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Accounting Principles, 6e

Weygandt, Kieso, & Kimmel

Prepared by Marianne Bradford, Ph. D. Bryant College

John Wiley & Sons, Inc.

CHAPTER 18
THE STATEMENT OF CASH FLOWS
After studying this chapter, you should be able to: 1 Indicate the primary purpose of the statement of cash flows. 2 Distinguish among operating, investing, and financing activities. 3 Prepare a statement of cash flows using the indirect method. 4 Prepare a statement of cash flows using the direct method. 5 Analyze the statement of cash flows.

PREVIEW OF CHAPTER 18
THE STATEMENT OF CASH FLOWS

The Statement of Cash Flows: Purpose and Format


Purpose

Format

Meaning

of cash flows

Usefulness
Preparation Indirect & direct methods

Classifications Significant

noncash activities

PREVIEW OF CHAPTER 18
THE STATEMENT OF CASH FLOWS

Section 1: Indirect Method


Determining net increase/decrease in
cash

OR

Section 2: Direct Method


Determining net increase/decrease in
cash

Determining net cash provided/used


by operating activities

Determining net cash provided/used by operating activities

Determining net cash provided/used


by investing and financing activities

Determining net cash provided/used


by investing and financing activities

PREVIEW OF CHAPTER 18
THE STATEMENT OF CASH FLOWS

Analysis of the Statement of Cash Flows


Current Cash Cash

cash debt coverage ratio

return on sales ratio

debt coverage ratio

STUDY OBJECTIVE 1

Indicate the primary purpose of the statement of cash flows.

PURPOSE OF THE STATEMENT OF CASH FLOWS


The primary purpose of the statement of cash flows (SCF) is to provide information about an entitys cash receipts and cash payments during a period. A secondary objective is to provide information about its 1) operating, 2) investing, and 3) financing activities of an entity during a period. It provides answers to the following simple, but important, questions about an enterprise: 1 Where did the cash come from during the period? 2 What was the cash used for during the period? 3 What was the change in the cash balance during the period?

MEANING OF CASH FLOWS


The SCF is usually prepared using cash and cash equivalents as its basis. Cash equivalents are short-term, highly liquid investments that are both: 1 readily convertible to known amounts of cash, and 2 so near to their maturity that their market value is relatively insensitive to changes in interest rates.

STUDY OBJECTIVE 2

Distinguish among operating, investing, and financing activities.

CLASSIFICATION OF CASH FLOWS


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 productive long-lived assets, 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 and providing them with a return on their investment.

CLASSIFICATION OF CASH FLOWS


The category of operating activities is the most important because it shows the cash provided by company operations. Note the following general guidelines: 1) Operating activities involve income determination (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.

ILLUSTRATION 18-1 BUSINESS ACTIVITIES SHOWN ON THE STATEMENT OF CASH FLOWS

Operating Activities

Investing Activities

Financing Activities

ILLUSTRATION 18-1 TYPICAL RECEIPTS AND PAYMENTS CLASSIFIED BY ACTIVITY


Types of Cash Inflows and Outflows Operating activities Cash inflows: From sale of goods or services From returns on loans (interest received) and on equity securities (dividends received) Cash outflows: To suppliers for inventory To employees for services To government for taxes To lenders for interest To others for expenses

ILLUSTRATION 18-1 TYPICAL RECEIPTS AND PAYMENTS CLASSIFIED BY ACTIVITY


Investing activities Cash inflows: From sale of property, plant, and equipment From sale of 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 debt or equity securities of other entities To make loans to other entities Financing activities Cash inflows: From sale of equity securities (companys own stock) From issuance of debt (bonds and notes) Cash outflows: To stockholders as dividends To redeem long-term debt or reacquire capital stock

SIGNIFICANT NONCASH ACTIVITIES


Not all of a companys significant activities involve cash. Examples of significant noncash activities are: 1 Issuance of common stock to purchase assets. 2 Conversion of bonds into common stock. 3 Issuance of debt to purchase assets. 4 Exchange of plant assets. Significant financing and investing activities that do not affect cash are not reported in the body of the SCF. Such activities are reported in either 1 a separate schedule at the bottom of the SCF or 2 in a separate note or supplementary schedule to the financial statements.

ILLUSTRATION 18-2
FORMAT OF STATEMENT OF CASH FLOWS
The general format of the SCF Is the 3 activities previously discussed operating, investing, and financing plus the significant noncash investing and financing activities.
COMPANY NAME Statement of Cash Flows 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) Net cash provided (used) by financing activities Net increase (decrease) in cash Cash at beginning of period Cash at end of period Noncash investing and financing activities (List of individual noncash transactions)

XX XXX XX XXX XX XXX XXX XXX XXX XXX

FORMAT OF THE STATEMENT OF CASH FLOWS


Differences between net income and net cash provided by operating activities are illustrated by the following results from recent annual reports for the same fiscal year (all data are in millions of dollars).

Company Kmart Corporation Wal-Mart Stores, Inc. The GAP, Inc. J. C. Penney Company, Inc. Sears, Roebuck and Co. The May Department Stores Company

Net Income $ 518 4430 1127 594 1948 849

Net Cash from Operations $ 1237 7580 1478 1058 3090 1505

USEFULNESS OF THE STATEMENT OF CASH FLOWS


The information in the SCF should help investors, creditors and others assess the following aspects of the firms financial position: 1 The entitys ability to generate future cash flows. 2 The entitys ability to pay dividends and meet obligations. 3 The reasons for the difference between net income and net cash provided (used) by operating activities. 4 The cash investing and financing transactions during the period.

PREPARING THE STATEMENT OF CASH FLOWS


The SCF is prepared differently from the 3 other basic financial statements. 1 It is not prepared from the adjusted trial balance. 2 The SCF deals with cash receipts and payments, so the accrual concept is not used in the preparation of the SCF. The information to prepare this statement usually comes from 3 sources: 1 Comparative balance sheet. 2 Current income statement. 3 Additional information.

ILLUSTRATION 18-3 THREE MAJOR STEPS IN PREPARING THE STATEMENT OF CASH FLOWS
Step 1: Determine the net increase/decrease in cash.

The difference between the beginning and ending cash balances can be easily computed from comparative balance sheets.

+ or XYZ Goods

Step 2: Determine net cash provided/used by operating activities.

This step involves analyzing not only the current years income statement but also comparative balance sheets and selected additional data.

Step 3: Determine net cash provided/used by investing and financing activities.

This step involves analyzing comparative balance sheet data and selected additional information for their effects on cash.

For Sale

Investing

Financing

USAGE OF INDIRECT AND DIRECT METHODS


In order to determine net cash provided/used by operating activities, the operating activities section must be converted from accrual basis to cash basis. This conversion may be accomplished by 1) the indirect method or 2) the direct method. The indirect method is used extensively in practice, as shown below. The indirect is favored by companies for 2 reasons: 1) it is easier to prepare and 2) it focuses on the differences between net income and net cash flow from operating activities.
1.7% Direct Method

98.3% Indirect Method

STUDY OBJECTIVE 3

Prepare a statement of cash flows using the indirect method.

SECTION 1 STATEMENT OF CASH FLOWS INDIRECT METHOD


The transactions of the Computer Services Company for 2002 and 2003 are used to illustrate and explain the indirect method of preparing the SCF. First Year of Operations 2002 1 Computer Services Company started on January 1, 2002, when it issued 50,000 shares of $1 par value common stock for $50,000 cash. 2 The company rented its office space and furniture and rendered consulting services throughout the first year.

ILLUSTRATION 18-4
COMPARATIVE BALANCE SHEET, 2002, WITH INCREASES AND DECREASES
The comparative balance sheets at the beginning and end of 2002 showing increases and decreases are shown below.
COMPUTER SERVICES COMPANY Comparative Balance Sheets Change Jan. 1, 2002 Increase/Decrease $ 0 $ 34,000 Increase 0 30,000 Increase 0 10,000 Increase $ 0

Assets Cash Accounts receivable Equipment Total Liabilities and Stockholders Equity Accounts payable Common stock Retained earnings Total

Dec. 31, 2002 $ 34,000 30,000 10,000 $ 74,000

$ 4,000 50,000 20,000 $ 74,000

$ 0 0 0 $ 0

$ 4,000 Increase 50,000 Increase 20,000 Increase

ILLUSTRATION 18-5 INCOME STATEMENT AND ADDITIONAL INFORMATION, 2002


The income statement and additional information for Computer Services Company are shown below.
COMPUTER SERVICES COMPANY Income Statement For the Year Ended December 31, 2002 Revenues Operating expenses Income before income taxes Income tax expense Net income $ 85,000 40,000 45,000 10,000 $ 35,000

Additional information: (1) Examination of selected data indicates that a dividend of $15,000 was declared and paid during the year. (2) The equipment was purchased at the end of 2002. No depreciation was taken in 2002.

ILLUSTRATION 18-6 NET INCOME VERSUS NET CASH PROVIDED BY OPERATING ACTIVITIES
The indirect method starts with net income and converts it to net cash provided by operating activities. In other words, the indirect method adjusts net income for items that affect reported net income but do not affect cash. Noncash charges in the income statement are added back to net income. Likewise, noncash credits are deducted. The result is to calculate net cash provided by operating activities.
Accrual Basis of Accounting Earned Revenues Cash Basis of Accounting
Eliminate noncash revenues

Net Income

Adjustments to Reconcile Net Income to Net Cash Provided by Operations

Net Cash Provided by Operating Activities

Incurred Expenses

Eliminate noncash expenses

ILLUSTRATION 18-7
ANALYSIS OF ACCOUNTS RECEIVABLE
When accounts receivable increase during the year, revenues on an accrual basis are higher than are revenues on a cash basis. In other words, operations of the period caused revenues to increase, but not all of these revenues resulted in an increase in cash. Some of increase in revenues had to result in an increase in accounts receivable. As shown below, Computer Services Company had $85,000 in revenues, but collected only $55,000 in cash. Therefore, to convert net income into net cash provided by operating activities, the increase of $30,000 in accounts receivable must be deducted from net income.
ACCOUNTS RECEIVABLE 0 Receipts from customers 85,000 30,000

1/1/02 12/31/02

Balance Revenues Balance

55,000

ILLUSTRATION 18-8
ANALYSIS OF ACCOUNTS PAYABLE
When accounts payable increase during the year, operating expenses on an accrual basis are higher than they are on a cash basis. For Computer Services Company, operating expenses reported in the income statement were $40,000. Since Accounts Payable increased $4,000, only $36,000 ($40,000 $4,000) of the expenses were paid in cash. To adjust net income to net cash provided by operating activities, the increase of $4,000 must be added to net income.
Payments to creditors ACCOUNTS PAYABLE 36,000 1/1/02 Balance Operating expenses 12/31/02 Balance 0 40,000 4,000

ILLUSTRATION 18-9
PRESENTATION OF NET CASH PROVIDED BY OPERATING ACTIVITIES, 2002 INDIRECT METHOD
The changes in accounts receivable and accounts payable were the only changes in current assets and current liabilities during the year for Computer Services Company. Therefore, any other revenues or expenses reported in the income statement were received or paid in cash. The operating activities section of the SCF for Computer Services Company is shown below.
COMPUTER SERVICES COMPANY Partial Statement of Cash Flows Indirect Method For the Year Ended December 31, 2002 Cash flows from operating activities Net income $ 35,000 Adjustments to reconcile net income to net cash provided by operating activities: Increase in accounts receivable $ ( 30,000) Increase in accounts payable 4,000 ( 26,000) Net cash provided by operating activities $ 9,000

ILLUSTRATION 18-10
ANALYSIS OF RETAINED EARNINGS
The reasons for the net increase of $20,000 in Retained Earnings are determined by analysis. 1 Net income increased Retained Earnings by $35,000. 2 The additional information below the income statement in Illustration 18-5 indicates that a cash dividend of $15,000 was declared and paid. The increase due to net income is reported in the operating activities section while the cash dividend paid is reported in the financing activities section. This analysis can also be made directly from the Retained Earnings account as shown below.
RETAINED EARNINGS 15,000 1/1/02 Balance 12/31/02 Net income 12/31/02 Balance

12/31/02

Cash dividend

0 35,000 20,000

ILLUSTRATION 18-11 STATEMENT OF CASH FLOWS, 2002 INDIRECT METHOD


COMPUTER SERVICES COMPANY Statement of Cash Flows Indirect Method For the Year Ended December 31, 2002 Cash flows from operating activities Net income $ 35,000 Adjustments to reconcile net income to net cash provided by operating activities: Increase in accounts receivable $ ( 30,000) Operating Increase in accounts payable 4,000 ( 26,000) Net cash provided by operating activities activities provided 9,000 Cash flows from investing activities $9,000 cash, Purchase of equipment ( 10,000) investing activities Net cash used by investing activities ( 10,000) Cash flows from financing activities used $10,000 cash, Issuance of common stock 50,000 while financing Payment of cash dividends ( 15,000) 35,000 activities provided Net increase in cash 34,000 $35,000 cash. Cash at beginning of period 0 Cash at end of period $ 34,000

ILLUSTRATION 18-12
COMPARATIVE BALANCE SHEET, 2003, WITH INCREASES AND DECREASES
The comparative balance sheets at the beginning and end of 2003 showing increases and decreases are shown to the right.
COMPUTER SERVICES COMPANY Comparative Balance Sheets December 31 Assets Cash Accounts receivable Prepaid expenses Land Building Accumulated depreciation building Equipment Accumulated depreciation equipment Total Liabilities and Stockholders Equity Accounts payable Bonds payable Common stock Retained earnings Total 2003 $ 56,000 20,000 4,000 130,000 160,000 ( 11,000) 27,000 ( 3,000) $ 383,000 2002 $ 34,000 30,000 0 0 0 0 10,000 0 $ 74,000 Change Increase/Decrease $ 22,000 Increase 10,000 Decrease 4,000 Increase 130,000 Increase 160,000 Increase 11,000 Increase 17,000 Increase 3,000 Increase

59,000 130,000 50,000 144,000 $ 383,000

4,000 0 50,000 20,000 0

$ 55,000 Increase 130,000 Increase 0 124,000 Increase

ILLUSTRATION 18-13 INCOME STATEMENT AND ADDITIONAL INFORMATION, 2003


COMPUTER SERVICES COMPANY Income Statement For the Year Ended December 31, 2003 Revenues Operating expenses (excluding depreciation) Depreciation expense Loss on sale of equipment Income from operations Income tax expense Net income $ 507,000 $ 261,000 15,000 3,000

The income statement and additional information for 2003 for Computer Services Company are shown to the right.

279,000 228,000 89,000 $ 139,000

Additional information: (1) In 2003, the company declared and paid a $15,000 cash dividend. (2) The company obtained land through the issuance of $130,000 of long-term bonds. (3) A building costing $160,000 was purchased for cash; equipment costing $25,000 was also purchased for cash. (4) During 2003, the company sold equipment with a book value of $7,000 (cost $8,000, less accumulated depreciation of $1,000) for $4,000 cash.

ILLUSTRATION 18-14
ANALYSIS OF ACCUMULATED DEPRECIATION EQUIPMENT
The increase in Accumulated Depreciation Equipment was $3,000, which does not represent depreciation expense for the year since the account was debited $1,000 as a result a sale of some equipment. Depreciation expense for 2003 was $4,000 ($3,000 + $1,000). This amount is added to net income to determine net cash provided by operating activities. The T-account below provides information about the changes that occurred in this account in 2003.
ACCUMULATED DEPRECIATION EQUIPMENT Accumulated depreciation on 1/1/03 Balance equipment sold 1,000 Depreciation expense 12/31/03 Balance

0 4,000 3,000

ILLUSTRATION 18-15
PRESENTATION OF NET CASH PROVIDED BY OPERATING ACTIVITIES, 2003 INDIRECT METHOD

Net cash provided by operating activities for 2003 is $218,000 as calculated below.
COMPUTER SERVICES COMPANY Partial Statement of Cash Flows Indirect Method For the Year Ended December 31, 2003 Cash flows from operating activities Net income $ 139,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense $ 15,000 Loss on sale of equipment 3,000 Decrease in accounts receivable 10,000 Increase in prepaid expenses ( 4,000) Increase in accounts payable 55,000 79,000 Net cash provided by operating activities $ 218,000

ILLUSTRATION 18-16

ANALYSIS OF EQUIPMENT
Equipment increased $17,000, which was a net increase that resulted from 2 transactions: 1) a purchase of equipment of $25,000 and 2) the sale of equipment costing $8,000 for $4,000. These transactions are classified as investing activities and each should be reported separately. The purchase of equipment should therefore be reported as an outflow of cash for $25,000 and the sale should be reported as an inflow of cash for $4,000. The T-account below shows the reasons for the change in this account during the year.
EQUIPMENT 10,000 Cost of old equipment 25,000 27,000

1/1/03 12/31/03

Balance Purchase of equipment Balance

8,000

ILLUSTRATION 18-17 STATEMENT OF CASH FLOWS, 2003 INDIRECT METHOD


COMPUTER SERVICES COMPANY Statement of Cash Flows For the Year Ended December 31, 2003 Cash flows from operating activities Net income $ 139,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense $ 15,000 Loss on sale of equipment 3,000 Decrease in accounts receivable 10,000 Increase in prepaid expenses ( 4,000) Increase in accounts payable 55,000 79,000 Net cash provided by operating activities 218,000

ILLUSTRATION 18-17 STATEMENT OF CASH FLOWS, 2003 INDIRECT METHOD

Cash flows from investing activities Purchase of building Purchase of equipment Sale of equipment Net cash used by investing activities Cash flows from financing activities Payment of cash dividends Net cash used by financing activities Net increase in cash Cash at beginning of period Cash at end of period Noncash investing and financing activities Issuance of bonds payable to purchase land

$(160,000) ( 25,000) 4,000 (181,000) ( 15,000) ( 15,000) 22,000 34,000 $ 56,000

$ 130,000

ILLUSTRATION 18-18 ADJUSTMENTS FOR CURRENT ASSETS AND CURRENT LIABILITIES


The SCF prepared by the indirect method starts with net income. It then adds or deducts items not affecting cash to arrive at net cash provided by operating activities. The additions and deductions consist of: 1) changes in specific current assets and current liabilities and 2) noncash charges reported in the income statement. A summary of the adjustments for current assets and current liabilities is provided in Illustration 18-18.
Adjustments to Convert Net Income to Net Cash Provided by Operating Activities Add to Deduct from Net Income Net Income Decrease Increase Decrease Increase Decrease Increase Increase Decrease Increase Decrease

Current Assets and Current Liabilities Accounts receivable Inventory Prepaid expenses Accounts payable Accrued expenses payable

ILLUSTRATION 18-19 ADJUSTMENTS FOR NONCASH CHARGES

Adjustments for the noncash charges reported in the income statement are made as shown in Illustration 18-19.
Noncash Charges Depreciation expense Patent amortization expense Depletion expense Loss on sale of asset Adjustments to Convert Net Income to Net Cash Provided by Operating Activities Add Add Add Add

STUDY OBJECTIVE 4

Prepare a statement of cash flows using the direct method.

SECTION 2 STATEMENT OF CASH FLOWS DIRECT METHOD


The transactions of Juarez Company for 2002 and 2003 are used to illustrate and explain the indirect method of preparing the SCF. First Year of Operations 2002 1 Juarez Company started on January 1, 2002, when it issued 300,000 shares of $1 par value common stock for $300,000 cash. 2 The company rented its office, sales space, and equipment.

ILLUSTRATION 18-20
COMPARATIVE BALANCE SHEET, 2002, WITH INCREASES AND DECREASES
The comparative balance sheets at the beginning and end of 2002 showing increases and decreases are shown to the right.
JUAREZ COMPANY Comparative Balance Sheet Change Increase/Decrease $ 159,000 Increase 15,000 Increase 160,000 Increase 8,000 Increase 80,000 Increase

Assets Cash Accounts receivable Inventory Prepaid expenses Land Total Liabilities and Stockholders Equity Accounts payable Accrued expenses payable Common stock Retained earnings Total

Dec. 31, 2002 $ 159,000 15,000 160,000 8,000 80,000 $ 422,000

Jan. 1, 2002 $ 0 0 0 0 0 $ 0

$ 60,000 20,000 300,000 42,000 $ 422,000

$ 0 $ 60,000 Increase 0 20,000 Increase 0 300,000 Increase 0 42,000 Increase $ 0

ILLUSTRATION 18-21 INCOME STATEMENT AND ADDITIONAL INFORMATION, 2002


The income statement and additional information for Juarez Company are shown below.
JUAREZ COMPANY Income Statement For the Year Ended December 31, 2002 Revenues from sales Cost of goods sold Gross profit Operating expenses Income before income taxes Income tax expense Net income $ 780,000 450,000 330,000 170,000 160,000 48,000 $ 112,000

Additional information: (1) Dividends of $70,000 were declared and paid in cash. (2) The accounts payable increase resulted from the purchase of merchandise.

ILLUSTRATION 18-22 MAJOR CLASSES OF CASH RECEIPTS AND PAYMENTS


Cash Receipts Cash Payments = Net Cash Provided by Operating Activities
To suppliers

From sales of goods and services to customers

To employees

For operating expenses

Net cash provided by operating activities

For interest and dividends From receipts of interest and dividends on loans and investments

For taxes

CASH RECEIPTS FROM CUSTOMERS


The income statement for Juarez Company reported revenues from customers of $780,000. To determine the amount of cash receipts, the increase in accounts receivable is deducted from sales revenues. Conversely, a decrease in accounts receivable is added to sales revenues, since cash receipts from customers exceed sales revenues.

ILLUSTRATION 18-23 COMPUTATION OF CASH RECEIPTS FROM CUSTOMERS

For Juarez Company, accounts receivable increased $15,000, so that cash receipts from customers were $765,000, calculated as shown Illustration 18-24 in Illustration 18-23.
Revenues from sales Deduct: Increase in accounts receivable Cash receipts from customers

Computation of Cash Receipts from Customers $ 780,000 15,000 $ 765,000

ILLUSTRATION 18-24 ANALYSIS OF ACCOUNTS RECEIVABLE

Cash receipts from customers may also be determined from an analysis of Accounts Receivable as shown in Illustration 18-24.
Illustration 18-25 Analysis of Accounts Receivable ACCOUNTS RECEIVABLE Balance 0 Receipts from customers Revenues from sales 780,000 Balance 15,000

1/1/02 12/31/02

765,000

ILLUSTRATION 18-25
FORMULA TO COMPUTE CASH RECEIPTS FROM CUSTOMERS DIRECT METHOD

The relationships among cash receipts from customers, revenues from sales, and changes in accounts receivable are shown in Illustration 18-25.
Cash receipts from customers

Revenues from sales

+ Decrease in accounts receivable or Increase in accounts receivable

ILLUSTRATION 18-26

COMPUTATION OF PURCHASES
Juarez Company reported cost of goods sold on its income statement of $450,000. To determine purchases, cost of goods sold must be adjusted for the change in inventory. An increase (decrease) in inventory is added to (deducted from) cost of goods sold to arrive at purchases. In 2002, Juarez Illustration 18-27 Companys inventory increased $160,000. Computation of Illustration Purchases 18-26. Purchases are calculated in
Cost of goods sold Add: Increase in inventory Purchases $ 450,000 160,000 $ 610,000

ILLUSTRATION 18-27 COMPUTATION OF CASH PAYMENTS TO SUPPLIERS Cash payments to suppliers are then determined by adjusting purchases for the change in accounts payable. An accounts payable increase (decrease) is deducted from (added to) purchases. Cash payments to Illustrationin 18-28 suppliers are calculated Illustration 18-27.
Computation of Cash Payments to Suppliers Purchases Deduct: Increase in accounts payable Cash payments to suppliers $ 610,000 60,000 $ 550,000

ILLUSTRATION 18-28

ANALYSIS OF ACCOUNTS PAYABLE

Cash payments to suppliers may also be determined from an analysis of Accounts Payable as shown in Illustration 18-28.
Illustration 18-29 Analysis of Accounts Payable ACCOUNTS PAYABLE 550,000 1/1/02 Balance Purchases 12/31/02 Balance Payments to creditors 0 610,000 60,000

ILLUSTRATION 18-29
FORMULA TO COMPUTE CASH PAYMENTS TO SUPPLIERS DIRECT METHOD

The relationship among cash payments to suppliers, cost of goods sold, changes in inventory, and changes in accounts payable is shown in Illustration 18-29.
Cash payments to suppliers

=
Cost of goods sold

+ Increase in inventory + Decrease in accounts payable or or Decrease in inventory Increase in accounts payable

ILLUSTRATION 18-30 COMPUTATION OF CASH PAYMENTS FOR OPERATING EXPENSES


Operating expenses of $170,000 were reported on Juarezs income statement. To convert operating expenses to cash payments for operating expenses, the increase in prepaid expenses of $8,000 must be added to operating expenses. A decrease in prepaid expenses would be deducted from operating expenses. The increase in accrued expenses of $20,000 must be deducted, while a decrease would be added. Juarez Companys cash payments for operating expenses are calculated in Illustration 18-31 Illustration 18-30.
Computation of Cash Payments for Operating Expenses Operating expenses Add: Increase in prepaid expenses Deduct: Increase in accrued expenses payable Cash payments for operating expenses $ 170,000 8,000 ( 20,000) $ 158,000

ILLUSTRATION 18-31
FORMULA TO COMPUTE CASH PAYMENTS FOR OPERATING EXPENSES DIRECT METHOD
Operating expenses

Cash payments for operating expenses

+ Increase in prepaid expenses or - Decrease in prepaid expenses

+ Decrease in accrued expenses payable or - Increase in accrued expenses payable

ILLUSTRATION 18-32 OPERATING ACTIVITIES SECTION DIRECT METHOD


All of the revenues and expenses in the 2002 income statement have now been adjusted to cash basis. The operating activities section of the SCF is shown below.
JUAREZ COMPANY Partial Statement of Cash Flows Direct Method For the Year Ended December 31, 2002 Cash flows from operating activities Cash receipts from customers Cash payments: To suppliers For operating expenses For income taxes Net cash provided by operating activities $ 765,000 $ 550,000 158,000 48,000

756,000 $ 9,000

ILLUSTRATION 18-33
ANALYSIS OF RETAINED EARNINGS
The reasons for the net increase of $42,000 in Retained Earnings are determined by analysis. 1 Net income increased Retained Earnings by $112,000. 2 The additional information below the income statement in Illustration 18-21 indicates that a cash dividend of $70,000 was declared and paid. The increase due to net income is reported in the operating activities section while the cash dividend paid is reported in the financing activities section. This analysis can also be made directly from the Retained Earnings account as shown below.
RETAINED EARNINGS 70,000 1/1/02 Balance 12/31/02 Net income 12/31/02 Balance

12/31/02

Cash dividend

0 112,000 42,000

ILLUSTRATION 18-34 STATEMENT OF CASH FLOWS, 2002 DIRECT METHOD


JUAREZ COMPANY Statement of Cash Flows Direct Method For the Year Ended December 31, 2002 Cash flows from operating activities Cash receipts from customers Cash payments: To suppliers For operating expenses For income taxes Net cash provided by operating activities Cash flows from investing activities Purchase of land Net cash used by investing activities Cash flows from financing activities Issuance of common stock Payment of cash dividend Net cash provided by financing activities Net increase in cash Cash at beginning of period Cash at end of period

The SCF for 2002 for Juarez Company shows that operating activities provided $9,000 cash, investing activities used $80,000 cash, while financing activities provided $230,000 cash.

$ 765,000 $ 550,000 158,000 48,000

(756,000) 9,000

( 80,000) ( 80,000) 300,000 ( 70,000) 230,000 159,000 0 $ 159,000

ILLUSTRATION 18-35
COMPARATIVE BALANCE SHEET, 2003, WITH INCREASES AND DECREASES
The comparative balance sheets at the beginning and end of 2003 showing increases and decreases are shown below.
JUAREZ COMPANY Comparative Balance Sheet December 31 Assets Cash Accounts receivable Inventory Prepaid expenses Land Equipment Accumulated depreciation equipment Total 2003 $ 191,000 12,000 130,000 6,000 180,000 160,000 ( 16,000) $ 663,000 2002 $ 159,000 15,000 160,000 8,0000 80,000 0 0 $ 422,000 Change Increase/Decrease $ 32,000 Increase 3,000 Decrease 30,000 Decrease 2,000 Decrease 100,000 Increase 160,000 Increase 16,000 Increase

ILLUSTRATION 18-35
COMPARATIVE BALANCE SHEET, 2003, Change WITH INCREASES AND DECREASES Assets 2000 1999 Increase/Decrease
Cash Accounts receivable Inventory Prepaid expenses Land Equipment Accumulated depreciation equipment Total Liabilities and Stockholders Equity Accounts payable Accrued expenses payable Income taxes payable Bonds payable Common stock Retained earnings Total $ 191,000 12,000 130,000 6,000 180,000 160,000 ( 16,000) $ 663,000 $ 159,000 15,000 160,000 8,0000 80,000 0 0 $ 422,000 $ 32,000 Increase 3,000 Decrease 30,000 Decrease 2,000 Decrease 100,000 Increase 160,000 Increase 16,000 Increase

JUAREZ COMPANY Comparative Balance Sheet December 31

52,000 15,000 12,000 90,000 400,000 94,000 $ 663,000

60,000 $ 8,000 Decrease 20,000 5,000 Decrease 0 12,000 Increase 0 90,000 Increase 300,000 100,000 Increase 52,000 Increase 42,000 $ 422,000

ILLUSTRATION 18-36 INCOME STATEMENT AND ADDITIONAL INFORMATION, 2003


JUAREZ COMPANY Income Statement For the Year Ended December 31, 2003 Revenues from sales $ 975,000 Cost of goods sold $ 660,000 Operating expenses (excluding depreciation) 176,000 Depreciation expense 18,000 Loss on sale of store equipment 1,000 855,000 Income before income taxes 120,000 The income statement and Income tax expense 36,000 Net income additional information for 2003 $ 84,000 Additional information: (1) In 2003, the company declared and paid a $32,000 cash dividend. (2) Bonds were issued at face value for $90,000 in cash. (3) Equipment costing $180,000 was purchased for cash. (4) Equipment costing $20,000 was sold for $17,000 cash when the book value of the Equipment was $18,000. (5) Common stock of $100,000 was issued to acquire land.

for Juarez Company are shown.

ILLUSTRATION 18-37 COMPUTATION OF CASH RECEIPTS FROM CUSTOMERS


Revenues from sales were $975,000. Cash receipts from customers were greater than sales revenues since accounts receivable decreased $3,000. Cash receipts from customers were $978,000, as calculated below.

Revenues from sales Add: Decrease in accounts receivable Cash receipts from customers

$ 975,000 3,000 $ 978,000

ILLUSTRATION 18-38 COMPUTATION OF CASH PAYMENTS TO SUPPLIERS


Purchases are calculated using cost of goods sold of $660,000. The inventory decrease of $30,000 is deducted from cost of goods sold. Purchases are then adjusted by the accounts payable decrease of $8,000. Cash payments Illustration 18-39 to suppliers are calculated Illustrationto 18-38. Computation of Cashin Payments Suppliers

Cost of goods sold Deduct: Decrease in inventory Purchases Add: Decrease in accounts payable Cash payments to suppliers

$ 660,000 30,000 630,000 8,000 $ 638,000

ILLUSTRATION 18-39
COMPUTATION OF CASH PAYMENTS FOR OPERATING EXPENSES
Operating expenses (exclusive of depreciation expense) was $176,000 for 2000. The $2,000 decrease in prepaid expenses is deducted and the $5,000 decrease in accrued expenses payable is added in determining cash payments for operating expenses, as shown in Illustration 18-39.

Illustration 18-40 Computation of Cash Payments for Operating Expenses Operating expenses, exclusive of depreciation Deduct: Decrease in prepaid expenses Add: Decrease in accrued expenses payable Cash payments for operating expenses $ 176,000 ( 2,000) 5,000 $ 179,000

ILLUSTRATION 18-40
COMPUTATION OF CASH PAYMENTS FOR INCOME TAXES Income tax expense reported on the income statement was $36,000. The $12,000 increase in income taxes payable must be deducted from income tax expense to determine cash payments for income taxes. Cash payments for income taxes were Illustration 18-41 $24,000 as shown in Illustration 18-40.

Computation of Cash Payments for Income Taxes Income tax expense Deduct: Increase in income taxes payable Cash payments for income taxes $ 36,000 12,000 $ 24,000

ILLUSTRATION 18-41
FORMULA TO COMPUTE CASH PAYMENTS FOR INCOME TAXES DIRECT METHOD

The relationships among cash payments for income taxes, income tax expense, and changes in income taxes payable are shown in the formula in Illustration 18-41.
Cash payments for income taxes

Income tax expense

+ Decrease in income taxes payable or Increase in income taxes payable

ILLUSTRATION 18-42
ANALYSIS OF EQUIPMENT AND RELATED ACCUMULATED DEPRECIATION
The comparative balance sheet shows that Equipment increased $160,000 in 2003. The additional information in Illustration 1836 that the increase resulted from 2 investing transactions: 1) equipment costing $180,000 was purchased for cash and 2) equipment costing $20,000 was sold for $17,000 cash when its book value was $18,000. For Juarez Company, the investing activities section will show: 1) the $180,000 purchase of equipment as an outflow of cash and 2) the $17,000 sale of equipment as an inflow of cash.
1/1/03 12/31/03 Balance Cash purchase Balance EQUIPMENT 0 Cost of equipment sold 180,000 160,000 20,000

ILLUSTRATION 18-42
ANALYSIS OF EQUIPMENT AND RELATED ACCUMULATED DEPRECIATION

Sale of equipment

ACCUMULATED DEPRECIATION EQUIPMENT 2,000 1/1/03 Balance Depreciation expense 12/31/03 Balance

0 18,000 16,000

ILLUSTRATION 18-43 STATEMENT OF CASH FLOWS, 2003 DIRECT METHOD


JUAREZ COMPANY Statement of Cash Flows Direct Method For the Year Ended December 31, 2003 Cash flows from operating activities Cash receipts from customers Cash payments: To suppliers For operating expenses For income taxes Net cash provided by operating activities Cash flows from investing activities Purchase of equipment Sale of equipment Net cash used by investing activities Cash flows from financing activities Issuance of bonds payable Payment of cash dividend Net cash provided by financing activities Net increase in cash

$ 978,000 $ 638,000 179,000 24,000

(841,000) 137,000

(180,000) 17,000 (163,000) 90,000 ( 32,000) 58,000 32,000

ILLUSTRATION 18-43 STATEMENT OF CASH FLOWS, 2003 Cash flows from operating activities Cash receipts from customers $ 978,000 DIRECT METHOD
Cash payments: To suppliers For operating expenses For income taxes Net cash provided by operating activities Cash flows from investing activities Purchase of equipment Sale of equipment Net cash used by investing activities Cash flows from financing activities Issuance of bonds payable Payment of cash dividend Net cash provided by financing activities Net increase in cash Cash at beginning of period Cash at end of period Noncash investing and financing activities Issuance of common stock to purchase land $ 638,000 179,000 24,000 (841,000) 137,000

JUAREZ COMPANY Statement of Cash Flows Direct Method For the Year Ended December 31, 2000

(180,000) 17,000 (163,000) 90,000 ( 32,000) 58,000 32,000 159,000 $ 191,000

$ 100,000

STUDY OBJECTIVE 5

Analyze the statement of cash flows.

ILLUSTRATION 18-45 THE GAP, INC. DATA USED IN FLOW ANALYSIS

CASH

The GAP, Inc. reported the following information in its 2000 annual report:
Gap, Inc. ($ in millions) Fiscal 2000 Fiscal 1999

Current Liabilities Total Liabilities Net Sales Net Cash provided by operating activities

$1,753 2,956 11,635 1,478

$1,553 2,390 9,054 1,394

ILLUSTRATION 18-45 CURRENT CASH DEBT COVERAGE RATIO


A disadvantage of the current ratio is that it employs year-end balances of current asset and current liability accounts. Such year-end balances may not be representative of the companys current position during most of the year. The current cash debt coverage ratio partially corrects this problem and is calculated by dividing average current liabilities into net cash provided by operating activities. The current cash debt coverage ratio for The GAP, Inc. for 2000 is calculated below.
Net Cash Provided by Operating Activities

Average Current Liabilities

Current Cash Debt Coverage Ratio

$1,478 2

$1,753 + $1,553

.89:1

ILLUSTRATION 18-46

CASH RETURN ON SALES RATIO


The cash return on sales ratio is the cash based ratio that is the counterpart of the profit margin percentage. This ratio is calculated by dividing net sales into net cash provided by operating activities. The current return on sales ratio for The GAP, Inc. for 2000 is calculated below.

Net Cash Provided by Operating Activities

Net Sales

Cash Return on Sales Ratio

$1,478

$11,635

13%

ILLUSTRATION 18-47

CASH DEBT COVERAGE RATIO


The cash basis measure of solvency is the cash debt coverage ratio the ratio of net cash provided by operating activities to average total liabilities. This ratio demonstrates a companys ability to repay its liabilities from net cash provided by operating activities, without having to liquidate the assets it employs. The cash debt coverage ratio for The GAP, Inc. for 2000 is calculated below.
Net Cash Provided by Operating Activities

Average Total Liabilities

Cash Debt Coverage Ratio

$1,478 2

$2,956 + $2,390

.55:1

COPYRIGHT

Copyright 2002 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

CHAPTER 18
THE STATEMENT OF CASH FLOWS

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