Thus, a company's statement of cash flows provides external users with information about its liquidity, financial flexibility, operating ability and risk. The statement of cash flows provides relevant information about a company's cash receipts and cash payments that is useful for assessing its liquidity, financial flexibility, operating ability and risk.
N ET C ASH F LOW F ROM O PERATING A CTIVITIES
Although depreciation expense reduces net income (and long-term assets), there is no cash outflow for operating activities. That is, there is a reduction in net income (and long-term assets), but no operating cash outflow.
Direct Method
A company "adjusts" for these differences to help calculate its net cash flow from operating activities. Note that depreciation expense is not included in net cash flows from operating activities because it did not result in an outflow of cash.
Indirect Method
However, the direct method is criticized because it does not "link" the net income reported in a company's income statement to the net cash generated by operating activities reported in the cash flow statement. In the previous indirect method example, we made just a few simple adjustments to convert net income into net cash flow from operating activities.
I NFORMATION F OR P REPARATION O F S TATEMENT
V ISUAL I NSPECTION M ETHOD OF A NALYSIS
Simple Example (Visual Inspection Method)
There are only two cash flows from investing activities: a cash payment and a cash receipt. There are also two cash flows from financing activities: a cash receipt and a cash payment.
W ORKSHEET (S PREADSHEET ) M ETHOD OF A NALYSIS
As a result of these two cash flows, net cash of $3,500 is provided by the financing activities of the Leyton Company during 2007, as we show in Exhibit 22-3. Note also that, with the exception of depreciation, the adjustments to net income in the net cash flow from operating activities section involve changes in current asset (other than cash) and current liability accounts.
Steps in Preparation (Worksheet Method)
Note any changes in non-cash accounts that occurred during the current period. Entries in the worksheet must account for any changes to the non-cash accounts recorded in step 2.
Comprehensive Example (Worksheet Method)
Final Worksheet Entry
In step 5, a check of the debit and credit entries in the upper part of the spreadsheet shows that all the changes in the non-cash accounts have been accounted for. A final spreadsheet entry is made to record the increase in cash and bring the debit and credit column totals into balance.
Preparation of Statement
If the direct method is used, a company must include a reconciliation of net income to net cash flow from operating activities. The indirect method calculates a company's net cash flow from operating activities by converting its net income from an accrual basis to a cash flow basis. The indirect method is the most commonly used method for preparing net cash flows from operating activities.
S PECIAL T OPICS
The calculation of a company's net cash flow from operating activities involves an adjustment to net income for differences in when the company records revenues and expenses and when it receives and pays cash, as well as for non-cash items (such as depreciation expense), amortization costs for intangibles assets) that affect net income but do not result in a cash receipt or payment. The direct method calculates and reports a company's net cash flow from operating activities by calculating the company's cash flows for each operating activity and then subtracting its cash flows for each operating activity. A company's net cash flows from investing and financing activities are identified through an analysis of the changes in the balance sheet accounts (generally non-current assets and liabilities) and a review of any supplementary information.
Sale of Depreciable Asset
In preparing the worksheet entry for this transaction, two changes are made: (1) instead of debiting Cash, the line Receipts from Sale of Equipment under the heading Cash Flows from Investing Activities is debited for $2,100, and (2) the line Gain on Sale of Equipment is credited under the heading Net cash flow from operating activities to subtract profit from net income to avoid double counting and correctly reflect cash provided by operating activities. 8,900 and (2) instead of crediting profit, the caption Net Cash Flow from Operating Activities: Profit on Retirement of Bonds is credited with $800 to subtract the profit from net income to properly reflect cash provided by operating activities. Retirement of bonds paid at a loss is treated in a similar manner, except that the caption Net cash flow from operating activities: Loss on retirement of bonds is debited so that the loss is added to net income because it did not include cash outflow from operations.
Interest Paid and Income Taxes Paid
Increase in interest liability Increase in income tax liability Amortization of premiums for bonds payable Decrease in deferred tax liability. Example: Interest and Income Taxes Refer again to the information about Jones Company shown in Examples 22-4 and 22-5. Income Taxes Paid $2,820 Based on these calculations, Jones Company reports interest paid of $500 and income taxes paid of $2,820 in its 2007 statement of cash flows shown in Example 22-6.
Flexibility in Reporting
The disadvantage is that it removes from the statement a key factor in assessing the quality of the company's net income and its relationship to cash flows. By referring the poll to a separate schedule, this analysis can be overlooked by external users. For this reason, we advocate that a company include the reconciliation directly on its cash flow statement, which most companies do.
Partial Cash Investing and Financing Activities
Temporary and Long-Term Investments
The Company does not include this portion of the increase in the carrying amount of the temporary investment in its 2007 statement of cash flows because there was no cash outflow. The company reports the first two items in its 2008 statement of cash flows in the usual way.♦. It reports income as a cash flow from investing activities and subtracts the gain from net income (or adds the loss to net income) in the usual way in its statement of cash flows.
Financial Institutions
The Company also adds any premium amortization for this type of investment to net income in the operating activities section of the statement of cash flows because the amortization reduced the interest income to an amount lower than the cash received. It reports cash flows from purchases, sales and maturities of trading securities as cash flows from operating activities. As we discussed earlier in the chapter, the FASB concluded that companies should report interest accrued and interest paid as cash flows related to operating activities.
Cash Dividends Declared
However, the Board determined that companies must report collections and principal payments of notes receivable and notes payable as cash flows related to their investing and financing activities, respectively. The Board concluded that financial institutions should report the cash flows from purchases or sales of these trading accounts in the operating activities section of the statement of cash flows.19 In reaching this conclusion, the FASB reasoned that these types of assets for financial institutions are similar to inventory for other businesses and, as such, are part of operating activities. The company then reports the dividends paid as a cash payment in the cash flows from financing activities section of its statement of cash flows.
Cash Flows for Compensatory Share Option Plans
When a company follows a policy of declaring a dividend in one year and paying the dividend in the following year, its Dividend Payable account balance will change during each year. A comparison of the change in the account balance with the dividends reported on the statement of retained earnings will determine the worksheet entry needed to account for the cash dividends. If the corporation is subject to a 30% tax rate and uses the indirect method of reporting its cash flows from operating activities, then it will report the.
Effects of Exchange Rates
For example, suppose Petricka Corporation reported net income of $500,000 and had a current year tax deduction of $800,000 for compensation expenses because employees exercised stock options. In prior years, the Company had recorded a compensation expense of $700,000 for this compensatory stock option plan for financial reporting purposes. Excessive Tax Benefits from Compensating Stock Option Plan $30,000 For more details, see Figure 4 in Appendix A of FASB Statement No.
Cash Flow Per Share
Disclosure
SUPPLEMENTAL FINANCIAL STATEMENT DATA
- How did Kellogg’s net cash flow from operating activities differ from its net income for 2004? Explain this difference
- What type of activities did Kellogg invest in for 2004?
- What kind of financing activities did Kellogg’s engage in for 2004?
Selling a depreciable asset generally involves an increase in cash (classified as an investing activity), elimination of the carrying amount of the asset, and recognition of a non-cash gain or loss (the difference between the carrying amount and the proceeds from the sale), which requires a adjustment of the net result in the operating activity part of the cash flow statement prepared according to the indirect method. The retirement of bonds generally involves a decrease in cash (classified as a financing activity), the elimination of the carrying amount of the bonds, and the recognition of a non-cash gain or loss (the difference between the carrying amount of the bonds and the cash paid to liquidate the bonds), which requires an adjustment to the net income in the operating activities section of the cash flow statement prepared under the indirect method. When the share options are exercised, the decrease in the deferred tax asset is reversed to the net income from operating activities in the cash flow statement.
A PPENDIX : D IRECT M ETHOD FOR R EPORTING O PERATING C ASH F LOWS
However, the unrealized change in the market value of these securities is not included in the cash flow statement. The amortization of any premium or discount related to this long-term investment is a non-cash item that requires an adjustment to net income in the operating activities section of the statement of cash flows prepared under the indirect method. On a statement of cash flows prepared under the indirect method, a company must add the increase in compensation expense and subtract the increase in the deferred tax asset when calculating net cash flows from operating activities.
O PERATING C ASH F LOWS
The sale or purchase of debt securities classified as held-to-maturity is recorded as a cash inflow or outflow from investing activities. Cash dividends declared in the current year and paid in the following year are recorded as a cash payment for financing activities in the paid year. The recognition of compensation expense (a non-cash item) related to compensatory stock option plans results in an increase in a deferred tax asset.
Operating Cash Inflows
Interest income and dividend income, plus the decrease in interest/dividends receivable or minus the increase in interest/dividends receivable, and plus the amortization of the bond investment premium or minus the amortization of the bond investment discount. Other operating income, less gains on disposal of assets and liabilities, and less income from investments recognized under the equity method.
Operating Cash Outflows
On the other hand, an increase in the deferred income of a retail company may be due to the collection of rent (for a sublease) in advance. That is, the accounts receivable balance increased from $0 to $5,000 from the beginning to the end of the year. As we show at the top of Example 22-7, by subtracting the $5,000 increase in Accounts Receivable from the $72,000 in Sales Revenue, the company determines that it collected $67,000 from customers during the year.
P ROCEDURES FOR S TATEMENT P REPARATION
Visual Inspection Method
Since this is a "non-cash" item on the income statement and is reported separately from other operating expenses, no adjustment to operating cash flows is made. Example 22-9 shows the cash flows from operating activities section of Betha's statement of cash flows under the direct method. The Company includes cash flows from investing activities and cash flows from financing activities in a normal manner to complete the statement of cash flows.
Worksheet Method
E XAMPLE : W ORKSHEET (S PREADSHEET ) AND D IRECT M ETHOD
Operating Cash Flows
Investing and Financing Cash Flows
The changes in these accounts during the year represent potential operating cash receipts or payments. These changes are the results of investing or financing activities and are treated like the changes in the non-current accounts discussed in Step 4(C). Accounts for the changes in the remaining current assets (other than cash) and current liabilities, as well as the changes in non-current accounts.
Completion of Worksheet and Statement
Investing and Financing Activities Not Affecting Cash Investing Activities
Using the direct method of operating cash flows, prepare a spreadsheet (spreadsheet) to support a 2007 statement of cash flows. Outline the general format of the statement of cash flows (indirect method). Using the direct method of operating cash flows, prepare a spreadsheet (spreadsheet) to support a 2007 statement of cash flows.
