BUS103: Introduction to Financial Accounting

Accountants follow specific procedures when preparing a statement of cash flows.

We show these procedures using the financial statements and additional data for Welby Company in Exhibit 52.

After determining the change in cash, the first step in preparing the statement of cash flows is to calculate the cash flows from operating activities, using either the direct or indirect method. The second step is to analyze all of the noncurrent accounts and additional data for changes resulting from investing and financing activities. The third step is to arrange the information gathered in steps 1 and 2 into the proper format for the statement of cash flows.

The direct method converts the income statement from the accrual basis to the cash basis. Accountants must consider changes in balance sheet accounts that are related to items on the income statement. The accounts involved are all current assets or current liabilities. The following schedule shows which balance sheet accounts are related to the items on Welby's income statement:

Income statement Items	Related balance sheet items	Cash flows from Operating activities
Sales	Accounts receivable	Cash received trom customers
Cost of goods sold	Accounts payable and merchandise inventory	Cash paid for merchandise
Operating expenses and taxes	Accrued liabilities and prepaid expenses	Cash paid for operating expenses

For other income statement items, the relationship is often obvious. For instance, salaries payable relates to salaries expense, federal income tax payable relates to federal income tax expense, prepaid rent relates to rent expense, and so on.

The table below shows how income statement items are affected by balance sheet accounts:

		Cash basis
Accrual Basis		(Cash flows from operating activities)
Sales	+ Decrease or – Increase in Accounts Receivable	(=) Cash received from customers
Cost of goods sold	+ Increase or – Decrease in Merchandise Inventory and	(=) Cash paid for Merchandise
	(+) Decrease or – Increase in Accounts Payable
Operating expenses	Decrease or – Increase in related accrued liability
	And	(=) Cash paid for operating expense
	Increase or – Decrease in related prepaid expense

Noncash operating expenses (such as depreciation expense and amortization expense), revenues, gains, and losses are reduced to zero in the cash basis income statement.

Welby Company
Comparative balance sheet
2010 December 31 and 2009
	2010	2009	Increase / (Decrease)
Assets
Cash	$21,000	$ 10,000	$11,000
Accounts receivable	30,000	20,000	10,000
Merchandise inventory	26,000	30,000	(4,000)
Equipment	70,000	50,000	20,000
Accumulated depreciation -	(10,000)	(5,000)	(5,000)
Equipment
Total assets	$137,000	$105,000	$32,000
Liabilities and stockholders' equity
Accounts payable	$9,000	$ 15,000	$(6,000)
Accrued liabilities payable	2,000	-0-	2,000
Common stock ($10 par value)	90,000	60,000	30,000
Retained earnings	36,000	30,000	6,000
Total liabilities and stockholders' equity	$137,000	$105,000	$32,000
Welby Company
Income statement
For the year ended 2010 December 31
Sales		$140,000
Cost of goods sold		100,000
Gross margin		$ 40,000
Operating expenses (other than $25,000 depreciation)
Depreciation expense	5,000	30,000
Net income		$ 10,000
Additional data
1. Equipment purchased for cash during 2010 amounted to $20,000.
2. Common stock with a par value of $30,000 was issued at par for cash.
3. Cash dividends declared and paid in 2010 totaled $4,000.

Exhibit 52: Financial statements and other data

Welby Company
Working paper to convert income statement from accrual basis to cash basis
For the year ended 2010 December 31
	Accrual Basis		Add	Deduct	Cash Basis (Cash Activities)	Flows from Operating
Sales		$140,000		$10,000*		$130,000
Cost of goods sold	$100,00		$6,000†	4,000‡	$102,000
Operating expenses	25,000			2,000	23,00
Depreciation expense	5,000			5,000
	______				-0-
		$130,000				125,000
Net income		$10,000				$5,000
* Increase in Accounts Receivable.
†Decrease in Accounts Payable.
‡Decrease in Merchandise Inventory.
§Increase in Accrued Liabilities Payable.

Exhibit 53: Working paper to convert income statement from accrual basis to cash basis

As a general rule, an increase in a current asset (other than cash) decreases cash inflow or increases cash outflow. Thus, when accounts receivable increases, sales revenue on a cash basis decreases (some customers who bought merchandise have not yet paid for it). When inventory increases, cost of goods sold on a cash basis increases (increasing cash outflow). When a prepaid expense increases, the related operating expense on a cash basis increases. (For example, a company not only paid for insurance expense but also paid cash to increase prepaid insurance). The effect on cash flows is just the opposite for decreases in these other current assets.

An increase in a current liability increases cash inflow or decreases cash outflow.

Thus, when accounts payable increases, cost of goods sold on a cash basis decreases

(instead of paying cash, the purchase was made on credit). When an accrued liability (such as salaries payable) increases, the related operating expense (salaries expense) on a cash basis decreases. (For example, the company incurred more salaries than it paid). Decreases in current liabilities have just the opposite effect on cash flows.

Welby Company had no prepaid expenses. The current assets and current liabilities affecting the income statement items changed as follows:

	Increase	Decrease
Accounts receivable	$10,000
Merchandise inventory		$4,000
Accounts payable		6,000
Accrued liabilities payable	2,000

Thus, Welby converted its income statement to a cash basis as shown in Exhibit 53.

The indirect method makes certain adjustments to convert net income to cash flows from operating activities. Welby must analyze the effects of changes in current accounts (other than cash) on cash. The firm should also take into account noncash items such as depreciation that affected net income but not cash. Welby had only one such item - depreciation expense of USD 5,000. Applying these adjustments to Welby's financial statements and other data in Exhibit 52 yields the following schedule:

Cash flow from operating activities:
Net income	$10,000
Adjustments to reconcile net income to net cash provided by operating activities:
Increase in accounts receivable	(10,000)
Decrease in merchandise inventory	4,000
Decrease in accounts payable	(6,000)
Increase in accrued liabilities payable	2,000
Depreciation expense	5,000
Net cash provided by operating activities	$5,000

Notice that both the direct and indirect methods result in USD 5,000 net cash provided by operating activities.

You can use the following table to make the adjustments to net income for the changes in current assets and current liabilities:

For changes in these current assets and current liabilities:	Make these adjustments to convert accrual basis net income to cash basis net income:
	Add	Deduct
Accounts receivable	Decrease	Increase
Merchandise inventory	Decrease	Increase
Prepaid expenses	Decrease	Increase
Accounts payable	Increase	Decrease
Accrued liabilities payable	Increase	Decrease

Note that you would handle all changes in current asset accounts in a similar manner. All changes in current liability accounts require the opposite treatment of the current asset changes. Use this table in making these adjustments:

For changes in-	Add the changes to net income	Deduct the changes from net income
Current assets	Decreases	Increases
Current liabilities	Increases	Decreases

In applying the rules in this table, add a decrease in a current asset to net income, and deduct an increase in a current asset from net income. For current liabilities, add increases to net income, and deduct decreases from net income.

Under the indirect method, the amount of cash flows from operating activities is calculated as follows:

Accrual basis net income

+ or - Changes in noncash current asset and current liability accounts

+ Expenses and losses not affecting cash

- Revenues and gains not affecting cash

= Cash flows from operating activities

After analyzing the changes in current accounts for their effect on cash, we examine the noncurrent accounts and additional data. Remember that a change in a noncurrent account usually comes about because cash is received or disbursed.

In the Welby example, we must analyze four noncurrent accounts: Retained Earnings, Equipment, Accumulated Depreciation - Equipment, and Common Stock.

• The analysis of the noncurrent accounts can begin with any of the noncurrent accounts; we begin by reviewing the Retained Earnings account. Retained Earnings is the account to which net income or loss for the period was closed. The USD 6,000 increase in this account consists of USD 10,000 of net income less USD 4,000 of dividends paid. 

Retained earnings
		Beg. Bal.	30,000
Dividends	4,000	Net income	10,000
		End bal.	36,000

 

The net income amount is in the income statement. We enter both net income and dividends on the statement of cash flows in Exhibit 54, Part B. The USD 10,000 net income is the starting figure in determining cash flows from operating activities.

Thus, we enter the net income of USD 10,000 on the statement in the cash flows from operating activities section. The dividends are shown as a deduction in the cash flow from financing activities section.

• The Equipment account increased by USD 20,000. The dividends are shown as a deduction in the cash flow from financing activities section. The additional data indicate that USD 20,000 of equipment was purchased during the period. A purchase of equipment is a deduction in the cash flows from investing activities section.
• The USD 5,000 increase in the Accumulated Depreciation - Equipment account equals the amount of depreciation expense in the income statement for the period. As shown earlier, because depreciation does not affect cash, under the indirect (addback) method we add it back to net income on the statement of cash flows to convert accrual net income to a cash basis.
• The USD 30,000 increase in common stock resulted from the issuance of stock at par value, as disclosed in the additional data (item 2) in Exhibit 52. An issuance of stock in the statement of cash flows is a positive amount in the cash flows from financing activities section.

After we have analyzed the noncurrent accounts, we can prepare the statement of cash flows from the information generated. Part A of Exhibit 54 presents the statement of cash flows for Welby using the direct method. Part B shows the statement of cash flows for Welby using the indirect method. The appendix to this chapter shows how a working paper can be used to assist in preparing a statement of cash flows for the Welby Company under the indirect method. However, we believe you will gain a greater conceptual understanding by not using a working paper.

The statement of cash flows has three major sections: cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities. The format in the operating activities section differs for the direct and indirect methods. The direct method adjusts each item in the income statement to a cash basis. The indirect method makes these same adjustments but to net income rather than to each item in the income statement. Both methods eliminate not only the effects of noncash items, such as depreciation, but also gains and losses on sales of plant assets.

The only item in the cash flows from investing activities section is the cash outflow of USD 20,000 for the purchase of equipment. In a more complex situation, other items could be included in this category.

Two items are under the cash flows from financing activities section: The issuance of common stock resulted in a cash inflow of USD 30,000 and the payment of dividends resulted in a cash outflow of USD 4,000.

The last line of the statement is the USD 11,000 increase in cash for the year. Other examples could result in a decrease in cash for the year.

If the direct method is used, the reconciliation of net income to net cash flows from operating activities (the indirect method) must be shown in a separate schedule. However, if the indirect method is used and the reconciliation is shown in the statement of cash flows, no such separate schedule is required. Possibly this is one of the reasons why so many companies use the indirect method.

However, if the indirect method is used, the amount of interest and income taxes paid must be provided in related disclosures, usually immediately below the statement of cash flows. For instance, if Welby Company had paid interest of USD 200 and income taxes of USD 8,000, these facts would be reported as follows:

A. Direct Method

Welby Company
Statement of cash flows
For the year ended 2010 December 31
Cash flows from operating activities:
Cash received from customers	$130,000
Cash paid for merchandise	(102,000)
Cash paid for operating expenses	(23,000)
Net cash provided by operating activities		$5,000
Cash flows from investing activities:
Purchase of equipment		(20,000)
Cash flows from financing activities:
Proceeds from issuing common stock	$ 30,000
Paid cash dividends	(4,000)
Net cash provided by financing activities		26,000
Net increase (decrease) in cash		$11,000

 

B. Direct Method

Welby Company
Statement of cash flows For the year ended
2010 December 31
Cash flows from operating activities:
Net income	$10,000
Adjustments to reconcile net income to net cash
Provided by operating activities:
Increase in accounts receivable	(10,000)
Decrease in merchandise inventory	4000
Decrease in accounts payable	(6,000)
Increase in accrued liabilities payable	2,000
Depreciation expense	5,000
Net cash provided by operating activities		$ 5,000
Cash flows from investing activities:
Purchase of equipment		(20,000)
Cash flows from financing activities:
Proceeds from issuing common stock	$ 30,000
Paid cash dividends	(4,000)
Net cash provided by financing activities		26,000
Net increase (decrease) in cash		$11,000

Exhibit 54: Statement of cash flows-Welby company

Supplemental cash flow information:
Interest paid	$ 200
Income taxes paid	8,000