ACCTG 211 1st Edition Lecture 15Outline of Last Lecture I. Statement of Cash FlowsII. Two Methods of FlowsIII. Unit 7 Example Problem Outline of Current Lecture II. Recap of Direct MethodIII. Introducing Indirect Method IV. Example of Indirect Method Current LectureI. Important Items from Unit 7a. Why SOCF?i. Provides financial statement readers with both an “accrual-based” and a “cash-based” picture of business resultsii. What is needed to prepare SOCF?iii. Balance Sheet, Income Statement, “Additional information” (provided)b. Basic format of SOCFi. The change in Cash from the Balance sheet is split into three cash flow categories: CFFO (Operating), CFFI (Investing), CFFF (Financing)ii. CFFO is related to Income Statement activities; CFFI is related to changes in Long-Term Asset accounts; CFFF is related to changes in Long-Term Liabilities accounts and changes in Equity accountsiii. Reconciliation at bottom of SOCF: Net Change in CF + Beg Cash = End CashII. There are 2 different ways to prepare CFFO: Direct and Indirect methodsa. Direct Method i. Goal: derive CFFO directly. Cash Inflows minus Cash Outflows Equals CFFO.ii. Key: turn each item on the Income Statement into an Operating Cash Flow.iii. Process: solve for the “cash effect” in each accrual-based Income Statement item by evaluating a “roll forward” of related accrual account(s).b. Indirect Method These notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.i. Goal: indirectly reconcile accrual-based Net Income to CFFO.ii. Key: start with Net Income, then “unwind” accrual effects to arrive at CFFO.iii. Process: start with Net Income, then deal with any Depreciation (or Amortization or Depletion), then deal with any gains or losses on the sale of Long-Term Assets, then deal with any changes in accrual accounts (Current Assets or Current Liabilities). c. Direct Method vs. Indirect Methodi. If direct method is used, companies must also present a “reconciliation ofNet Income to CFFO.” So companies that use the direct method must alsoprovide the indirect method.ii. Both methods result in the same CFFOIII. Example: CFFO Direct Methoda. Goal: derive CFFO directly. Cash Inflows minus Cash Outflows Equals CFFO.b. Starting point: Top of the Income Statement (Sales).c. How to solve:i. Key: turn each item on the Income Statement into an Operating Cash Flow.1. Sales: Cash Collected from Customers (Inflow)2. COGS: Cash Paid to Vendors for Inventory (Outflow)3. Selling Expenses: Cash Paid for Selling Expenses (Outflow)4. General Expenses: Cash Paid for General Expenses (Outflow)5. Interest Expense: Cash Paid for Interest (Outflow)6. Income Tax Expense: Cash Paid for Income Taxes (Outflow)a. Result: Net Income is converted into Cash Flows from Operating Activities (either a net Inflow or net Outflow).ii. Process: solve for the “cash effect” in each accrual-based Income Statement item by evaluating a “roll forward” of related accrual account(s).1. Cash Collected from Customers (Sales: use A/R)2. Cash Paid to Vendors for Inventory (COGS: use Inv, then A/P)3. Cash Paid for Selling Expenses (Sell Exp: no accrual acct)4. Cash Paid for General Expenses (**)5. Cash Paid for Interest (IntExp: no accrual acct)6. Cash Paid for Income Taxes (Inc Tax Exp: use Tax Pay)a. ** Depreciation Expense has no associated operating cash flows, so pull that out first. Then, deal with Rent Expense via Prepaid Rent. Remaining $500 had no accrual account, so assumed cash-only.IV. Indirect Methoda. Indirect Method follows a different process to derive CFFOi. Start with Net Income, not Salesii. Then “unwind” accrual effects of Net Income to arrive at CFFO.iii. The Indirect Method is a reconciliationof Net Income to CFFOiv. We will follow a scripted processv. Important to note: items in the Operating section of a SOCF employing the Indirect method are NOT cash flows in and of themselves; rather, theyare reconciling itemsthat help us understand how to “unwind” the accrual effect of Net Income to arrive at CFFO.V. Indirect Method EXAMPLEa. Goal: indirectly reconcile accrual-based Net Income to CFFO.b. Starting point: Bottom of the Income Statement (Net Income).c. Objective: reconcile accrual-based Net Income to CFFOd. Four Steps for Indirect Method Operating Section:i. Step 1: Start with Net Income (accrual-based)1. Step 1: Start with Net Incomeii. Step 2: Add Back Depreciation Expense (or Amortization Expense or Depletion Expense)1. Step 2: Add Back Depreciation Expense2. What is the journal entry to record depreciation?3. Does this journal entry involve cash?4. Step 2: Add Back Depreciation Expense5. An increase in depreciation expense leads to a decrease in accrual-based income6. But for depreciation itself, cash-based NI does not change relativeto accrual-based NI7. Step 2: Add Back Depreciation Expense8. The goal of the indirect method is to reconcile accrual-based income with cash-based income9. In the reconciliation: eliminate the effect of depreciationiii. Step 3: Add Back Loss or Back out Gain on Sale of L/T Assets1. Step 3: Add Back Loss on Sale of Long-Term Assets2. In the JE where a “loss” appears, is the loss a debit or a credit?3. Is the “loss” itself a cash item or a non-cash item?4. Losses “act like” expenses, in that they decrease Net Income5. An increase in a loss on the sale of long-term assets leads to a decrease in accrual-based income6. But for the loss itself, cash-based NI does not change relative to accrual-based NI (note: the cash increase associated with the sale of the L/T asset will be dealt with as an investing activity)7. The goal of the indirect method is to reconcile accrual-based income with cash-based income8. In the reconciliation: eliminate the effect of the loss on sale9. In the JE where a “gain” appears, is the gain a debit or a credit?10. Is the “gain” itself a cash item or a non-cash item?11. Gains “act like” revenues, in that they increase Net Income12. An increase in a gain on the sale of long-term assets leads to an increase in accrual-based income 13. But for the gain itself, cash-based NI does not change relative to accrual-based NI (note: the cash increase associated with the sale of the L/T asset will be dealt with as an investing activity)14. The goal of the indirect method is to reconcile accrual-based income with cash-based