Chapter 6
The Statement of Cash Flows
SOLUTIONS
1.The two primary purposes of the statement of cash flows are to provide information about the firm’s operating cash receipts and cash payments and to provide information about the cash flows associated with the firm’s investing and financing activities.
2.Cash equivalents are short-term, highly liquid investments such as treasury bills, commercial paper, and money market funds. These investments are readily convertible to known amounts of cash.
3.The three cash flow categories included in the statement of cash flows are:
- Operating. Operating activities are those activities that enter into the calculation of net income.
Net cash provided by operating activities is the “bottom line” of the cash flow statement.
- Investing. The primary investing activities are the purchase and sale of land, buildings,
equipment, and investments involving securities of other entities.
- Financing. Financing activities involve the receipt of cash from and the repayment of cash to
owners and lenders.
4.A growing company might report negative cash from operating and investing activities as a sign of the cash that is being spent in business expansion. A growing company would also experience positive cash from financing activities in order to fund this growth. A mature company in a stable industry would probably have positive cash from operations, a small negative cash from investing activities in order to finance asset replacements, and negative cash from financing activities as loans are repaid and large dividends are paid to shareholders.
5.Two significant non-cash activities that you might expect to find disclosed in the notes to the financial statements are assets acquired through a mortgage or in exchange for stock or a conversion of a debt obligation into an equity position such as conversion of bonds into stock.
6.Conceptually, the statement of cash flows is the easiest financial statement to prepare because the preparation of a statement of cash flows is no more complicated than a simple three-way sorting of transactions into operating, investing, and financing transactions.
7.The following transactions affect both net income and cash flows:
- Sale of merchandise (services) for cash
- Payment to suppliers for merchandise inventory that has been sold
- Payment to employees for salaries and wages
- Payment of income taxes
The following transactions change net income but have no effect on cash flows from operations:
- Recording of depreciation expense
- Recognition of gains or losses on the sale of assets
- Recognition of a restructuring charge
8.The six steps in the process for preparing a statement of cash flows using income statement and balance sheet data are:
1.Compute the change in the cash balance.
2.Convert the income statement from an accrual-basis to a cash-basis summary of operations.
3.Analyze the long-term assets to identify the cash flow effects of investing activities.
4.Analyze the long-term debt and stockholders’ equity accounts to determine the cash flow
effects of any financing transactions.
5.Prepare the formal statement of cash flows.
6.Disclose any significant investing or financing transactions that did not involve cash.
9.Depreciation is added back to net income in computing cash from operating activities using the indirect method because depreciation does not involve an outflow of cash. Since depreciation expense is initially subtracted to arrive at net income, adding it back effectively eliminates depreciation from the computation of cash from operations.
10.Gains are subtracted and losses are added to compute cash flow from operations when using the indirect method in order to avoid double counting. For example, the cash flow effect of an equipment sale is shown in the investing activities section of the cash flow statement. To avoid double counting, any gain or loss on the sale of the equipment should be excluded from the operating activities section. In order to exclude a gain from the operating activities section, it must be subtracted from net income. A loss must be added back to net income in the operating activities section.
11.In general, one should analyze the current assets and current liabilities in computing cash from operating activities. To analyze cash from investing activities, one should look at the long-term asset accounts. To analyze cash from financing activities, one should look at the long-term debt and the equity accounts.
12.To find cash collected from customers (using the direct method):
Beginning accounts receivable $ 220,000
+ Sales during the year 270,000
= Total amount to be collected $ 490,000
– Ending accounts receivable (amount not yet collected) (160,000)
= Cash collected from customers $ 330,000
13.The direct method is favored by many users of financial statements because it is easy to understand. Even a financial statement novice can decipher operating cash flow information when it is presented using the direct method. On the other hand, the indirect method is favored and used by most companies because it is relatively easy to construct from existing balance sheet and income statement data. In addition, the indirect method highlights the reasons for the difference between net income and cash from operations.
14.Depreciation is not a source of cash. Higher depreciation expense means lower net income. However, since the depreciation expense is added back in computing cash from operating activities, there is no net effect on operating cash flow. To repeat, depreciation is not a source of cash. Note: Depreciation tax deductions do reduce the amount of cash paid for income taxes.
15.If the balance in a prepaid asset account increases during the year, this means that the cash paid for that item (to replenish the account) was more than the expense, or consumption, associated with that item.
16.If the account Unearned Revenue increases during a period, this represents an additional inflow of cash for services that have not yet been performed With the direct method, this is shown as additional cash collected from customers. With indirect method, the increase in the liability Unearned Revenue is shown as an addition to operating cash flow.
17.Increases in current assets result in a subtraction from net income to arrive at cash flow from operations when using the indirect method because an increase represents cash that otherwise would have been available for buying equipment or paying dividends that is tied up in the form of that current asset. A decrease is added in the computation of cash flow from operations because a decrease means cash has been freed for other purposes.
18.With respect to the account Property, Plant & Equipment and the related Accumulated Depreciation account, the three most common events that can occur are purchases, sales, and depreciation. A purchase is shown as a cash outflow from investing activities. A sale is a cash inflow from investing activities. Depreciation expense is included in the computation of net income but, because it is a non-cash expense, is eliminated by adding it back in computing cash from operating activities.
19.The Retained Earnings account increases because of net income, which is included in the computation of cash from operating activities. The Retained Earnings account decreases because of net losses which are also part of the computation of cash from operating activities. The Retained Earnings account also decreases because of cash dividends which are reported as part of financing activities.
20.A forecasted statement of cash flows allows management to see the relationship between forecasted operating cash flow and the cash needed for investing activities. If there is an expected shortfall in available cash, a company can either use the forecasted information in obtaining additional financing or the company can scale back its expansion plans in order to reduce the drain on cash.
21.Lenders can make use of a forecasted statement of cash flows to see whether it seems likely that a company can continue to meet its existing debt obligations. An investor can use the projected cash flow statement to evaluate the likelihood that a company will be able to continue making dividend payments.
EXERCISES
E 6-1 Transactions Affecting Cash Flows
Effect on Cash
Transaction Increase Decrease No Effect
a.Amortization of intangible asset X
b.Conversion of preferred stock to common stock X
c.Sales on account X
d.Purchase of inventory on account X
e.Declaration of a dividend X
f.Payment of accounts payable X
g.Collection of accounts receivable X
h.Depreciation on factory building X
i.Sale of building at a loss X
j.Retirement of debt through issuance of common stock X
E 6-2 Types of Activities Affecting Cash Flow
a.Payment of federal income taxes 1 Operating
b.Dividend payments to shareholders 3 Financing
c.Repayment of short–term obligations 3 Financing
d.Loans made to another company 2 Investing
e.Payments made to acquire a business 2 Investing
f.Salaries paid to employees 1 Operating
g.Interest paid to lenders 1 Operating
h.Dividends received from investments 1 Operating
i.Cash paid to acquire treasury stock 3 Financing
E 6-3 Purpose and Format of the Statement of Cash Flows
1.The two primary purposes of the cash flow statement are to provide information about the firm’s cash receipts and cash payments and to provide information about the investing and financing activities of the firm. This statement is useful to present and potential investors and creditors because it helps them assess:
a.the firm’s ability to generate future cash flows.
b.the firm’s ability to meet its obligations and pay dividends and its need for outside financing.
c.the reasons for the differences between income and cash receipts and payments.
d.both the cash and non-cash aspects of the firm’s investing and financing activities.
2.The following methods are used to report cash flows from operations:
a.The direct method, which involves reporting the major types of operating receipts and cash payments, such as receipts from the sale of goods and services and payments to suppliers of inventory. Cash flows from operating activities are the difference between the total operating receipts and the total operating payments.
b.The indirect method, which involves presenting a reconciliation between net income and net cash flows from operations. Essentially, the accrual-based income statement is reconciled to a cash-basis statement.
3.The following categories of activities must be disclosed on the statement of cash flows:
a.Operating activities, which include all transactions that are not considered either investing or financing activities. Therefore, operating activities consist primarily of delivering or producing goods for sale and providing services. Cash flows from operating activities are really the cash effect of the transactions that enter into the determination of net income.
b.Investing activities, which include cash inflows and outflows from lending money and collecting on loans and from acquiring and selling securities and productive assets such as property, plant, and equipment.
c.Financing activities, which include obtaining resources from owners and providing them a return on their investment and obtaining borrowed resources from creditors and repaying those borrowings. Common examples include issuance of notes, bonds, mortgages, and other short- or long-term borrowings and the issuance of common and preferred stock.
4.The FASB requires that information about the non-cash investing and financing activities be disclosed outside the formal statement of cash flows. These transactions should be clearly identified as not involving cash receipts or payments. An example of such a transaction is when a firm issues common stock in exchange for plant and equipment.
E 6-4 Accounts Used for Cash Flow Analysis
Income Statement Balance Sheet
a.SalesAccounts Receivable
b.Cost of Goods SoldInventory, Accounts Payable
c.Depreciation ExpenseAccumulated Depreciation
d.Amortization ExpenseAccumulated Amortization
or associated asset account
e.Rent ExpensePrepaid Rent or Rent Payable
f.Interest ExpenseInterest Payable
g.Insurance ExpensePrepaid Insurance
h.Income Tax ExpenseIncome Taxes Payable, Prepaid Income tax
E 6-5 Classifying Cash Flow Activities
a.Financing activity, increase cash
b.Investing activity, increase cash
c.Financing activity, decrease cash
d.Operating activity, decrease cash
e.Investing activity, decrease cash
f.Investing and financing, non-cash transaction
g.Financing activity, decrease cash
E 6-6 Format of the Statement of Cash Flows
1.Wilcox Inc.
Statement of Cash Flows
For the Year Ended December 31, 2006
Cash flows from operating activities:
Receipts from customers$ 276,000
Payments for inventory (211,200)
Payments for operating expenses (62,400)
Payments for interest (40,800)
Payments for taxes (37,800)
Net cash used in operating activities $(76,200)
Cash flows from investing activities:
Proceeds from sale of equipment$ 66,000
Purchase of equipment (276,000)
Net cash used in investing activities (210,000)
Cash flows from financing activities:
Proceeds from loan$ 240,000
Sale of stock 180,000
Payment of dividends (52,800)
Net cash provided by financing activities 367,200
Net Cash Increase for the Period $81,000
2.The cash inflow and outflow summary report initially prepared by Wilcox Inc. obscures the fact that Wilcox’s operations consumed $76,200 in cash during 2006. Cash from operating activities is a key indicator of company performance. From the formal statement of cash flows, we can see that Wilcox needed to obtain $420,000 in financing in order to meet its cash needs for the year. The three-category statement of cash flows is much more informative than is the summary inflow/outflow statement prepared by Wilcox.
E 6-7 Understanding the Statement of Cash Flows
Looking at the cash flow statement, we see that the majority of the cash generated from operating and financing activities was invested in KCA Company. If this investment was made with the intention of acquiring (or merging with) KCA Company, then the financial statements of KCA Company must be examined to assess the impact of this investment on the overall profitability of Potsie Company. We also notice that Potsie Company retired bonds of $400,000, issued $500,000 of common stock, and issued $800,000 of long-term debt. Further, the dividends paid totaled $200,000.
Even though there was a net increase in cash of $65,000, this is far less than the cash provided by operations of $165,000. Further, the amount of investing and financing activities that took place indicates that the company may be going through a major reorganization.
E 6-8 Determining Cash Payments for Inventory Purchases
Ending inventory$ 265,000
+ Cost of goods sold during the year 900,000
= Total amount of inventory needed during the year$ 1,165,000
– Beginning inventory (inventory already on hand) (232,500)
= Inventory purchased during the year$ 932,500
+ Beginning balance in accounts payable 120,000
= Total amount owed for inventory purchases$ 1,052,500
– Ending balance in accounts payable (amount not yet paid) (100,000)
= Cash paid for inventory purchases$ 952,500
E 6-9 Determining Cash Payments for Inventory Purchases
Ending inventory$ 60,000
+ Cost of goods sold during the year 350,000
= Total amount of inventory needed during the year$ 410,000
– Beginning inventory (inventory already on hand) (40,000)
= Inventory purchased during the year$ 370,000
+ Beginning balance in accounts payable 25,000
= Total amount owed for inventory purchases$ 395,000
– Ending balance in accounts payable (amount not yet paid) (20,000)
= Cash paid for inventory purchases$ 375,000
E 6-10 Determining Cash Flows from Operations
Payne Company
Cash Flows from Operating Activities
Net cash flows from operating activities
Net income$ 275,000
Depreciation expense 9,000
Increase in accounts receivable (45,000)
Increase in prepaid insurance (1,400)
Decrease in supplies 2,000
Decrease in accounts payable (8,000)
Net cash provided by operating activities$ 231,600
E 6-11 Determining Cash Flows from Operations
Amulek Corporation
Cash Flows from Operating Activities
Net cash flows from operating activities
Net income$ 675,000
Depreciation expense 139,500
Less: Gain on sale of land (25,500)
Less: Increase in accounts receivable (26,100)
Plus: Decrease in inventory 18,900
Plus: Increase in accounts payable 13,500
Net cash provided by operating activities$ 795,300
E 6-12 Cash Flow Impact of Gains and Losses
1.If Pecan uses the direct method of reporting cash from operating activities, nothing with respect to the computer sale will be reported in the operating activities section. The $50,000 cash proceeds from the computer sale will be reported as a cash inflow from investing activities.
2.The $50,000 cash proceeds from the computer sale will be reported as a cash inflow from investing activities. In addition, if Pecan uses the indirect method of reporting cash from operating activities, the impact of the $20,000 loss must be removed from net income. In order to do so, the $20,000 loss is added back in computing cash from operating activities.
E 6-13 Complete Statement of Cash Flows: Indirect Method
LaForge Company
Statement of Cash Flows (Indirect Method)
For the Year Ended December 31, 2006
Cash flows from operating activities:
Net Income $ 70
Adjustments:
Depreciation$ 60
Decrease in accounts receivable 50
Increase in inventory (30)
Increase in prepaid general expenses (8)
Increase in accounts payable 25
Increase in interest payable 2
Decrease in income taxes payable (17) 82
Net cash provided by operating activities $ 152
Cash flows from investing activities:
Sale of plant assets$ 200
Purchase of plant assets (349)1
Net cash used in investing activities (149)
Cash flows from financing activities:
Issuance of bonds payable $ 402
Issuance of stock 383
Payment of cash dividends (75)
Net cash provided by financing activities 3
Net increase in cash and cash equivalents $ 6
Cash and cash equivalents at beginning of year 16
Cash and cash equivalents at end of year $ 22
COMPUTATIONS:
1Beginning plant assets$ 1,000
Less: Plant assets sold 330
$ 670
Add: Ending plant assets 1,019
Difference (plant assets purchased)$ 349
2Beginning bonds payable$ 77
Ending bonds payable 117
Increase (bonds payable issued)$ 40
3Beginning paid-in capital$ 300
Ending paid-in capital 338
Increase (stock issued)$ 38
The following matrix can be used in computing cash from operating activities: