The Income Statement and Statement of Cash Flows THE STATEMENT OF CASH FLOWS Purpose of the Statement of Cash Flows The purpose of the statement of cash flows is to identify the sources and uses of cash and the change in cash from the beginning to the end of the accounting period. The sources (cash receipts) and uses (cash disbursements) are classified into three categories. 1. Operating Activities: Cash receipts from sales and cash disbursements for cost of goods sold and operating expenses that are incurred to generate the sales. For financial accounting purposes operating activities include the receipt of dividends and interest and the payment of interest. 2. Investing Activities: Cash paid for the acquisition of fixed assets and investments and cash received from their disposition. 3. Financing Activities: Cash received from the issuance of debt or equity financing and cash paid for the retirement of financing as well as the payment of dividends. Content and Format of the Statement of Cash Flows The basic format of the statement of cash flows is as follows: Cash flows from operating activities $Cash flows from investing activities $Cash flows from financing activitie $ Net increase (decrease in cash for the year) $Beginning cash balance $Ending cash balance $ Preparation of the Statement of Cash Flows There are two approaches to preparing the statement of cash flows. In the direct method operating activities are presented as total cash receipts from sales and cash disbursements for cost of sales and other operating activities. In the indirect method operating activities are a reconciliation of net income. In this course we will be using the indirect method. Net income $Add: Noncash charges $ Increases in current liabilities $ Decreases in current assets $Less: Increases in current assets $ Decreases in current liabilities $Add: Losses from investing or financing activities $Less: Gains from investing or financing activities $ $ Net cash provided by (used by) operating activities $Cash flows from operating activities: E:\Teaching\3321\web\module2\c4\tnotes\c4b.doc 1/31/2007 1The Income Statement and Statement of Cash Flows Use of the Cash Flows Worksheet Using the cash flows worksheet simplifies the process of preparing a statement of cash flows. We will be using a cash flows worksheet to complete the exercises assigned in this lesson. The worksheet starts with a listing of the beginning and ending balances of each account on the balance sheet. We then examine changes in each account and enter those amounts in a multi-column worksheet. For example, Spencer Company had a cash balance of $70,000 at the beginning of 2002 and a cash balance of $100,000 at the end of the year. The change in cash of $30,000 needs to be separated into operating activities, investing activities and financing activities. The work sheet is our starting point to complete this task. 2002 2001 Increase DecreaseCash 100,000 70,000 30,000 Accounts receivable 50,000 60,000 10,000 Investments 30,000 60,000 30,000 Equipment 300,000 250,000 50,000 Less: Accumulated depreciation (110,000) (90,000) 20,000 Current liabilities (50,000) (60,000) 10,000 Capital stock (160,000) (160,000) Retained earnings (160,000) (130,000) 30,000 - - 90,000 60,000 Increase in cash 30,000 60,000 60,000 Spencer CompanyCash Flow WorksheetFor the year ended December 31, 2002Changes in Cash In analyzing the changes in cash we can see from the work sheet the increases in current assets result in decreases in cash. If we make sales on credit the amounts are included in net income but are not reflected in the cash account. Likewise when we pay down our current liabilities this uses cash which is not reflected in the net income amount. Once we have reconciled the increases and decreases in cash as a result of changes in the account balances we are ready to examine the income statement. In this case the company had net income of $60,000. Also included in the income statement was a loss on the sale of investments. The change in the investments account reflects the original cost of the investment that was sold. In analyzing the accounts we also discover that dividends were declared and paid in the amount of $30,000 during the E:\Teaching\3321\web\module2\c4\tnotes\c4b.doc 1/31/2007 2The Income Statement and Statement of Cash Flows year. With this information on hand we can now extend the work sheet. The following shows the extensions to the Operating Activities columns (items shaded in green). Increase Decrease Increase DecreaseCash 30,000 Accounts receivable 10,000 10,000 Investments 30,000 Equipment 50,000 Less: Accumulated depreciation 20,000 20,000 Current liabilities 10,000 10,000 Capital stockRetained earnings 30,000 90,000 60,000 Increase in cash 30,000 60,000 60,000 Analysis of retained earnings:Net income 60,000 Dividends paidLoss on sale of investments 10,000 100,000 10,000 Changes in cash flow 30,000 90,000 10,000 10,000 OperatingSpencer CompanyCash Flow WorksheetFor the year ended December 31, 2002Changes in Cash The extension to operating activities includes the extension of changes in current assets and current liabilities as well as non-cash charges to net income such as depreciation expense. We were not given any information regarding the disposition of fixed assets with accumulated depreciation so therefore the change in accumulated depreciation is the depreciation expense charged to net income for the year. Rather than analyzing the changes in the retained earnings account on a single line we have expanded the analysis in the section below the balance sheet accounts (items shaded in pink). We start with net income which is the starting point for the operating activities and add back the loss on sale of investments. The amount is included in net income on the income statement but belongs in the investing activities section of the cash flow statement. We can think of this as just a transfer from one section to another. E:\Teaching\3321\web\module2\c4\tnotes\c4b.doc 1/31/2007 3The Income Statement and Statement of Cash Flows After extending all of the information to the operating activities portion of the work sheet we foot the columns and calculate a cash inflow of $100,000 and a cash outflow of $10,000 to give us a net cash inflow for the year of $90,000 (items shaded in yellow). This information will be