Reporting and Analyzing Cash Flows

The purpose of the cash flow statement is to report cash receipts (inflows) and cash payments (outflows) during a period. To illustrate, we prepare the operating activities section of the statement of cash flows for Genesis.

Decision Insight

The third major step in preparing the statement of cash flows is calculating and reporting cash flows from investing activities. We then analyze the changes in these accounts to determine their effect, if any, on cash and report the cash flow effects in the investing activities section of the statement of cash flows. Many other asset transactions (including those involving current notes receivable and investments in certain securities) are considered investing activities and can affect a company's cash flows.

The fourth major step in preparing the statement of cash flows is to calculate and report cash flows from financing activities. This transaction is reported as a significant non-cash investing and financing activity in a footnote or a separate schedule to the statement of cash flows. This is formally reported at the bottom of the statement of cash flows as shown in both exhibits 12.7 and 12.11.

Decision Maker

The fifth and final step in preparing the statement is reporting the beginning and ending cash balances and proving that the net change in cash is explained by operating, investing, and financing cash flows.

Analyzing Cash Sources and Uses

Cash Flow on Total Assets

B Prepare a statement of cash flows using the direct method for year 2009

Planning the Solution

Solution to Demonstration Problem

This appendix explains how to use a spreadsheet to prepare the cash flow statement using the indirect method.

Preparing the Indirect Method Spreadsheet

APPENDIX

We also enter data in the Analysis of Changes columns (key for additional information items m to m) to explain changes in accounts and determine cash flows for operating, investing and financing activities.

Entering the Analysis of Changes on the Spreadsheet

Since adjustments i, j and are more demanding, we show them in the following debit and credit form. These entries are for our understanding; these are not the entries that are actually made in the journals. Increase in receivables Increase in merchandise inventory Increase in prepaid expenses Decrease in payables to suppliers Decrease in interest obligations Increase in income tax obligations Depreciation costs.

Cash flows from operations are calculated using the direct method by adjusting the items of the income statement based on the occurrence of the business event on a cash basis. The framework for reporting cash receipts and cash payments for the operating part of the cash flow statement under the direct method is as shown in Exhibit 12B.1.

Operating Cash Receipts

Operating Cash Payments

Step 1

The adjustment amount is calculated assuming that all cash paid for salaries and other operating expenses is initially debited to Prepaid Expenses. Formula to Compute Cash Paid for Salaries and Operating Expenses—Direct Method Prepaid expenses increase by $2,000 in the period, which means that cash paid for salaries and other operating expenses. Alternatively, we can express the cash paid for salaries and other operating expenses as equal to the reported expenses of $216,000 plus the $2,000 increase in prepaid expenses.1.

Cash Paid for Interest and Income Taxes Calculating operating cash flow for interest and taxes is similar to calculating operating expenses. If cash payments are debited directly to the expense account, the total cash for salaries and other operating expenses still equals the $216,000 expense plus. Debt settlement results in cash outflows equal to the cash paid to settle the debt, regardless of whether the debt is settled at a profit or a loss.

Summary of Adjustments for Direct Method

Thus, depreciation expense is never reported on a statement of cash flows using the direct method, nor is depletion or amortization expense. Loss on Sale of Assets Sales of assets often result in gains and losses that are reported as part of net income, but the amount of recorded gain or loss does not reflect any cash flow in these transactions. Asset sales result in cash inflows equal to the amount of cash received, regardless of whether the asset was sold at a gain or a loss.

Thus, the loss or gain on an asset sale is never reported using the direct method in a cash flow statement. Gain on Repayment of Debt Repayment of debt typically produces a gain or loss that is reported as part of net income, but that gain or loss does not reflect the cash flow in this transaction. This cash outflow is reported under financing activities; the loss or gain from servicing debt is never reported using the direct method in a cash flow statement.

Direct Method Format of Operating Activities Section

Summary

Entrepreneur Several factors can explain an increase in net cash flows when a net loss is reported, including (1) early recognition of costs relative to revenue generated (such as research and development), (2) cash advances on long-term sales contracts not yet in the income statement, (3) issuances of debt or equity for cash to finance expansion, (4) cash sales of assets, (5) deferrals of cash payments, and (6) cash advances on sales. The analysis should focus on the components of both net loss and net cash flows and their implications for future performance. The direct method of reporting net cash flows provided or used by operating activities summarizes major cash inflows from operating activities minus cash outflows to obtain the net cash inflow or outflow from operating activities.

Reporter Your initial reaction based on the company's $600,000 loss with a $550,000 decrease in net cash flow is not positive. The statement of cash flows reports changes in the sum of cash plus cash equivalents. Use the following information to determine the net cash provided or used by operating activities.

Additional Quiz Questions are available at the book’s Website

Six key steps are used when using the spreadsheet to prepare the statement (see Appendix). The three categories of cash inflows and outflows are operating activities, investing activities, and financing activities. Profit from the sale of plant assets is deducted from net profit, because the sale of plant assets is not a business activity; is an investment activity for the amount of money received from its sale.

When a statement of cash flows is prepared using the direct method, what are some operating cash flows. If a company reports a positive net profit for the year, can it also show a net cash outflow from operations. Refer to Best Buy's statement of cash flows in Appendix A. a) Which method is used to calculate net cash provided by operating activities.

Discussion Questions

Use the following information to determine this company's cash flows from operating activities using the indirect method.

QUICK STUDY

Analyses of sources
B Computing cash from
B Computing operating
Computing cash

Which of the three competitors is the strongest, as shown by the cash flow statement. Analyze and discuss the strength of Peña's cash flow on total assets relative to Garcia's. Use only the direct method to work out the cash provided or used from the operating activities section of the statement of cash flows for this business.

Purchases of furniture amount to $90,000 cash, on which no depreciation is required because they are acquired at the end of the year. Use the indirect method to prepare the cash provided or used only from operating activities section of the statement of cash flows for this company.

EXERCISES

Cash flow from
A Noncash accounts
B Cash flow classification
Cash flow classification
Cash flows from operating
Cash flows from operating
B Computation of cash
B Cash flows from operating
Preparation of statement of
Cash flows from investing
Cash flows from financing
B Preparation of statement of
B Preparation of statement of
Reporting cash flows from

Assuming that this company uses the direct method of reporting cash provided by operating activities, indicate where each item would appear on the statement of cash flows by placing an x in the appropriate column. Statement of cash flows of non-cash investments reported on the operating financing of investments and the financing statement. Use the following income statement and information on changes in noncash current assets and current liabilities to prepare only the operating cash flow section of the indirect method cash flow statement.

Use the direct method to prepare only the cash provided or used by the operating activities section of the statement of cash flows for this company. Use the direct method to prepare the statement of cash flows for the year ended June 30, 2009. Use the following information about Valencia Company's cash flows to prepare a complete statement of cash flows (direct method) for the year ended December 31, 2009.

PROBLEM SET A

Statement of cash flows
B Statement of cash flows (direct
A Cash flows spreadsheet
B Statement of cash flows
Computing cash flows from

Prepare a complete cash flow statement; reports its business activities according to the direct method. Prepare a complete statement of cash flows using a spreadsheet as in Figure 12A.1; reports its business activities according to the indirect method. Prepare a complete cash flow statement; reports the incoming and outgoing cash flows from operating activities according to the indirect method.

Prepare a complete statement of cash flows using a spreadsheet as in Figure 12A.1; reporting operational activities according to the indirect method. Prepare a complete cash flow statement; reports its cash flows from operating activities using the direct method. Prepare only the Cash Flows from Operating Activities section of the 2009 Cash Flow Statement using the indirect method.

PROBLEM SET B

B Computing cash flows from
B Statement of cash flows (direct
B Statement of cash flows
Computing cash flows from
B Computing cash flows from

Analyze and discuss the statement of cash flows prepared in Part 1, paying particular attention to the wisdom of the cash dividend payment. Prepare a complete statement of cash flows using a spreadsheet as in Appendix 12A.1; report its operating activities using the indirect method. Identify debits and credits in the Analysis of Changes columns with letters that correspond to the following list of transactions and events. Prepare a complete statement of cash flows using a spreadsheet as in Appendix 12A.1; report operating activities according to the indirect method.

Identify the debits and credits in the Analysis of Changes columns by letters that correspond to the following list of transactions and events. Prepare only the cash flows from operating activities section of the company's 2009 statement of cash flows using the direct method.

SERIAL PROBLEM

Prepare a statement of cash flows for Success Systems using the indirect method for the three months ended March 31, 2010. Recall that owner Adriana Lopez contributed $25,000 to the business in exchange for additional inventory in the first quarter of 2010 and received $4,800 in cash dividends.

REPORTING IN ACTION

BEYOND THE NUMBERS

However, inventory costs increased significantly in year 4 and cash flows from operations will probably decrease by 25%. From experience, she knows that the banker will review operating cash flows for years 1 through 4 and will want a projected number for year 5. Gish knows that a steady upward trend in operating cash flows for years 1 through 4 will help her case.

She decides to exercise her discretion as an owner and considers several business actions that will change her operating cash flow in year 4 from a decrease to an increase.

ETHICS CHALLENGE

COMMUNICATING IN PRACTICE

TAKING IT TO THE NET

B Identify and explain the formula for computing cash flows from operating activities using the direct method for one of the following items

TEAMWORK IN ACTION

ENTREPRENEURIAL DECISION

HITTING THE ROAD

Key comparative information for DSG international plc (DSGiplc.com) follows. GLOBAL DECISION C1 C2 C4

How does DSG's ratio compare to Best Buy's, Circuit City's and RadioShack's ratios from BTN 12-2.

ANSWERS TO MULTIPLE CHOICE QUIZ