Purpose of the Statement of Cash Flow - Elementary Financial Accounting | ACCT 201, Study notes of Financial Accounting

Download Purpose of the Statement of Cash Flow - Elementary Financial Accounting | ACCT 201 and more Study notes Financial Accounting in PDF only on Docsity! CHAPTER 12 Purpose of the Statement of Cash Flows The statement of cash flows is considered a major financial statement, as are the income statement, balance sheet, and statement of stockholders' equity. The statement of cash flows provides a great deal of information and answers certain questions that the other three statements do not. Its presentation is required whenever an income statement is prepared. The statement of cash flows shows the effects on cash and cash equivalents of the operating, investing, and financing activities of a company for an accounting period. The principal purpose of the statement of cash flows is to provide information about a company's cash receipts and cash payments during an accounting period. The secondary purpose of the statement of cash flows is to provide information about a company's operating, investing, and financing activities during the period. Classification of Cash Flows The statement of cash flows categorizes cash receipts and cash payments as operating, investing, and financing activities. • Operating activities include receiving cash from customers for the sale of goods and services, receiving interest and dividends on loans and investments, and making cash payments for wages, goods and services purchased, interest, and taxes. • Investing activities include purchasing and selling long-term assets and marketable securities (other than cash equivalents), as well as making and collecting on loans. • Financing activities include issuing and buying back capital stock, as well as borrowing and repaying loans on a short- or long-term basis (issuing bonds and notes). Dividends paid are also included in this category, but the repayment of accounts payable or accrued liabilities is not. Significant Non-Cash Activities The statement of cash flows should be accompanied by a schedule of non-cash investing and financing transactions. Such transactions represent simultaneous investing and financing activities that do not, however, result in an inflow or outflow of cash. These activities include: • the issuance of stock for assets; • the conversion of bonds into stock; • the issuance of debt for assets; and • the exchange of plant assets Format Of The Statement of Cash Flows The cash flows from operating activities always appears first. It is followed by the investing activities section and then the financing activities section. In the formal statement of cash flows, individual cash inflows and outflows from investing and financing activities are shown separately in their respective categories. (e.g., inflows from sale of plant assets is reported separately from outflows from investing in plant assets). The Corporate Life Cycle All products go through a series of phases called the product life cycle, and a corporation’s cash flow reflects these phases. The phases (in order of their occurrence) are often referred to as follows: • Introductory Phase. During this phase, the corporation is likely to have a cash deficit in its operations because the product’s sales are small and the promotional expenses are great. There may also be a great deal of expenditures for research and development activities. During this phase, the corporation is likely to have a deficit in its investing activities because it is spending a great deal on investing in plant assets. These deficits will be covered through financing transactions. • Growth Phase. During this phase, the sales revenue will increase. Despite this, the growth in its inventories and supplies and the need to increase the amount of credit offered to customers represent a significant need for cash in a corporation’s operations. This phase is usually characterized by additional spending on research and development activities. During this phase, there is still a significant need for investments in plant assets. All of these needs will still require a cash infusion from financing transactions. • Maturity Phase. A product in this phase is often referred to as a “cash cow.” A company’s operations should produce cash flow, and there is a shrinking demand for investments in plant assets. As a result of the foregoing, there is little need for a cash infusion from financing transactions. Indirect Method Consider the balance sheet equation: Assets = Liabilities + Owner’s Equity Cash + Curr. Assets + LT Assets = Curr. Liab. + LT Liab. + Equity ∆ Cash + ∆ Curr. Assets + ∆ LT Assets = ∆ Curr. Liab. + ∆ LT Liab. + ∆ Equity ∆ Cash = -∆ Curr. Assets - ∆ LT Assets + ∆ Curr.Liab.+ ∆ LT Liab. + ∆ Equity So cash changes in the opposite way from other assets and the same way as liabilities and equity. With the Indirect Method we assume that a change in a balance sheet account is matched by a change in cash. This is true for every change in the balance sheet accounts except for changes due to non-cash transactions (e.g., the purchase of an asset in exchange for stock). As a general rule, the changes for the following balance sheet accounts are assumed to affect the following activities: Activity Changes In These Accounts Fall Within The Activity In Question Operations Current Assets Current Liabilities Net Income and Loss Also add back non cash expenses like depreciation Investing Long Term Assets Financing Long Term Liabilities Stockholder’s Equity (excluding Net Income) Illustration of the Indirect Method We are going to use the T-Account approach to the Indirect Method. It is a very simple approach to use because: • You mechanically go through every balance sheet account; and • You note every change with an equal amount of debits and credits. Because of these characteristics, it is difficult to skip an item. A company has the following financial statements for the current and last years: Balance Sheet Assets Current Year Last Year Cash $164,800 $ 50,000 Accounts Receivable 165,200 200,000 Merchandise Inventory 350,000 450,000 Prepaid Rent 2,000 3,000 Furniture and Fixtures 148,000 144,000 Accumulated Depreciation Furniture and Fixtures (42,000) (24,000) ------------- -------------- Total Assets $788,000 $823,000 ======= ======== Liabilities Accounts Payable $143,400 $200,400 Income Taxes Payable 1,400 4,400 Notes Payable (Long-Term) 40,000 20,000 Bonds Payable 100,000 200,000 Equity Common Stock ($20 par value) 240,000 200,000 Paid-In Capital in Excess of Par Value 181,440 121,440 Retained Earnings 81,760 76,760 -------------- -------------- Total Liabilities & Equity $788,000 $823,000 ======== ======== Income Statement Net Sales $1,609,000 Cost of Goods Sold (1,127,800) ---------------- Gross Margin $ 481,200 Operating Expenses (including Depreciation Expense of $46,800) (449,400) ---------------- Income From Operations $ 31,800 Other Income/Expense Gain on Sale of Furniture and Fixtures $ 7,000 Interest Expense (23,200) ------------ Total Other Income/Expense (16,200) ---------------- Income Before Income Taxes $ 15,600 Income Tax Expense (4,600) ---------------- Net Income $ 11,000 ========= Additional information for the current year: • Furniture and fixtures that cost $35,600 with accumulated depreciation of $28,800 were sold at a gain of $7,000. • Furniture and fixtures were purchased in the amount of $39,600. • A $20,000 note payable was paid and $40,000 was borrowed on a new note. • Bonds Payable in the amount of $100,000 were converted into 2,000 shares of common stock. • $6,000 in cash dividends were declared and paid. The Accounts Payable have decreased by $57,000: Accounts Payable $57,000 The Income Taxes Payable have decreased by $3,000: Income Taxes Payable $3,000 The Notes Payable have increased by $20,000: Notes Payable $20,000 The Bonds Payable have decreased by $100,000: Bonds Payable $100,000 The Common Stock has increased by $40,000: Common Stock $40,000 The Additional Paid-In Capital has increased by $60,000: Additional Paid-In Capital $60,000 The Retained Earnings has increased by $5,000: Retained Earnings $5,000 All of these figures above the line drawn in each T-Account represents the total change in the account and we must now duplicate it below the line in each account. Except for the non-cash transactions, we will explain the change with a corresponding entry in a large Cash T-Account that has been divided into three parts for Operations, Investing, and Financing: Cash Operations Investing Financing With the Indirect Method, we will work from the Net Income from the Income Statement. The Net Income increased the Corporation’s Retained Earnings. The Net Income is also the basis for the calculation of Cash Flow From Operations. So, we enter the Net Income ($11,000) as a credit to Retained Earnings (It increased Retained Earnings) and a debit to Cash (It increased Cash). Thus we have equal debits and credits: Retained Earnings $5,000 $11,000 Cash Operations Net Income $11,000 Next, look at the additional information. We are told that $6,000 in cash dividends were declared and paid. Dividends reduce Retained Earnings (debit), and the payment of a cash dividend is an outflow of Cash. Thus, Cash is reduced (credit). We have equal debits and credits of $6,000: Retained Earnings $5,000 $6,000 $11,000 ============== ============== If you net the credit of $11,000 (Net Income) and debit of $6,000 (Dividends), we have explained how Retained earnings had a net increase of $5,000. The payment of a dividend involves equity, and therefore should be recorded as a financing transaction. Having explained the change in Retained Earnings, we draw a double line below the account to show that we are finished with this account. Cash Operations Net Income $11,000 Investing Financing Pay Dividends $6,000 Look at the Additional Information again. We see that Bonds Payable in the amount of $100,000 were converted into 2,000 shares of common stock. With a bond conversion, you take the carrying value of the bonds off the balance sheet, and issue stock for the exact amount of the carrying value. D. Bonds Payable $100,000 Cr. Common Stock $40,000 Additional Paid-In Capital 60,000 Cash Operations Net Income $11,000 Investing Purchase of Furniture $39,600 Financing Issue Notes Payable $40,000 Pay Dividends $6,000 Pay Notes Payable $20,000 From the Income Statement, we can see that the depreciation expense for the current year is $46,800. Depreciation Expense increases Accumulated Depreciation (credit). Depreciation does not cost any cash, but under the accrual method, it reduced Net Income. The purpose of the Indirect Method is to convert the accrual method Net Income into a cash method Net Income. Thus, we want to increase Cash From Operations by the amount of Depreciation Expense. If you have trouble with this logic, remember that we need an equal amount of debits and credits. You know that Depreciation Expense increases Accumulated Depreciation with a credit. So, Cash needs a debit of $46,800. Accumulated Depreciation $18,000 $46,800 Cash Operations Net Income $11,000 Plus Depreciation $46,800 Investing Purchase of Furniture $39,600 Financing Issue Notes Payable $40,000 Pay Dividends $6,000 Pay Notes Payable $20,000 Look at the Additional Information. Furniture and fixtures that cost $35,600 with accumulated depreciation of $28,800 were sold at a gain of $7,000. Note the journal entry from that sale: D. Cash $13,800 Accumulated Depreciation 28,800 Cr. Furniture and Fixtures $35,600 Gain 7,000 You want to do this journal entry to the T-Accounts noted in the journal entry: Accumulated Depreciation $18,000 $28,800 $46,800 ============= ============ Furniture & Fixtures $4,000 $39,600 $35,600 ============= ============ The debit to Cash for $13,800 is a cash inflow from the sale of a Long-Term Asset, which is an investing activity. We received $13,800 from that sale. The $13,800 sales price includes the gain from the sale. But the gain is part of Net Income, which appears under Operations. You are counting the gain twice – Once in Operations and Once in Investing. You take the credit to gain and place it in operations to take the gain out of the Net Income. (The Credit will offset the Net Income, which is a Debit to Cash From Operations.) Cash Operations Net Income $11,000 Furniture Gain $7,000 Plus Depreciation $46,800 Investing Sale of Furniture $13,800 Purchase of Furniture $39,600 Financing Issue Notes Payable $40,000 Pay Dividends $6,000 Pay Notes Payable $20,000 We have explained the changes to Furniture & Fixtures and Accumulated Depreciation. The only accounts left unexplained are the current assets and current liabilities. These changes to the accounts are entered below the line in each T-Account and an offsetting debit or credit is entered to Cash Flow From Operations: Accounts Receivable $34,800 $34,800 =============== ============= Merchandise Inventory $100,000 $100,000 ============== ============= Prepaid Rent $1,000 $1,000 ============== ============= Accounts Payable $57,000 $57,000 =============== ============= Income Taxes Payable $3,000 $3,000 =============== ============= Cash Operations Net Income $11,000 Furniture Gain $7,000 Depreciation $46,800 Decrease in A/P $57,000 Decrease in A/R $34,800 Decrease in Tax Pay $3,000 Decrease in Inven. $100,000 Decrease in Prep. Rent $1,000 Cash Flow From Operations: $126,600 Investing Sale of Furniture $13,800 Purchase of Furniture $39,600 Cash Flow From Investing: -$25,800 Financing Issue Notes Payable $40,000 Pay Dividends $6,000 Pay Notes Payable $20,000 Cash Flow From Financing: $14,000 Total Cash Flow For Current Year: $114,800 Plus: Beginning Balance of Cash: $50,000 Ending Balance of Cash: $164,800 The Direct Method Under the direct method, (net) cash flows from operating activities are determined by taking cash receipts from sales, adding interest and dividends