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 meth-ods. The indirect method would involve beginning with net income and adding or sub-tracting 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 estab-lished. 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 deter-mining 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 infor-mation 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 let-ter 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... 36,300
Retained Earnings... 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... 25,100
Dividends Payable... 4,400 Cash Flows—Financing... 20,700
Accumulated Depreciation—Buildings... 30,000 Cash Flows—Investing... 10,000
Buildings... 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... 105,000
Cash Flows—Investing... 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... 102,500
Investments... 96,000
Cash Flows—Operating... 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 seg-regate the cash and noncash components of this transaction:
(f) Land... 68,500
Cash Flows—Investing... 68,500 (g) Land... 40,000
Common Stock... 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 FASBStatement 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 acquisi-tion of machinery is:
Machinery and Equipment... 12,000
Cash Flows—Investing... 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 oper-ations by the following adjustments:
(i) Cash Flows—Operating... 20,900
Accumulated Depreciation—Buildings... 5,600
Accumulated Depreciation—Machinery and Equipment... 15,300
(j) Cash Flows—Operating... 5,000
Patents... 5,000
(k) During the year, bonds were issued at their face value of $30,000. The entry is:
Cash Flows—Financing... 30,000
Bonds Payable... 30,000
(l) Cash Flows—Operating... 10,500
Accounts Receivable... 10,500 (m) Cash Flows—Operating... 1,500
Inventories... 1,500 (n) Prepaid Operating Expenses... 4,500
Cash Flows—Operating... 4,500
(o) Accounts Payable... 6,700
Cash Flows—Operating... 6,700
(p) Cash Flows—Operating... 500
Income Taxes Payable... 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... 2,000
Cash Flows—Investing... 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... 8,700
Cash... 8,700 Cash Flows—Operating (a) 36,300 (e) 6,500 (i) 20,900 (n) 4,500 (j) 5,000 (o) 6,700 (l) 10,500 (m) 1,500 (p) 500 57,000 Cash Flows—Investing (c) 10,000 (d) 105,000 (e) 102,500 (f) 68,500 (h) 12,000 (q) 2,000 75,000 Cash Flows—Financing (k) 30,000 (b) 20,700 9,300
Cash Flows Summary
57,000
75,000 9,300
(r) 8,700
75,000 75,000
Net cash provided by operating activities
Net cash used in investing activities
Net cash provided by financing activities
Cash and Cash Equivalents Beg. bal. 55,000 (r) 8,700 End. bal. 46,300 Available-for-Sale Securities Beg. bal. 10,000 (q) 2,000 End. bal. 12,000 Accounts Receivable Beg. bal. 70,500 (l) 10,500 End. bal. 60,000 Inventories Beg. bal. 76,500 (m) 1,500 End. bal. 75,000 Investments
Beg. bal. 106,000 (e) 96,000 End. bal. 10,000
Prepaid Operating Expenses
Beg. bal. 12,000 (n) 4,500 End. bal. 16,500 Land Beg. bal. 75,000 (f) 68,500 (g) 40,000 End. bal. 183,500 Buildings Beg. bal. 225,000 (c) 40,000 (d) 105,000 End. bal. 290,000 Accumulated Depreciation—Buildings (c) 30,000 Beg. bal. 155,000 (i) 5,600 End. bal. 130,600
Machinery and Equipment
Beg. bal. 120,000 (h) 12,000 End. bal. 132,000
Accounts Payable
(o) 6,700 Beg. bal. 97,700 End. bal. 91,000
Income Taxes Payable
Beg. bal. 9,500 (p) 500 End. bal. 10,000 Patents Beg. bal. 40,000 (j) 5,000 End. bal. 35,000 Accumulated Depreciation— Machinery and Equipment
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... $ 36,300 Adjustments:
Depreciation expense... 20,900 Amortization of patents... 5,000 Gain on sale of investments... (6,500) Decrease in accounts receivable... 10,500 Decrease in inventories... 1,500 Increase in prepaid operating expenses... (4,500) Decrease in accounts payable... (6,700) Increase in income taxes payable... 500
Net cash provided by operating activities... $57,000
Cash flows from investing activities:
Involuntary conversion of building... $ 10,000 Construction of building... (105,000) Sale of long-term investments... 102,500 Purchase of land... (68,500) Purchase of machinery and equipment... (12,000) Purchase of available-for-sale securities... (2,000)
Net cash used in investing activities... (75,000)
Cash flows from financing activities:
Issuance of bonds... $ 30,000 Payment of cash dividends... (20,700)
Net cash provided by financing activities... 9,300
Net decrease in cash and cash equivalents... $ (8,700)
Cash and cash equivalents at beginning of year... 55,000
Cash and cash equivalents at end of year... $46,300
Supplemental Disclosure: Cash payments for:
Interest... $ 3,600 Income taxes... 23,500 Noncash transaction:
Land acquired by issuing common stock... 40,000
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%.
Income tax expense (reported in the income statement)... $24,000 Deduct increase in income taxes payable... (500) Amount of cash paid for income taxes... $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 T-account 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 straightfor-ward. 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: oper-ating, 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 help-ful 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 bal-ance sheet and the income statement, the statement of cash flows is one of the three pri-mary 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 posi-tion.
Western Resources, Inc.
Work Sheet for Statement of Cash Flows—Indirect Method For the Year Ended December 31, 2002
Balance Adjustments Balance
Dec. 31, Dec. 31,
Accounts 2001 Debit Credit 2002
Debits
Cash and Cash Equivalents... 55,000 (r) 8,700 46,300
Available-for-Sale Securities... 10,000 (q) 2,000 12,000
Accounts Receivable... 70,500 (l) 10,500 60,000
Inventories... 76,500 (m) 1,500 75,000
Prepaid Operating Expenses... 12,000 (n) 4,500 16,500
Investments ... 106,000 (e) 96,000 10,000
Land... 75,000 (f) 68,500
(g) 40,000 183,500
Buildings... 225,000 (d) 105,000 (c) 40,000 290,000
Machinery and Equipment... 120,000 (h) 12,000 132,000
Patents... 40,000 (j) 5,000 35,000
790,000 860,300
Credits
Accumulated Depreciation—Buildings... 155,000 (c) 30,000 (i) 5,600 130,600
Accumulated Depreciation—Machinery and Equipment... 43,500 (i) 15,300 58,800
Accounts Payable... 97,700 (o) 6,700 91,000
Income Taxes Payable... 9,500 (p) 500 10,000
Dividends Payable... –0– (b) 4,400 4,400
Bonds Payable... –0– (k) 30,000 30,000
Common Stock... 250,000 (g) 40,000 290,000
Retained Earnings... 234,300 (b) 25,100 (a) 36,300 245,500
790,000 293,800 293,800 860,300
Cash flows from operating activities:
Net income... (a) 36,300
Adjustments:
Depreciation expense... (i) 20,900
Amortization of patents... (j) 5,000
Gain on sale of investments... (e) 6,500
Decrease in accounts receivable... (l) 10,500
Decrease in inventories... (m) 1,500
Increase in prepaid operating expenses... (n) 4,500
Decrease in accounts payable... (o) 6,700
Increase in income taxes payable... (p) 500
Cash flows from investing activities:
Involuntary conversion of building... (c) 10,000
Construction of building... (d) 105,000
Sale of long-term investments... (e) 102,500
Purchase of land... (f) 68,500
Purchase of machinery and equipment... (h) 12,000
Purchase of available-for-sale securities... (q) 2,000
Cash flows from financing activities:
Issuance of bonds... (k) 30,000
Payment of cash dividends... (b) 20,700
217,200 225,900
Net decrease in cash... (r) 8,700
