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More free books @ www.BingEbook.com Chapter 8: Reporting Cash Flows and Changes in Owners’ Equity Today, businesses use computers in their accounting systems, as you know. It’s conceivable that a company could design its data entry procedures and computer programs such that at the end of the year the computer would spit out exactly the information needed to prepare the statement of cash flows. Evidently this is not done by many businesses. In most businesses this financial statement is assembled the old fashion way — the accountant sits down and organizes the information pretty much by hand. The information can be put into a spreadsheet program to do the tedious computations and groupings. Reporting Cash Flows Regardless of how the accountant goes about organizing the information needed to prepare it, the statement of cash flows is fundamentally the same for every business. Figure 8-4 presents the business’s statement of cash flows for 2007. The format of this financial statement is in accordance with the official standard governing reporting cash flows. Figure 8-4 presents cash flows for only one year, but most public companies present a two- or three-year comparative statement of cash flows. Their financial reporting practices are heavily influenced by the requirements of the Securities and Exchange Commission (SEC). (Financial reports of private businesses aren’t in the public domain, so it’s hard to generalize about their reporting practices in this respect.) Statement of Cash Flows for 2007 Cash Flow from Operating Activities Net Income $405,000 Accounts receivable increase ($35,000) Inventory increase ($45,000) Prepaid expenses increase ($15,000) Depreciation expense $191,000 Accounts payable increase $35,000 Accrued expenses payable increase $40,000 $576,000 Cash Flow from Investing Activities ($425,000) Capital expenditures Cash Flow from Financing Activities Short-term notes payable increase $125,000 Long-term notes payable increase $125,000 Issue of capital stock Cash dividends to shareowners Figure 8-4: Statement of cash Increase in cash during year flows for the Beginning cash balance business. Ending cash balance $50,000 ($250,000) $50,000 $201,000 $700,000 $901,000 167 More free books @ www.BingEbook.com 168 Part II: Preparing Financial Statements In the statement of cash flows, transactions are grouped into three types (see Figure 8-4): ⻬ Operating activities: The section reports the determinants of the cash increase or decrease attributable to the profit-making operations of the business during the period, and the final amount of cash flow from operating activities for the period — a positive $576,000 in the example. ⻬ Investing activities: This section includes expenditures for long-term operating assets and proceeds from the disposal of these assets (if any), and the net cash increase or decrease from these activities for the period — a negative $425,000 in the example. . ⻬ Financing activities: This section includes the cash flows from borrowing and paying debt, owners investing capital in the business and return of capital to them, and cash dividends to owners, and the net cash increase or decrease from these activities for the period — a positive $50,000 in the example. The “bottom line” of the statement is the net cash increase or decrease from the three types of activities reported in the statement — a positive $201,000 in the example. As you see in Figure 8-4, this $201,000 increase is not the bottom line in the literal sense, because the beginning cash balance is added to the net cash increase during the year to arrive at the ending balance of cash. The $201,000 increase in cash during the year is the bottom line in the sense that the three main types of activities caused cash to increase this amount during the year. Financial statement readers definitely want to know whether the company’s cash balance increased or decreased during the year, and they want to know the principal reasons for the increase or decrease. These are the reasons for reporting the statement of cash flows. Many investment analysts and financial reporters — who should know better — take an unadvisable shortcut to calculate a number they call cash flow from profit: Depreciation is added to net income to produce cash flow from profit. However, it’s misleading to single out depreciation as if it were the only factor that affects cash flow from profit. Depreciation expense should be put in the broader context of all the asset and liability changes that affect cash flow from profit. This is exactly the purpose of the first section of the statement of cash flows that reports the cash flow from operating activities (see Figure 8-4). Depreciation often is the largest factor for the difference between cash flow and net income, as it is in the example shown in Figure 8-4. But changes in other assets and liabilities also affect cash flow from profit. In some situations, these other changes overwhelm depreciation and are the main reasons for the difference between cash flow and profit. For instance, a business may lease all its fixed assets and have no depreciation expense. A business needs to generate sufficient cash flow from profit to pay cash dividends to shareowners. In Figure 8-4, the business generated $576,000 cash flow from profit for the year and it paid out $250,000 cash dividends to its stockholders. This comparison is one of many the reader of the statement of cash flows can make to judge the cash flow policies and decisions of the business. Given that the business needed $425,000 for investments in fixed assets during the year, should it have paid out such a large portion of its cash flow from profit? This is just one of many important issues that creditors and shareowners should ponder in reading a statement of cash flows. Connecting Balance Sheet Changes with Cash Flows As I have said more than once in this book, the three primary financial statements of a business are intertwined and interdependent. The numbers in the statement of cash flows are More free books @ www.BingEbook.com Chapter 8: Reporting Cash Flows and Changes in Owners’ Equity derived from the changes in the business’s balance sheet accounts during the year. Changes in the balance sheet accounts drive the amounts reported in the statement of cash flows. The lines of connection between changes in the business’s balance sheet accounts during the year and the information reported in the statement of cash flows are shown in Figure 8-5. Note that the $155,000 net increase in retained earnings is separated between the $405,000 net income for the year and the $250,000 cash dividends for the year: ($405,000 net income – $250,000 dividends = $155,000 net increase in retained earnings). Balance Sheets Changes from Year-End 2006 to Year-End 2007 Assets Cash Cash Flow from Operating Activities $201,000 Net Income $405,000 Accounts Receivable $35,000 Accounts receivable increase ($35,000) Inventory $45,000 Inventory increase ($45,000) Prepaid Expenses $15,000 Prepaid expenses increase ($15,000) Depreciation expense $191,000 Property, Plant, & Equipment Accumulated Depreciation $425,000 ($191,000) Accounts payable increase $35,000 Accrued expenses payable increase $40,000 $576,000 Cash Flow from Investing Activities Liabilities & Owners’ Equity Accounts Payable $35,000 Accrued Expenses Payable $40,000 Short-term Notes Payable $125,000 Figure 8-5: Connections between the Long-term Notes Payable balance sheet Owners’ Equity: changes Capital Stock and the Retained Earnings statement of cash flows. $125,000 Capital expenditures Cash Flow from Financing Activities Short-term notes payable increase $125,000 Long-term notes payable increase $125,000 Issue of capital stock Cash dividends to shareowners $50,000 $155,000 ($425,000) $50,000 ($250,000) $50,000 Increase in cash during year $201,000 Beginning cash balance $700,000 Ending cash balance $901,000 Balance sheet account changes, such as those shown in Figure 8-5, are the basic building blocks for preparing a statement of cash flows. These changes in assets, liabilities, and owners’ equity accounts are the amounts reported in the statement of cash flows (as shown in Figure 8-5), or the changes are used to determine the cash flow amounts (as in the case of the change in retained earnings, which is separated into its net income component and its dividends component). Note in the cash flow from operating activities section in Figure 8-5 that net income is listed first, then several adjustments are made to net income to determine the amount of cash flow from operating activities. The assets and liabilities included in this section are those that are part and parcel of the profit-making activity of a business. For example, the accounts receivable asset is increased (debited) when sales are made on credit. The inventory asset account is decreased (credited) when recording cost of goods sold expense. The accounts payable account is increased (credited) when recording expenses that haven’t been paid. And so on. 169 More free books @ www.BingEbook.com 170 Part II: Preparing Financial Statements The rules for cash flow adjustments to net income are: ⻬ An asset increase during the period decreases cash flow from profit ⻬ A liability decrease during the period decreases cash flow from profit ⻬ An asset decrease during the period increases cash flow from profit ⻬ A liability increase during the period increases cash flow from profit Following the third listed rule, the $191,000 depreciation expense for the year is a positive adjustment, or add-back to net income — see Figure 8-4. Recording depreciation expense reduces the book value of the fixed assets being depreciated. Well, to be more precise, recording depreciation increases the balance of the accumulated depreciation contra account that is deducted from the original cost of fixed assets. Recording depreciation does not involve a cash outlay. The cash outlay occurred when the business bought the assets being depreciated, which could be years ago. This format of the cash flow from operating activities section shown in Figure 8-4 is referred to as the indirect method (a rather technical term). The large majority of public businesses use this method to report their cash flow from operating activities. However, the authoritative accounting standard on this matter permits an alternative method for reporting cash flow from operating activities, which is called the direct method (not that this term is any clearer than the other). Very few businesses elect this alternative format, and I do not explain it here. But you should know that a business has this option for reporting cash flow from operating activities. 10. The comparative balance sheet for a business (without its owners’ equity accounts) is presented in Figure 8-3. (Note that this is a different business example than the main example in the chapter.) The company didn’t issue additional capital stock shares during the year and didn’t pay cash dividends to its shareowners. Please refer to your answers to Questions 6 and 7. You need to know the net income of the business for the year, and you should use your answer to Question 7 as a check in answering this question. Prepare the company’s statement of cash flows for 2007. Solve It More free books @ www.BingEbook.com Chapter 8: Reporting Cash Flows and Changes in Owners’ Equity 11. The beginning and ending balances of certain accounts in a company’s balance sheet are as follows: Beginning Balance Ending Balance Changes ($35,000) Accounts Receivable $500,000 $465,000 Inventory $780,000 $860,000 $80,000 Prepaid Expenses $110,000 $105,000 ($5,000) Accounts Payable $350,000 $325,000 ($25,000) Accrued Expenses Payable $165,000 $175,000 $10,000 The business records $145,000 depreciation expense for the year and its net income is $258,000 for the year. Determine its cash flow from operating activities for the year. Present your answer in the indirect format for cash flow from operating activities in the statement of cash flows. Solve It 12. Referring to the scenario in Question 11, assume that the facts remain the same except that the business doesn’t record depreciation expense in the year. Instead, it leases all its fixed assets and pays rent. The rent expense for the year is $145,000. (Note that the rent expense is the same amount as depreciation expense in Question 11.) Determine its cash flow from operating activities for the year. Present your answer for reporting cash flow from operating activities according to the indirect format (as illustrated in Figure 8-4). Solve It 171 More free books @ www.BingEbook.com 172 Part II: Preparing Financial Statements Answers for Problems on Reporting Cash Flows and Changes in Owners’ Equity The following are the answers to the practice questions presented earlier in this chapter. a After you revise your net income answer (see the example question), the president tells you that he has since talked with other directors of the business and realized that he was wrong about the cash dividends. Now he’s fairly certain that $250,000 cash dividends were paid to shareowners during 2007 and that the business issued additional capital stock shares for $50,000. Based on this additional information, what amount of net income did the business earn in 2007? Net income is $405,000. The net effect on owners’ equity is the same as in the example question; the capital stock issue increases net worth $50,000 and the cash dividend decreases net worth $250,000. b A business reports $500,000 net loss for the year just ended. It didn’t issue or retire any capital stock shares during the year, and it didn’t pay cash dividends because of its loss in the year. Did its net worth decrease $500,000 during the year? Did its cash balance decrease $500,000 during the year because of its loss? Yes, net loss decreased net worth (owners’ equity) $500,000. There were no other transactions that affected owners’ equity during the year (no capital stock issue and no cash dividends). To determine whether its cash balance decreased $500,000 because of the business’s loss, you need to know the changes in the assets and liabilities of the business that are affected by its sales and expenses. You can’t answer this cash flow question without this information. If the business didn’t record any depreciation expense in the year, and if the balances of the various assets and liabilities affected by sales and expenses remained absolutely flat during the year, then and only then would the loss decrease cash $500,000 during the year. But this is a highly unlikely scenario for the business. c Can the net worth of a business go negative? If so, explain briefly how this may happen and if it means that the business would have a negative cash balance. Yes, the net worth of a business can go negative. A large enough loss in the year could wipe out all owners’ equity and more, or repeated losses year after year could drive owners’ equity into the negative column. Remember that a loss decreases the retained earnings balance of a business. The loss for the year or cumulative losses over time can push retained earnings into a large negative balance. The negative balance of retained earnings can become more than the balance in the owners’ equity invested capital account. In this case, owners’ equity would be negative. Regarding the second question, you have to put your finger on what a negative cash balance is. Usually, a negative cash balance refers to an overdrawn bank checking account balance in which the business has written checks for more than exists in its account. Banks don’t typically allow overdraws to happen and refuse to honor checks after the checking account balance is drawn down to zero. However, a bank may tolerate a temporary negative balance for a good customer, but a business with a negative owners’ equity hardly qualifies as a good customer. Generally speaking, the cash balance of a business can’t go below zero (or, it can’t go negative). d Please refer to Figure 8-1 that presents the comparative balance sheet of the business and to Figure 8-2 that presents its statement of changes in stockholders’ equity. Suppose the business had paid $175,000 cash dividends (instead of $250,000) to stockholders in 2007. In this scenario, which dollar amounts in the business’s comparative balance sheet would be different as the result of this one change? More free books @ www.BingEbook.com Chapter 8: Reporting Cash Flows and Changes in Owners’ Equity Just one relatively small difference, like the one in this problem, causes several changes in the balance sheet. In the following answer, the amounts that are different are shaded so that you can easily identify them. Balance Sheets at Year-ends 2006 and 2007 Assets 2006 2007 Cash $700,000 $976,000 $276,000 Accounts Receivable $500,000 $535,000 $35,000 Inventory $780,000 $825,000 $45,000 Prepaid Expenses $110,000 $125,000 $15,000 Current Assets $2,090,000 $2,461,000 Property, Plant, & Equipment $2,450,000 $2,875,000 $425,000 Accumulated Depreciation ($685,000) ($876,000) ($191,000) Cost Less Depreciation $1,765,000 $1,999,000 Total Assets $3,855,000 $4,460,000 Accounts Payable $350,000 $385,000 Accrued Expenses Payable $165,000 $205,000 $40,000 Short-term Notes Payable $500,000 $625,000 $125,000 Current Liabilities $1,015,000 $1,215,000 Long-term Notes Payable $1,000,000 $1,125,000 Changes Liabilities & Owners’ Equity $35,000 $125,000 Owners Equity: $750,000 $800,000 $50,000 Retained Earnings $1,090,000 $1,320,000 $230,000 Total Owners’ Equity $1,840,000 $2,120,000 $3,855,000 $4,460,000 Capital Stock Total Liabilities & Owners’ Equity e Suppose the business in the example (see Figure 8-2) did not issue additional shares of capital stock in 2007 and did not distribute dividends to its stockholders in either 2006 or 2007. In this scenario, is the statement of changes in stockholders’ equity needed? Should it be presented in the company’s 2007 annual financial report? Well, if the business did prepare and report this statement it would look as follows: Statement of Changes in Stockholders’ Equity Capital Stock Balance at end of 2005 $750,000 $922,000 $750,000 $1,240,000 $750,000 $1,645,000 Net Income - 2006 Balance at end of 2006 $318,000 Net Income - 2007 Balance at end of 2007 Retained Earnings $405,000 You can make a good case that there’s no need for presenting the statement of changes in stockholders’ equity in the company’s annual report because it contains so little information in addition to what’s already in the comparative balance sheet. The statement does report that net income is added to the retained earnings balance each year, but most financial statement readers should understand this point. On the other hand, one could argue that showing no dividends and no issue of capital stock either year sends a message that the company is conserving its cash and presumably has a need for the cash. On balance, therefore, most businesses would go ahead and report a statement of changes in stockholders’ equity. If a reader isn’t interested enough to read the statement, he or she can skip it. You never know; some business investors and creditors read every financial statement and every footnote, and these people expect to see the statement of changes in stockholders’ equity in the financial report. 173 More free books @ www.BingEbook.com 174 Part II: Preparing Financial Statements f Figure 8-3 presents a business’s comparative balance sheet that’s missing the information for owners’ equity. Assume that the company didn’t issue additional capital stock shares during the year and didn’t pay cash dividends to its shareowners during the year. Determine its net income for the year 2007. The company’s net income for 2007 is determined as follows: 2006 2007 Total Assets $2,046,000 $2,135,000 Current Liabilities ($800,000) ($745,000) Long-term Notes Payable ($400,000) ($525,000) $846,000 $865,000 Net Worth at Year-end ($846,000) Net Income for 2007 $19,000 The business didn’t issue capital stock and didn’t pay dividends during the year, so $19,000 is its net income. In other words, the increase in net worth consists entirely of the increase in retained earnings caused by net income for the year. You may think the net income in this scenario is a rather paltry amount, and you’d be right. Generally, a business expects to earn annual net income equal to 10 to 15 percent or more of its owners’ equity. Owners’ equity is the investment by the owners in the business, and the owners expect to earn a return on their investment. Based on the $846,000 balance of owners’ equity at the start of 2007, a 15 percent return on investment would require about $127,000 net income. The company had better improve its profit performance, or else. g From the information presented in Figure 8-3, determine the company’s cash flow from profit (operating activities) for 2007. Using the method of solving for the unknown factor you set up the problem as follows: Summary of Cash Flows For the Year Cash flow from operating activities ???? Cash flow from investing activities ($163,000) Cash flow from financing activities $75,000 Decrease in cash during the year ($31,000) Solving for the unknown factor, cash flow from profit is $57,000 for the year. In Figure 8-3, you can see that the company increased cash $75,000 from its notes payable transactions during the year ($125,000 increase in long-term notes payable – $50,000 pay down on short-term notes payable = $75,000 net increase). The business didn’t raise money by issuing capital stock during the year and didn’t pay cash dividends during the year. So the net cash increase from its financing activities is $75,000. It spent $163,000 on property, plant and equipment (see Figure 8-3). Therefore, cash flow from profit must have increased cash $57,000: ($57,000 cash increase from profit – $163,000 capital expenditures + $75,000 cash from financing activities = $31,000 decrease in cash during year). Did you follow all this? I hope so. Cash flow analysis isn’t for sissies, is it? More free books @ www.BingEbook.com Chapter 8: Reporting Cash Flows and Changes in Owners’ Equity h A company’s net worth decreased $425,000 during the year just ended. It didn’t pay cash dividends during the year, and it didn’t issue or retire capital stock during the year. Determine its profit or loss for the year. All the decrease in net worth in this scenario must be due to the loss for the year. So, the bottom-line is that the business suffered a $425,000 loss for the year. Does this loss mean that bankruptcy is just around the corner? A loss doesn’t necessarily mean that the business is out of cash and unable to pay its debts on time. The business could have plenty of cash to buy time enough to correct its problems and move into the black. Then again, if this is the tenth straight year of losses, the business may be hanging on by a thread and may have to declare bankruptcy. i A company’s net worth decreased $585,000 during the year just ended. It didn’t pay cash dividends during the year, but it issued additional capital stock shares during the year for $150,000. Determine its profit or loss for the year. The company’s net worth increased $150,000 from the issue of capital stock. If the business had experienced a break-even year (sales revenue - expenses = zero), its net worth would have increased $150,000. But, its net worth actually decreased $585,000 during the year. Therefore, the company must have reported a $735,000 loss for the year. j The comparative balance sheet for a business (without its owners’ equity accounts) is presented in Figure 8-3. (Note that this is a different business example than the main example in the chapter.) The company didn’t issue additional capital stock shares during the year and didn’t pay cash dividends to its shareowners. Please refer to your answers to Questions 6 and 7. You need to know the net income of the business for the year, and you should use your answer to Question 7 as a check in answering this question. Prepare the company’s statement of cash flows for 2007. Statement of Cash Flows for 2007 Cash Flow from Operating Activities Net Income Accounts receivable decrease Inventory increase Prepaid expenses increase Depreciation expense Accounts payable decrease Accrued expenses payable increase $19,000 $46,000 ($58,000) ($6,000) $61,000 ($16,000) $11,000 $57,000 Cash Flow from Investing Activities ($163,000) Capital expenditures Cash Flow from Financing Activities Short-term notes payable increase ($50,000) Long-term notes payable increase $125,000 $75,000 Decrease in cash during year ($31,000) Beginning cash balance $456,000 Ending cash balance $425,000 175 More free books @ www.BingEbook.com 176 Part II: Preparing Financial Statements k The beginning and ending balances of certain accounts in a company’s balance sheet are as follows: Beginning Balance Ending Balance Changes ($35,000) Accounts Receivable $500,000 $465,000 Inventory $780,000 $860,000 $80,000 Prepaid Expenses $110,000 $105,000 ($5,000) Accounts Payable $350,000 $325,000 ($25,000) Accrued Expenses Payable $165,000 $175,000 $10,000 The business records $145,000 depreciation expense for the year and its net income is $258,000 for the year. Determine its cash flow from operating activities for the year. Present your answer in the indirect format for cash flow from operating activities in the statement of cash flows. Net Income Accounts receivable decrease Inventory increase Prepaid expenses decrease l $258,000 $35,000 ($80,000) $5,000 Depreciation expense $145,000 Accounts payable decrease ($25,000) Accrued expenses payable increase $10,000 Cash Flow from Operating Activities $348,000 Referring to the scenario in Question 11, assume that the facts remain the same except that the business doesn’t record depreciation expense in the year. Instead, it leases all its fixed assets and pays rent. The rent expense for the year is $145,000. (Note that the rent expense is the same amount as depreciation expense in Question 11.) Determine its cash flow from operating activities for the year. Present your answer for reporting cash flow from operating activities according to the indirect format (as illustrated in Figure 8-4). Net Income Accounts receivable decrease Inventory increase $258,000 $35,000 ($80,000) Prepaid expenses decrease $5,000 Accounts payable decrease ($25,000) Accrued expenses payable increase $10,000 Cash Flow from Operating Activities $203,000 For added insight, compare this answer with the answer to Question 11. Cash flow from profit in this situation is $145,000 less than in the scenario for Question 11 because the business didn’t record depreciation expense. Instead, it paid $145,000 rent expense during the year.