Depreciation
Information about cash flows can influence
decision makers in many ways . For
example , if a company’s regular
operations bring in more cash than it uses ,
investors will value the company
higher than if property and equipment must be
sold to finance operations .
Information about cash flow can help creditors
decide whether a company will
have enough cash to pay its debts as they mature.
Management and
investors use cash flow information to evaluate a company’s
ability to meet
unexpected obligations . Cash flow information is also used to
evaluate
company’s ability to take advantage of new business opportunities
that may
arise. In November 1987, the FASB issued Statement of
Financial
Accounting Standards "statement of cash flow " This standard
requires
businesses to include a statement of cash flow in all financial
reports that
contain both a balance sheet and an income statement. The
primary purpose of
this statement is to present information about a company’s
cash receipts and
disbursements during the reporting period. Direct Method of
Presenting Cash Flow
from Operating Activities When you prepare a statement
of cash flow , the net
cash provided by operating activities can be
calculated two different ways . One
is called Direct Method the other is
Indirect Method .When the direct method is
used , you separately list each
major class of operating cash receipts and each
major class of cash payments
. Then the payments are subtracted from the
receipts to determine the net
cash provided by operating activities. The FASB
encourage companies to use
direct method. Indirect Method of Presenting Cash
Flow from Operating
Activities The indirect method is not as informative as
direct method because
it does not disclose the individual cash inflows and
outflows from operating
activities. Instead the direct method discloses only the
net cash provided by
operating activities . When the indirect method is used ,
the net income is
listed first . Then it is adjusted for items that are
necessary to reconcile
net income to the net cash provided by operating
activities . For example ,
you know that depreciation expense is subtracted in
the calculation of net
income . But , depreciation expense does not involve a
current cash payment.
Therefore, depreciation expense is added back to net
income in the process of
reconciling net income to the net cash provided by
operating activities. Cash
and Cash Equivalents In Statement of Financial
Accounting Standards , the
FASB concluded that a statement of cash flow should
explain the difference
between the beginning and the ending balances of cash and
cash equivalents.
Prior to this new standard ,cash equivalents were generally
understood to be
short term , temporary investments of cash . However , not all
short-term
investments meet the FASB definition of cash equivalents . To qualify
as a
cash equivalent , an investment must satisfy two criteria . These are:
1-
The investments must be readily convertible to a known amount of cash.
2- The
investments must be sufficiently close to its maturity date so that
its market
value is relatively insensitive to interest rate changes.
Classifying Cash
Transactions A statement of cash flow describes the
changes in cash plus cash
equivalents. Therefore, cash payments to purchase
cash equivalents and cash
receipts from selling cash equivalents are not
reported on the statement. All
other cash receipts and payments are
classified as operating , investing or
financing activities. Within each
category , individual cash receipts and
payments are summarized and described
in a manner that clearly presents the
general nature of the company’s cash
transactions . Then , the summarized cash
receipts and payments within each
category are netted against each other . A
category provides a net cash flow
if the receipts in the category exceed the
payments . And if the payments in
a category exceed the receipts , the category
is a net user of cash during
the period. Operating Activities You should
recognize the operating
activities generally include only transactions that
relate to the calculation
of net income . However, some income statement items
are not related to the
operating activities . As disclosed in a statement of
cash flows , operating
activities involve the production or purchase of
merchandise and the sale of
goods and services to customers . Operating
activities also include the
expenditures related to administering the business.
In fact , cash flow
from operating activities include all cash flows from
transactions that are
not defined as investing or financing activities . Cash
Flows from
Operating Activities Cash Inflows Cash Outflows -Cash sales to
customers
-Payments to employees for salaries and -Cash collections from
credit
customers wages -Receipts of cash dividends from stock -Payments to
suppliers of
goods and services investments in other entities -Payments to
government
agencies for taxes -Refunds from suppliers fines and penalties
-Cash collected
from a lawsuit -Interest payments, net of amounts capitalized
-Receipts of
interest payments -Cash refunds to customers Investing
Activities Transactions
that involve making and collecting loans or that
involve purchasing and selling
plant assets , other productive assets , and
investments are called investing
activities. Usually , investing activities
involve the purchase or sale of
assets that are classified on the balance
sheet as plant and equipment ,
intangible assets , or long term investments .
However, the purchase and sale of
short term investments other than cash
equivalents are also investing
activities. Cash Flows from Investing
Activities Cash Inflows Cash Outflows
-Proceeds from selling assets -Payments
to purchase assets -Proceeds from
collecting loans -Payments to acquire
securities -Proceeds from selling
securities -Payments to acquire dept
securities -Proceeds from sale of loans
made by -Payments in the form of
loans made to other the enterprise parties
Financing Activities A
companies transactions with its owners and long term
creditors are called
financing activities. Also , financing activities include
borrowing cash on a
short term basis. However, cash payments to settle credit
purchases of
merchandise, whether on account or by note, are operating
activities.
Payments of interest expense are also operating activities. Cash
Flows
from Financing Activities Cash Inflows Cash Outflows -Proceeds from
the
issuance of -Payments of dividends and other distributions securities to
owners
-Proceeds from the issuance of -Payments to purchase treasury stock
bonds and
notes payable -Repayments of cash loans -Proceeds from other short
or long
-Payments of the principal amounts involved term borrowing
transactions in long
term credit arrangements Preparing a Statement of Cash
Flows The information you
need to prepare a statement of cash flow comes from
a variety of sources . These
include comparative balance sheets at the
beginning and the end of the
accounting period , an income statement for the
period and a careful analysis of
each non cash balance sheet account . Grover
Company (Example) Grover
Company’s December 31, 1989 and 1990 balance
sheets and 1990 income statement
are illustrated. The objective is to prepare
a statement of cash flow that
explains the $5000 increase in cash , based on
these financial statements and
the additional information about 1990
transactions that follows: 1- All accounts
payable balances resulted from
merchandise purchases . 2- Plant assets that cost
$70,000 were purchased by
paying $10,000 cash and issuing $60,000 of bonds
payable to seller. 3- Plant
assets with an original cost of $30,000 and
accumulated depreciation of
$12,000 were sold for $12,000 cash. The result was a
$6,000 loss. 4The
proceeds from issuing 3,000 shares of common stock was
$15,000. 5- The
$16,000 gain on retirement of bonds resulted from paying $18,000
to retire
bonds with a book value of $34,000. 6- Cash dividends of $14,000
were
declared and paid. GROVER COMPANY Balance sheet December 31, 1990 and
1989 1990
1989 Assets Current Assets: Cash $ 17,000 $ 12,000 Accounts
Receivable 60,000
40,000 Merchandise Inventory 84,000 70,000 Prepaid
Expenses 6,000 4,000 Total
Current Assets $ 167,000 $ 126,000 Long Term
Assets: Plant Assets $250,000
$210,000 Less: accumulated depreciation 60,000
190,000 48,000 162,000 Total
Assets: $357,000 $288,000 Liabilities
Current Liabilities: Accounts Payable $
35,000 $ 40,000 Interest Payable
3,000 4,000 Income Taxes Payable 22,000 12,000
Total Current Liabilities
$ 60,000 $ 56,000 Long Term Liabilities: Bonds Payable
90,000 64,000
Total Liabilities: $ 150,000 $ 210,000 Stockholders’ Equity
Contributed
Capital: Common stock $10 par value $ 95,000 $ 80,000 Retained
earnings
112,000 88,000 Total stockholders’ equity 207,000 168,000 Total
liabilities
and stockholders’ equity $ 357,000 $ 288,000 GROVER COMPANY
Income
Statement For Year Ended December 31,
1990
Sales....................................................... $
590,000 Cost of
goods sold...................................... $ 300,000
Wages and other
operating expenses............. 216,000
Interest
expense......................................... 7,000 Income
taxes
expense................................. 15,000
Depreciation
expense.................................. 24,000 (562,000) Loss
on sale of
plants.................................. (6,000) Gain on
retirement of
debt............................ 16,000
Net
Income................................................ $ 38,000
Operating
Activities We begin the analysis by calculating the cash flows
from operating
activities. In general, this involve adjusting the income
statement items that
relate to operating activities for changes in their
related balance sheet
accounts. Cash Received From Customers: Accounts
receivable increased from
$40,000 to $60,000 , cash receipts from customers
are equal to sales of $590,000
plus the $40,000 beginning balance less the
$60,000 ending balance, or $570,000.
Cash received from customers = Sales
- Increase in accounts receivable If the
balance of accounts receivable
decreases Cash received from customers = Sales +
Decrease in accounts
receivable $570,000 of cash Grover Company received from
customers is shown
on the statement of cash flows as a cash inflow from
operating activities.
Cash Payments For Merchandise: $14,000 increase in
merchandise inventory is
added to cost of goods of $300,000 to get purchase of
$314,000. Purchases of
$314,000 plus a beginning balance of $40,000 , less the
ending balance of
$35,000 , equals each payments of $319,000 . + Increase in
merchandise
inventory Purchases = Cost of goods sold - Decrease in merchandise
inventory
And, + Decrease in accounts pay. Cash payments for merchandise
=
Purchases - Increase in accounts pay. Grover Company’s payments of
$319,000
for merchandise are reported on the statement of cash flows as a
cash outflow
from operating activities. Cash Payments for Wages and Other
Operating Expenses:
Prepaid expenses increased by $2,000 during the
period , the cash payments for
wages and other operating expenses were $2,000
more than the reported expense.
Thus, the amount for wages and other
operating expenses is $216,000 plus $2,000
or $218,000 If Grover Company’s
balance sheets had shown accrued liabilities ,
you would also have to adjust
the expense for the change in accrued liabilities.
Cash paid for Wages
and +inc. prepaid exp. +dec. accrued liab. wages and other =
other operating
operating expenses expenses - dec. prepaid exp. -inc. accrued
liab. Payments
for Interest and Taxes: Interest payments were $8,000 and income
tax payments
were $5,000 + decrease in related payable Cash Payment = Expense -
increase
in related payable Investing Activities: Investing activities usually
refer
to transactions that affect long term assets. Recall from the
information
that was provided about Grover Company’s transactions that the
company
purchased plant assets and also sold plant assets. Both of these
activities are
investing activities. Purchase of plant assets: Grover Company
purchase plant
assets that cost $70,000 by issuing $60,000 of bonds payable
to the seller and
paying the $10,000 balance in cash. The $10,000 payment is
reported as a cash
outflow on the statement of cash flows. Sale of Plant
Assets: Grover Company
sold plant assets that cost $30,000 and were
depreciated $12,000. The result of
sale was a loss of $6000 and a cash
receipt of $12,000. This cash receipt is
reported on the statement of cash
flows as a cash inflow from investing
activities. Financing Activities:
Financing activities usually relate to a
company’s long term dept and
stockholder’s equity accounts. In the
information about Grover Company, there
were four transactions that involved
financing activities . One of these ,
the $60,000 issuance of bonds payable to
purchase plant assets. The remaining
tree transactions were the retirement of
bonds , the issuance of common stock
, and the payment of cash dividends.
Payment to Retire Bonds Payable:
Grover Company’ December 31 ,1990, balance
sheet showed bonds payable of
$34,000 . These were retired for $18,000 cash in
1990. The income
statement reports the $16,000 difference as a gain. The
statement of cash
flows shows the $18,000 payment as a cash outflow from
financing activities.
Receipt from Common Stock Issuance: During 1990, Grover
Company issued
3000 shares of common stock for $5 per share. This $15,000 cash
receipt is
reported on the statement of cash flow as a financing activity. Look
at the
December 31, 1989, and 1990 balance sheets. Notice that the Common
Stock
account balance increased from $80,000 at the beginning of 1990 to
$95,000 at
the end of 1990. Thus, $15,000 stock issue reconciles the change
in the Common
Stock account. Payment of Cash Dividends: According to the
facts provided about
Grover Company’s transactions , cash dividend of
$14,000 were paid during
1990. This payment is reported as a cash outflow
from financing activities.
Also , note that the effects of this $14,000
payment and the reported net income
of $38,000 fully reconcile the beginning
and ending balances of retained
earnings . GROVER COMPANY Statement of Cash
Flows ( Direct Method ) For Year
Ended December 31, 1990 Operating
Activities: Cash received from
customers......................... $ 570,000
Cash provide by operating
activities.................. $ 570,000 Cash paid
for merchandise
............................. (319,000) Cash paid for wages
and other
expenses........... (218,000) Interest
paid
................................................. (8,000) Income
taxes
paid.......................................... (5,000) Cash disbursed
for
operating activities............... (550,000) Net Cash Provided By
Operating
Activities............ $ 20,000 Investing Activities: Receipt
from sale of plant
asset......................... $ 12,000 Payment to
purchase plant
asset........................ (10,000) Net Cash Used In
Investing
Activities.................... 2,000 Financing Activities:
Payments to retire
bonds................................. $ (18,000) Proceeds
from issuing
stock............................. 15,000
Dividends
paid............................................... (14,000) Net
Cash Provided
By Financing Activities............. (17,000) Net Increase
(decrease) In
Cash.......................... $ 5,000 Cash and Cash
Equivalents , beginning of
year....... $ 12,000 Cash and Cash Equivalents ,
end of year...............
$
17,000