The balance sheet, income statement, and retained earnings statement provide only limited, Essays (high school) of English

Download The balance sheet, income statement, and retained earnings statement provide only limited and more Essays (high school) English in PDF only on Docsity! STATEMENT OF CASH FLOWS The balance sheet, income statement, and retained earnings statement provide only limited information about a company’s cash flows (cash receipts and cash payments). For example, comparative balance sheets show the net increase in property, plant, and equipment (PPE) during the year. But, they do not show how the additions were financed or paid for. The income statement shows net income based on the accrual basis of accounting. But, it does not indicate the amount of cash generated by operating activities. The statement of stockholders’ equity (in case of corporation) 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. (Weygandt et al., 2018) Usefulness of the Statement of Cash Flows A statement of cash flows is an essential component within the set of basic financial statements. It provides information about the cash receipts and cash disbursements of an entity during a period. As an analytical tool, it is useful in determining the short-term viability of an entity, particularly its ability to pay its obligations. 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 helps investors, creditors, and others assess the following (Weygandt et al., 2018): 1. The entity’s ability to generate future cash flows. By examining relationships between items in the statement of cash flows, investors can better predict the amounts, timing, and uncertainty of future cash flows 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 flow 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. Reporting the sources, uses, and net increase or decrease in cash helps investors, creditors, and others know what is happening to a company’s most liquid resource. Because most individuals maintain a checkbook and prepare a tax return on a cash basis, they can comprehend the information reported in the statement of cash flows. The statement of cash flows provides answers to the following simple but important questions: 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? (Kieso et al., 2019) Measurement of Cash Flows For purposes of this statement, cash is defined as including both cash and cash equivalents. Cash equivalents are investments that can be quickly converted to cash. They have a maturity of 90 days or less when they are purchased, and they include the following:  Money market accounts  Commercial paper (short-term corporate notes)  Treasury bills Because cash and cash equivalents are combined, the statement of cash flows does not report transactions between cash and cash equivalents, such as cash paid to purchase cash equivalents and cash received from selling cash equivalents. Conversion of cash into cash equivalents or conversion of cash equivalents into cash are not cash flow activities. Thus, the purchase of an instrument classified as cash equivalent is not a cash flow activity. Likewise, the termination of money market placements (which is a cash equivalent) into cash is not a cash flow activity, and is, therefore, not presented in the statement of cash flows. (Shaw) Presentation of Statement of Cash Flows Companies classify cash receipts and cash payments during a period into three (3) different activities in the statement of cash flows—operating, investing, and financing activities. 1. Operating activities involve the cash effects of transactions that enter into the determination of net income. Cash flows from operating activities are primarily derived from the main revenue-producing activities of the business. As discussed in the previous topics, revenue is reported on the income statement on the year when the goods are delivered or when services are rendered. On the other hand, collections from customers will be reported on the statement of cash flows on the year when cash is received. Also, expenses are reported on the income statement when it is incurred. However, cash disbursements for these expenses are reported on the statement of cash flows on the year payments are made. The following are examples of operating activities: a. Cash received from customers (cash receipts from the sale of goods or rendering of services) b. Cash received from fees, commissions, and other income c. Cash payments to suppliers d. Cash payments to employees e. Cash payments for other operating expenses f. Interest payments 2. Investing activities include making and collecting loans and acquiring and disposing of investments (both debt and equity) and property, plant, and equipment. Cash flows from investing activities is the second section on the statement of cash flows. Cash flows from investing activities hints on the company’s ability to generate future cash flows. Negative cash flows from investing activities imply that the company used cash to acquire long-term assets intended to generate cash and revenue in the future. On the other hand, positive cash flow may indicate that the company is divesting or downsizing. Examples include: a. Cash payments to acquire PPE, intangibles and other long-term assets b. Cash receipts from the sale of PPE, intangibles and other long-term assets c. Cash advances and loans made to other parties (long-term notes receivable) d. Cash collections on long-term notes receivable 3. Financing activities involve liability and owners’ equity items. They include (a) obtaining resources from owners and providing them with a return on their investment, and (b) borrowing money from creditors and repaying the amounts borrowed. Cash flows information arising from financing activities is useful in predicting claims on future cash flows by providers of capital to the enterprise. It involves cash flow transactions with long-term creditors and shareholders. Examples include: a. Cash proceeds from issuing shares b. Cash received from issuing notes or getting a long-term loan from a bank (long-term notes payable) c. Cash dividends distributed to shareholders d. Cash withdrawals of owners e. Cash paid for principal of long-term debt To compute the payment for cash dividends, you may use the following formula: Net income P xxx Add: Retained Earnings, beg. xxx Less: Retained Earnings, end. xxx Payments for dividends P xxx Additional information for 201B: 1. The accounts payable balances result from inventory purchases. 2. Purchased P60,000 in plant assets by issuing P60,000 of notes payable. 3. Sold plant assets with a book value of P8,000 (original cost of P20,000 and accumulated depreciation of P12,000) for P2,000 cash, yielding a P6,000 loss. 4. Received P15,000 cash from issuing 3,000 ordinary shares 5. Paid P18,000 cash to retire notes with a P34,000 book value, yielding P16,000 gain. 6. Declared and paid cash dividends of 14,000. To prepare the statement of cash flows, we will use the illustration given. An enterprise should report cash flows from operating activities using either the: a. Direct method, whereby major classes of gross cash receipts and gross cash payments are disclosed; or b. Indirect method, whereby the profit or loss is adjusted for the effects of transactions of a non-cash nature, any deferrals or accruals of past or future operating cash receipts or payments, and items of income or expense associated with investing or financing cash flows. The direct method separately lists operating cash receipts (such as cash received from customers) and operating cash payments (such as cash paid to suppliers). The cash payments are then deducted from cash receipts. The indirect method reports net income and then adjusts it for items that do not affect cash. It does not report individual items of cash inflows and cash outflows from operating activities. The net cash amount provided by operating activities is identical under both the direct and indirect methods. The difference is with the computation and presentation. The Financial Accounting Standards Board (FASB) has expressed a preference for the direct method but allows the use of either method. The presentation of cash flow from investing and financing activities are just the same for both methods. DIRECT METHOD International Accounting Standards (IAS) 7 encourages enterprises to report cash flows from operating activities using direct method because it provides information that may be useful in estimating future cash flows that are not available under the indirect method. Furthermore, the direct method shows each major class of cash receipts and cash disbursements or payments. The amounts reported as cash receipts and cash payments under the direct method are taken by converting the accrual basis revenues and expenses from the income statement to a cash basis by considering the changes in the related accounts in the statement of financial position. The following are the major classes of cash receipts and cash payments: Cash Received from Customers. If all sales are for cash, cash received from customers equals the sales reported on the income statement. When some or all sales are on credit, the amount of sales must be adjusted for the change in Accounts Receivable. Using the information in the financial statements given, the cash received from customers is computed as follows: Accounts Receivable Beg balance 40,000 Sales 590,000 Cash receipts 570,000 End balance 60,000 Cash receipts can also be computed using as sales of P590,000 less increase in accounts receivable of P20,000. Cash Paid to Suppliers. This is computed by analyzing cost of goods sold and inventory. If all inventory purchases are for cash and the balance of Inventory is unchanged, the amount of cash paid for inventory equals cost of goods sold, which is uncommon. Also, some or all purchases are often made on credit, which changes the Accounts Payable balance. When the balances of Inventory and Accounts Payable change, the cost of goods sold must be adjusted to compute the cash paid to suppliers. The first step is to use the change in Inventory and the cost of goods sold amount to compute the purchases for the period. An increase in inventory means that the company bought more than it sold, and this is added to the inventory balance. If there is a decrease in inventory, then this is deducted from the cost of goods sold. The amount of purchases is computed as follows: Inventory Beg balance 70,000 Purchases 314,000 COGS 300,000 End balance 84,000 The amount of purchases for the period can also be computed as cost of goods sold of P300,000 plus the increase in inventory of P14,000. The second step is to use the change in accounts payable and the cost of purchases to compute the cash paid to suppliers. Using a T- account: Accounts Payable Beg balance 40,000 Cash payments 319,000 Purchases 314,000 End balance 35,000 Alternatively, cash paid to suppliers is equal to purchases of P314,000 plus the P5,000 decrease in accounts payable. Cash Paid for Wages and Other Operating Expenses. In the income statement of Exodus, all operating expenses are combined. To compute the cash paid for wages and other operating expenses, we adjust for any changes in the related balance sheet accounts. Look for any prepaid expenses and accrued expenses related to wages and other operating expenses. The balance sheet shows prepaid expenses, but there are no accrued liabilities. The adjustment is computed by assuming that all cash paid for wages and other operating expenses is initially debited to Prepaid Expenses. You may also refer to the Adjusting Process topic in 01 Review of the Accounting Process for a more detailed discussion about prepaid expenses and accrued expenses. Using a T-account: Prepaid Expenses Beg balance 4,000 Cash payments 218,000 Wages and Other Operating Exp. 216,000 End balance 6,000 Alternatively, this can be computed as wages and other operating expenses plus the increase in prepaid expenses of P2,000. Cash Paid for Accrued Expenses. The balance sheet of Exodus does not report any accrued expenses, but it is still included in the formula to explain the adjustment to cash when they exist. A decrease in accrued expenses means that the company paid cash for more goods or services than received this period, so cash paid is higher than the recorded expense. On the other hand, an increase implies that the company paid less cash than what was received, so cash paid is less than the recorded expense. Cash Paid for Interest and Income Taxes. Computing operating cash flows for interest and taxes requires adjustments for amounts reported on the income statement for changes in related balance sheet accounts. The Exodus income statement shows interest expense of P7,000 and income taxes expense of P15,000. To compute the cash paid, adjust the interest expense for the change in interest payable and adjust the income taxes expense for the change in income taxes payable. These computations involve reconstructing both liability accounts and show cash paid for interest of P8,000 and cash paid for income taxes of P5,000. Interest Payable Beg balance 4,000 Cash paid for interest 8,000 Interest expense 7,000 End balance 3,000 Income Tax Payable Beg balance 12,000 Cash paid for taxes 5,000 Income tax expense 15,000 End balance 22,000 Analyzing Additional Expenses, Gains, and Losses Exodus Company has three (3) more items reported on its income statement: depreciation, loss on sale of assets, and gain on retirement of debt. 1. Depreciation Expense. Depreciation expense is P24,000. It is considered a noncash expense because depreciation has no cash flows. Depreciation expense is not reported on a statement of cash flows using the direct method; nor is depletion or amortization expense. 2. Loss on Sale of Assets. Sale of assets frequently result in gains and losses reported as part of net income, but the amount of recorded gain or loss does not impact cash. Thus, the gain or loss on a sale of assets is not reported on a statement of cash flows using the direct method. 3. Gain on Retirement of Debt. Retirement of debt usually yields a gain or loss reported as part of net income, but that gain or loss does not impact cash. Thus, the gain or loss from retirement of debt is never reported on a statement of cash flows using the direct method. A summary of adjustments for direct method are as follows: Item Accrual Basis Adjustments Required Cash Basis Cash Receipts From sales Net sales/Sales revenue + Accounts Receivable, beg. - Accounts Receivable, end. or + Decrease in accounts receivable or - Increase in accounts Receivable = Cash receipts from customers From rent, interest, or dividends Rent revenue Interest revenue Dividend revenue + (Rent, interest, dividend) Receivable, beg. - (Rent, interest, dividend) Receivable, end. or + Increase in receivable or - Decrease in receivable = Cash receipts from rent, interest or dividends Cash Payments To suppliers Cost of Goods Sold + Inventory, end + Accounts Payable, beg. - Inventory, beg. - Accounts Payable, beg. or + Increase in Inventory - Decrease in Inventory + Decrease in accounts payable - Increase in accounts payable = Cash paid to suppliers For operating expenses Operating Expenses (e.g., insurance, rent) + Prepaid Expense, end + Accrued Expense, beg. - Prepaid Expense, beg. - Accrued Expense, end. = Cash paid for operating expenses To employees Wages (Salaries) Expense + Salaries Payable, beg. - Salaries Payable, end. or + Decrease in salaries payable or - Increase in salaries payable = Cash paid to employees