10 1 Chapter 10 Statement of Cash Flows

10 - 1 Chapter 10 Statement of Cash Flows © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

10 - 2 Learning Objectives After studying this chapter, you should be able to: u Explain the concept of the statement of cash flows. u Classify activities affecting cash as operating, investing, or financing activities. u Use the direct method to measure cash flows. u Determine cash flows from income statement and balance sheet accounts. u Use the indirect method to calculate cash flows from operations. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

10 - 3 Learning Objectives After studying this chapter, you should be able to: u Relate depreciation to cash flows provided by operating activities. u Reconcile net income to cash provided by operating activities. u Adjust for gains and losses from fixed asset sales and debt extinguishments in the statement of cash flows (Appendix 10 A). u Use the T-account approach to prepare the cash flow statement (Appendix 10 B). © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Overview of Statement of Cash Flows 10 - 4 u The statement of cash flows provides a thorough explanation of the changes that occurred in a firm’s cash balance during the entire accounting period. • The statement of cash flows reports cash receipts and payments of a company during a given period for operating, financing, and investing activities. • “Cash” includes cash and cash equivalents. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

10 - 5 Purposes of Cash Flow Statement u The FASB requires a statement of cash flows. • It shows the relationship of net income to changes in cash balances. • It reports past cash flows as an aid to: – Predicting future cash flows – Evaluating the way management generates and uses cash – Determining a company’s ability to pay interest and dividends and to pay debts when they are due • It identifies changes in the mix of productive assets. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

10 - 6 Purposes of Cash Flow Statement u The statement of cash flows, along with the income statement, explains why balance sheet items have changed during the period. • The balance sheet shows the status of a company at a point in time. • The statement of cash flows and the income statement show the performance of a company over a period of time. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition December 2003 Horngren, Sundem, and Elliott

10 - 7 Purposes of Cash Flow Statement u The relationship among the balance sheet, income statement, and statement of cash flows: Balance Sheet December 31, 20 X 2 Balance Sheet December 31, 20 X 3 Income Statement of Cash Flows © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

10 - 8 Typical Activities Affecting Cash u Cash is affected by two primary areas of a firm. • Operating management - largely concerned with the major day-to-day activities that generate revenues and expenses • Financial management - largely concerned with where to get cash and how to use cash for the benefit of the entity © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

10 - 9 Typical Activities Affecting Cash u Operating activities - transactions that affect the income statement u Investing activities - activities that involve (1) providing and collecting cash as a lender or as an owner of securities and (2) acquiring and disposing of plant, property, equipment, and other long-term productive assets u Financing activities - activities that include obtaining resources as a borrower or issuer of securities and repaying creditors and owners © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

10 - 10 Typical Activities Affecting Cash Typical operating activities Cash inflows u u u Cash outflows Collections from customers Interest and dividends collected Other operating receipts © 2002 Prentice Hall Business Publishing u u Cash payments to suppliers Cash payments to employees Interest and tax payments Other operating cash payments Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

10 - 11 Typical Activities Affecting Cash Typical investing activities Cash outflows Cash inflows u u u Sale of property, plant, and equipment Sale of securities that are not cash equivalents Receipt of loan repayments © 2002 Prentice Hall Business Publishing u u u Purchase of property, plant, and equipment Purchase of securities that are not cash equivalents Making loans Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

10 - 12 Typical Activities Affecting Cash Typical financing activities Cash inflows u u u Cash outflows Borrowing cash from creditors Issuing equity securities Issuing debt securities u u u © 2002 Prentice Hall Business Publishing Repayment of amounts borrowed Repurchase of equity shares (including treasury stock) Payment of dividends Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Approaches to Calculating the Cash Flow from Operating Activities 10 - 13 u Two approaches may be used to compute cash flow from operating activities. • Direct method - the method that calculates net cash provided by operating activities as collections minus operating distributions • Indirect method - the method that adjusts the accrual net income to reflect only cash receipts and outlays u Under either method, the final cash flow from operating activities will be the same. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Approaches to Calculating the Cash Flow from Operating Activities 10 - 14 u Under the direct method, income statement amounts are adjusted for changes in related asset and liability accounts. • Each revenue and expense account calculated under the accrual method is adjusted to reflect the actual cash paid or received. u Under the indirect method, accrual net income is adjusted to reflect only cash transactions. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Approaches to Calculating the Cash Flow from Operating Activities 10 - 15 u The FASB prefers the direct method because it shows operating cash receipts and payments in a way that is easy for investors to understand. u The indirect method is more common because many people are used to thinking in terms of net income. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Transactions Affecting Cash Flows from All Sources 10 - 16 Effects of operating transactions on cash: Sales of goods and services for cash Sales of goods and services on credit Receive dividends or interest Collection of accounts receivable Recognize cost of goods sold Purchase inventory for cash Purchase inventory on credit Pay trade accounts payable + 0 + + 0 0 - “ 0” denotes that the transaction has no effect on cash. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Transactions Affecting Cash Flows from All Sources 10 - 17 Effects of operating transactions on cash: Accrue operating expenses Pay operating expenses Accrue taxes Pay taxes Accrue interest Pay interest Prepay expenses for cash Write off prepaid expenses Charge depreciation or amortization 0 0 0 “ 0” denotes that the transaction has no effect on cash. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Transactions Affecting Cash Flows from All Sources 10 - 18 Effects of investing activities on cash: Purchase fixed assets for cash Purchase fixed assets by issuing debt Sell fixed assets Purchase securities that are not cash equivalents Sell securities that are not cash equivalents Make a loan 0 + + - “ 0” denotes that the transaction has no effect on cash. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Transactions Affecting Cash Flows from All Sources 10 - 19 Effects of financing transactions on cash: Increase long-term or short-term debt Reduce long-term or short-term debt Sell common or preferred shares Repurchase or retire common or preferred shares Purchase treasury stock Pay dividends Convert debt to common stock Reclassify long-term debt to short-term debt + + 0 0 “ 0” denotes that the transaction has no effect on cash. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

10 - 20 Cash Flow and Earnings u The income statement and the statement of cash flows fill different critical information needs. • The income statement shows how a company’s owners’ equity changes a result of operations. as – It matches revenues and expenses using the accrual concept and provides measure of economic activity. a • The statement of cash flows focuses on the net cash flow from operating activities. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

A Detailed Example of the Direct Method 10 - 21 ECO-BAG COMPANY Balance Sheet (in thousands) December 31, 20 X 3 and 20 X 2 Current assets: Cash Accounts receivable Inventory Total current assets Fixed assets, gross Accum. depreciation Net Total assets © 2002 Prentice Hall Business Publishing $ 16 45 100 $161 581 (101) 480 $ 25 25 60 $110 330 (110) 220 $641 $330 ======== Current liabilities: Accounts payable $ 74 Wages and salaries payable 25 $ 6 4 Total current liabilities Long-term debt Stockholders’ equity 99 125 417 10 5 315 $641 $330 ======== Total liabilities and stockholders’ equity Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

A Detailed Example of the Direct Method 10 - 22 ECO-BAG COMPANY Statement of Income (in thousands) for the Year Ended December 31, 20 X 3 Sales Costs and expenses: Cost of goods sold Wages and salaries Depreciation Interest Total costs and expenses Income before income taxes Income taxes Net income $200 $100 36 17 4 157 43 20 $ 23 ==== © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

A Detailed Example of the Direct Method 10 - 23 ECO-BAG COMPANY Statement of Cash Flows (in thousands) for the Year Ended December 31, 20 X 3 CASH FLOWS FROM OPERATING ACTIVITIES: Cash collections from customers Cash payments: To suppliers To employees For interest For taxes Total cash payments Net cash provided by operating activities © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition $ 180 $ 72 15 4 20 (111) $ 69 Horngren, Sundem, and Elliott

A Detailed Example of the Direct Method 10 - 24 ECO-BAG COMPANY Statement of Cash Flows (in thousands) for the Year Ended December 31, 20 X 3 (continued) CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of fixed assets Proceeds from sale of fixed assets Net cash used by investing activities © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition $(287) 10 (277) Horngren, Sundem, and Elliott

A Detailed Example of the Direct Method 10 - 25 ECO-BAG COMPANY Statement of Cash Flows (in thousands) for the Year Ended December 31, 20 X 3 (continued) CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from issue of long-term debt Proceeds from issue of common stock Dividends paid Net cash provided by financing activities Net decrease in cash Cash, December 31, 20 X 2 Cash, December 31, 20 X 3 $120 98 (19) 199 (9) 25 $ 16 ==== © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

A Detailed Example of the Direct Method 10 - 26 u The first step in developing the statement of cash flows is to compute the amount of the change in cash from the beginning to the end of the period. • This calculation is often included at the bottom of the statement. • The net change is added to the beginning balance to compute the ending balance. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

A Detailed Example of the Direct Method u In 10 - 27 this example, cash decreases by $9, 000. • Operating activities contribute $69, 000 cash during the period. • Investing activities use $277, 000 cash during the period. • Financing activities contribute $199, 000 cash during the period. u This example shows how a firm may have net income but still have a decline in cash. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Changes in the Balance Sheet Equation 10 - 28 u The balance sheet equation can be rearranged as follows: Cash = Liabilities + Equity - Noncash Assets or DCash = DL + DSE - DNCA Any change (D) in a noncash item (liability, equity, or asset) must be accompanied by a change in cash to keep the equation balanced. • If a noncash item changes, what effect does it have on cash? © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Changes in the Balance Sheet Equation 10 - 29 u The statement of cash flows focuses on the change in the noncash accounts as a way of explaining how and why the amount of cash changes during a given period. Change in cash = Change in all noncash accounts or What happened to cash = Why it happened © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Computing Cash Flows from Operating Activities 10 - 30 u Collections from sales to customers are usually the largest source of operating cash inflows. u Disbursements for purchases of goods to be sold and operating expenses are usually the largest sources of operating cash outflows. u Operating cash inflows minus operating cash outflows equals the net cash provided by (or used by) operating activities. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Working from Income Statement Amounts to Cash Amounts 10 - 31 u Accountants often compute collections and other operating cash flow items from figures in the income statement. • Many accountants use the balance sheet along with additional information and familiarity with the causes of certain changes in balance sheet amounts to compute the cash flow items. • However, many accounting systems are not capable of providing detailed information needed for that method. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Working from Income Statement Amounts to Cash Amounts 10 - 32 u In our example, $180, 000 was collected from customers. That amount is determined as follows: + – Sales Beginning accounts receivable Potential collections Ending accounts receivable Cash collections from customers $200, 000 25, 000 $225, 000 45, 000 $180, 000 ======== or Sales Decrease (increase) in accounts receivable Cash collections from customers u $200, 000 (20, 000) $180, 000 ======== Note that the increase in A/R means that sales > collections. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Working from Income Statement Amounts to Cash Amounts 10 - 33 u The difference between cost of goods sold and cash payments to suppliers can be determined by looking at inventory and accounts payable. + – Ending inventory Cost of goods sold Inventory to account for Beginning inventory Purchases of inventory $100, 000 $200, 000 (60, 000) $140, 000 Beginning trade accounts payable Purchases of inventory Total amount to be paid in cash Ending trade accounts payable Accounts paid in cash $ © 2002 Prentice Hall Business Publishing ======== 6, 000 140, 000 $146, 000 (74, 000) $ 72, 000 ======== Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Working from Income Statement Amounts to Cash Amounts 10 - 34 u The effects of inventory and accounts payable on the previous slide can be combined into one calculation as follows: Cost of goods sold $100, 000 Increase (decrease) in inventory 40, 000 Decrease (increase) in trade accounts payable (68, 000) Payments to suppliers $ 72, 000 ======== © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Working from Income Statement Amounts to Cash Amounts 10 - 35 u Cash payments to employees can be determined by examining wages and salaries payable. + – Beginning wages and salaries payable Wages and salaries expense Total to be paid in cash Ending wages and salaries payable Cash payments to employees $ 4, 000 36, 000 $ 40, 000 (25, 000) $ 15, 000 ======= or Wages and salaries expense Decrease (increase) in wages and salaries payable Cash payments to employees © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition $ 36, 000 (21, 000) $ 15, 000 ======= Horngren, Sundem, and Elliott

Working from Income Statement Amounts to Cash Amounts 10 - 36 u Notice in this example that both interest payable and income taxes payable were zero at the beginning and end of the period. • This means that the entire amounts of interest expense and income tax expense were incurred and paid during the period, so the cash flows are the amounts of the expenses, $4, 000 and $20, 000, respectively. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Comparison of Income Statement and Cash Flow Statement 10 - 37 u Most accrual-based revenues and expenses are naturally linked to related asset or liability accounts. • The cash effects on the income statement accounts are moderated by changes in their related balance sheet accounts. u The balance sheet approach relies on adjusting accrual net income for changes in related balance sheet accounts. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Comparison of Income Statement and Cash Flow Statement u. A 10 - 38 summary of the balance sheet approach: Change in Related Noncash Asset Opposite Effects Income Statement Amount Change in Related Liability © 2002 Prentice Hall Business Publishing Subtract Increase or Add Decrease Cash Flow Amount Add Increase or Subtract Decrease Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Comparison of Income Statement and Cash Flow Statement 10 - 39 u Remember, to determine whether to add or subtract an increase or a decrease, any change in a noncash asset, liability, or equity account must be accompanied by change in cash that keeps the balance sheet equation in balance. DCash = DL + DSE - DNCA © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Comparison of Income Statement and Cash Flow Statement 10 - 40 u Common adjustments to convert income statement amounts to cash flow amounts: Income statement Amount Sales revenue Cost of goods sold Wages expense Rent expense Insurance expense Depreciation expense Amortization expense © 2002 Prentice Hall Business Publishing Related Noncash Asset Accounts receivable Merchandise inventory Prepaid wages Prepaid rent Prepaid insurance Property, plant, & equipment Intangible assets Introduction to Financial Accounting, 8 th Edition Related Liability Unearned revenue Accounts payable Wages payable Rent payable Insurance payable Horngren, Sundem, and Elliott

Computing Cash Flows from Investing and Financing Activities 10 - 41 u Cash flows from investing activities - arise from the sale and purchase of property, plant, and equipment and other long-lived assets u Cash flows from financing activities - arise from issuing debt or equity or repurchasing debt or equity © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Computing Cash Flows from Investing and Financing Activities 10 - 42 u The idea behind the investing and financing activities sections is that long-lived assets are investments; sources of capital finance the purchase of these investments. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Computing Cash Flows from Investing and Financing Activities 10 - 43 u Analysis of balance sheet items for investing and financing activities: • Increases in cash (cash inflows) stem from – Increases in liabilities or stockholders’ equity – Decreases in noncash assets • Decreases in cash (cash outflows) stem from – Decreases in liabilities or stockholders’ equity – Increases in noncash assets © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Computing Cash Flows from Investing and Financing Activities u Changes 10 - 44 in fixed assets can usually be explained by: • Assets acquired • Asset dispositions • Depreciation expense Increase in net plant = Acquisitions - Disposals - Depreciation assets © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Computing Cash Flows from Investing and Financing Activities u Changes 10 - 45 in stockholders’ equity can be explained by: • New issuances of stock • Net income • Dividends Increase in stockholders’ = New issuance + Net income - Dividends equity © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Noncash Investing and Financing Activities 10 - 46 u Noncash items do not affect cash, so they do not belong in the statement of cash flows. u Because noncash transactions are similar to cash transactions, readers of the statements of cash flows should be informed of such transactions. • Such items must be included in a separate schedule accompanying the statement of cash flows. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

10 - 47 The Crisis of Negative Cash Flow u Although investors make many decisions based on net income, earnings numbers do not tell the whole story of what is happening inside a company. • Sometimes companies can show lots of net income, but that net incomes from selling off assets to meet its obligations. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Preparing a Statement of Cash Flows - The Indirect Method 10 - 48 u In calculating cash flows from operating activities, the alternative to the direct method is the indirect method. • The indirect method is generally more convenient. • The indirect method reconciles accrual net income to cash flows from operating activities. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Reconciliation of Net Income to Net Cash Provided by Operations u The 10 - 49 indirect method begins with net income. • Additions or deductions are made for changes in related asset or liability accounts (items that affect net income and net cash flow differently). u If a company uses the direct method, the FASB requires such a reconciliation using the indirect method. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Reconciliation of Net Income to Net Cash Provided by Operations u Items 10 - 50 included in the reconciliation: • Depreciation is added back to net income because it was deducted in arriving at net income, but it does not represent a use of cash. • Increases in noncash current assets result in less cash flow from operations, so such increases are deducted from net income. • Decreases in noncash current assets result in more cash flow from operations, so such decreases are added back to net income. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Reconciliation of Net Income to Net Cash Provided by Operations u Items 10 - 51 included in the reconciliation (continued): • Increases in current liabilities result in more cash flow from operations, so such increases are added back to net income. • Decreases in current liabilities result in less cash flow from operations, so such decreases are deducted from net income. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Reconciliation of Net Income to Net Cash Provided by Operations 10 - 52 u The general rules for additions and deductions to adjust net income using the indirect method are the same as those for adjusting line items on the income statement under the direct method. u Remember: DCash = DL + DSE - DNCA © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Reconciliation of Net Income to Net Cash Provided by Operations 10 - 53 u The cash flows from operating activities for Eco. Bag Company: Net income Adjustments to reconcile net income to net cash provided by operating activities Depreciation Net increase in accounts receivable Net increase in inventory Net increase in accounts payable Net increase in wages and salaries payable Total additions and deductions Net cash provided by operating activities © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition $23 $ 17 (20) (40) 68 21 46 $ 69 ======= Horngren, Sundem, and Elliott

Reconciliation of Net Income to Net Cash Provided by Operations 10 - 54 u As stated earlier, depreciation is an allocation of historical cost to expense over a period of time. u Depreciation does not entail a current outflow of cash, therefore, it is a noncash expense. u Depreciation is added back to net income to compute cash flows from operating activities simply to cancel its deduction in calculating net income. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

10 - 55 Reconciling Items Add charges (expenses) not requiring cash Depreciation Depletion Amortization of intangible assets Nonoperating losses Amortization of bond discount Deduct credits to income (revenue) not providing cash Nonoperating gains Amortization of bond premium Adjust for changes in current assets and liabilities relating to operating activities Changes in noncash Current Assets deduct increases add decreases © 2002 Prentice Hall Business Publishing Changes in noncash Current Liabilities add increases deduct decreases Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

10 - 56 Reconciling Items u Nonoperating gains and losses are gains and losses that are not part of the normal ongoing activities of the business but are included in net income. u Gains (losses) must be deducted (added back) from net income because they arise from activities other than operations. • The transaction that created the gain or loss must be included elsewhere on the statement of cash flows, including the gain or loss; removing it from net income keeps the gain or loss from being included twice. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

10 - 57 Reconciling Items Boyd Corporation sells a piece of land for $50, 000 in cash. The land originally cost $75, 000. The loss on the sale is $25, 000. How does this transaction affect the operating activities section of the statement of cash flows? © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

10 - 58 Reconciling Items u Net income includes the loss of $25, 000. The cash flow from the sale is $50, 000, but this is not cash from operations. u The $50, 000 cash flow from the sale is included in the investing activities section (sale of longlived asset). u The $25, 000 is added back to net income in the reconciliation to avoid including elements of the sale in two places on the statement of cash flows. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

More on the Statement of Cash Flows 10 - 59 u Two items that occur frequently on the statement of cash flows are: • Gains or losses on disposal of fixed assets • Gains or losses on early retirement of debt © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Gain or Loss on Disposal of Fixed Assets 10 - 60 u As stated before, gains and losses must be deducted or added to net income to arrive at net cash flows from operating activities. • They are nonoperating items that are included in net income, so they must be removed. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

Gain or Loss on Early Retirement of Debt 10 - 61 u Issuing and retiring debt are financing activities. Any gain or loss on early retirement is included in net income. • These gains or losses must be removed from net income in essentially the same way as gains or losses from sales of fixed assets. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

T-Account Approach to Statement of Cash Flows 10 - 62 u When complicated or numerous activities are encountered while trying to prepare the statement of cash flows, the T-account approach may be easier to use. • The T-account approach is an easier way of ensuring that all the appropriate activities are identified and treated properly. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

T-Account Approach to Statement of Cash Flows 10 - 63 u The T-account approach is merely another way of applying the balance sheet equation. • The technique helps identify investing and financing transactions. u This method again focuses on the changes in the noncash accounts to explain why cash changed. © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott

10 - 64 Introduction to Financial Accounting 8 th Edition Power. Point Presentation Developed by: Eddie Metrejean, MTAX, CPA University of Mississippi Images provided by New Vision Technology 1 -800 -387 -0732 nvtech. com © 2002 Prentice Hall Business Publishing Introduction to Financial Accounting, 8 th Edition Horngren, Sundem, and Elliott