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www.downloadslide.net Chapter 15 The Statement of Cash Flows BUSINESS INSIGHT Deliga Corporation Deliga Corporation is a distributor of accessories for cell phones, iPods, iPhones, and other small electronic devices. Deliga’s managers have just finished preparing the company’s financial statements for 2015. Although they are satisfied with net sales for the year—$825,000— they are concerned because cash flows from operating activities are less than net income ($58,300 vs. $82,200) and because cash and cash equivalents decreased by $8,000 during the year. The company has recently been having difficulty paying its bills on time. Strong cash flows are critical to achieving and maintaining liquidity. If cash flows exceed the amount a company needs for operations and expansion, it will not have to borrow additional funds. It can use excess cash to reduce debt, thereby lowering its debt to equity ratio and improving its financial position. That, in turn, can increase the market value of its stock. Deliga’s statement of cash flows provides the company’s managers, as well as its stockholders and potential investors, with information that is essential to evaluating the strength of the company’s cash flows and liquidity. LEARNING OBJECTIVES Describe the principal purposes and concepts underlying the statement of cash flows, and identify its components and format. Use the indirect method to determine cash flows from operating activities. Determine cash flows from investing activities. Determine cash flows from financing activities. Analyze the statement of cash flows. 1. Concept ▶ How do relevance and classification apply to the statement of cash flows? 2. Accounting Application ▶ How is the statement of cash flows prepared using the indirect method? Robert Kneschke/Shutterstock.com 3. Business Application ▶ What measures may be used to explain the apparent cause of Deliga’s operating cash flow problem and the decline in its cash and cash equivalents? Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. www.downloadslide.net 602 Chapter 15: The Statement of Cash Flows Section 1 concepts Concepts ■■ Relevance ■■ Classification ■■ Disclosure Concepts Underlying the Statement of Cash Flows Cash flows enable a company to pay expenses, debts, employees’ wages, and taxes and to invest in the assets it needs for its operations. Without sufficient cash flows, a company cannot grow and prosper. Because of the importance of cash flows, one must be alert to the possibility that items may be incorrectly classified in a statement of cash flows and that the statement may not fully disclose all pertinent information. This chapter identifies the classifications used in a statement of cash flows and explains how to analyze the statement. The statement of cash flows shows how a company’s operating, investing, and financing activities have affected cash during a period. It explains the net increase (or decrease) in cash during the period. For purposes of this statement, cash is defined as including both cash and cash equivalents. Cash equivalents are investments that can be quickly converted to cash. They have a maturity of 90 days or less when they are purchased, and they include the following: Relevant Learning Objective Describe the principal purposes and concepts underlying the statement of cash flows, and identify its components and format. ■■ ■■ ■■ Money market accounts Commercial paper (short-term corporate notes) U.S. Treasury bills A company invests in cash equivalents to earn interest on cash that would otherwise be temporarily idle. Suppose, for example, that a company has $1,000,000 that it will not need for 30 days. To earn a return on this amount, the company could place the cash in an account that earns interest (such as a money market account), lend the cash to another corporation by purchasing that corporation’s short-term notes (commercial paper), or purchase a short-term obligation of the U.S. government (a Treasury bill). Cash equivalents should not be confused with short-term investments, also called marketable securities. Marketable securities have a maturity of more than 90 days but are intended to be held only until cash is needed for current operations. Purchases of marketable securities are treated as cash outflows, and sales of marketable securities are treated as cash inflows. Conversely, transfers between the Cash account and cash equivalents are not treated as cash inflows or cash outflows. Relevance of the Statement of Cash Flows The statement of cash flows provides information about a company’s cash receipts and cash payments during a period, as well as about a company’s operating, investing, and financing activities. Some information about those activities may be inferred from other financial statements, but the statement of cash flows summarizes all transactions that affect cash. Despite the importance of the statement of cash flows in assessing the liquidity of companies in the United States, there has been considerable variation in its use and format in other countries. For example, in many countries, the statement shows the change in working capital rather than the change in cash and cash equivalents. Although the European Union’s principal directives for financial reporting do not address the statement of cash flows, international accounting standards require it, and international financial markets expect it to be presented. As a result, most multinational companies include the statement in their financial reports. Most European countries adopted the statement of cash flows when the European Union adopted international accounting standards. Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. © Cengage Learning 2014 © loops7 / iStockphoto.com How Universal Is the Statement of Cash Flows? www.downloadslide.net Concepts Underlying the Statement of Cash Flows 603 The information provided by the statement of cash flows is relevant to management in operating the business, as well as to investors and creditors in making investment and lending decisions. Management uses the statement of cash flows to: ■■ ■■ ■■ assess liquidity (e.g., to determine whether short-term financing is needed to pay current liabilities). determine dividend policy. evaluate the effects of major policy decisions involving investments and financing needs. Investors and creditors use the statement of cash flows to assess a company’s ability to: ■■ ■■ ■■ ■■ ■■ manage cash flows. generate positive future cash flows. pay its liabilities. pay dividends and interest. anticipate the need for additional financing. Classification of Cash Flows Amazon.com is the largest online retailer in the world and one of the 500 largest companies in the United States. Exhibit 1 shows the company’s consolidated statements of cash flows for 2011, 2010, and 2009. As you can see, this statement has three major classifications: operating, investing, and financing activities. The classifications of operating, investing, and financing activities are illustrated in Exhibit 2 and summarized next. Operating Activities The first section of the statement of cash flows is cash flow from operating activities. Operating activities involve the cash inflows and outflows from activities that enter into the determination of net income. Cash inflows in this category include cash receipts from the sale of goods and services and from the sale of trading securities. ­Trading securities are a type of marketable security that a company buys and sells for making a profit in the near term as opposed to holding them indefinitely for investment purposes. Cash inflows from operating activities also include interest received on loans and dividends received on investments. Cash outflows from operating activities include cash payments for wages, inventory, expenses, interest, taxes, and the purchase of trading securities. Investing Activities The second section of the statement of cash flows is cash flows from investing activities. Investing activities involve the acquisition and sale of property, plant, and equipment and other long-term assets, including long-term investments. They also involve the acquisition and sale of short-term marketable securities, other than trading securities, and the making and collecting of loans. Cash flows provided by investing activities include the cash received from selling marketable securities and long-term assets and from collecting on loans. Cash flows used by investing activities include the cash expended on purchasing these securities and assets and the cash lent to borrowers. Cash outflows for property, plant, and equipment, or capital expenditures, are usually shown separately from cash inflows from sales of these assets, as they are in Amazon.com’s statement in Exhibit 1. However, when the inflows are not material, some companies combine these two lines to show the net amount of outflow. Study Note: Operating activities involve the day-to-day sale of goods and services, investing activities involve long-term assets and investments, and financing activities deal with stockholders’ equity accounts and debt (borrowing). Financing Activities The third section of the statement of cash flows is cash flows from financing activities. Financing activities involve obtaining resources from stockholders and creditors. Cash inflows include the proceeds from stock issues and from short- and long-term borrowing. Cash outflows include the repayments of loans (excluding interest) and payments to owners, including cash dividends. Treasury stock transactions are also considered financing activities. Repayments of accounts payable or accrued liabilities are not considered repayments of loans. They are classified as cash outflows under operating activities. Cash Balances A reconciliation of the beginning and ending balances of cash appears at the bottom of the statement. These cash balances will tie into the cash balances on the balance sheet. Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. www.downloadslide.net 604 Chapter 15: The Statement of Cash Flows Exhibit 1 Consolidated Statement of Cash Flows Amazon.com, Inc. Consolidated Statements of Cash Flows (In millions) Operating Activities: Net income Adjustments to reconcile net income to net cash from operating activities: Depreciation and amortization Stock-based compensation Other operating expense (income), net Losses (gains) on sales of marketable securities, net Other expense (income), net Deferred income taxes Excess tax benefits from stock-based compensation Changes in operating assets and liabilities: Inventories Accounts receivable, net and other Accounts payable Accrued expenses and other Additions to unearned revenue Amortization of previously unearned revenue Net cash provided by operating activities Investing Activities: Purchases of fixed assets, including internal-use software and website development Acquisitions, net of cash received and other Sales and maturities of marketable securities and other investments Purchases of marketable securities and other investments Net cash provided by (used in) investing activities Financing Activities: Excess tax benefits from exercises of stock options Common stock repurchased (treasury stock) Proceeds from long-term debt and other Repayments of long-term debt and capital lease obligations Net cash provided by (used in) financing activities Foreign-currency effect on cash and cash equivalents Net (decrease) increase in cash and cash equivalents Cash and cash equivalents, beginning of year Cash and cash equivalents, end of year 2011 2010 2009 $   631 $ 1,152 $   902 1,083 557 154 (4) (56) 136 (62) 568 424 106 (2) (79) 4 (259) 378 341 103 (4) (15) 81 (105) (1,777) (866) 2,997 1,067 1,064 (1,021) $ 3,903 (1,019) (295) 2,373 740 687 (905) $ 3,495 (531) (481) 1,859 300 1,054 (589) $ 3,293 (1,811) (705) 6,843 (6,257) $ (1,930) (979) (352) 4,250 (6,279) $(3,360) (373) (40) 1,966 (3,890) $(2,337) 62 (277) 177 (444) $    (482) 1 $ 1,492 3,777 $ 5,269 259 — 143 (221) $ 181 17 $ 333 3,444 $ 3,777 105 — 87 (472) $   (280) (1) $   675 2,769 $   3,444 Source: Amazon.com, Inc., Annual Report, 2011 (adapted). Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. © Cengage Learning 2014 For the Years Ended www.downloadslide.net 605 Concepts Underlying the Statement of Cash Flows Exhibit 2 Cash Inflows Activities Classification of Cash Inflows and Cash Outflows Cash Outflows To pay wages From sale of goods and services to customers From receipt of interest or dividends on loans or investments To purchase inventory Operating Activities From sale of marketable securities (trading) To pay expenses To pay interest To pay taxes To purchase marketable securities (trading) From sale of property, plant, and equipment and other long-term assests From sale of short-term marketable securities (except trading) and long-term investments To purchase property, plant, and equipment and other long-term assets Investing Activities To make loans © Cengage Learning 2014 From collection of loans From sale of preferred or common stock To purchase short-term marketable securities (except trading) and long-term investments To reacquire preferred or common stock Financing Activities To repay debt From issuance of debt To pay dividends Required Disclosure of Noncash Investing and Financing Transactions Companies occasionally engage in significant noncash investing and financing transactions. These transactions involve only long-term assets, long-term liabilities, or stockholders’ equity. For instance, a company might exchange a long-term asset for a longterm liability, settle a debt by issuing capital stock, or take out a long-term mortgage to purchase real estate. Although noncash transactions represent significant investing and financing activities, they are not reflected in the body of the statement of cash flows because they do not affect current cash inflows or outflows. They will, however, affect future cash flows. For this reason, they must be disclosed in a separate schedule, usually following the statement of cash flows. Alternate Presentations of Operating Activities There are two ways of presenting operating activities on the statement of cash flows. ■■ The direct method converts each item on the income statement from the accrual basis to the cash basis. The operating activities section of the statement of cash flows under the direct method follows in simplified format. Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. www.downloadslide.net 606 Chapter 15: The Statement of Cash Flows Cash Flows from Operating Activities Cash receipts from: Sales xxx Interest xxx Less cash payments for: Purchases xxx Operating expenses xxx xxx Interest payments Income taxes xxx Cash flows from operating activities ■■ xxx xxx The direct and indirect methods always produce the same amount of cash flows from operating activities. The direct method presentation of operating cash flows is more straightforward than that of the indirect method, but it is more difficult to implement in practice. Few accounting systems provide the data easily to make the calculations necessary for the direct method. Further, when the direct method is presented, preparation and disclosure of the indirect method of presenting cash flows from operating activities is also required. Analysts prefer the indirect method to the direct method because it begins with net income and derives cash flows from operations. Analysts can readily identify the factors that cause cash flows from operations to differ from net income. Companies prefer the indirect method because it is easier and less expensive to prepare. As a result, the indirect method is the overwhelming choice of most companies and accountants. A survey of large companies shows that 98 percent use this method.1 The Direct Method May Become More Important Under IFRS In the interest of converging U.S. GAAP with international financial reporting standards (IFRS), the IASB is promoting the use of the direct method, even though it is more costly for companies to prepare. IFRS will continue to require a reconciliation of net income and net cash flows from operating activities similar to what is now done in the indirect method. CVS’s statement of cash flows, as shown in the Supplement to Chapter 16, is one of the few U.S. companies to use the direct method with a reconciliation. Thus, its approach is very similar to what all companies may do if the U.S. adopts IFRS. Mango Corporation engaged in the transactions that follow. Identify each transaction as (a) an operating activity, (b) an investing activity, (c) a financing activity, (d) a noncash transaction, or (e) not on the statement of cash flows. 1. Purchased office equipment, a long-term investment. 2. Decreased accounts receivable. 3. Sold land at cost. 4. Issued long-term bonds for plant assets. 5. Increased inventory. 6. Issued common stock. 7. Repurchased common stock. 8. Issued notes payable. 9. Increased income taxes payable. 10. Purchased a 60-day Treasury bill. 11. Purchased a long-term investment. 12. Declared and paid a cash dividend. SOLUTION 1. b; 2. a; 3. b; 4. d; 5. a; 6. c; 7. c; 8. c; 9. a; 10. e (cash equivalent); 11. b; 12. c Try It! SE1, SE6, E1A, E1B Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. © Cengage Learning 2014 © loops7 / iStockphoto.com xxx xxx The indirect method does not require the conversion of each item on the income statement. It lists only the items necessary to convert net income to cash flows from operations in the following format: Cash Flows from Operating Activities Net income Adjustments to reconcile net income to net cash flows from operating activities: xxx Plus non-cash expenses Plus or minus changes in current assets and current liabilities xxx Cash flows from operating activities Study Note: The direct and indirect methods relate only to the operating activities section of the statement of cash flows. They are both acceptable for financial reporting purposes. xxx www.downloadslide.net 607 Step One: Determining Cash Flows from Operating Activities Section 2 Accounting Applications Accounting Applications ■■ Determining cash flows from operating activities using the indirect method ■■ Determining cash flows from investing activities ■■ Determining cash flows from financing activities Step One: Determining Cash Flows from Operating Activities As shown in Exhibit 3, preparing a statement of cash flows involves four steps: ■■ ■■ ■■ Determine cash flows from operating activities. Determine cash flows from investing activities. Determine cash flows from financing activities. Prepare the statement of cash flows. Exhibit 3 Preparation of the Statement of Cash Flows Step 1 © Cengage Learning 2014 Determine cash flows from investing activities. 1: 2: 3: 4: In this section, we begin with determining cash flows from operating activities. Relevant Learning Objectives Use the indirect method to determine cash flows from operating activities. Step Step Step Step ■■ Determine Cash Flows from Operating Activities Step 2 Determine Cash Flows from Investing Activities Step 3 Determine Cash Flows from Financing Activities Step 4 Prepare the Statement of Cash Flows General Journal Date 2010 July FIRST BANK 3 Description Prepaid rent Post. Ref. Debit 411 3,200 General Ledger Credit 4,800 Income Summary TITLE DEED Date 2010 July Item 31 Closing 31Cash Closing Account No. 314 Balance Post. Debit Debit Credit Ref. Miller Design Studio, Inc. Credit J4 J4 Post-Closing Trial Balance July 31, 2010 4,800 3,210 Accounts Receivable Office Supplies Prepaid Rent Office Equipment Accumulated Depreciation —Office Equipment Accounts Payable 4,800 1,590 $22,480 5,000 3,660 1,600 16,320 $ Determine cash flows from financing activities. 300 6,280 $49,060 $49,060 To demonstrate the preparation of the statement of cash flows, we will use data for Eureka Corporation. Eureka’s income statement for 2014 is presented in Exhibit 4, and its balance sheets for December 31, 2014 and 2013 appear in Exhibit 5. Exhibit 5 also shows the balance sheet accounts that we use for analysis and whether the change in each account is an increase or a decrease. Exhibit 4 Income Statement © Cengage Learning 2014 Eureka Corporation Income Statement For the Year Ended December 31, 2014 Sales Cost of goods sold Gross margin Operating expenses (including depreciation expense of $37,000) Operating income Other income (expenses): Interest expense Interest income Gain on sale of investments Loss on sale of plant assets Income before income taxes Income taxes expense Net income $698,000 520,000 $178,000 147,000 $ 31,000 $(23,000) 6,000 12,000     (3,000)    (8,000) $ 23,000 7,000 $ 16,000 Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. www.downloadslide.net 608 Chapter 15: The Statement of Cash Flows Exhibit 5 Comparative Balance Sheets Showing Changes in Accounts Eureka Corporation Comparative Balance Sheets December 31, 2014 and 2013 Increase or Decrease 2014 2013 Change $ 47,000 47,000 144,000    1,000 $ 239,000 $ 115,000 $ 715,000   (103,000) $ 612,000 $ 966,000 $ 15,000 55,000 110,000    5,000 $185,000 $127,000 $505,000   (68,000) $437,000 $749,000 $ 32,000 (8,000) 34,000    (4,000) $ 54,000 $  (12,000) $210,000   (35,000) $175,000 $217,000 Increase Decrease Increase Decrease $ 50,000 12,000   3,000 $ 65,000 $ 43,000 9,000    5,000 $ 57,000 $  7,000 3,000    (2,000) $  8,000 Increase Increase Decrease 295,000 $ 360,000 245,000 $302,000 50,000 $ 58,000 Increase $ 276,000 214,000 141,000 (25,000) $ 606,000 $ 966,000 $200,000 115,000 132,000         0 $447,000 $749,000 $ 76,000 99,000 9,000   (25,000) $159,000 $217,000 Increase Increase Increase Increase Assets Current assets: Cash Accounts receivable (net) Inventory Prepaid expenses Total current assets Investments Plant assets Less accumulated depreciation Total plant assets Total assets Decrease Increase Increase Liabilities Current liabilities: Accounts payable Accrued liabilities Income taxes payable Total current liabilities Long-term liabilities: Bonds payable Total liabilities The income statement indicates how successful a company has been in earning an income from its operating activities. However, because that statement is prepared on an accrual basis, it does not reflect the inflow and outflow of cash related to operating activities. Revenues are recorded even though the company may not yet have received the cash, and expenses are recorded even though the company may not yet have expended the cash. Thus, to ascertain cash flows from operations in step 1 in preparing the statement of cash flows, the figures on the income statement must be converted from an accrual basis to a cash basis. As Exhibit 6 shows, the indirect method focuses on adjusting items on the income statement to reconcile net income to net cash flows from operating activities. These items include the following: ■■ ■■ ■■ Depreciation, amortization, and depletion Gains and losses Changes in the balances of current asset and current liability accounts. Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. © Cengage Learning 2014 Stockholders’ Equity Common stock, $5 par value Additional paid-in capital Retained earnings Treasury stock Total stockholders’ equity Total liabilities and stockholders’ equity www.downloadslide.net 609 Step One: Determining Cash Flows from Operating Activities © Cengage Learning 2014 Exhibit 6 Indirect Method of Determining Net Cash Flows from Operating Activities Accrual Basis of Accounting Earned Revenues Net Income Incurred Expenses Cash Basis of Accounting Net Cash Flows from Operating Activities Adjustments to Reconcile Net Income to Net Cash Flows from Operating Activities These adjusting items can be seen in the schedule in Exhibit 7, which shows the reconciliation of Eureka’s net income to net cash flows from operating activities. Each adjusting item requires a different type of analysis as illustrated in the sections that follow. Exhibit 7 © Cengage Learning 2014 Schedule of Cash Flows from Operating Activities: Indirect Method Eureka Corporation Schedule of Cash Flows from Operating Activities For the Year Ended December 31, 2014 Cash flows from operating activities: Net income Adjustments to reconcile net income to net cash flows from operating activities: Depreciation $  37,000 Gain on sale of investments (12,000) Loss on sale of plant assets 3,000 Changes in current assets and current liabilities: Decrease in accounts receivable 8,000 Increase in inventory (34,000) Decrease in prepaid expenses 4,000 Increase in accounts payable 7,000 Increase in accrued liabilities 3,000 Decrease in income taxes payable      (2,000) Net cash flows from operating activities $16,000 14,000 $30,000 Depreciation, Amortization, and Depletion Study Note: Operating expenses on the income statement include depreciation expense, which does not require a cash outlay. Although the cash payments made for plant assets, intangible assets, and natural resources appear in the investing activities section of the statement of cash flows, the depreciation expense, amortization expense, and depletion expense associated with these assets appear in the operating activities section. The amount of these expenses can usually be found in the income statement or in a note to the financial statements. Depreciation Financial Statement Information Eureka’s income statement (Exhibit 4) shows $37,000 of depreciation expense. Journal Entry   A  5  L  1  SE 237,000         237,000 Depreciation Expense Accumulated Depreciation To record annual depreciation on plant assets Dr. 37,000 Cr. 37,000 Cash Flow Analysis Depreciation $37,000 Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. www.downloadslide.net 610 Chapter 15: The Statement of Cash Flows When depreciation expense is recorded, the Cash account is not affected. Thus, net income needs to be adjusted upward by the amount of depreciation, or $37,000, because depreciation expense involves no current outlay of cash even though it appears on the income statement. Amortization and depletion expenses are handled in exactly the same way as depreciation expense. Gains and Losses Study Note: Gains and losses by themselves do not represent cash flows; they are merely bookkeeping adjustments. For example, when a long-term asset is sold, the proceeds (cash received), not the gain or loss, constitute cash flow. Like depreciation expense, gains and losses that appear on the income statement do not affect cash flows from operating activities and need to be subtracted from or added to net income. The actual cash flows from these transactions are reflected in the investing and financing activities sections of the statement of cash flows. Gain—Sale of Investments Financial Statement Information Eureka’s income statement (Exhibit 4) shows a $12,000 gain on the sale of investments. Cash Flow Analysis Gain on sale of investments ($12,000) This amount is subtracted from net income to reconcile net income to net cash flows from operating activities. The reason for doing this is that the $12,000 is included in the investing activities section of the statement of cash flows as part of the cash from the sale of the investment. Because the gain has already been included in the calculation of net income, the $12,000 gain must be subtracted to prevent double counting. Loss—Sale of Plant Assets Financial Statement Information Eureka’s income statement shows a $3,000 loss on the sale of plant assets. Cash Flow Analysis Loss on sale of plant assets $3,000 As was the case with depreciation expense, a loss on the sale of assets is added to net income to reconcile net income to net cash flows from operating activities. The cash received associated with the transaction that resulted in this loss is reflected in the investing activities section of the statement of cash flows. Changes in Current Assets As explained in this section and the next, changes in current assets and current liabilities require a different approach to reconcile net income to cash flows from operating activities. Decreases in current assets other than cash have positive effects on cash flows, and increases in current assets have negative effects on cash flows: ▼ A decrease in a current asset frees up invested cash, thereby increasing cash flow. ▲ An increase in a current asset consumes cash, thereby decreasing cash flow. Decrease in Current Assets—Accounts Receivable Financial Statement Information Eureka’s balance sheet (Exhibit 5) shows an $8,000 decrease in accounts receivable. We can conclude that collections were $8,000 more than sales recorded for the year. Cash Flow Analysis Decrease in account receivable $8,000 Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.