T-Account Approach to Preparing a Statement of Cash Flows ...
[Pages:7] 266
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Foundations of Financial Accounting
With these adjustments to the income statement, we can now present the operating activities section of the statement of cash flows using either the direct or indirect methods. The indirect method would involve beginning with net income and adding or subtracting the adjustments (in the third column of the matrix) to arrive at cash flow from operations of $57,000. The direct method would simply detail the figures presented in the fourth column of the matrix. The formal cash flow statement, using the indirect method, is shown later in this section.
T-Account Approach to Preparing a Statement of Cash Flows--Indirect Method
With a comprehensive T-account approach, special "cash flow" T-accounts are established. These accounts are used to summarize cash flows from operations and from investing and financing activities during the period. They provide the basis for preparing the formal cash flow statement. Individual T-accounts are also established for Cash and all other balance sheet accounts.
During the process of analysis, the change in each account is explained as providing or using cash. In the three T-accounts summarizing cash flows from operating, investing, and financing activities, a debit represents an increase in cash, while a credit reflects a decrease. Once the changes in all balance sheet accounts have been reconciled and the cash flow T-accounts balanced, the formal cash flow statement can be prepared.
In preparing a cash flow statement for Western Resources, Inc., we begin by determining the change in the cash balance, in this case an $8,700 decrease. All noncash accounts may now be analyzed using the T-accounts illustrated on pages 268 and 269.As noted, the cash flow statement is prepared directly from the cash flow T-accounts and is illustrated following those T-accounts.
Generally, the most efficient approach to developing T-accounts for a statement of cash flows is to begin with an analysis of the change in Retained Earnings. After the change in Retained Earnings has been accounted for, the remaining noncash accounts should be reviewed in conjunction with the income statement and supplementary information to determine what additional adjustments are required. Operating income should be adjusted to determine the actual amount of cash provided or used by operations [items (e), (i), (j), and (l) ? (p)]. Analysis must also be made to determine all other cash flows from investing and financing activities [items (b), (c), (d), (e), (f), (h), (k), and (q)] and to reflect significant investing and financing activities that have no effect on cash [item (g)].
Explanations for individual adjustments for Western Resources, Inc., follow. The letter preceding each explanation corresponds with that used in the T-accounts, which are presented on pages 268 and 269. Entries are presented to help explain the preparation of a statement of cash flows. They are not journal entries that would be recorded in the accounting records.
(a) Net income is recorded in the T-accounts as follows:
Cash Flows--Operating ....................................................................................... Retained Earnings ...........................................................................................
36,300
36,300
(b) The cash dividends declared and deducted from retained earnings are adjusted for the change in the dividends payable balance in arriving at the amount of dividends actually paid during the year. The entry would be:
Retained Earnings ................................................................................................. Dividends Payable .......................................................................................... Cash Flows--Financing ..................................................................................
25,100
4,400 20,700
(c) The destruction of the building and the subsequent insurance reimbursement have the effect of providing cash of $10,000, the proceeds from the insurance company. The entry would be:
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Accumulated Depreciation--Buildings ................................................................ Cash Flows--Investing ..........................................................................................
Buildings ..........................................................................................................
30,000 10,000
40,000
(d) The buildings account was increased by the cost of constructing a new building, $105,000. The cost of the new building is reported separately as an investment of cash by the following entry:
Buildings ................................................................................................................ Cash Flows--Investing ....................................................................................
105,000
105,000
(e) The sale of long-term investments was recorded by a credit to the asset account at cost, $96,000, and a credit to a gain on sale of investment account. At the end of the period, the gain account was closed to Retained Earnings as part of income from continuing operations. Because the effect of the sale was to provide cash of $102,500, this amount is reported as cash provided by investing activities. The investments account balance is reduced, and cash provided by operations is decreased by the amount of the gain. The following adjustment is made:
Cash Flows--Investing .......................................................................................... Investments....................................................................................................... Cash Flows--Operating .................................................................................
102,500
96,000 6,500
(f) and (g) Land was acquired at a price of $108,500; payment was made in common stock valued at $40,000 and cash of $68,500. Two separate entries are made to segregate the cash and noncash components of this transaction:
(f) Land ................................................................................................................. Cash Flows--Investing ...............................................................................
(g) Land ................................................................................................................. Common Stock............................................................................................
68,500 40,000
68,500 40,000
The issuance of common stock for land has no effect on cash, but it is a significant transaction that should be disclosed separately. Recall that the body of the cash flow statement reports only transactions affecting cash, in accordance with FASB Statement No. 95.
(h) Machinery costing $12,000 was acquired during the year. Payment was made in cash and is reported as cash used for investing purposes. The adjustment for the acquisition of machinery is:
Machinery and Equipment ................................................................................... Cash Flows--Investing ....................................................................................
12,000
12,000
(i) and (j) The changes in the accumulated depreciation accounts and in the patents account result from the recognition of depreciation and amortization expenses for the period. These noncash expenses are added in computing cash flows from operations by the following adjustments:
(i) Cash Flows--Operating ................................................................................. Accumulated Depreciation--Buildings...................................................... Accumulated Depreciation--Machinery and Equipment .........................
(j) Cash Flows--Operating ................................................................................. Patents .........................................................................................................
20,900 5,000
5,600 15,300
5,000
(k) During the year, bonds were issued at their face value of $30,000. The entry is:
Cash Flows--Financing ........................................................................................ Bonds Payable.................................................................................................
30,000
30,000
(l)?(p) In preparing a cash flow statement, operating income must be adjusted from an accrual basis to a cash basis, as explained earlier in the chapter. The entries (l) through (p) reflect that analysis for Western Resources, Inc.:
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(l) Cash Flows--Operating ................................................................................. Accounts Receivable...................................................................................
(m) Cash Flows--Operating ................................................................................. Inventories ...................................................................................................
(n) Prepaid Operating Expenses.......................................................................... Cash Flows--Operating.............................................................................
(o) Accounts Payable............................................................................................ Cash Flows--Operating.............................................................................
(p) Cash Flows--Operating ................................................................................. Income Taxes Payable ................................................................................
10,500 1,500 4,500 6,700 500
10,500 1,500 4,500 6,700 500
(q) As noted earlier in the chapter, available-for-sale securities are treated differently from other current assets in preparing a cash flow statement. The adjustment to reflect the purchase of $2,000 of available-for-sale securities would be:
Available-for-Sale Securities ................................................................................ Cash Flows--Investing ....................................................................................
2,000
2,000
(r) After all changes in account balances have been reconciled and the effects of the changes on cash flow have been recorded in the cash flows T-accounts, the balances of those T-accounts are determined and transferred to a Cash Flows Summary T-account as shown below. The excess of credits (decreases in cash) over debits (increases in cash) is equal to the net change in the cash balance for the period of $8,700. The following entry is made to reflect the net decrease in cash:
Net Decrease in Cash ........................................................................................... Cash .................................................................................................................
8,700
8,700
Net cash provided by operating activities
Cash Flows--Operating
(a)
36,300 (e)
(i)
20,900 (n)
(j)
5,000 (o)
(l)
10,500
(m)
1,500
(p)
500
57,000
6,500 4,500 6,700
Net cash used in investing activities
Cash Flows--Investing
(c)
10,000 (d)
105,000
(e)
102,500 (f)
68,500
(h)
12,000
(q)
2,000
75,000
Net cash provided by financing activities
Cash Flows--Financing
(k)
30,000 (b)
20,700
9,300
Net cash provided--operating Net cash used--investing Net cash provided--financing Net decrease in cash
Cash Flows Summary
57,000
9,300
(r)
8,700
75,000
75,000 75,000
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Cash and Cash Equivalents
Beg. bal. End. bal.
55,000 (r) 46,300
8,700
Available-for-Sale Securities
Beg. bal. (q)
End. bal.
10,000 2,000
12,000
Beg. bal. End. bal.
Accounts Receivable 70,500 (l) 60,000
10,500
Beg. bal. End. bal.
Inventories 76,500 (m) 75,000
1,500
Prepaid Operating Expenses
Beg. bal. (n)
End. bal.
12,000 4,500
16,500
Land
Beg. bal. (f) (g)
End. bal.
75,000 68,500 40,000
183,500
Investments
Beg. bal. End. bal.
106,000 (e) 10,000
Buildings
Beg. bal. (d)
End. bal.
225,000 (c) 105,000
290,000
96,000 40,000
Accumulated Depreciation--Buildings
(c)
30,000 Beg. bal. 155,000
(i)
5,600
End. bal. 130,600
Machinery and Equipment
Beg. bal. (h)
End. bal.
120,000 12,000
132,000
Accumulated Depreciation-- Machinery and Equipment
Beg. bal. (i)
End. bal.
43,500 15,300
58,800
Beg. bal. End. bal.
Patents 40,000 (j) 35,000
5,000
Accounts Payable
(o)
6,700 Beg. bal.
97,700
End. bal.
91,000
Income Taxes Payable
Beg. bal. (p) End. bal.
9,500 500
10,000
Dividends Payable
Beg. bal. (b) End. bal.
0 4,400
4,400
Bonds Payable
Beg. bal. (k) End. bal.
0 30,000
30,000
Common Stock
Beg. bal. 250,000 (b)
(g)
40,000
End. bal. 290,000
Retained Earnings
25,100 Beg. bal. (a) End. bal.
234,300 36,300
245,500
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All T-accounts are now complete, and a statement of cash flows for Western Resources, Inc., can be prepared in an appropriate format, such as the one below.
Western Resources, Inc. Statement of Cash Flows For the Year Ended December 31, 2002
Cash flows from operating activities: Net income..................................................................................................... Adjustments: Depreciation expense .............................................................................. Amortization of patents........................................................................... Gain on sale of investments .................................................................... Decrease in accounts receivable............................................................. Decrease in inventories ........................................................................... Increase in prepaid operating expenses ................................................ Decrease in accounts payable ................................................................ Increase in income taxes payable...........................................................
Net cash provided by operating activities.................................................... Cash flows from investing activities:
Involuntary conversion of building ............................................................... Construction of building ................................................................................ Sale of long-term investments ....................................................................... Purchase of land ............................................................................................ Purchase of machinery and equipment ........................................................ Purchase of available-for-sale securities ......................................................
Net cash used in investing activities ............................................................. Cash flows from financing activities:
Issuance of bonds .......................................................................................... Payment of cash dividends............................................................................
Net cash provided by financing activities ....................................................
Net decrease in cash and cash equivalents ....................................................... Cash and cash equivalents at beginning of year...............................................
Cash and cash equivalents at end of year .........................................................
Supplemental Disclosure: Cash payments for: Interest ...................................................................................................... Income taxes ............................................................................................ Noncash transaction: Land acquired by issuing common stock................................................
$ 36,300
20,900 5,000 (6,500)
10,500 1,500 (4,500) (6,700) 500
$ 10,000 (105,000) 102,500
(68,500) (12,000)
(2,000)
$ 30,000 (20,700)
$ 3,600 23,500
40,000
$57,000
(75,000)
9,300 $ (8,700)
55,000 $46,300
A reader analyzing the cash flow statement for Western Resources, Inc., can readily see that $57,000 cash was provided internally from operating activities. This amount was not sufficient to satisfy the investment needs of the company, and so additional cash was generated from external financing activities involving the issuance of bonds. The cash generated from operations clearly met the need for payment of cash dividends, but when other cash needs are considered, the total cash outflow exceeded the total inflow of cash for the period, causing the cash balance to decrease by $8,700, or 15.8%.
In addition to the formal statement of cash flows, supplemental disclosure is required for significant noncash investing and financing transactions. Thus, Western Resources would report the acquisition of land valued at $40,000 in exchange for common stock. When the indirect method is used to report operating activities, the amount of cash paid for interest and income taxes also must be disclosed. For Western Resources, the amount paid for interest, $3,600, is taken directly from the income statement because there is no interest payable at the beginning or end of the year. The amount paid for taxes is determined as follows:
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Income tax expense (reported in the income statement) .......................................................... Deduct increase in income taxes payable ..............................................................................
Amount of cash paid for income taxes ..................................................................................
$24,000 (500)
$23,500
In the Western Resources illustration, the supplemental disclosures are presented in a schedule accompanying the statement of cash flows. Alternatively, the information could be presented in the notes to the financial statements.
Work Sheet Approach to Preparing a Statement of Cash Flows--Indirect Method
This section illustrates a work sheet approach to preparing a statement of cash flows using the indirect method. As shown, this approach produces the same results as the Taccount approach; only the format is different. To highlight the similarities in the two approaches, the information and account analysis used in the T-account illustration for Western Resources, Inc., will also be used for the work sheet illustration.
Using a work sheet, such as the one on page 272, facilitates the analysis of account changes when using the indirect method. The format of the work sheet is straightforward. The first amount column contains the beginning balances, then there are two columns for analysis of transactions to arrive at the ending balances in the fourth column.
In preparing a work sheet, accumulated depreciation balances, instead of being reported as credit balances in the debit (asset) section, may be more conveniently listed with liability and owners' equity balances in the credit section. Similarly, contra liability accounts and contra owners' equity balances may be separately recognized and more conveniently listed with assets in the debit section.
The lower portion of the work sheet shows the major categories of cash flows: operating, investing, and financing. A debit in the lower section means an increase in cash, while a credit is a decrease in cash. It is from the lower section of the work sheet that the formal statement of cash flows is prepared. In following the illustration, it may be helpful to refer to the detailed explanations for individual adjustments described on 266?268. Once the changes in all accounts have been reconciled and the work sheet is complete, the formal cash flow statement can be prepared, as illustrated on page 270.
CONCLUSION
This chapter has been an overview of the statement of cash flows. Along with the balance sheet and the income statement, the statement of cash flows is one of the three primary financial statements. However, because it is relatively new (required only since 1988), it sometimes does not receive the emphasis that it deserves. Cash flow variables and ratios are only now starting to make it into the mainstream of financial statement analysis. You are now a cash flow statement expert; be patient with those who learned their accounting back in the pre-1988 days of the statement of changes in financial position.
All the basic aspects of cash flow reporting and disclosure have been covered in this chapter. Additional complexities are introduced in later chapters as appropriate. An expanded illustration, incorporating these complexities, is provided in the last chapter of the text. You might start thinking now about how the cash flow statement will be affected by revenue recognition assumptions, FIFO and LIFO, capitalize or expense decisions, operating leases, bonds issued at a discount, stock splits and dividends. . . .
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Western Resources, Inc. Work Sheet for Statement of Cash Flows--Indirect Method
For the Year Ended December 31, 2002
Accounts
Debits
Cash and Cash Equivalents......................................................... Available-for-Sale Securities ....................................................... Accounts Receivable .................................................................... Inventories .................................................................................... Prepaid Operating Expenses ...................................................... Investments .................................................................................. Land ..............................................................................................
Buildings ....................................................................................... Machinery and Equipment .......................................................... Patents ..........................................................................................
Balance Dec. 31,
2001
55,000 10,000 70,500 76,500 12,000 106,000
225,000 120,000
40,000 790,000
Adjustments
Debit
Credit
(q)
2,000
(n)
4,500
75,000
(g)
40,000
(d) 105,000
(h)
12,000
(r)
8,700
(l)
10,500
(m)
1,500
(e) 96,000
(f)
68,500
(c)
40,000
(j)
5,000
Credits
Accumulated Depreciation--Buildings ....................................... Accumulated Depreciation--Machinery and Equipment .......... Accounts Payable......................................................................... Income Taxes Payable.................................................................. Dividends Payable ....................................................................... Bonds Payable ............................................................................. Common Stock ............................................................................. Retained Earnings........................................................................
155,000 43,500 97,700 9,500 ?0? ?0?
250,000 234,300
790,000
(c)
30,000
(o)
6,700
(b)
25,100
293,800
(i)
5,600
(i)
15,300
(p)
500
(b)
4,400
(k)
30,000
(g) 40,000
(a) 36,300
293,800
Cash flows from operating activities: Net income ............................................................................. Adjustments: Depreciation expense ...................................................... Amortization of patents ................................................... Gain on sale of investments............................................. Decrease in accounts receivable ..................................... Decrease in inventories.................................................... Increase in prepaid operating expenses......................... Decrease in accounts payable......................................... Increase in income taxes payable ...................................
Cash flows from investing activities: Involuntary conversion of building........................................ Construction of building ........................................................ Sale of long-term investments................................................ Purchase of land .................................................................... Purchase of machinery and equipment ................................ Purchase of available-for-sale securities...............................
Cash flows from financing activities: Issuance of bonds................................................................... Payment of cash dividends ....................................................
Net decrease in cash...................................................................
(a)
36,300
(i)
20,900
(j)
5,000
(l)
10,500
(m)
1,500
(p)
500
(c)
10,000
(e) 102,500
(k)
30,000
217,200
(r)
8,700
225,900
(e)
6,500
(n)
4,500
(o)
6,700
(d) 105,000
(f)
68,500
(h) 12,000
(q)
2,000
(b) 20,700 225,900
225,900
Balance Dec. 31,
2002
46,300 12,000 60,000 75,000 16,500 10,000
183,500 290,000 132,000
35,000 860,300
130,600 58,800 91,000 10,000 4,400 30,000
290,000 245,500 860,300
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