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c12StatementofCashFlows.qxd 8/31/10 12:21 PM Page 622 12 chapter STATEMENT OF CASH FLOWS ✓ ● the navigator ● Scan Study Objectives ● Read Feature Story ● Scan Preview After studying this chapter, you should be able to: ● Read Text and Answer Do it! p. 627 p. 636 p. 640 1 Indicate the usefulness of the statement of cash flows. ● Work Using the Decision Toolkit ● Review Summary of Study Objectives 3 Explain the impact of the product life cycle on a company’s cash flows. ● Work Comprehensive Do it! p. 656 4 Prepare a statement of cash flows using the indirect method. ● Answer Self-Test Questions 5 Use the statement of cash flows to evaluate a company. ● Complete Assignments ● Go to WileyPLUS for practice and tutorials ● 622 Read A Look at IFRS p. 680 study objectives 2 Distinguish among operating, investing, and financing activities. c12StatementofCashFlows.qxd 8/31/10 12:21 PM Page 623 feature story In today’s environment, companies must be ready to should find new investment proj- respond to changes quickly in order to survive and ects that would bring higher returns, thrive. This requires that they manage their cash very or return some of the cash to stockholders. carefully. One company that managed cash success- Finally, Microsoft announced a plan to return cash fully in its early years was Microsoft. During those years, to stockholders, by paying a special one-time $32 bil- the company paid much of its payroll with stock op- lion dividend. This special dividend was so large that, tions (rights to purchase company stock in the future according to the U.S. Commerce Department, it at a given price) instead of cash. This strategy conserved cash and turned more than a thousand of its employees into millionaires during the company’s first 20 years G OT CAS H? of business. caused total personal income in the United States to rise by 3.7% in one month—the largest increase ever recorded by the agency. (It also made the holiday season brighter, especially for retailers in the Seattle area.) In recent years, Microsoft has had a different kind Microsoft also doubled its regular annual dividend to of cash problem. Now that it has reached a more $3.50 per share. Further, it announced that it would “mature” stage in life, it generates so much cash— spend another $30 billion buying treasury stock. In ad- roughly $1 billion per month—that it cannot always dition, Microsoft more recently offered to buy Yahoo figure out what to do with it. At one time, Microsoft for $44.6 billion (Yahoo declined the offer). Dividends, had accumulated $60 billion. stock buybacks, and acquisitions will help to deplete The company said it was accumulating cash to in- some of its massive cash horde, but as you will see in vest in new opportunities, buy other companies, and this chapter, for a cash-generating machine like Mi- pay off pending lawsuits. But for many years, the fed- crosoft, the company will be anything but cash-starved. eral government blocked attempts by Microsoft to Interestingly, in 2010 Google found itself in a buy anything other than small firms because it feared position similar to Microsoft’s. Its cash pile of $26.5 that purchase of a large firm would only increase billion was nearly 20% of the company’s value. That’s Microsoft’s monopolistic position. enough to pay a dividend of $80 per share. Unless it Microsoft’s stockholders have complained for can find large, worthwhile projects to invest in, Google years that holding all this cash was putting a drag on will also need to return a big chunk of its cash to the company’s profitability. Why? Because Microsoft shareholders. had the cash invested in very low-yielding government securities. Stockholders felt that the company either Source: “Business: An End to Growth? Microsoft’s Cash Bonanza,” The Economist (July 23, 2005), p. 61. INSIDE CHAPTER 12 . . . ● ● Net What ? (p. 626) Operating with Negative Cash (p. 629) 623 c12StatementofCashFlows.qxd 8/31/10 12:21 PM Page 624 preview of chapter 12 The balance sheet, income statement, and retained earnings statement do not always show the whole picture of the financial condition of a company or institution. In fact, looking at the financial statements of some well-known companies, a thoughtful investor might ask questions like these: How did Eastman Kodak finance cash dividends of $649 million in a year in which it earned only $17 million? How could United Airlines purchase new planes that cost $1.9 billion in a year in which it reported a net loss of over $2 billion? How did the companies that spent a combined fantastic $3.4 trillion on mergers and acquisitions in a recent year finance those deals? Answers to these and similar questions can be found in this chapter, which presents the statement of cash flows. The content and organization of this chapter are as follows. Statement of Cash Flows The Statement of Cash Flows: Usefulness and Format • • • • • • • Usefulness Classifications Significant noncash activities Format Corporate life cycle Preparation Indirect and direct methods Preparation of the Statement of Cash Flows—Indirect Method • Step 1: Operating activities • Step 2: Investing and financing activities • Step 3: Net change in cash Using Cash Flows to Evaluate a Company • Free cash flow • Assessing liquidity and solvency The Statement of Cash Flows: Usefulness and Format The balance sheet, income statement, and retained earnings statement provide only limited information about a company’s cash flows (cash receipts and cash payments). For example, comparative balance sheets show the increase in property, plant, and equipment during the year. But they do not show how the additions were financed or paid for. The income statement shows net income. But it does not indicate the amount of cash generated by operating activities. The retained earnings statement shows cash dividends declared but not the cash dividends paid during the year. None of these statements presents a detailed summary of where cash came from and how it was used. study objective 1 Indicate the usefulness of the statement of cash flows. USEFULNESS OF THE STATEMENT OF CASH FLOWS The statement of cash flows reports the cash receipts and cash payments from operating, investing, and financing activities during a period, in a format that reconciles the beginning and ending cash balances. The information in a statement of cash flows helps investors, creditors, and others assess: 1. The entity’s ability to generate future cash flows. By examining relationships between items in the statement of cash flows, investors make predictions of the amounts, timing, and uncertainty of future cash flows better than they can from accrual-basis data. 2. The entity’s ability to pay dividends and meet obligations. If a company does not have adequate cash, it cannot pay employees, settle debts, or pay dividends. Employees, creditors, and stockholders should be particularly interested in this statement because it alone shows the flows of cash in a business. 624 c12StatementofCashFlows.qxd 8/31/10 12:21 PM Page 625 The Statement of Cash Flows: Usefulness and Format 3. The reasons for the difference between net income and net cash provided (used) by operating activities. Net income provides information on the success or failure of a business enterprise. However, some financial statement users are critical of accrual-basis net income because it requires many estimates. As a result, users often challenge the reliability of the number. Such is not the case with cash. Many readers of the statement of cash flows want to know the reasons for the difference between net income and net cash provided by operating activities. Then they can assess for themselves the reliability of the income number. 4. The cash investing and financing transactions during the period. By examining a company’s investing and financing transactions, a financial statement reader can better understand why assets and liabilities changed during the period. CLASSIFICATION OF CASH FLOWS The statement of cash flows classifies cash receipts and cash payments as operating, investing, and financing activities. Transactions and other events characteristic of each kind of activity are as follows. 1. Operating activities include the cash effects of transactions that create revenues and expenses. They thus enter into the determination of net income. 2. Investing activities include (a) cash transactions that involve the purchase or disposal of investments and property, plant, and equipment, and (b) lending money and collecting the loans. 3. Financing activities include (a) obtaining cash from issuing debt and repaying the amounts borrowed, and (b) obtaining cash from stockholders, repurchasing shares, and paying dividends. 625 Ethics Note Though we would discourage reliance on cash flows to the exclusion of accrual accounting, comparing cash from operations to net income can reveal important information about the “quality” of reported net income. Such a comparison can reveal the extent to which net income provides a good measure of actual performance. study objective 2 Distinguish among operating, investing, and financing activities. The operating activities category is the most important. It shows the cash provided by company operations. This source of cash is generally considered to be the best measure of a company’s ability to generate sufficient cash to continue as a going concern. Illustration 12-1 (page 626) lists typical cash receipts and cash payments within each of the three classifications. Study the list carefully. It will be very useful in solving homework exercises and problems. Note the following general guidelines: 1. Operating activities involve income statement items. 2. Investing activities involve cash flows resulting from changes in investments and long-term asset items. 3. Financing activities involve cash flows resulting from changes in long-term liability and stockholders’ equity items. Companies classify as operating activities some cash flows related to investing or financing activities. For example, receipts of investment revenue (interest and dividends) are classified as operating activities. So are payments of interest to lenders. Why are these considered operating activities? Because companies report these items in the income statement, where results of operations are shown. SIGNIFICANT NONCASH ACTIVITIES Not all of a company’s significant activities involve cash. Examples of significant noncash activities are: 1. 2. 3. 4. Direct issuance of common stock to purchase assets. Conversion of bonds into common stock. Direct issuance of debt to purchase assets. Exchanges of plant assets. International Note The statement of cash flows is very similar under GAAP and IFRS. One difference is that, under IFRS, noncash investing and financing activities are not reported in the statement of cash flows but instead are reported in the notes to the financial statements. c12StatementofCashFlows.qxd 626 8/31/10 12:21 PM Page 626 chapter 12 Statement of Cash Flows Illustration 12-1 Typical receipt and payment classifications Operating activities J AVA J AVA TIME TIME Investing activities S T O CK BOND Financing activities Helpful Hint Do not include noncash investing and financing activities in the body of the statement of cash flows. Report this information in a separate schedule below the statement of cash flows. Types of Cash Inflows and Outflows Operating activities—Income statement items Cash inflows: From sale of goods or services. From interest received and dividends received. Cash outflows: To suppliers for inventory. To employees for services. To government for taxes. To lenders for interest. To others for expenses. Investing activities—Changes in investments and long-term assets Cash inflows: From sale of property, plant, and equipment. From sale of investments in debt or equity securities of other entities. From collection of principal on loans to other entities. Cash outflows: To purchase property, plant, and equipment. To purchase investments in debt or equity securities of other entities. To make loans to other entities. Financing activities—Changes in long-term liabilities and stockholders’ equity Cash inflows: From sale of common stock. From issuance of debt (bonds and notes). Cash outflows: To stockholders as dividends. To redeem long-term debt or reacquire capital stock (treasury stock). Companies do not report in the body of the statement of cash flows significant financing and investing activities that do not affect cash. Instead, they report these activities in either a separate schedule at the bottom of the statement of cash flows or in a separate note or supplementary schedule to the financial statements. The reporting of these noncash activities in a separate schedule satisfies the full disclosure principle. In solving homework assignments, you should present significant noncash investing and financing activities in a separate schedule at the bottom of the statement of cash flows. (See the last entry in Illustration 12-2 for an example.) Accounting Across the Organization Net What? Net income is not the same as net cash provided by operations. The differences are illustrated by the following results from recent annual reports ($ in millions). Note the wide disparity among these companies that all engaged in retail merchandising. Company Kohl’s Corporation Wal-Mart Stores, Inc. JCPenney Company, Inc. Costco Wholesale Corp. Target Corporation ? Net Income $ 1,083 11,284 1,153 1,082 2,849 Net Cash Provided by Operations $ 1,234 20,169 1,255 2,076 4,125 In general, why do differences exist between net income and net cash provided by operating activities? (See page 680.) c12StatementofCashFlows.qxd 8/31/10 12:21 PM Page 627 The Statement of Cash Flows: Usefulness and Format 627 FORMAT OF THE STATEMENT OF CASH FLOWS The general format of the statement of cash flows presents the results of the three activities discussed previously—operating, investing, and financing—plus the significant noncash investing and financing activities. Illustration 12–2 shows a widely used form of the statement of cash flows. Illustration 12-2 Format of statement of cash flows COMPANY NAME Statement of Cash Flows Period Covered Cash flows from operating activities (List of individual items) Net cash provided (used) by operating activities Cash flows from investing activities (List of individual inflows and outflows) Net cash provided (used) by investing activities Cash flows from financing activities (List of individual inflows and outflows) XX XXX XX XXX XX Net cash provided (used) by financing activities XXX Net increase (decrease) in cash Cash at beginning of period XXX XXX Cash at end of period XXX Noncash investing and financing activities (List of individual noncash transactions) XXX The sum of the operating, investing, and financing sections equals the net increase or decrease in cash for the period. This amount is added to the beginning cash balance to arrive at the ending cash balance—the same amount reported on the balance sheet. before you go on... Do it! During its first week, Duffy & Stevenson Company had these transactions. 1. Issued 100,000 shares of $5 par value common stock for $800,000 cash. 2. Borrowed $200,000 from Castle Bank, signing a 5-year note bearing 8% interest. 3. Purchased two semi-trailer trucks for $170,000 cash. 4. Paid employees $12,000 for salaries and wages. 5. Collected $20,000 cash for services provided. Classify each of these transactions by type of cash flow activity. Solution 1. Financing activity 2. Financing activity 3. Investing activity 4. Operating activity 5. Operating activity Related exercise material: BE12-1, BE12-2, BE12-3, Do it! 12-1, E12-1, and E12-2. CASH FLOW ACTIVITIES Action Plan • Identify the three types of activities used to report all cash inflows and outflows. • Report as operating activities the cash effects of transactions that create revenues and expenses and enter into the determination of net income. • Report as investing activities transactions that (a) acquire and dispose of investments and productive long-lived assets and (b) lend money and collect loans. • Report as financing activities transactions that (a) obtain cash from issuing debt and repay the amounts borrowed and (b) obtain cash from stockholders and pay them dividends. c12StatementofCashFlows.qxd 628 8/31/10 12:21 PM Page 628 chapter 12 Statement of Cash Flows study objective 3 Explain the impact of the product life cycle on a company’s cash flows. THE CORPORATE LIFE CYCLE All products go through a series of phases called the product life cycle. The phases (in order of their occurrence) are introductory phase, growth phase, maturity phase, and decline phase. The introductory phase occurs at the beginning of a company’s life, when it is purchasing fixed assets and beginning to produce and sell products. During the growth phase, the company is striving to expand its production and sales. In the maturity phase, sales and production level off. During the decline phase, sales of the product fall due to a weakening in consumer demand. In the same way that products have life cycles, companies have life cycles as well. Companies generally have more than one product, and not all of a company’s products are in the same phase of the product life cycle at the same time. This sometimes makes it difficult to classify a company’s phase. Still, we can characterize a company as being in one of the four phases because the majority of its products are in a particular phase. Illustration 12-3 shows that the phase a company is in affects its cash flows. In the introductory phase, we expect that the company will not be generating positive cash from operations. That is, cash used in operations will exceed cash generated by operations in the introductory phase. Also, the company will be spending considerable amounts to purchase productive assets such as buildings and equipment. To support its asset purchases, the company will have to issue stock or debt. Thus, during the introductory phase, we expect cash from operations to be negative, cash from investing to be negative, and cash from financing to be positive. Financing 0 Operating Negative Cash Flow Positive Illustration 12-3 Impact of product life cycle on cash flows Investing Introductory Growth Maturity Phase Decline During the growth phase, we expect to see the company start to generate small amounts of cash from operations. During this phase, cash from operations on the statement of cash flows will be less than net income on the income statement. One reason income will exceed cash flow from operations during this period is explained by the difference between the cash paid for inventory and the amount expensed as cost of goods sold. Since the company projects increasing sales, the size of inventory purchases must increase. Thus, in the growth phase, the company will expense less inventory on an accrual basis than it purchases on a cash basis. Also, collections on accounts receivable will lag behind sales, and accrual sales during a period will exceed cash collections during that period. Cash needed for asset acquisitions will continue to exceed cash provided by operations, requiring that the company make up the deficiency by issuing new stock or debt. Thus, in the growth phase, the company continues to show negative cash from investing and positive cash from financing. c12StatementofCashFlows.qxd 8/31/10 12:21 PM Page 629 The Statement of Cash Flows: Usefulness and Format 629 During the maturity phase, cash from operations and net income are approximately the same. Cash generated from operations exceeds investing needs. Thus, in the maturity phase, the company can start to pay dividends, retire debt, or buy back stock. Finally, during the decline phase, cash from operations decreases. Cash from investing might actually become positive as the company sells off excess assets. Cash from financing may be negative as the company buys back stock and retires debt. Consider Microsoft: During its early years, it had significant product development costs and little revenue. Microsoft was lucky in that its agreement with IBM to provide the operating system for IBM PCs gave it an early steady source of cash to support growth. As noted in the Feature Story, one way Microsoft conserved cash was to pay employees with stock options rather than cash. Today, Microsoft could best be characterized as being in the maturity phase. It continues to spend considerable amounts on research and development and investment in new assets. For the last three years, though, its cash from operations has exceeded its net income. Also, cash from operations over this period exceeded cash used for investing, and common stock repurchased exceeded common stock issued. For Microsoft, as for any large company, the challenge is to maintain its growth. In the software industry, where products become obsolete very quickly, the challenge is particularly great. Investor Insight Operating with Negative Cash Listed here are recent amounts of net income and cash provided (used) by operations, investing, and financing for a variety of companies. The final column suggests their likely phase in the life cycle based on these figures. Company ($ in millions) Amazon.com LDK Solar United States Steel Kellogg Southwest Airlines Starbucks ? Net Income Cash Provided (Used) by Operations $ 476 (144) $1,405 (81) 879 1,103 645 673 1,745 1,503 2,845 1,331 Cash Provided (Used) by Investing $ (42) (329) (4,675) (601) (1,529) (1,202) Cash Provided (Used) by Financing $ (50) 462 (1,891) (788) 493 (172) Why do companies have negative cash from operations during the introductory phase? (See page 680.) PREPARING THE STATEMENT OF CASH FLOWS Companies prepare the statement of cash flows differently from the three other basic financial statements. First, it is not prepared from an adjusted trial balance. It requires detailed information concerning the changes in account balances that occurred between two points in time. An adjusted trial balance will not provide the necessary data. Second, the statement of cash flows deals with cash receipts and payments. As a result, the company must adjust the effects of the use of accrual accounting to determine cash flows. The information to prepare this statement usually comes from three sources: • Comparative balance sheets. Information in the comparative balance sheets indicates the amount of the changes in assets, liabilities, and stockholders’ equities from the beginning to the end of the period. Likely Phase in Life Cycle Early maturity Introductory/ early growth Maturity Early decline Maturity Maturity c12StatementofCashFlows.qxd 630 8/31/10 12:21 PM Page 630 chapter 12 Statement of Cash Flows • • Current income statement. Information in this statement helps determine the amount of cash provided or used by operations during the period. Additional information. Such information includes transaction data that are needed to determine how cash was provided or used during the period. Preparing the statement of cash flows from these data sources involves three major steps, explained in Illustration 12-4 below. Illustration 12-4 Three major steps in preparing the statement of cash flows Step 1: Determine net cash provided/used by operating activities by converting net income from an accrual basis to a cash basis. This step involves analyzing not only the current year's income statement but also comparative balance sheets and selected additional data. Buying & selling goods Step 2: Analyze changes in noncurrent asset and liability accounts and record as investing and financing activities, or disclose as noncash transactions. Inve g ncin stin g Fina This step involves analyzing comparative balance sheet data and selected additional information for their effects on cash. Step 3: Compare the net change in cash on the statement of cash flows with the change in the cash account reported on the balance sheet to make sure the amounts agree. + Usage of Methods 99% Indirect Method 1% Direct Method or – The difference between the beginning and ending cash balances can be easily computed from comparative balance sheets. INDIRECT AND DIRECT METHODS In order to perform step 1, a company must convert net income from an accrual basis to a cash basis. This conversion may be done by either of two methods: (1) the indirect method or (2) the direct method. Both methods arrive at the same total amount for “Net cash provided by operating activities.” They differ in how they arrive at the amount. The indirect method adjusts net income for items that do not affect cash to determine net cash provided by operating activities. A great majority of companies (99%) use this method, as shown in the nearby chart.1 Companies favor the indirect method for two reasons: (1) It is easier and less costly to prepare, and (2) it focuses on the differences between net income and net cash flow from operating activities. The direct method shows operating cash receipts and payments. It is prepared by adjusting each item in the income statement from the accrual basis to the cash basis. The FASB has expressed a preference for the direct method, but allows the use of either method. The next section illustrates the more popular indirect method. Appendix 12A illustrates the direct method. Appendix 12B demonstrates an approach that employs T accounts to prepare the statement of cash flows. Many students find the 1 Accounting Trends and Techniques—2009 (New York: American Institute of Certified Public Accountants, 2009). c12StatementofCashFlows.qxd 8/31/10 12:21 PM Page 631 Preparation of the Statement of Cash Flows—Indirect Method 631 T-account approach provides a useful structure. We encourage you to give it a try as you walk through the Computer Services example. Preparation of the Statement of Cash Flows—Indirect Method To explain how to prepare a statement of cash flows using the indirect method, we use financial information from Computer Services Company. Illustration 12-5 presents Computer Services’ current and previous-year balance sheets, its current-year income statement, and related financial information. COMPUTER SERVICES COMPANY Comparative Balance Sheets December 31 Assets 2012 2011 Change in Account Balance Increase/Decrease Current assets Cash $ 55,000 $ 33,000 $ 22,000 Increase Accounts receivable 20,000 30,000 10,000 Decrease Inventory 15,000 10,000 5,000 Increase Prepaid expenses 5,000 1,000 4,000 Increase Property, plant, and equipment Land 130,000 20,000 110,000 Increase Buildings 160,000 40,000 120,000 Increase Accumulated depreciation—buildings (11,000) (5,000) 6,000 Increase Equipment 27,000 10,000 17,000 Increase Accumulated depreciation—equipment (3,000) (1,000) 2,000 Increase Total assets $398,000 $138,000 Liabilities and Stockholders’ Equity Current liabilities Accounts payable Income taxes payable Long-term liabilities Bonds payable Stockholders’ equity Common stock Retained earnings Total liabilities and stockholders’ equity $ 28,000 $ 12,000 6,000 8,000 $ 16,000 Increase 2,000 Decrease 130,000 20,000 110,000 Increase 70,000 164,000 50,000 48,000 20,000 Increase 116,000 Increase $398,000 $138,000 COMPUTER SERVICES COMPANY Income Statement For the Year Ended December 31, 2012 Revenues Cost of goods sold Operating expenses (excluding depreciation) Depreciation expense Loss on sale of equipment Interest expense Income before income tax Income tax expense Net income $507,000 $150,000 111,000 9,000 3,000 42,000 315,000 192,000 47,000 $145,000 study objective 4 Prepare a statement of cash flows using the indirect method. Illustration 12-5 Comparative balance sheets, income statement, and additional information for Computer Services Company