numbers indicate cash inflows (receipts), and negative numbers indicate cash outflows (payments). COMPUTER SERVICES COMPANY Statement of Cash Flows—Indirect Method For the Year Ended December 31, 2017 Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense Loss on disposal of plant assets Decrease in accounts receivable Increase in inventory Increase in prepaid expenses Increase in accounts payable Decrease in income taxes payable Net cash provided by operating activities Cash flows from investing activities Sale of equipment Purchase of building Purchase of equipment Net cash used by investing activities Cash flows from financing activities Issuance of common stock Payment of cash dividends Net cash used by financing activities Net increase in cash Cash at beginning of period $ 145,000 $ 9,000 3,000 10,000 (5,000) (4,000) 16,000 (2,000) 27,000 172,000 4,000 (120,000) (25,000) (141,000) 20,000 (29,000) (9,000) 22,000 33,000 Cash at end of period $ 55,000 Noncash investing and financing activities Issuance of bonds payable to purchase land $ 110,000 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 12-13 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 12-4 (page 597). Preparing a Statement of Cash Flows—Indirect Method 605 ACCOUNTING ACROSS THE ORGANIZATION Burning Through Our Cash © Soubrette/iStockphoto 2b ? DO IT! Box (cloud storage), Cyan (game creator), Fireeye (cyber security), and Mobile Iron (mobile security of data) are a few of the tech companies that recently have issued or are about to issue stock to the public. Investors now have to determine whether these tech companies have viable products and high chances for success. An important consideration in evaluating a tech company is determining its financial flexibility—its ability to withstand adversity if an economic setback occurs. One way to measure financial flexibility is to assess a company’s cash burn rate, which determines how long its cash will hold out if the company is expending more cash than it is receiving. Fireeye, for example, burned cash in excess of $50 million in 2013. But the company also had over $150 million as a cash cushion, so it would take over 30 months before it runs out of cash. And even though Box has a much lower cash burn rate than Fireeye, it still has over a year’s cushion. Compare that to the tech companies in 2000, when over one-quarter of them were on track to run out of cash within a year. And many did. Fortunately, the tech companies of today seem to be better equipped to withstand an economic setback. Source: Shira Ovide, “Tech Firms’ Cash Hoards Cool Fears of a Meltdown,” Wall Street Journal (May 14, 2014). What implications does a company’s cash burn rate have for its survival? (See WileyPLUS for this answer and additional questions.) Indirect Method Use the following information to prepare a statement of cash flows using the indirect method. REYNOLDS COMPANY Comparative Balance Sheets December 31 Assets Cash Accounts receivable Inventory Prepaid expenses Land Buildings Accumulated depreciation—buildings Equipment Accumulated depreciation—equipment Totals 2017 2016 $ 54,000 $ 37,000 68,000 26,000 54,000 –0– 4,000 6,000 45,000 70,000 200,000 200,000 (21,000) (11,000) 193,000 68,000 (28,000) (10,000) $569,000 $386,000 $ 23,000 10,000 110,000 220,000 206,000 $ 40,000 –0– 150,000 60,000 136,000 $569,000 $386,000 Change Increase/Decrease $ 17,000 Increase 42,000 Increase 54,000 Increase 2,000 Decrease 25,000 Decrease –0– 10,000 Increase 125,000 Increase 18,000 Increase Liabilities and Stockholders’ Equity Accounts payable Accrued expenses payable Bonds payable Common stock ($1 par) Retained earnings Totals $ 17,000 10,000 40,000 160,000 70,000 Decrease Increase Decrease Increase Increase 606 12 Statement of Cash Flows REYNOLDS COMPANY Income Statement For the Year Ended December 31, 2017 Sales revenue Cost of goods sold Operating expenses Interest expense Loss on disposal of equipment $890,000 $465,000 221,000 12,000 2,000 700,000 Income before income taxes Income tax expense 190,000 65,000 Net income $125,000 Additional information: 1. Operating expenses include depreciation expense of $33,000. 2. Land was sold at its book value for cash. 3. Cash dividends of $55,000 were declared and paid in 2017. 4. Equipment with a cost of $166,000 was purchased for cash. Equipment with a cost of $41,000 and a book value of $36,000 was sold for $34,000 cash. 5. Bonds of $40,000 were redeemed at their face value for cash. 6. Common stock ($1 par) of $160,000 was issued for cash. Action Plan ? Determine net cash provided/used by operating activities by adjusting net income for items that did not affect cash. ? Determine net cash provided/used by investing activities and financing activities. ? Determine the net increase/decrease in cash. SOLUTION REYNOLDS COMPANY Statement of Cash Flows—Indirect Method For the Year Ended December 31, 2017 Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense Loss on disposal of equipment Increase in accounts receivable Increase in inventory Decrease in prepaid expenses Decrease in accounts payable Increase in accrued expenses payable $ 125,000 $ 33,000 2,000 (42,000) (54,000) 2,000 (17,000) 10,000 Net cash provided by operating activities Cash flows from investing activities Sale of land Sale of equipment Purchase of equipment 59,000 25,000 34,000 (166,000) Net cash used by investing activities Cash flows from financing activities Redemption of bonds Sale of common stock Payment of dividends (107,000) (40,000) 160,000 (55,000) Net cash provided by financing activities 65,000 Net increase in cash Cash at beginning of period 17,000 37,000 Cash at end of period Related exercise material: BE12-4, BE12-5, BE12-6, BE12-7, (66,000) $ 54,000 DO IT! E12-2b, E12-5, E12-6, and E12-7. Using the Statement of Cash Flows to Evaluate a Company 3 ? LEARNING OBJECTIVE Use the statement of 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 the corporate life cycle and free cash flow. THE CORPORATE LIFE CYCLE ILLUSTRATION 12-14 Impact of product life cycle on cash flows Financing 0 Operating Negative Cash Flow Positive 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 decrease 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 12-14 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. Investing Introductory Growth Maturity Phase Decline 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 607 608 12 Statement of Cash Flows 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 activities 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. INVESTOR INSIGHT Operating with Negative Cash Listed here are amounts (in millions) of net income and net cash provided (used) by operating, investing, and financing activities for a variety of companies at one time. The final column suggests each company's likely phase in the life cycle based on these figures. Neil Barclay/Retna Company Net Income Net Cash Provided (Used) by Operating Activities Amazon.com LDK Solar $ 476 (144) $1,405 (81) 879 1,103 645 673 1,745 1,503 2,845 1,331 United States Steel Kellogg Southwest Airlines Starbucks Net Cash Provided (Used) by Investing Activities Net Cash Provided (Used) by Financing Activities $ $ (42) (329) (4,675) (601) (1,529) (1,202) (50) 462 (1,891) (788) 493 (172) Likely Phase in Life Cycle Early maturity Introductory/ early growth Maturity Early decline Maturity Maturity Why do companies have negative net cash provided by operating activities during the introductory phase? (Go to WileyPLUS for this answer and additional questions.) Using the Statement of Cash Flows to Evaluate a Company 609 FREE CASH FLOW In the statement of cash flows, net cash provided by operating activiDECISION TOOLS ties is intended to indicate the cash-generating capability of the comFree cash flows helps users depany. Analysts have noted, however, that cash provided by operating termine the amount of cash the activities fails to take into account that a company must invest company generated to expand in new fixed assets just to maintain its current level of operations. operations or pay dividends. 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 $80,000 dividend. In practice, free cash flow is often calculated with the formula in Illustration 12-15. Alternative definitions also exist. Free Cash Net Cash Provided Capital Cash = − − Flow by Operating Activities Expenditures Dividends ILLUSTRATION 12-15 Free cash flow Illustration 12-16 provides basic information excerpted from the 2014 statement of cash flows of Apple (prior to the payment of its first dividends). Real World ILLUSTRATION 12-16 Apple’s cash flow information ($ in millions) APPLE INC. Statement of Cash Flows Information (partial) 2014 Net cash provided by operating activities Cash flows from investing activities Additions to property and equipment and intangibles Purchases of investments Sales of investments Acquisitions of companies Maturities of investments Other Net cash used by investing activities Cash paid for dividends $ 59,713 $ (9,571) (217,128) 189,301 (3,765) 18,810 (226) (22,579) (11,126) Apple’s free cash flow is calculated as shown in Illustration 12-17 (in millions). Apple generated approximately $39 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. Net cash provided by operating activities Less: Expenditures on property, plant, and equipment Dividends paid $59,713 9,571 11,126 Free cash flow $39,016 Also note that Apple’s cash from operations of $59.7 billion exceeds its 2014 net income of $39.5 billion by $20.2 billion. This lends additional credibility to ILLUSTRATION 12-17 Calculation of Apple’s free cash flow ($ in millions) 610 12 Statement of Cash Flows Apple’s income number as an indicator of potential future performance. If anything, Apple’s net income might understate its actual performance. KEEPING AN EYE ON CASH Cash flow is closely monitored by analysts and investors for many reasons and in a variety of ways. One measure that is gaining increased attention is “price to cash flow.” This is a variant of the price to earnings (P-E) ratio, which has been a staple of analysts for a long time. The difference is that rather than divide the company’s stock price by its earnings per share (an accrual-accounting–based number), the price to cash flow ratio divides the company’s stock price by its cash flow per share. A high measure suggests that the stock price is high relative to the company’s ability to generate cash. A low measure indicates that the company’s stock might be a bargain. The following table provides values for some well-known companies in a recent year. While you should not use this measure as the sole factor in choosing a stock, it can serve as a useful screen by which to identify companies that merit further investigation. 3 ? DO IT! Company Price/Cash Flow Price/EPS Microsoft Apple Nike Wal-Mart Jet Blue 55.6 11.1 19.1 9.0 7.9 62.5 12.5 24.8 15.7 11.1 Free Cash Flow Chicago Corporation issued the following statement of cash flows for 2017. CHICAGO CORPORATION Statement of Cash Flows—Indirect Method For the Year Ended December 31, 2017 Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense Loss on disposal of plant assets Decrease in accounts receivable Increase in inventory Decrease in accounts payable Net cash provided by operating activities Cash flows from investing activities Sale of investments Purchase of equipment $ 19,000 $ 8,100 1,300 6,900 (4,000) (2,000) 29,300 1,100 (19,000) Net cash used by investing activities Cash flows from financing activities Issuance of stock Payment on long-term note payable Payment for dividends Net cash used by financing activities Net increase in cash Cash at beginning of year Cash at end of year 10,300 (17,900) 10,000 (5,000) (9,000) (4,000) 7,400 10,000 $ 17,400 Appendix 12A: Statement of Cash Flows—Direct Method 611 (a) Compute free cash flow for Chicago Corporation. (b) Explain why free cash flow often provides better information than “Net cash provided by operating activities.” SOLUTION (a) Free cash flow = $29,300 − $19,000 − $9,000 = $1,300 (b) Net cash provided by operating activities fails to take into account that a company must invest in new plant assets just to maintain the current level of operation. Companies must also maintain dividends at current levels to satisfy investors. The measurement of free cash flow provides additional insight regarding a company’s cash-generating ability. Related exercise material: BE12-9, BE12-10, BE12-11, BE12-12, USING DO IT! Action Plan ? Compute free cash flow as Net cash provided by operating activities − Capital expenditures − Cash dividends. 12-3, E12-9, and E12-10. DECISION TOOLS—INTEL CORPORATION Intel Corporation is the leading producer of computer chips for personal computers. Its primary competitor is AMD. Financial statement data for Intel are provided below. INTEL CORPORATION Statement of Cash Flows For the Year Ended December 31, 2014 (in millions) 2014 Net cash provided by operating activities Net cash used for investing activities Net cash used for financing activities $ 20,418 (9,905) (13,626) Net increase (decrease) in cash and cash equivalents $ (3,113) Note. Cash spent on property, plant, and equipment in 2014 was $10,105. Cash paid for dividends was $4,409. INSTRUCTIONS Calculate free cash flow for Intel and compare it with that of AMD (−$193 million). SOLUTION Intel’s free cash flow is $5,904 million ($20,418 − $10,105 − $4,409). AMD’s is −$193 million. This gives Intel a huge advantage in the ability to move quickly to invest in new projects. *4 ? LEARNING OBJECTIVE APPENDIX 12A: Prepare a statement of cash flows using the direct method. To explain and illustrate the direct method, we will use the transactions of Computer Services Company for 2017 to prepare a statement of cash flows. Illustration 12A-1 (page 612) presents information related to 2017 for the company. 612 12 Statement of Cash Flows ILLUSTRATION 12A-1 Comparative balance sheets, income statement, and additional information for Computer Services Company COMPUTER SERVICES COMPANY Comparative Balance Sheets December 31 Assets 2017 Current assets Cash Accounts receivable Inventory Prepaid expenses Property, plant, and equipment Land Buildings Accumulated depreciation—buildings Equipment Accumulated depreciation—equipment Total assets 2016 Change in Account Balance Increase/Decrease $ 55,000 $ 33,000 $ 22,000 Increase 20,000 30,000 10,000 Decrease 15,000 10,000 5,000 Increase 5,000 1,000 4,000 Increase 130,000 160,000 (11,000) 27,000 (3,000) 20,000 40,000 (5,000) 10,000 (1,000) 110,000 Increase 120,000 Increase 6,000 Increase 17,000 Increase 2,000 Increase $398,000 $138,000 Liabilities and Stockholders’ Equity Current liabilities Accounts payable Income taxes payable Long-term liabilities Bonds payable Stockholders’ equity Common stock Retained earnings Total liabilities and stockholders’ equity $ 28,000 $ 12,000 $ 16,000 Increase 6,000 8,000 2,000 Decrease 130,000 20,000 110,000 Increase 70,000 164,000 50,000 48,000 20,000 Increase 116,000 Increase $398,000 $138,000 COMPUTER SERVICES COMPANY Income Statement For the Year Ended December 31, 2017 Sales revenue Cost of goods sold Operating expenses (excluding depreciation) Depreciation expense Loss on disposal of plant assets Interest expense Income before income tax Income tax expense Net income $507,000 $150,000 111,000 9,000 3,000 42,000 315,000 192,000 47,000 $145,000 Additional information for 2017: 1. Depreciation expense was comprised of $6,000 for building and $3,000 for equipment. 2. The company sold equipment with a book value of $7,000 (cost $8,000, less accumulated depreciation $1,000) for $4,000 cash. 3. Issued $110,000 of long-term bonds in direct exchange for land. 4. A building costing $120,000 was purchased for cash. Equipment costing $25,000 was also purchased for cash. 5. Issued common stock for $20,000 cash. 6. The company declared and paid a $29,000 cash dividend. Appendix 12A: Statement of Cash Flows—Direct Method 613 To prepare a statement of cash flows under the direct approach, we will apply the three steps outlined in Illustration 12-3 (page 596). 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. Cash Receipts – Cash Payments Fragile From sales of goods and services to customers This End Up = ILLUSTRATION 12A-2 Major classes of cash receipts and payments Net Cash Provided by Operating Activities To suppliers To employees For operating expenses For interest From receipts of interest and dividends on loans and investments For taxes 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 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 Net cash provided by operating activities 614 12 Statement of Cash Flows the decrease in accounts receivable. For Computer Services, accounts receivable decreased $10,000. Thus, cash receipts from customers were $517,000, computed as shown in Illustration 12A-3. ILLUSTRATION 12A-3 Computation of cash receipts from customers Sales revenue Add: Decrease in accounts receivable $ 507,000 10,000 Cash receipts from customers $517,000 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-4 Analysis of accounts receivable Accounts Receivable 1/1/17 ? HELPFUL HINT The T-account shows that sales revenue plus decrease in accounts receivables equals cash receipts. ILLUSTRATION 12A-5 Formula to compute cash receipts from customers— direct method 12/31/17 Balance Sales revenue Balance 30,000 507,000 Receipts from customers 517,000 20,000 Illustration 12A-5 shows the relationships among cash receipts from customers, sales revenue, and changes in accounts receivable. Cash Receipts from Customers = Sales Revenue + Decrease in Accounts Receivable or − Increase in Accounts Receivable CASH PAYMENTS TO SUPPLIERS Computer Services 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 2017, Computer Services’ inventory increased $5,000. It computes purchases as follows. ILLUSTRATION 12A-6 Computation of purchases Cost of goods sold Add: Increase in inventory $ 150,000 5,000 Purchases $155,000 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, cash payments to suppliers were $139,000, computed as follows. ILLUSTRATION 12A-7 Computation of cash payments to suppliers Purchases Deduct: Increase in accounts payable $ 155,000 16,000 Cash payments to suppliers $139,000 Appendix 12A: Statement of Cash Flows—Direct Method 615 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-8 Analysis of accounts payable Accounts Payable Payments to suppliers 1/1/17 139,000 12/31/17 Balance Purchases Balance 12,000 155,000 28,000 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 to Suppliers = Cost of Goods Sold + Increase in Inventory or − Decrease in Inventory + Decrease in Accounts Payable or − Increase in Accounts Payable ? HELPFUL HINT The T-account shows that purchases less increase in accounts payable equals payments to suppliers. ILLUSTRATION 12A-9 Formula to compute cash payments to suppliers—direct method 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’ cash payments for operating expenses were $115,000, computed as follows. Operating expenses Add: Increase in prepaid expenses $ 111,000 4,000 Cash payments for operating expenses $115,000 ILLUSTRATION 12A-10 Computation of cash payments for operating expenses Illustration 12A-11 shows the relationships among cash payments for operating expenses, changes in prepaid expenses, and changes in accrued expenses payable. Cash Payments for = Operating Expenses Operating Expenses + Increase in Prepaid Expense or − Decrease in Prepaid Expense + − Decrease in Accrued Expenses Payable or Increase in Accrued Expenses Payable ILLUSTRATION 12A-11 Formula to compute cash payments for operating expenses—direct method 616 12 Statement of Cash Flows DEPRECIATION EXPENSE AND LOSS ON DISPOSAL OF PLANT ASSETS Computer Services’ depreciation expense in 2017 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 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 2016 or 2017, 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-12 Computation of cash payments for income taxes Income tax expense Add: Decrease in income taxes payable $ 47,000 2,000 Cash payments for income taxes $49,000 Illustration 12A-13 shows the relationships among cash payments for income taxes, income tax expense, and changes in income taxes payable. ILLUSTRATION 12A-13 Formula to compute cash payments for income taxes— direct method Cash Payments for Income Taxes = Income Tax Expense + Decrease in Income Taxes Payable or − Increase in Income Taxes Payable The operating activities section of the statement of cash flows of Computer Services is shown in Illustration 12A-14. ILLUSTRATION 12A-14 Operating activities section of the statement of cash flows Cash flows from operating activities Cash receipts from customers Less: Cash payments: To suppliers For operating expenses For interest expense For income taxes Net cash provided by operating activities $517,000 $139,000 115,000 42,000 49,000 345,000 $172,000 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. Appendix 12A: Statement of Cash Flows—Direct Method 617 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 ? HELPFUL HINT additional information, Computer Services 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, page 618.) The investing and financing activities are measured and reported the same under both the direct and indirect methods. INCREASE IN BUILDINGS As the additional data indicate, Computer Services acquired an office building for $120,000 cash. This is a cash outflow reported in the investing activities section. (See Illustration 12A-16, page 618.) 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. ILLUSTRATION 12A-15 Analysis of equipment Equipment 1/1/17 Balance 10,000 Purchase of equipment 25,000 12/31/17 Balance Cost of equipment sold 8,000 27,000 The following entry shows the details of the equipment sale transaction. Cash Accumulated Depreciation—Equipment Loss on Disposal of Plant Assets Equipment 4,000 1,000 3,000 A = L + SE +4,000 +1,000 8,000 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 (page 618). INCREASE IN RETAINED EARNINGS Retained earnings increased $116,000 dur- ing 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—2017 Illustration 12A-16 (page 618) shows the statement of cash flows for Computer Services Company. −8,000 −3,000 Exp Cash Flows +4,000 ? HELPFUL HINT When companies issue stocks or bonds for cash, the actual proceeds will appear in the statement of cash flows as a financing inflow (rather than the par value of the stocks or face value of bonds). 618 12 Statement of Cash Flows ILLUSTRATION 12A-16 Statement of cash flows, 2017—direct method COMPUTER SERVICES COMPANY Statement of Cash Flows—Direct Method For the Year Ended December 31, 2017 Cash flows from operating activities Cash receipts from customers Less: Cash payments: To suppliers For operating expenses For income taxes For interest expense Net cash provided by operating activities Cash flows from investing activities Sale of equipment Purchase of building Purchase of equipment $ 517,000 $ 139,000 115,000 49,000 42,000 345,000 172,000 4,000 (120,000) (25,000) Net cash used by investing activities Cash flows from financing activities Issuance of common stock Payment of cash dividends Net cash used by financing activities (141,000) 20,000 (29,000) (9,000) Net increase in cash Cash at beginning of period 22,000 33,000 Cash at end of period $ 55,000 Noncash investing and financing activities Issuance of bonds payable to purchase land $ 110,000 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 612). *5 ? LEARNING OBJECTIVE APPENDIX 12B: Use the T-account approach to prepare a statement of cash flows. 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: Assets = Liabilities + Equity Now, let’s rewrite the left-hand side as: Cash + Noncash Assets = Liabilities + Equity Next, rewrite the equation by subtracting Noncash Assets from each side to isolate Cash on the left-hand side: Cash = Liabilities + Equity − Noncash Assets Finally, if we insert the Δ symbol (which means “change in”), we have: ? Cash = ? Liabilities + ? Equity − ? Noncash Assets Appendix 12B: Statement of Cash Flows—T-Account Approach 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 12-3 (page 596). 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. 619 ILLUSTRATION 12B-1 T-account approach Cash Operating (1) Net income (2) Depreciation expense (3) Loss on equipment (4) Accounts receivable (7) Accounts payable 145,000 9,000 3,000 10,000 16,000 5,000 4,000 2,000 Inventory (5) Prepaid expenses (6) Income taxes payable (8) Net cash provided by operating activities 172,000 Investing (3) Sold equipment 4,000 Financing (12) Issued common stock 20,000 120,000 25,000 Purchased building (10) Purchased equipment (11) 141,000 Net cash used by investing activities 29,000 Dividend paid (13) 9,000 Net cash used by financing activities 22,000 Accounts Receivable Inventory 30,000 10,000 (4) 20,000 Buildings Prepaid Expenses 10,000 (5) 5,000 1,000 (6) 4,000 20,000 (9) 110,000 15,000 5,000 130,000 Accumulated Depreciation—Buildings 40,000 (10) 120,000 5,000 6,000 (2) 160,000 11,000 Accounts Payable 12,000 16,000 (7) 28,000 Land Income Taxes Payable Accumulated Depreciation—Equipment Equipment 10,000 (11) 25,000 8,000 (3) (3) 1,000 27,000 Bonds Payable 3,000 Common Stock 8,000 20,000 110,000 (9) 50,000 20,000 (12) 6,000 130,000 70,000 (8) 2,000 1,000 3,000 (2) Retained Earnings 48,000 145,000 (1) (13) 29,000 164,000 1. Post net income as a debit to the operating section of the Cash T-account and a credit to Retained Earnings. Make sure to label all adjustments to the Cash T-account. It also helps to number each adjustment so you can trace all of them if you make an error. 620 12 Statement of Cash Flows 2. Post depreciation expense as a debit to the operating section of Cash and a credit to each of the appropriate accumulated depreciation accounts. 3. Post any gains or losses on the sale of property, plant, and equipment. To do this, it is best to first prepare the journal entry that was recorded at the time of the sale and then post each element of the journal entry. For example, for Computer Services the entry was: Cash Accumulated Depreciation—Equipment Loss on Disposal of Plant Assets Equipment 4,000 1,000 3,000 8,000 The $4,000 cash entry is a source of cash in the investing section of the Cash account. Accumulated Depreciation—Equipment is debited for $1,000. The Loss on Disposal of Plant Assets is a debit to the operating section of the Cash T-account. Finally, Equipment is credited for $8,000. 4–8. Next, post each of the changes to the noncash current asset and current liability accounts. For example, to explain the $10,000 decline in Computer Services’ accounts receivable, credit Accounts Receivable for $10,000 and debit the operating section of the Cash T-account for $10,000. 9. Analyze the changes in the noncurrent accounts. Land was purchased by issuing bonds payable. This requires a debit to Land for $110,000 and a credit to Bonds Payable for $110,000. Note that this is a significant noncash event that requires disclosure at the bottom of the statement of cash flows. 10. Buildings is debited for $120,000, and the investing section of the Cash T-account is credited for $120,000 as a use of cash from investing. 11. Equipment is debited for $25,000 and the investing section of the Cash T-account is credited for $25,000 as a use of cash from investing. 12. Common Stock is credited for $20,000 for the issuance of shares of stock, and the financing section of the Cash T-account is debited for $20,000. 13. Retained Earnings is debited to reflect the payment of the $29,000 dividend, and the financing section of the Cash T-account is credited to reflect the use of Cash. 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. ? REVIEW AND PRACTICE LEARNING OBJECTIVES REVIEW 1 Discuss the usefulness and format 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. 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. 2 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. Practice Multiple-Choice Questions 3 Use the statement of cash flows to evaluate a company. During the introductory stage, net cash provided by operating activities and net cash provided by investing activities are negative, and net cash provided by 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 provided by investing activities becomes positive (from selling off assets), and net cash provided by financing activities becomes more negative. 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. *4 Prepare a statement of cash flows using the direct method. The preparation of the statement of cash flows 621 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. *5 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 12-3 (page 596), entering debit and credit amounts as needed. DECISION TOOLS REVIEW DECISION CHECKPOINTS INFO NEEDED FOR DECISION Net cash provided by operating activities, cash spent on fixed assets, and cash dividends Net cash provided Free Capital Cash by − − cash 5 expenditures dividends operating flow activities HOW TO EVALUATE RESULTS Significant free cash flow indicates greater potential to finance new investment and pay additional dividends. ? How much cash did the company generate to either expand operations or pay dividends? TOOL TO USE FOR DECISION GLOSSARY REVIEW Direct method A method of determining net cash provided by operating activities by adjusting each item in the income statement from the accrual basis to the cash basis. The direct method shows operating cash receipts and payments. (p. 596). Financing activities Cash flow activities that include (a) obtaining cash from issuing debt and repaying the amounts borrowed and (b) obtaining cash from stockholders, repurchasing shares, and paying dividends. (p. 592). Free cash flow Net cash provided by operating activities after adjusting for capital expenditures and cash dividends paid. (p. 609). Indirect method A method of preparing a statement of cash flows in which net income is adjusted for items that do not affect cash, to determine net cash provided by operating activities. (p. 596). Operating activities Cash flow activities that include the cash effects of transactions that create revenues and expenses and thus enter into the determination of net income. (p. 592). Product life cycle A series of phases in a product’s sales and cash flows over time. These phases, in order of occurrence, are introductory, growth, maturity, and decline. (p. 607). Statement of cash flows A basic financial statement that provides information about the cash receipts and cash payments of an entity during a period, classified as operating, investing, and financing activities, in a format that reconciles the beginning and ending cash balances. (p. 592). ? Investing activities Cash flow activities that include (a) transactions that involve the purchase or disposal of investments and property, plant, and equipment using cash, and (b) lending money and collecting the loans. (p. 592). PRACTICE MULTIPLE-CHOICE QUESTIONS (LO 1) 1. Which of the following is incorrect about the statement of cash flows? (a) It is a fourth basic financial statement. (b) It provides information about cash receipts and cash payments of an entity during a period. (c) It reconciles the ending cash account balance to the balance per the bank statement. (d) It provides information about the operating, investing, and financing activities of the business. 622 12 Statement of Cash Flows (LO 1) 2. Which of the following will not be reported in the statement of cash flows? (a) The net change in stockholders’ equity during the year. (b) Cash payments for plant assets during the year. (c) Cash receipts from sales of plant assets during the year. (d) Sources of financing during the period. (LO 1) 3. The statement of cash flows classifies cash receipts and cash payments by these activities: (a) operating and nonoperating. (b) operating, investing, and financing. (c) financing, operating, and nonoperating. (d) investing, financing, and nonoperating. (LO 1) 4. Which is an example of a cash flow from an operating activity? (a) Payment of cash to lenders for interest. (b) Receipt of cash from the sale of common stock. (c) Payment of cash dividends to the company’s stockholders. (d) None of the above. (LO 1) 5. Which is an example of a cash flow from an investing activity? (a) Receipt of cash from the issuance of bonds payable. (b) Payment of cash to repurchase outstanding common stock. (c) Receipt of cash from the sale of equipment. (d) Payment of cash to suppliers for inventory. (LO 1) 6. Cash dividends paid to stockholders are classified on the statement of cash flows as: (a) operating activities. (b) investing activities. (c) a combination of (a) and (b). (d) financing activities. (LO 1) 7. Which is an example of a cash flow from a financing activity? (a) Receipt of cash from sale of land. (b) Issuance of debt for cash. (c) Purchase of equipment for cash. (d) None of the above (LO 1) 8. Which of the following is incorrect about the statement of cash flows? (a) The direct method may be used to report net cash provided by operating activities. (b) The statement shows the net cash provided (used) for three categories of activity. (c) The operating activities section is the last section of the statement. (d) The indirect method may be used to report net cash provided by operating activities. (c) amortization expense. (d) loss on disposal of equipment. 11. The following data are available for Bill Mack (LO 2) Corporation. Net income $200,000 Depreciation expense 40,000 Dividends paid 60,000 Gain on sale of land 10,000 Decrease in accounts receivable 20,000 Decrease in accounts payable 30,000 Use the indirect method to solve Questions 9 through 11. (LO 2) 9. Net income is $132,000, accounts payable increased $10,000 during the year, inventory decreased $6,000 during the year, and accounts receivable increased $12,000 during the year. Under the indirect method, what is net cash provided by operating activities? (a) $102,000. (c) $124,000. (b) $112,000. (d) $136,000. (LO 2) 10. Items that are added back to net income in determining net cash provided by operating activities under the indirect method do not include: (a) depreciation expense. (b) an increase in inventory. Use the direct method to solve Questions 16 and 17. *16. The beginning balance in accounts receivable is (LO 4) $44,000, the ending balance is $42,000, and sales during the period are $129,000. What are cash receipts from customers? (a) $127,000. (c) $131,000. (b) $129,000. (d) $141,000. *17. Which of the following items is reported on a state- (LO 4) ment of cash flows prepared by the direct method? (a) Loss on disposal of building. (b) Increase in accounts receivable. (c) Depreciation expense. (d) Cash payments to suppliers. Net cash provided by operating activities is: (a) $160,000. (c) $240,000. (b) $220,000. (d) $280,000. 12. The following are data concerning cash received (LO 2) or paid from various transactions for Orange Peels Corporation. Sale of land $100,000 Sale of equipment 50,000 Issuance of common stock 70,000 Purchase of equipment 30,000 Payment of cash dividends 60,000 Net cash provided by investing activities is: (a) $120,000. (c) $150,000. (b) $130,000. (d) $190,000. 13. The following data are available for Retique! Increase in accounts payable $ 40,000 Increase in bonds payable 100,000 Sale of investment 50,000 Issuance of common stock 60,000 Payment of cash dividends 30,000 (LO 2) Net cash provided by financing activities is: (a) $90,000. (c) $160,000. (b) $130,000. (d) $170,000. 14. Free cash flow provides an indication of a (LO 3) company’s ability to: (a) manage inventory. (b) generate cash to pay dividends. (c) generate cash to invest in new capital expenditures. (d) Both (b) and (c). 15. During the introductory phase of a com- (LO 3) pany’s life cycle, one would normally expect to see: (a) negative cash from operations, negative cash from investing, and positive cash from financing. (b) negative cash from operations, positive cash from investing, and positive cash from financing. (c) positive cash from operations, negative cash from investing, and negative cash from financing. (d) positive cash from operations, negative cash from investing, and positive cash from financing. Practice Exercises 623 SOLUTIONS 1. (c) The statement of cash flows does not reconcile the ending cash balance to the balance per the bank statement. The other choices are true statements. 2. (a) The net change in stockholders’ equity during the year is not reported in the statement of cash flows. The other choices are true statements. 3. (b) Operating, investing, and financing activities are the three classifications of cash receipts and cash payments used in the statement of cash flows. The other choices are therefore incorrect. 4. (a) Payment of cash to lenders for interest is an operating activity. The other choices are incorrect because (b) receipt of cash from the sale of common stock is a financing activity, (c) payment of cash dividends to the company’s stockholders is a financing activity, and (d) there is a correct answer. 5. (c) Receipt of cash from the sale of equipment is an investing activity. The other choices are incorrect because (a) the receipt of cash from the issuance of bonds payable is a financing activity, (b) payment of cash to repurchase outstanding common stock is a financing activity, and (d) payment of cash to suppliers for inventory is an operating activity. 6. (d) Cash dividends paid to stockholders are classified as a financing activity, not (a) an operating activity, (b) an investing activity, or (c) a combination of (a) and (b). 7. (b) Issuance of debt for cash is a financing activity. The other choices are incorrect because (a) the receipt of cash for the sale of land is an investing activity, (c) the purchase of equipment for cash is an investing activity, and (d) there is a correct answer. 8. (c) The operating section of the statement of cash flows is the first, not the last, section of the statement. The other choices are true statements. 9. (d) Net cash provided by operating activities is computed by adjusting net income for the changes in the three current asset/current liability accounts listed. An increase in accounts payable ($10,000) and a decrease in inventory ($6,000) are added to net income ($132,000), while an increase in accounts receivable ($12,000) is subtracted from net income, or $132,000 + $10,000 + $6,000 − $12,000 = $136,000, not (a) $102,000, (b) $112,000, or (c) $124,000. 10. (b) An increase in inventory is subtracted, not added, to net income in determining net cash provided by operating activities. The other choices are incorrect because (a) depreciation expense, (c) amortization expense, and (d) loss on disposal of equipment are all added back to net income in determining net cash provided by operating activities. 11. (b) Net cash provided by operating activities is $220,000 (Net income $200,000 + Depreciation expense $40,000 − Gain on disposal of land $10,000 + Decrease in accounts receivable $20,000 − Decrease in accounts payable $30,000), not (a) $160,000, (c) $240,000, or (d) $280,000. 12. (a) Net cash provided by investing activities is $120,000 (Sale of land $100,000 + Sale of equipment $50,000 − Purchase of equipment $30,000), not (b) $130,000, (c) $150,000, or (d) $190,000. Issuance of common stock and payment of cash dividends are financing activities. 13. (b) Net cash provided by financing activities is $130,000 (Increase in bonds payable $100,000 + Issuance of common stock $60,000 − Payment of cash dividends $30,000), not (a) $90,000, (c) $160,000, or (d) $170,000. Increase in accounts payable is an operating activity, and sale of investment is an investing activity. 14. (d) Free cash flow provides an indication of a company’s ability to generate cash to pay dividends and to invest in new capital expenditures. Choice (a) is incorrect because other measures besides free cash flow provide the best measure of a company’s ability to manage inventory. Choices (b) and (c) are true statements, but (d) is the better answer. 15. (a) During the introductory phase of a company’s life cycle, the company will most likely finance its operations and investing activities through borrowing or the issuance of stock. This means negative cash from operations and investing, and positive cash from financing. The other choices are incorrect because during the introductory phase of a company’s life cycle, the company will most likely (b) purchase long-term assets which requi...

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