23-1 prepared by coby harmon university of california, santa barbara intermediat e accounting...

23-1

Prepared by Prepared by Coby Harmon Coby Harmon

University of California, Santa BarbaraUniversity of California, Santa Barbara

IntermediatIntermediate e

AccountingAccounting

IntermediatIntermediate e

AccountingAccounting

Prepared by Prepared by Coby Harmon Coby Harmon

University of California, Santa BarbaraUniversity of California, Santa BarbaraWestmont CollegeWestmont College

INTERMEDIATE

ACCOUNTINGF I F T E E N T H E D I T I O N

Prepared byCoby Harmon

University of California, Santa BarbaraWestmont College

kikieesosowweeygandtygandtwarfiwarfieeldld

team for successteam for success

23-2

PREVIEW OF CHAPTERPREVIEW OF CHAPTER

Intermediate Accounting15th Edition

Kieso Weygandt Warfield

2323

23-3

6. Identify sources of information for a statement of cash flows.

7. Contrast the direct and indirect methods of calculating net cash flow from operating activities.

8. Discuss special problems in preparing a statement of cash flows.

9. Explain the use of a worksheet in preparing a statement of cash flows.

After studying this chapter, you should be able to:

LEARNING OBJECTIVESLEARNING OBJECTIVESLEARNING OBJECTIVESLEARNING OBJECTIVES

1. Describe the purpose of the statement of cash flows.

2. Identify the major classifications of cash flows.

3. Prepare a statement of cash flows.

4. Differentiate between net income and net cash flow from operating activities.

5. Determine net cash flows from investing and financing activities.

Statement of Cash Statement of Cash Flows Flows 2323

23-4

A Frenzied Focus on EarningsA Frenzied Focus on Earnings

Earnings-per-share usually makes the head-Earnings-per-share usually makes the head-lineslines

E.g. Yahoo!’s Earnings ScoreboardE.g. Yahoo!’s Earnings Scoreboardhttp://biz.yahoo.com/z/extreme.html

Yet, earnings don’t tell the whole storyYet, earnings don’t tell the whole story In fact, relying on earnings without looking at In fact, relying on earnings without looking at

cash flows is a recipe for misinterpretationcash flows is a recipe for misinterpretation

23-5

Cash Flow: Cash Flow: Shining a Light on EarningsShining a Light on Earnings

Problem with earnings: can be manipulated Problem with earnings: can be manipulated through creative accountingthrough creative accounting GAAP requires accrual accounting, full of GAAP requires accrual accounting, full of

estimates and judgment calls . . . & gimmicksestimates and judgment calls . . . & gimmicks

Advantage of cash flow: much harder to Advantage of cash flow: much harder to fudge, provides a reality checkfudge, provides a reality check You either got (or paid) $$ or you didn’t. Period.You either got (or paid) $$ or you didn’t. Period.

23-6

Buffetology:Buffetology:Mimicking the MasterMimicking the Master

Warren Warren Buffet,Buffet,

World’s Most World’s Most Famous Famous InvestorInvestor

- Uses a cash flow model as a major pillar of - Uses a cash flow model as a major pillar of investing strategyinvesting strategy

- Hard to argue with a guy who bought - Hard to argue with a guy who bought Berkshire Hathaway for $15/share and each Berkshire Hathaway for $15/share and each

share is worth over $100k today (22% share is worth over $100k today (22% average compound return)average compound return)

23-7

Buffetology at WorkBuffetology at WorkExampleExample

Cash Flow Track Record of XYX Company 2003 2004 2005 2006 2007 2008 2009 2010 AVG

Free Cash Flow 145 223 224 290 313 274 252 238 259

Avg Growth Rate in FCF = 9.4%

Projected Cash Flows of XYZ Company 2011 2012 2013 2014 2015 2016 2017 2018 2019+TOTAL

Projected Cash Flows 283 310 339 371 406 444 486 531

PV of Projected CF, 8% 262 266 269 273 276 280 283 287 5667 7863

Market Cap Today (# shares times price) 9.53m * $585/sh 5575

Discount Percentage (stock is undervalued by 29%) 29%

23-8

Putting Earnings on TrialPutting Earnings on Trial

When net earnings > oper. cash flow, it When net earnings > oper. cash flow, it raises suspicions of aggressive earnings raises suspicions of aggressive earnings management and should be investigated.management and should be investigated.

Furthermore, if this condition persists for Furthermore, if this condition persists for several periods, questions about viability several periods, questions about viability need to be raisedneed to be raised

Example: W.T. GrantExample: W.T. Grant

23-9A Classic Example . . A Classic Example . .

..

W. T. Grant Co.W. T. Grant Co.W. T. Grant Co.W. T. Grant Co.““Retailing With A Difference”Retailing With A Difference”

23-10

W.T. Grant Building, NYC, 1974W.T. Grant Building, NYC, 1974

W.T. Grant was the W.T. Grant was the largest U.S. retailer in largest U.S. retailer in

1970 and reported profits 1970 and reported profits almost right up until it’s almost right up until it’s bankruptcy in 1975. If bankruptcy in 1975. If investors had looked at investors had looked at its cash flows instead of its cash flows instead of profits, they would have profits, they would have seen a different story. seen a different story. The cash flows for all The cash flows for all

years (except two) in the years (except two) in the decade prior to decade prior to

bankruptcy were bankruptcy were negative. This should negative. This should

have been a tell-tale sign.have been a tell-tale sign.

23-11

4040

2020

-20-20

00

-40-40

-100-100

Millions of Millions of DollarsDollars

1968196819661966 19701970 19721972 19741974

Working Capital Working Capital Provided By OperationsProvided By Operations

Net IncomeNet Income

Cash Flow Provided Cash Flow Provided by Operationsby Operations

What went wrong at WT Grant?What went wrong at WT Grant?

23-12

W.T. Grant Collapse:W.T. Grant Collapse:A Catalyst for ChangeA Catalyst for Change

The bankruptcy of W.T. Grant helped launch The bankruptcy of W.T. Grant helped launch a campaign for better disclosure of cash a campaign for better disclosure of cash flows.flows.

A study of 45,000 firms that filed for A study of 45,000 firms that filed for bankruptcy in the 1980s showed that 60% bankruptcy in the 1980s showed that 60% had a profitable bottom line, but none had had a profitable bottom line, but none had positive operating cash flow.positive operating cash flow.

In 1987, the FASB finally got around to In 1987, the FASB finally got around to requiring the current cash flow statement requiring the current cash flow statement formatformat

23-13

Summary: “Watch Cash Flow” Quoth Summary: “Watch Cash Flow” Quoth the Bankerthe Banker

Once upon a mid-night dreary as I pondered Once upon a mid-night dreary as I pondered weak and weary, over many a curious weak and weary, over many a curious volume of accounting lore,volume of accounting lore,

Seeking gimmicks (without scruple) to squeeze Seeking gimmicks (without scruple) to squeeze through some new loophole, suddenly I through some new loophole, suddenly I heard a knock at the door,heard a knock at the door,

Only this, and nothing moreOnly this, and nothing more

23-14


Then I felt a queasy tingling and I heard the Then I felt a queasy tingling and I heard the cash-a-jingling, as my fearsome banker cash-a-jingling, as my fearsome banker entered whom I’d oft’ seen beforeentered whom I’d oft’ seen before

His face was money-green and in his eyes His face was money-green and in his eyes there could be seen dollar-signs glittering as there could be seen dollar-signs glittering as he reckoned up the score.he reckoned up the score.

““Cash flow,” said the banker and nothing more.Cash flow,” said the banker and nothing more.

23-15


I had always thought it fine to show a jet-black I had always thought it fine to show a jet-black bottom line, but the banker yelled a bottom line, but the banker yelled a resounding “No,resounding “No,

Your receivables are high, mounting upwards Your receivables are high, mounting upwards to the sky, and write-offs loom, Watch cash to the sky, and write-offs loom, Watch cash flow,” he said. “Watch cash flow!”flow,” he said. “Watch cash flow!”

23-16


Then I tried to tell the story of our lovely Then I tried to tell the story of our lovely inventory, which though large is full of inventory, which though large is full of delightful stuff.delightful stuff.

But the banker saw its growth and with a might But the banker saw its growth and with a might oath, waved his arms and shouted “Enough!oath, waved his arms and shouted “Enough!

Pay the interest and don’t give any guff.”Pay the interest and don’t give any guff.”

23-17


Next I looked for items not of cash to replace Next I looked for items not of cash to replace the ever-outward flow of cashthe ever-outward flow of cash

But to keep things in the black, I held But to keep things in the black, I held depreciation back, to which the banker yelled depreciation back, to which the banker yelled “Rash.”“Rash.”

He quivered and his teeth began to gnashHe quivered and his teeth began to gnash

23-18


Mustering courage, I finally asked him for a Mustering courage, I finally asked him for a loan and he responded with a groan, that the loan and he responded with a groan, that the rate would be prime plus eightrate would be prime plus eight

And to guarantee my purity he’d insist on some And to guarantee my purity he’d insist on some security, all the assets plus the scalp upon security, all the assets plus the scalp upon my patemy pate

Only this, a sub-standard rateOnly this, a sub-standard rate

23-19


Though my bottom line is black, I am flat upon Though my bottom line is black, I am flat upon my back, my cash goes out fast and it comes my back, my cash goes out fast and it comes in slow.in slow.

The growth of my receivables is almost The growth of my receivables is almost unbelievable, the result is certain woeunbelievable, the result is certain woe

And I hear the banker utter an ominous growlAnd I hear the banker utter an ominous growl

““Watch cash flow,” he said. “Watch cash Watch cash flow,” he said. “Watch cash flow.”flow.”

23-20

Where Does Where Does it Fit in?it Fit in?

The Statement of Cash FlowsThe Statement of Cash Flows

Cash Cash FlowsFlows

BSBS

ISIS

SCOSCOEE

23-21

Primary purpose:

To provide information about a company’s cash receipts

and cash payments during a period.

Secondary objective:

To provide cash-basis information about the company’s

operating, investing, and financing activities.

LO 1

Preparation of Statement of Cash Flows

23-22

Provides information to help assess:

1. Entity’s ability to generate future cash flows.

2. Entity’s ability to pay dividends and meet obligations.

3. Reasons for difference between net income and net cash

flow from operating activities.

4. Cash and noncash investing and financing transactions.

LO 1

Usefulness of the Statement of Cash Flows


23-23













23-24

Income

Statement Items

Operating Activities

Changes in Investments and

Long-Term Asset Items

Investing Activities

Changes in Long-Term

Liabilities and Stockholders’

Equity

Financing Activities

LO 2

Classification of Cash Flows


23-25

Illustration 23-1 Classification of Typical Cash Inflows and Outflows

LO 2


23-26

Illustration 23-1 Classification of Typical Cash Inflows and Outflows

LO 2


23-27

Statement of Cash Flows:Statement of Cash Flows: Connecting the Dots Connecting the Dots

Accrual Cash

Sales 1000 900 100 of uncollected sales

Cost of Sales 600 590 10 of unpaid inventory

Gross Profit 400 310Oper. Expenses 300 250 50 of depreciation

Net Income 100 60Borrowed $$ 50Paid Dividends 40Purchased Equip. 70Increase in cash 0

23-28

Statement of Cash FlowsStatement of Cash Flows

OPERATING ACTIVITIES

Operating activities should provide cash . . . this is the cash

engine, the life blood of the company.

Net Income 100

Depreciation +50

Increase in Accounts Receivable -100

Increase in Accounts Payable +10

Net Cash from Oper. Activities +60

INVESTING ACTIVITIES Investing activities should use cash . . . This is how the engine is

kept running smoothlyPurchased Equipment -70

Net Cash used by Invest. Activities -70

FINANCING ACTIVITIESFinancing activities could either provide or use cash, depending on position in produce life cycle.

Dividends Paid -40

Borrowed Money +50

Net Cash from Fin. Activities +10

NET CHANGE IN CASH 0

23-29

The basis recommended by the FASB for the statement of

cash flows is actually “cash and cash equivalents.” Cash

equivalents are short-term, highly liquid investments that are

both:

Readily convertible to known amounts of cash, and

So near their maturity that they present insignificant risk of

changes in interest rates.

Generally, only investments with original maturities of three

months or less qualify under this definition.

LO 2


23-30 3030

The Product Life CycleThe Product Life Cycle

A series of phases all products go throughA series of phases all products go through The phases are often referred to as the: The phases are often referred to as the:

introductory phaseintroductory phase growth phasegrowth phase maturity phasematurity phase decline phase. decline phase.

The phase a company is in affects its cash The phase a company is in affects its cash flows.flows.

23-31

Company Product Life

Cycle

LO 2


23-32

Introductory PhaseIntroductory Phase

To support asset purchases the company may To support asset purchases the company may issue stock or debt. Expect:issue stock or debt. Expect:

cash from operations to be negativecash from operations to be negative cash from investing to be negative.cash from investing to be negative. cash from financing to be positive.cash from financing to be positive.

23-33

The company is striving to expand its production The company is striving to expand its production and salesand sales..

Expect:Expect: small amounts of cash to be generatedsmall amounts of cash to be generated

from operations. from operations. cash from investing to be negative.cash from investing to be negative. cash from financing to be positive.cash from financing to be positive.

Growth PhaseGrowth Phase

23-34

Sales and production level-offSales and production level-offExpect:Expect: cash from operations to exceed investing cash from operations to exceed investing

needs.needs. cash from investing to be neutral.cash from investing to be neutral. cash from financing to be negative.cash from financing to be negative.

Maturity PhaseMaturity Phase

23-35

Sales and production declineSales and production declineExpect:Expect: cash from operations to declinecash from operations to decline cash from investing to possibly become cash from investing to possibly become

positive.positive. cash from financing to possibly become cash from financing to possibly become

negativenegative

Decline PhaseDecline Phase

23-36

Cash Flow Patterns: Start UpCash Flow Patterns: Start Up

MATCH: Moving ahead in faith . . . somebody MATCH: Moving ahead in faith . . . somebody believes in you and is backing it up with bucks believes in you and is backing it up with bucks (start-up pattern)(start-up pattern)

COMPANY: A B C D EOperating +500 +300 +300 -100 -200Investing -400 +100 +200 -200 +400Financing -100 +200 -500 +300 -200Net Incr (Decr) 0 +600 0 0 0

ANSWER: D, Start-up PatternANSWER: D, Start-up Pattern

23-37

Cash Flow Patterns:Cash Flow Patterns:Normal FlowNormal Flow

MATCH: Going strong & ensuring strength for MATCH: Going strong & ensuring strength for tomorrow (normal cash flow)tomorrow (normal cash flow)

COMPANY: A B C D EOperating +500 +300 +300 -100 -200Investing -400 +100 +200 -200 +400Financing -100 +200 -500 +300 -200Net Incr (Decr) 0 +600 0 0 0

ANSWER: A, Normal PatternANSWER: A, Normal Pattern

23-38

Cash Flow Patterns: MaturityCash Flow Patterns: Maturity

MATCH: Making cash-hungry creditors or owners MATCH: Making cash-hungry creditors or owners happy (maturity pattern)happy (maturity pattern)

COMPANY: A B C D EOperating +300 +300 +300 -100 -200Investing -400 +100 +200 -200 +400Financing +100 +200 -500 +300 -200Net Incr (Decr) 0 +600 0 0 0

ANSWER: C, Maturity PatternANSWER: C, Maturity Pattern

23-39

Cash Flow Patterns:Cash Flow Patterns:Cash Build UpCash Build Up

MATCH: Hoarding cash, maybe for future takeover MATCH: Hoarding cash, maybe for future takeover or expansion .or expansion .


ANSWER: B, Cash Build-UpANSWER: B, Cash Build-Up

23-40

Cash Flow Pattern: Decline StageCash Flow Pattern: Decline Stage

MATCH: Poor health and getting ready to die MATCH: Poor health and getting ready to die (liquidation)(liquidation)


ANSWER: E, Decline StageANSWER: E, Decline Stage

23-41

LiquidityLiquidity

Liquidity is the ability of a business to meet its Liquidity is the ability of a business to meet its immediate obligations.immediate obligations.

One measure of liquidity is the current ratio. One measure of liquidity is the current ratio. A disadvantage of the current ratio is that it uses A disadvantage of the current ratio is that it uses

year-end balances of current assets and current year-end balances of current assets and current liabilities (may not be representative of a company's liabilities (may not be representative of a company's position during most of the year.) position during most of the year.)

Other measures of liquidity include free cash Other measures of liquidity include free cash flow, current debt coverage ratio, and debt flow, current debt coverage ratio, and debt coverage ratio.coverage ratio.

23-42

Cash Provided By Operations Cash Provided By Operations

– – Capital ExpendituresCapital Expenditures

– – Dividends Paid Dividends Paid

== Free Cash Flow Free Cash Flow

Free Cash FlowFree Cash Flow

This concept is used heavily by Warren Buffet to value a company – see slides 6-7

23-43

Assessing Liquidity and Assessing Liquidity and SolvencySolvencyLiquidity Liquidity is the ability to pay obligations expected is the ability to pay obligations expected to become due within the next year.to become due within the next year.

Using Cash Flows to Evaluate a CompanyUsing Cash Flows to Evaluate a CompanyUsing Cash Flows to Evaluate a CompanyUsing Cash Flows to Evaluate a Company

Illustration Illustration 12-1812-18

A value below 0.40 times is cause for A value below 0.40 times is cause for additional investigation.additional investigation.

SO 5 Use the statement of cash flows to evaluate a SO 5 Use the statement of cash flows to evaluate a company.company.

23-44

Assessing Liquidity and Assessing Liquidity and SolvencySolvencySolvencySolvency is the ability of a company to survive over is the ability of a company to survive over the long term.the long term.

Illustration Illustration 12-1912-19

A ratio below 0.20 times is cause for A ratio below 0.20 times is cause for additional investigationadditional investigation..

Using Cash Flows to Evaluate a CompanyUsing Cash Flows to Evaluate a CompanyUsing Cash Flows to Evaluate a CompanyUsing Cash Flows to Evaluate a Company

23-45 LO 2 Identify the major classifications of cash flows.LO 2 Identify the major classifications of cash flows.

Format of the Statement of Cash Format of the Statement of Cash FlowsFlows

Format of the Statement of Cash Format of the Statement of Cash FlowsFlows

Order of Presentation:Order of Presentation:

1.1. Operating activities. Operating activities.

2.2. Investing activities.Investing activities.

3.3. Financing activities.Financing activities.

Direct MethodDirect Method

Indirect MethodIndirect Method

23-46

Indirect and Direct MethodsIndirect and Direct Methods

The choice of methods affects only the The choice of methods affects only the operating operating activities sectionactivities section; ; investing & financing activities investing & financing activities sections are the same.sections are the same.

Both methods arrive at the same total amount for Both methods arrive at the same total amount for “Net cash” provided by operating activities.“Net cash” provided by operating activities.

The methods differ in disclosing the items that The methods differ in disclosing the items that make up the total operating activities amount.make up the total operating activities amount.

23-47

Indirect and Direct MethodsIndirect and Direct Methods

Direct MethodDirect Method: move down the income statement : move down the income statement from top to bottom directly converting each from top to bottom directly converting each section from an accrual to a cash basissection from an accrual to a cash basis

Indirect MethodIndirect Method: start with net income and : start with net income and adjust for all non-cash revenue and expensesadjust for all non-cash revenue and expenses

If the direct method is used, a reconciliation to net If the direct method is used, a reconciliation to net income must also be provided (which essentially income must also be provided (which essentially means the indirect method must also be done.)means the indirect method must also be done.)

23-48

Indirect MethodIndirect Method

Most companies (98.8%) favor the indirect Most companies (98.8%) favor the indirect method for the following reasons:method for the following reasons: it is easier to prepareit is easier to prepareThe direct method is not only harder to prepare, The direct method is not only harder to prepare,

but it essentially requires that the indirect method but it essentially requires that the indirect method also be done (which is twice as much work)also be done (which is twice as much work)

it focuses on the differences between net income it focuses on the differences between net income and net cash flow from operating activitiesand net cash flow from operating activities

it tends to reveal less company information to it tends to reveal less company information to competitors.competitors.

23-49

Statement Statement of Cash of Cash FlowsFlows

Statement Statement of Cash of Cash FlowsFlows

Cash flows from operating activities:Net income 145,000$

Adjustments to reconcile net income to net cashprovided by operating activities:

Depreciation expense 9,000 Loss on sale of equipment 3,000 Decrease in accounts receivable 10,000 Increase in inventory (5,000) Increase in prepaid expenses (4,000) Increase in accounts payable 16,000 Decrease in income taxes payable (2,000)

Net cash provided by operating activities 172,000 Cash flows from investing activities:

Purchase of building (120,000) Purchase of equipment (25,000) Sale of equipment 4,000

Net cash used by investing activities (141,000) Cash flows from financing activities:

Issuance of common stock 20,000 Payment of cash dividends (29,000)

Net cash used by financing activities (9,000) Net increase in cash 22,000 Cash at beginning of period 33,000 Cash at end of period 55,000$

IndirecIndirect t

MethoMethodd

23-50

Statement of Cash Flows-Direct MethodStatement of Cash Flows-Direct MethodStatement of Cash Flows-Direct MethodStatement of Cash Flows-Direct Method

Statement of Statement of cash cash flows,direct flows,direct methodmethod

23-51

Format of the Statement of Cash Flows

Illustration 23-2

LO 2

23-52

Three Sources of Information:

1. Comparative balance sheets.

2. Current income statement data.

3. Selected transaction data.

Three Major Steps:

Step 1. Determine change in cash.

Step 2. Determine net cash flow from

operating activities.

Step 3. Determine net cash flows from

investing and financing activities. LO 2

Steps in Preparation


23-53













23-54

Illustration: Tax Consultants Inc. started on January 1, 2013,

when it issued 60,000 shares of $1 par value common stock

for $60,000 cash. The company rented its office space,

furniture, and equipment, and performed tax consulting

services throughout the first year.

The comparative balance sheets at the beginning and end of

the year 2013 appear in Illustration 23-3. Illustration 23-4

shows the income statement and additional information for

Tax Consultants.

LO 3

Illustrations—Tax Consultants Inc.

23-55

Illustration 23-3Illustration 23-3Comparative Balance Sheets, Tax Consultants Inc., Year 1

Illustration 23-4Income Statement, Tax Consultants Inc., Year 1


23-56

Step 1: Determine the Change in CashIllustration 23-3

LO 3


23-57













23-58

Company must determine revenues and expenses on a

cash basis.

Eliminate the effects of income statement transactions

that do not result in an increase or decrease in cash.

Convert net income to net cash flow from operating

activities through either a direct method or an indirect

method.

Step 2: Determine the Net Cash Flow from Operating Activities

LO 4


23-59

Illustration 23-5Net Income versus Net Cash Flow from Operating Activities

LO 4


Step 2: Determine the Net Cash Flow from Operating Activities

23-60

Accounts Receivable

1/1/13 Balance

0Revenues

125,000

Receipts from customers

89,00012/31/13 Balance

36,000

Increase in Accounts Receivable—Indirect Method

Illustration 23-6


LO 4

Accounts receivable increased by $36,000 (from $0 to $36,000)

during the year.

When the Accounts Receivable balance increases, cash receipts are

lower than revenue earned under the accrual basis.

23-61

Accounts Receivable

1/1/13 Balance

0Revenues

125,000


89,00012/31/13 Balance

36,000

Increase in Accounts Receivable—Indirect MethodIllustration 23-6


LO 4

The increase in accounts receivable is subtracted from net income to

arrive at net cash provided by operating activities.Illustration 23-7

23-62

Increase in Accounts Payable—Indirect Method


LO 4

Accounts payable increased by $5,000 during the year.

When accounts payable increase during the year, expenses on an

accrual basis exceed those on a cash basis.

Illustration 23-7

23-63 LO 4

23-64













23-65

Tax Consultants Inc.

Illustration 23-3

Illustration 23-8

Step 3: Determine Net Cash Flows from Investing and Financing Activities

23-66


Illustration 23-3

Illustration 23-8


23-67


Illustration 23-3

Illustration 23-8


23-68


Illustration 23-3

Illustration 23-8


23-69


Illustration 23-3

Illustration 23-8


23-70

Statement of Cash Flows—2013Illustration 23-8


LO 5

23-71

Illustration: Norman Company’s financial statements for the year

ended December 31, 2014, contained the following condensed

information.

Operating Activities — Indirect Method

2014 2013 Change

Service revenue 840,000$ Operating expenses 624,000 Depreciation expense 60,000 Loss on sale of equipment 26,000

Income before income tax 130,000 Income tax 40,000

Net income 90,000$

Accounts receivable 37,000$ 59,000$ (22,000)$ Accounts payable 46,000 31,000 15,000 Income taxes payable 4,000 8,500 (4,500)

LO 5

23-72

Cash flows from operating activities

Net income 90,000$

Adjustment to reconcile net income

to net cash provided by operating activities:

Depreciation expense 60,000

Loss on sale of equipment 26,000

Decrease in accounts receivable 22,000

Increase in accounts payable 15,000

Decrease in income taxes payable (4,500)

Net cash provided by operating activities 208,500

Prepare the operating activities section of the statement of cash flows

using the indirect method (Step 2).

Advance slide to uncover solution

Operating Activities — Indirect Method

LO 5

23-73

2014 2013 Change

Service revenue 840,000$ Operating expenses 624,000 Depreciation expense 60,000 Loss on sale of equipment 26,000

Income before income tax 130,000 Income tax 40,000

Net income 90,000$

Accounts receivable 37,000$ 59,000$ (22,000)$ Accounts payable 46,000 31,000 15,000 Income taxes payable 4,000 8,500 (4,500)

Norman Company’s financial statements for the year ended December

31, 2014, contained the following condensed information.

Assume accounts payable relates to

operating expenses.

Operating Activities — Direct Method

LO 5

23-74


using the Direct method (Step 2).

Illustration 23-22

Accounts Receivable

1/1/14 Balance

59,000Revenues

840,000


862,00012/31/14 Balance

37,000


LO 5

23-75

Accounts Payable

1/1/14 Balance

31,000Operating expenses

624,00012/31/14 Balance

46,000

Illustration 23-24

Payments to suppliers

609,000




LO 5

23-76

Income Tax Payable

1/1/14 Balance

8,500Income tax expense

40,00012/31/14 Balance

4,000

Payments for income tax

44,500

Illustration 23-24




LO 5

23-77

Cash flows from operating activities

Cash receipts from customers $ 862,000

Cash paid for operating expenses (609,000)

Cash paid for income taxes (44,500)

Net cash provided by operating activities $ 208,500




LO 5

23-78

Illustration: (a) Plant assets that had cost $25,000 6 years before

and were being depreciated on a straight-line basis over 10 years

with no estimated scrap value were sold for $5,300.

Step 3: Determine Net Cash Flow from Investing and Financing Activities

Plant assets (cost) 25,000$

Accumulated depreciation ([$25,000 ÷ 10] x 6) 15,000

Book value at date of sale 10,000

Sale proceeds (5,300)

Loss on sale 2,700$

LO 5

23-79

Statement of Cash Flows

Cash flow from operating activities

Net income (loss) (50,000)$

Adjustment to reconcile net income to cash:

Loss on sale 2,700


Gain on sale (9,000)

Cash from operations (34,300)

Cash flow from investing activities

Sale of plant assets 5,300

Sale of land 39,000

Cash from investing activities 44,300

Cash flow from financing activities

Sale of common stock 330,000

Purchase of company stock (47,000)

Cash from financing activities 283,000

Net Change in Cash 293,000$

Investing and Financing Activities

O

I

F

23-80

(b): During the year, 10,000 shares of common stock with a

stated value of $10 a share were issued for $33 a share.

Shares sold 10,000

Market value per share 33.00$

Value of shares 330,000$


LO 5

23-81





Loss on sale 2,700






Sale of land 39,000







O

I

F


23-82

(d): The company sustained a net loss for the year of

$50,000. Depreciation amounted to $22,000, and a gain of

$9,000 was realized on the sale of land for $39,000 cash.


LO 5

23-83





Loss on sale 2,700






Sale of land 39,000







O

I

F


23-84

(h): During the year, treasury stock costing $47,000 was

purchased.


LO 5

23-85



Net income (loss) (50,000.0)$


Loss on sale 2,700






Sale of land 39,000







O

I

F


23-86













23-87

Sources of Information for the Statement of Cash Flows

1. Comparative balance sheets.

2. An analysis of the Retained Earnings account.

3. Write-downs, amortization charges, and similar “book”

entries, such as depreciation, because they have no

effect on cash.

LO 6

23-88













23-89

Net Cash Flow from Operating Activities—Indirect Versus Direct Method

Adjustments Needed to Determine Net Cash Flow from Operating Activities.

Indirect Method

Illustration 23-18

LO 7

23-90

Illustration 23-21

Companies adjust each item in the income statement from the accrual basis to the cash basis.

Direct Method

LO 7


23-91 LO 7

23-92

Special Rules Applying to Direct and Indirect Methods


Companies that use the direct method are required, at a minimum, to

report separately:

Receipts

1.Cash collected from customers (including lessees, licensees, etc.).

2.Interest and dividends received.

3.Other operating cash receipts, if any.

LO 7

23-93

Special Rules Applying to Direct and Indirect Methods


Companies that use the direct method are required, at a minimum, to

report separately:

Payments

1.Cash paid to employees and suppliers of goods or services

(including suppliers of insurance, advertising, etc.).

2.Interest paid.

3.Income taxes paid.

4.Other operating cash payments, if any.LO 7

23-94













23-95

Special Problems in Statement Preparation

Amortization of limited-life intangible assets.

Amortization of bond discount or premium.

Depreciation and Amortization

Postretirement Benefit Costs

Company must adjust net income by the difference

between cash paid and the expense reported.

LO 8

Adjustments to Net Income

23-96


Affect net income but have no effect on cash.

Changes in Deferred Income Taxes

Equity Method of Accounting

Net increase in the investment account does not affect

cash flows.

Company must deduct the net increase from net income

to arrive at net cash flow from operating activities.

LO 8

23-97

A loss is added to net income to compute net cash flow

from operating activities because the loss is a noncash

charge in the income statement.

Company reports a gain in the statement of cash flows as

part of the cash proceeds from the sale of equipment

under investing activities, thus it deducts the gain from

net income to avoid double-counting—once as part of net

income and again as part of the cash proceeds from the

sale.

Loss and Gains

LO 8


23-98

Cash is not affected by recording the expense.

The company must increase net income by the amount of

compensation expense from share options in computing

net cash flow from operating activities.

Stock Options

LO 8


23-99

Companies should report either as investing activities or

as financing activities cash flows from extraordinary

transactions and other events whose effects are included

in net income, but which are not related to operations.

Extraordinary Items

LO 8


23-100

Because an increase in Allowance for Doubtful Accounts results from

a charge to bad debt expense, a company should add back an

increase in Allowance for Doubtful Accounts to net income to arrive

at net cash flow from operating activities.

Indirect Method

Illustration 23-28Accounts ReceivableBalances, Redmark Co.

LO 8

Special Problems

Accounts Receivable (Net)

23-101


One method of presenting this information in the statement of

cash flows:

Indirect Method

Illustration 23-29

LO 8

REDMARK CO.Statement of Cash Flows (Partial)

For The Year 2014

23-102


Alternate method (net approach) of presenting this

information in the statement of cash flows:Illustration 23-30

LO 8


For The Year 2014

Indirect Method

23-103


Company should not net Allowance for Doubtful Accounts

against Accounts Receivable.

Direct Method

Illustration 23-31

LO 8

REDMARK CO.Income Statement For The Year 2014

23-104


Company should not net Allowance

for Doubtful Accounts against

Accounts Receivable.

Illustration 23-31

Cash sales should be reported at $85,000 ($100,000 - 9,000 - 6,000).

Increase in Accounts Receivable

Illustration 23-32

LO 8

Direct MethodREDMARK CO.

Income Statement For The Year 2014


For The Year 2014

23-105

Some changes in working capital, although they affect cash,

do not affect net income.

Purchase of short-term available-for-sale securities.

Issuance of a short-term nontrade note payable for cash.

Cash dividend payable.

LO 8

Special Problems

Other Working Capital Changes

23-106

Illustration: If the net loss is $50,000 and the total amount of

charges to add back is $60,000, then net cash provided by

operating activities is $10,000.

Illustration 23-33Computation of Net CashFlow from OperatingActivities—Cash Inflow

LO 8

Special Problems

Net Losses

23-107

Common noncash transactions that a company should report

or disclose:

1. Acquisition of assets by assuming liabilities (including capital

lease obligations) or by issuing equity securities.

2. Exchanges of nonmonetary assets.

3. Refinancing of long-term debt.

4. Conversion of debt or preferred stock to common stock.

5. Issuance of equity securities to retire debt.

LO 8

Special Problems

Significant Noncash Transactions

23-108













23-109

Use of a Worksheet

A worksheet involves the following steps.

Step 1. Enter the balance sheet accounts and their beginning and

ending balances in the balance sheet accounts section.

Step 2. Enter the data that explain the changes in the balance

sheet accounts and their effects on the statement of cash flows in

the reconciling columns of the worksheet.

Step 3. Enter the increase or decrease in cash on the cash line

and at the bottom of the worksheet. This entry should enable the

totals of the reconciling columns to be in agreement.

LO 9

23-110

RELEVANT FACTS - Similarities

Both GAAP and IFRS require that companies prepare a statement of cash flows.

Both IFRS and GAAP require that the statement of cash flows should have three major sections—operating, investing, and financing—along with changes in cash and cash equivalents.

Similar to GAAP, the cash flow statement can be prepared using either the indirect or direct method under IFRS. For both IFRS and GAAP, most companies use the indirect method for reporting net cash flow from operating activities.

The definition of cash equivalents used in IFRS is similar to that used in GAAP.

LO 10 Compare the statement of cash flows under GAAP and IFRS.

23-111

RELEVANT FACTS - Differences

A major difference in the definition of cash and cash equivalents is that in certain situations, bank overdrafts are considered part of cash and cash equivalents under IFRS(which is not the case in GAAP). Under GAAP, bank overdrafts are classified as financing activities.

IFRS requires that non-cash investing and financing activities be excluded from the statement of cash flows. Instead, these non-cash activities should be reported elsewhere. This requirement is interpreted to mean that non-cash investing and financing activities should be disclosed in the notes to the financial statements instead of in the financial statements. Under GAAP, companies may present this information in the cash flow statement.

LO 10

23-112

RELEVANT FACTS - Differences

One area where there can be substantive differences between IFRS and GAAP relates to the classification of interest, dividends, and taxes. IFRS provides more alternatives for disclosing these items, while GAAP requires that except for dividends paid (which are classified as a financing activity), these items are all reported as operating activities.

LO 10

23-113

ON THE HORIZON

Presently, the IASB and the FASB are involved in a joint project on the presentation and organization of information in the financial statements. With respect to the cash flow statement specifically, the notion of cash equivalents will probably not be retained. The definition of cash in the existing literature would be retained, and the statement of cash flows would present information on changes in cash only. In addition, the IASB and FASB favor presentation of operating cash flows using the direct method only. This approach is generally opposed by the preparer community.

LO 10

23-114

Which of the following is true regarding the statement of cash flows

under IFRS?

a. The statement of cash flows has two major sections—operating

and nonoperating.

b. The statement of cash flows has two major sections—financing

and investing.

c. The statement of cash flows has three major sections—

operating, investing, and financing.

d. The statement of cash flows has three major sections—

operating, non-operating, and financing.

IFRS SELF-TEST QUESTION

LO 11

23-115

In the case of a bank overdraft:

a. GAAP typically includes the amount in cash and cash

equivalents.

b. IFRS typically includes the amount in cash equivalents but not

in cash.

c. GAAP typically treats the overdraft as a liability, and reports the

amount in the financing section of the statement of cash flows.

d. IFRS typically treats the overdraft as a liability, and reports the

amount in the investing section of the statement of cash flows.


LO 11

23-116

For purposes of the statement of cash flows, under IFRS interest paid

is treated as:

a. an operating activity in all cases.

b. an investing or operating activity, depending on use of the

borrowed funds.

c. either a financing or investing activity.

d. either an operating or financing activity, but treated consistently

from period to period.


LO 11

23-117

Copyright © 2013 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 permission 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.

Copyright

23-1 prepared by coby harmon university of california, santa barbara intermediat e accounting...

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