The Statement of Cash Flows: Usefulness and Format

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

Usefulness of the Statement of Cash Flows

The statement of cash flows reports the cash receipts, cash payments, and net change in cash resulting from operating, investing, and financing activities during a period. The information in a statement of cash flows should help investors, creditors, and others assess:

1. The entity's ability to generate future cash flows. By examining relationships between items in the statement of cash flows, investors can 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. 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) acquiring and disposing of investments and property, plant, and equipment, and (b) lending money and collecting the loans.

3. Financing activities include (a) obtaining cash from issuing debt and repaying the amounts borrowed, and (b) obtaining cash from stockholders, repurchasing shares, and paying dividends.

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

Illustration 17-1 lists typical cash receipts and cash payments within each of the three classifications. Study the list carefully. It will prove very useful in solving homework exercises and problems.

Illustration 17-1
Typical receipt and payment classifications

Note the following general guidelines:

1. Operating activities involve income statement items.

2. Investing activities involve cash flows resulting from changes in investments and long-term asset items.

3. Financing activities involve cash flows resulting from changes in long-term liability and stockholders’ equity items.

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

Significant Noncash Activities

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

1. Direct issuance of common stock to purchase assets.

2. Conversion of bonds into common stock.

3. Direct issuance of debt to purchase assets.

4. Exchanges of plant assets.

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.

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 17-2 on the next page for an example.)

Format of the Statement of Cash Flows

The general format of the statement of cash flows presents the results of the three activities discussed previously—operating, investing, and financing—plus the significant noncash investing and financing activities. Illustration 17-2 shows a widely used form of the statement of cash flows.

Illustration 17-2
Format of statement of cash flows

The cash flows from operating activities section always appears first, followed by the investing activities section and then the financing activities section. The sum of the operating, investing, and financing 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.

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Preparing the Statement of Cash Flows

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

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

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

Preparing the statement of cash flows from these data sources involves three major steps, explained in Illustration 17-3.

Illustration 17-3
Three major steps in preparing the statement of cash flows

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. A great majority of companies (98%) use this method, as shown in the nearby chart.¹ Companies favor the indirect method for two reasons. (1) It is easier and less costly to prepare, and (2) it focuses on the differences between net income and net cash flow from operating activities.

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

The next section illustrates the more popular indirect method. Appendix 17A illustrates the direct method.

Preparing the Statement of Cash Flows—Indirect Method

To explain how to prepare a statement of cash flows using the indirect method, we use financial information from Computer Services Company. Illustration 17-4 presents Computer Services’ current and previous-year balance sheets, its current-year income statement, and related financial information for the current year.

Illustration 17-4
Comparative balance sheets, income statement, and additional information for Computer Services Company

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

Step 1: Operating Activities

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

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

Under generally accepted accounting principles, most companies use the accrual basis of accounting. This basis requires that companies record revenue when their 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, 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 17-5 lists the three types of adjustments.

Illustration 17-5
Three types of adjustments to convert net income to net cash provided by operating activities

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

DEPRECIATION EXPENSE

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

Helpful Hint 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.

Illustration 17-6
Adjustment for depreciation

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

LOSS ON DISPOSAL OF EQUIPMENT

Illustration 17-1 states that cash received from the sale (disposal) of plant assets is reported in the investing activities section. Because of this, companies eliminate from net income all gains and losses related to the disposal of plant assets, 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 equipment (book value $7,000, less $4,000 cash received from disposal of equipment). The company's loss of $3,000 should not be included in the operating activities section of the statement of cash flows. Illustration 17-7 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.

Illustration 17-7
Adjustment for loss on disposal of equipment

If a gain on disposal 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 as a source of cash in the investing activities section of the statement of cash flows the actual amount of cash received from the sale.

CHANGES TO NONCASH CURRENT ASSET AND CURRENT LIABILITY ACCOUNTS

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

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

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

DECREASE IN ACCOUNTS RECEIVABLE Computer Services Company's accounts receivable decreased by $10,000 (from $30,000 to $20,000) during the period. For Computer Services, this means that cash receipts were $10,000 higher than sales revenue. The Accounts Receivable account in Illustration 17-8 shows that Computer Services Company had $507,000 in sales revenue (as reported on the income statement), but it collected $517,000 in cash.

Illustration 17-8
Analysis of accounts receivable

As shown in Illustration 17-9 (page 787), to adjust net income to net cash provided by operating activities, the company adds to net income the decrease of $10,000 in accounts receivable. When the Accounts Receivable balance increases, cash receipts are lower than sales revenue earned under the accrual basis. Therefore, the company deducts from net income the amount of the increase in accounts receivable, to arrive at net cash provided by operating activities.

INCREASE IN INVENTORY Computer Services Company's inventory increased $5,000 (from $10,000 to $15,000) during the period. The change in the Inventory account reflects the difference between the amount of inventory purchased and the amount sold. For Computer Services, this means that the cost of merchandise purchased exceeded the cost of goods sold by $5,000. As a result, cost of goods sold does not reflect $5,000 of cash payments made for merchandise. The company deducts from net income this inventory increase of $5,000 during the period, to arrive at net cash provided by operating activities (see Illustration 17-9). 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 net cash provided by operating activities, the company deducts from net income the $4,000 increase in prepaid expenses (see Illustration 17-9).

Illustration 17-9
Adjustments for changes in current asset accounts

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

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

INCREASE IN ACCOUNTS PAYABLE For Computer Services Company, Accounts Payable increased by $16,000 (from $12,000 to $28,000) during the period. That means the company received $16,000 more in goods than it actually paid for. As shown in Illustration 17-10 (below), to adjust net income to determine net cash provided by operating activities, the company adds to net income the $16,000 increase in Accounts Payable.

DECREASE IN INCOME TAXES PAYABLE When a company incurs income tax expense but has not yet paid its taxes, it records income tax payable. A change in the Income Taxes Payable account reflects the difference between income tax expense incurred and income tax actually paid. Computer Services’ Income Taxes Payable account decreased by $2,000. That means the $47,000 of income tax expense reported on the income statement was $2,000 less than the amount of taxes paid during the period of $49,000. As shown in Illustration 17-10, to adjust net income to a cash basis, the company must reduce net income by $2,000.

Illustration 17-10
Adjustments for changes in current liability accounts

Illustration 17-10 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. It then adds or deducts items to arrive at net cash provided by operating activities. The required adjustments are of three types:

1. Noncash charges such as depreciation, amortization, and depletion.

2. Gains and losses on the disposal of plant assets.

3. Changes in noncash current asset and current liability accounts.

Illustration 17-11 provides a summary of these changes.

Illustration 17-11
Adjustments required to convert net income to net cash provided by operating activities

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Step 2: Investing and Financing Activities

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

INCREASE IN LAND As indicated from the change in the Land account and the additional information, Computer Services Company purchased land of $110,000 by directly exchanging bonds for land. The issuance 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 17-13 on page 790.)

INCREASE IN BUILDINGS As the additional data indicate, Computer Services Company acquired an office building for $120,000 cash. This is a cash outflow reported in the investing activities section. (See Illustration 17-13 on page 790.)

INCREASE IN EQUIPMENT The Equipment account increased $17,000. The additional information explains that this net increase 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. 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 17-12
Analysis of equipment

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

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

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

INCREASE IN RETAINED EARNINGS Retained earnings increased $116,000 during the year. This increase can be explained by two factors. (1) Net income of $145,000 increased retained earnings. (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.

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).

STATEMENT OF CASH FLOWS—2014

Using the previous information, we can now prepare a statement of cash flows for 2014 for Computer Services Company as shown in Illustration 17-13.

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 17-13 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 17-4 (page 784).

Illustration 17-13
Statement of cash flows, 2014—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).

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Using Cash Flows to Evaluate a Company

Traditionally, investors and creditors used ratios based on accrual accounting. These days, cash-based ratios are gaining increased acceptance among analysts.

Free Cash Flow

In the statement of cash flows, net cash provided by operating activities is intended to indicate the cash-generating capability of the company. Analysts have noted, however, that net cash provided by operating activities fails to take into account that a company must invest in new fixed assets just to maintain its current level of operations. Companies also must at least maintain dividends at current levels to satisfy investors. 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 net 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 to expand the business or to pay an $80,000 dividend and continue to produce 10,000 computers. In practice, free cash flow is often calculated with the formula in Illustration 17-14. (Alternative definitions also exist.)

Illustration 17-14
Free cash flow

Illustration 17-15 provides basic information (in billions) excerpted from the 2011 statement of cash flows of Microsoft Corporation.

Illustration 17-15
Microsoft's cash flow information's ($ in millions)

Microsoft's free cash flow is calculated as shown in Illustration 17-16.

Illustration 17-16
Calculation of Microsoft's free cash flow ($ in millions)

Microsoft generated approximately $19.5 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 retirement of stock or debt, or the payment of dividends.

Also note that Microsoft's cash from operations of $27 billion exceeds its 2011 net income of $23.2 billion. This lends additional credibility to Microsoft's income number as an indicator of potential future performance. If anything, Microsoft's net income might understate its actual performance.

Oracle Corporation is one of the world's largest sellers of database software and information management services. Like Microsoft, its success depends on continuing to improve its existing products while developing new products to keep pace with rapid changes in technology. Oracle's free cash flow for 2011 was $9.7 billion. This is impressive but significantly less than Microsoft's amazing ability to generate cash.

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Comprehensive DO IT! 1

SUMMARY OF LEARNING OBJECTIVES

1   Indicate the usefulness of the statement of cash flows. The statement of cash flows provides information about the cash receipts, cash payments, and net change in cash resulting from the operating, investing, and financing activities of a company during the period.

2   Distinguish among operating, investing, and financing activities. Operating activities include the cash effects of transactions that enter into the determination of net income. Investing activities involve cash flows resulting from changes in investments and long-term asset items. Financing activities involve cash flows resulting from changes in long-term liability and stockholders’ equity items.

3   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.

4   Analyze the statement of cash flows. Free cash flow indicates the amount of cash a company generated during the current year that is available for the payment of additional dividends or for expansion.

GLOSSARY

Direct method A method that shows operating cash receipts and payments, making it more consistent with the objective of the statement of cash flows. (p. 783).

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. 779).

Free cash flow Net cash provided by operating activities adjusted for capital expenditures and dividends paid. (p. 793).

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. (pp. 783, 784).

Investing activities Cash flow activities that include (a) purchasing and disposing of investments and property, plant, and equipment using cash and (b) lending money and collecting the loans. (p. 778).

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. 778).

Statement of cash flows A basic financial statement that provides information about the cash receipts, cash payments, and net change in cash during a period, resulting from operating, investing, and financing activities. (p. 778).

APPENDIX 17A   Statement of Cash Flows—Direct Method

To explain and illustrate the direct method, we will use the transactions of Computer Services Company for 2014, to prepare a statement of cash flows. Illustration 17A-1 presents information related to 2014 for Computer Services Company.

Illustration 17A-1
Comparative balance sheets, income statement, and additional information for Computer Services Company

To prepare a statement of cash flows under the direct approach, we will apply the three steps outlined in Illustration 17-3 (page 782).

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 17A-2.

Illustration 17A-2
Major classes of cash receipts and payments

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

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

To determine the amount of cash receipts, the company deducts from sales revenue the increase in accounts receivable. On the other hand, there may be a decrease in accounts receivable. That would occur if cash receipts from customers exceeded sales revenue. In that case, the company adds to sales revenue the decrease in accounts receivable. For Computer Services Company, accounts receivable decreased $10,000. Thus, cash receipts from customers were $517,000, computed as shown in Illustration 17A-3.

Illustration 17A-3
Computation of cash receipts from customers

Computer Services can also determine cash receipts from customers from an analysis of the Accounts Receivable account, as shown in Illustration 17A-4.

Illustration 17A-4
Analysis of accounts receivable

Helpful Hint The T-account shows that sales revenue plus decrease in accounts receivable equals cash receipts.

Illustration 17A-5 shows the relationships among cash receipts from customers, sales revenue, and changes in accounts receivable.

Illustration 17A-5
Formula to compute cash receipts from customers—direct method

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

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

Illustration 17A-6
Computation of purchases

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

Illustration 17A-7
Computation of cash payments to suppliers

Computer Services also can determine cash payments to suppliers from an analysis of the Accounts Payable account, as shown in Illustration 17A-8

Illustration 17A-8
Analysis of accounts payable

Helpful Hint The T-account shows that purchases less increase in accounts payable equals payments to suppliers.

Illustration 17A-9 shows the relationships among cash payments to suppliers, cost of goods sold, changes in inventory, and changes in accounts payable.

Illustration 17A-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 Company's cash payments for operating expenses were $115,000, computed as follows.

Illustration 17A-10
Computation of cash payments for operating expenses

Illustration 17A-11 shows the relationships among cash payments for operating expenses, changes in prepaid expenses, and changes in accrued expenses payable.

Illustration 17A-11
Formula to compute cash payments for operating expenses—direct method

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

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

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

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

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

Illustration 17A-12
Computation of cash payments for income taxes

Illustration 17A-13 shows the relationships among cash payments for income taxes, income tax expense, and changes in income taxes payable.

Illustration 17A-13
Formula to compute cash payments for income taxes—direct method

The operating activities section of the statement of cash flows of Computer Services Company is shown in Illustration 17A-14.

Illustration 17A-14
Operating activities section of the statement of cash flows

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

Step 2: Investing and Financing Activities

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

INCREASE IN LAND As indicated from the change in the Land account and the additional information, Computer Services Company purchased land of $110,000 by directly exchanging bonds for land. The exchange of bonds payable for land has no effect on cash. But, it is a significant noncash investing and financing activity that merits disclosure in a separate schedule. (See Illustration 17A-16.)

INCREASE IN BUILDINGS As the additional data indicate, Computer Services Company acquired an office building for $120,000 cash. This is a cash outflow reported in the investing activities section. (See Illustration 17A-16.)

INCREASE IN EQUIPMENT The Equipment account increased $17,000. The additional information explains that this was a net increase that resulted from two transactions: (1) a purchase of equipment of $25,000, and (2) the sale for $4,000 of equipment costing $8,000. These transactions are investing activities. The company should report each transaction separately. The statement in Illustration 17A-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.

Helpful Hint The investing and financing activities are measured and reported the same under both the direct and indirect methods.

Illustration 17A-15
Analysis of equipment

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

INCREASE IN BONDS PAYABLE The Bonds Payable account increased $110,000. As indicated in the additional information, the company acquired land by directly exchanging bonds for land. Illustration 17A-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 17A-16.

INCREASE IN RETAINED EARNINGS Retained earnings increased $116,000 during the year. This increase can be explained by two factors. (1) Net income of $145,000 increased retained earnings and (2) dividends of $29,000 decreased retained earnings. The company adjusts net income to net cash provided by operating activities in the operating activities section. Payment of the dividends (not the declaration) is a cash outflow that the company reports as a financing activity in Illustration 17A-16.

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).

STATEMENT OF CASH FLOWS—2014

Illustration 17A-16 shows the statement of cash flows for Computer Services Company.

Illustration 17A-16
Statement of cash flows, 2014—direct method

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 17A-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 17A-1 (page 798).

SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 17A

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

Comprehensive DO IT! 2

APPENDIX 17B   Using a Worksheet to Prepare the Statement of Cash Flows—Indirect Method

When preparing a statement of cash flows, companies may need to make numerous adjustments of net income. In such cases, they often use a worksheet to assemble and classify the data that will appear on the statement. The worksheet is merely an aid in preparing the statement. Its use is optional. Illustration 17B-1 shows the skeleton format of the worksheet for preparation of the statement of cash flows.

The following guidelines are important in preparing a worksheet.

1. In the balance sheet accounts section, list accounts with debit balances separately from those with credit balances. This means, for example, that Accumulated Depreciation appears under credit balances and not as a contra account under debit balances. Enter the beginning and ending balances of each account in the appropriate columns. Enter as reconciling items in the two middle columns the transactions that caused the change in the account balance during the year.

   Illustration 17B-1
   Format of worksheet

   

   After all reconciling items have been entered, each line pertaining to a balance sheet account should “foot across.” That is, the beginning balance plus or minus the reconciling item(s) must equal the ending balance. When this agreement exists for all balance sheet accounts, all changes in account balances have been reconciled.

2. The bottom portion of the worksheet consists of the operating, investing, and financing activities sections. It provides the information necessary to prepare the formal statement of cash flows. Enter inflows of cash as debits in the reconciling columns. Enter outflows of cash as credits in the reconciling columns. Thus, in this section, the sale of equipment for cash at book value appears as a debit under investing activities. Similarly, the purchase of land for cash appears as a credit under investing activities.
3. The reconciling items shown in the worksheet are not entered in any journal or posted to any account. They do not represent either adjustments or corrections of the balance sheet accounts. They are used only to facilitate the preparation of the statement of cash flows.

Preparing the Worksheet

As in the case of worksheets illustrated in earlier chapters, preparing a worksheet involves a series of prescribed steps. The steps in this case are:

1. Enter in the balance sheet accounts section the balance sheet accounts and their beginning and ending balances.

2. Enter in the reconciling columns of the worksheet the data that explain the changes in the balance sheet accounts other than cash and their effects on the statement of cash flows.

3. Enter on the cash line and at the bottom of the worksheet the increase or decrease in cash. This entry should enable the totals of the reconciling columns to be in agreement.

To illustrate the preparation of a worksheet, we will use the 2014 data for Computer Services Company. Your familiarity with these data (from the chapter) should help you understand the use of a worksheet. For ease of reference, the comparative balance sheets, income statement, and selected data for 2014 are presented in Illustration 17B-2.

Illustration 17B-2
Comparative balance sheets, income statement, and additional information for Computer Services Company

Additional information for 2014:

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.

DETERMINING THE RECONCILING ITEMS

Companies can use one of several approaches to determine the reconciling items. For example, they can first complete the changes affecting net cash provided by operating activities, and then can determine the effects of financing and investing transactions. Or, they can analyze the balance sheet accounts in the order in which they are listed on the worksheet. We will follow this latter approach for Computer Services, except for cash. As indicated in step 3, cash is handled last.

ACCOUNTS RECEIVABLE The decrease of $10,000 in accounts receivable means that cash collections from sales revenue are higher than the sales revenue reported in the income statement. To convert net income to net cash provided by operating activities, we add the decrease of $10,000 to net income. The entry in the reconciling columns of the worksheet is:

INVENTORY Computer Services Company's inventory balance increases $5,000 during the period. The Inventory account reflects the difference between the amount of inventory that the company purchased and the amount that it sold. For Computer Services, this means that the cost of merchandise purchased exceeds 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. We deduct this inventory increase of $5,000 during the period from net income to arrive at net cash provided by operating activities. The worksheet entry is:

PREPAID EXPENSES An increase of $4,000 in prepaid expenses means that expenses deducted in determining net income are less than expenses that were paid in cash. We deduct the increase of $4,000 from net income in determining net cash provided by operating activities. The worksheet entry is:

LAND The increase in land of $110,000 resulted from a purchase through the issuance of long-term bonds. The company should report this transaction as a significant noncash investing and financing activity. The worksheet entry is:

Helpful Hint These amounts are asterisked in the worksheet to indicate that they result from a significant noncash transaction.

BUILDINGS The cash purchase of a building for $120,000 is an investing activity cash outflow. The entry in the reconciling columns of the worksheet is:

EQUIPMENT The increase in equipment of $17,000 resulted from a cash purchase of $25,000 and the disposal of equipment costing $8,000. The book value of the equipment was $7,000, the cash proceeds were $4,000, and a loss of $3,000 was recorded. The worksheet entries are:

ACCOUNTS PAYABLE We must add the increase of $16,000 in accounts payable to net income to determine net cash provided by operating activities. The work-sheet entry is:

INCOME TAXES PAYABLE When a company incurs income tax expense but has not yet paid its taxes, it records income taxes payable. A change in the Income Taxes Payable account reflects the difference between income tax expense incurred and income tax actually paid. Computer Services’ Income Taxes Payable account decreases 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. To adjust net income to a cash basis, we must reduce net income by $2,000. The worksheet entry is:

BONDS PAYABLE The increase of $110,000 in this account resulted from the issuance of bonds for land. This is a significant noncash investing and financing activity. Worksheet entry (d) above is the only entry necessary.

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 section. The worksheet entry is:

ACCUMULATED DEPRECIATION—BUILDINGS, AND ACCUMULATED DEPRECIATION—EQUIPMENT Increases in these accounts of $6,000 and $3,000, respectively, resulted from depreciation expense. Depreciation expense is a noncash charge that we must add to net income to determine net cash provided by operating activities. The worksheet entries are:

RETAINED EARNINGS The $116,000 increase in retained earnings resulted from net income of $145,000 and the declaration and payment of a $29,000 cash dividend. Net income is included in net cash provided by operating activities, and the dividends are a financing activity cash outflow. The entries in the reconciling columns of the worksheet are:

DISPOSITION OF CHANGE IN CASH The firm's cash increased $22,000 in 2014. The final entry on the worksheet, therefore, is:

As shown in the worksheet, we enter the increase in cash in the reconciling credit column as a balancing amount. This entry should complete the reconciliation of the changes in the balance sheet accounts. Also, it should permit the totals of the reconciling columns to be in agreement. When all changes have been explained and the reconciling columns are in agreement, the reconciling columns are ruled to complete the worksheet. The completed worksheet for Computer Services Company is shown in Illustration 17B-3.

Illustration 17B-3
Completed worksheet—indirect method

SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 17B

6   Explain how to use a worksheet to prepare the statement of cash flows using the indirect method. When there are numerous adjustments, a worksheet can be a helpful tool in preparing the statement of cash flows. Key guidelines for using a worksheet are as follows. (1) List accounts with debit balances separately from those with credit balances. (2) In the reconciling columns in the bottom portion of the worksheet, show cash inflows as debits and cash outflows as credits. (3) Do not enter reconciling items in any journal or account, but use them only to help prepare the statement of cash flows.
    The steps in preparing the worksheet are as follows. (1) Enter beginning and ending balances of balance sheet accounts. (2) Enter debits and credits in reconciling columns. (3) Enter the increase or decrease in cash in two places as a balancing amount.

APPENDIX 17C   Statement of Cash Flows—T-Account Approach

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

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

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

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

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

To implement this approach, first prepare a large Cash T-account with sections for operating, investing, and financing activities. Then, prepare smaller T-accounts for all of the other noncash balance sheet accounts. Insert the beginning and ending balances for each of these accounts. Once you have done this, then walk through the steps outlined in Illustration 17-3 (page 782). 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 17C-1 is numbered so you can follow them through the T-accounts.

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.

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:

Illustration 17C-1
T-account approach

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 Equipment 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.