Principles of Accounting- Preparing the Statement of Cash Flows

Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4a Fulbright Economics Teaching Program Ho Chi Minh City, Vietnam Academic Year: 2005-2006 Principles of Accounting 7/17/2006 Nguyễn Tấn Bình Lecture Notes 4a Preparing the Statement of Cash Flows 7/17/2006 Nguyen Tan Binh Nguyễn Tấn Bình Principles of accounting Fulbright Economics Teaching Program 2005-2006 Lecture 4a Cash Flows and Income The income statement and the statement of cash flows meet the different demands for information The income statement tells us how the firm has been operating to enrich the owners’ equity (looking at the results) The matching rule is applied for revenues and expenses; the accrual basis of accounting is used to measure the results of business activities The statement of cash flows concerns with the net cash flow generated from business activities 7/17/2006 Nguyễn Tấn Bình Preparing the Statement of Cash Flows Direct Method Bo Ho Company Balance Sheet, December 31 (amounts in thousands) Current Assets 2004 Cash 16 Receivables 45 Inventory 100 Total Current Assets 161 Fixed Assets, Acc Cost 581 Accumulated Depreciation(101) Fixed Assets, net 480 Total Assets 641 2003 25 25 60 $110 330 (110) 220 330 Current Debt 2004 Payables 74 Salaries Payable 25 2003 Total Current Debt 99 Long-term Debt 125 Owners’ Equity 417 10 315 Total Debt & OE 641 330 Notes: During 2004, the firm liquidated some fixed assets for book values and received 10 in cash; it also paid dividends of 19 7/17/2006 Nguyen Tan Binh Nguyễn Tấn Bình Principles of accounting Fulbright Economics Teaching Program 2005-2006 Lecture 4a Direct Method Bo Ho Company Income Statement ($1000) December 31, 2004 Revenue Expenses: Cost of Goods Sold Salaries Expense Depreciation Expense Interest Expense Total Expenses Earnings Before Tax Corporate Income Tax Net Income 7/17/2006 $200 100 36 17 157 43 20 $ 23 Nguyễn Tấn Bình Direct Method Bo Ho Company Statement of Cash Flows ($1000) December 31, 2004 CASH FLOW FROM OPERATING: Receipts from Customers Payments Suppliers Salaries Interest Taxes Total Payments Net Cash Flow from Operating (I) 7/17/2006 Nguyen Tan Binh Nguyễn Tấn Bình $ 180 $ 72 15 20 (111) $ 69 Principles of accounting Fulbright Economics Teaching Program 2005-2006 Lecture 4a Direct Method Bo Ho Company Statement of Cash Flows ($1000) December 31, 2004 (cont.) CASH FLOW FROM INVESTING: Payments for Purchases of Fixed Assets Collections from Liquidation of Fixed Assets Net Cash Flow from Investing (II) 7/17/2006 $(287) 10 (277) Nguyễn Tấn Bình Direct Method Bo Ho Company Statement of Cash Flows ($1000) December 31, 2004 (cont.) CASH FLOW FROM FINANCING: Long term Borrowing Stock Issue Dividends Paid Net Cash Flow from Financing (III) TOTAL NET CASH FLOW = I+II+III (decrease) Cash Balance, December 31, 2003 Cash Balance, December 31, 2004 7/17/2006 Nguyen Tan Binh Nguyễn Tấn Bình $120 98 (19) 199 (9) 25 $ 16 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4a Direct Method Step 1: Look at the change in the balance from the beginning to the end of period These numbers are often shown at the end of the cash flow statement • • Total net cash flow + the beginning cash balance = the ending cash balance Or, the ending cash balance – the beginning cash balance = total net cash flow 7/17/2006 Nguyễn Tấn Bình Direct Method In our example, cash balance reduces by $9,000 Operating activity during period provides $69,000 Investing activity uses $277,000 Financing activity generates $199,000 ($69,000 + 199,000 – 277,000 = - $9,000) It tells us, the firm shows a profit but its cash is decreasing 7/17/2006 Nguyen Tan Binh Nguyễn Tấn Bình 10 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4a Changes in Accounting Equation The accounting equation can be rearranged: Cash = Liabilities + OE – Non-cash Assets or ∆Cash = ∆Liabilities + ∆OE – ∆Non-cash Assets Any change (∆) in non-cash items (liabilities, owners’ equity, or assets) must be accompanied by a change in cash to keep the equation balance If a non-cash asset changes, how will it affect cash? 7/17/2006 Nguyễn Tấn Bình 11 Changes in Accounting Equation (cont.) The statement of cash flow concerns with changes in non-cash accounts as a means to explain why and how the cash balance changes during the accounting period Changes in Cash = Changes in all Non-cash Accounts or What happens to Cash? = Why does it happen? 7/17/2006 Nguyen Tan Binh Nguyễn Tấn Bình 12 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4a Cash Equation Assets = Liabilities + Owners’ Equity Current Assets + Fixed Assets = Liabilities + Owners’ Equity Cash + Receivables + Inventory = Liabilities + Owners’ Equity – Fixed Assets Cash = Liabilities + OE – FA – Receivables – Inventory A change in Liabilities or Owners’ Equity leads to a positive change in Cash A change in Assets leads to a negative change in Cash 7/17/2006 Nguyễn Tấn Bình 13 Calculating Cash Flow from Operating Activity Receipts from customers are the largest inflow from operating activity Disbursements for merchandise purchases and operating expenses are the largest outflow to operating activity Inflows minus (-) outflows equal the net cash flow generated from (or used by) operating activity 7/17/2006 Nguyen Tan Binh Nguyễn Tấn Bình 14 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4a From Amounts on the Income Statement to Items on the Statement of Cash Flows Accountants often calculate cash flows from income statement items Some accountants use the balance sheet with their experiences and additional information to determine changes in the balance sheet and calculate cash flow items However, most of corporate accounting systems cannot provide detailed information to follow this way 7/17/2006 Nguyễn Tấn Bình 15 From Amounts on the Income Statement to Items on the Statement of Cash Flows (cont.) In our example, $180,000 is collected from customers This amount is determined as follows: Revenue Beginning Receivables Total Receivables Ending Receivables Collections during Period $200,000 25,000 $225,000 45,000 $180,000 ======= Revenue Decrease (Increase) in Receivables Collections during Period (+) (=) (-) (=) $200,000 (20,000) $180,000 ======= Or Remember that an increase in receivables means collections < revenue 7/17/2006 Nguyen Tan Binh Nguyễn Tấn Bình 16 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4a From Amounts on the Income Statement to Items on the Statement of Cash Flows (cont.) The difference between the cost of goods sold and the amount paid to suppliers can be determined by looking at inventory and payables (+) (=) (-) (=) Ending Inventory Cost of Goods Sold Merchandise during Period Beginning Inventory Merchandise Purchased during Period $100,000 100,000 $200,000 (60,000) $140,000 ======= Beginning Payables (+) (=) (-) (=) $ Merchandise Purchased during Period Total Payables Ending Payables Amount Paid to Suppliers 7/17/2006 Nguyễn Tấn Bình 6,000 140,000 $146,000 (74,000) $ 72,000 ======= 17 From Amounts on the Income Statement to Items on the Statement of Cash Flows (cont.) Calculations on the previous slide for the amount paid to suppliers can be summarized as follows: Cost of Goods Sold Increase (Decrease) in Inventory Decrease (Increase) in Payables Amount Paid to Suppliers 7/17/2006 Nguyen Tan Binh Nguyễn Tấn Bình $100,000 40,000 (68,000) $72,000 18 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4a From Amounts on the Income Statement to Items on the Statement of Cash Flows (cont.) The salaries paid can be determined by salaries expense and salaries payable Beginning Salaries Payable (+) Salaries Expense during Period (=) Total Salaries Payable (-) Ending Salaries Payable (=) Salaries Paid $ 4,000 36,000 $ 40,000 (25,000) $ 15,000 Or, Salaries Expense during Period Decrease (Increase) in Salaries Payable Salaries Paid 7/17/2006 $ 36,000 (21,000) $ 15,000 Nguyễn Tấn Bình 19 From Amounts on the Income Statement to Items on the Statement of Cash Flows (cont.) Note that in our example, both interest payable and corporate tax payable have a zero balance at the beginning and the ending of period It means the total interest expense and tax have been accrued and paid off, so the cash flow equals the expenses, namely, $4,000 interest paid, and $20,000 tax paid 7/17/2006 Nguyen Tan Binh Nguyễn Tấn Bình 20 10 Principles of accounting Fulbright Economics Teaching Program 2005-2006 Lecture 4a Comparing the Income Statement and the Statement of Cash Flows Since revenues and expenses are recognized on the accrual basis of accounting, they are inevitably related to the balance sheet accounts The cash impacts on income statement accounts are balanced by the related balance sheet accounts The balance sheet approach is based on the net income, then adjusted for changes in the balance sheet accounts 7/17/2006 21 Nguyễn Tấn Bình Comparing the Income Statement and the Statement of Cash Flows (cont.) Summary of the balance sheet approach: Changes in Non-cash Assets Less Increase or Plus Decrease Negative Impact Amounts on Income Statement Changes in Liabilities & Owners’ Equity 7/17/2006 Nguyen Tan Binh Amounts on Balance Sheet Plus Increase or Less Decrease Nguyễn Tấn Bình 22 11 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4a Comparing the Income Statement and the Statement of Cash Flows (cont.) Remember, regardless plus or minus an increase or a decrease, any change in non-cash assets, liabilities, or owners’ equity is always accompanied by a change in cash to keep the accounting equation balance ∆Cash = ∆Liabilities + ∆Owners’ Equity – ∆Non-cash Assets 7/17/2006 23 Nguyễn Tấn Bình Comparing the Income Statement and the Statement of Cash Flows (cont.) The common adjustments to transfer the amounts on the income statement into cash flow items: Income Statement Non-cash Assets Liabilities Revenue Cost of Goods Sold Salaries Expense Rental Expense Insurance Expense Depreciation Expense Amortization Expense Receivables Purchases during Period Prepaid Salaries Prepaid Rental Prepaid Insurance Fixed Assets Intangible Assets Deferred Revenue Payables Salaries Payable Rental Payable Insurance Payable 7/17/2006 Nguyen Tan Binh Nguyễn Tấn Bình 24 12 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4a Calculating Cash Flows from Investing and Financing Activities Cash Flow from Investing Disbursements for fixed asset purchases and receipts from fixed asset liquidations Cash Flow from Financing Receipts from borrowing or stock issue, and disbursements for debt payments or equity payment to shareholders 7/17/2006 Nguyễn Tấn Bình 25 Calculating Cash Flows from Investing and Financing Activities (cont.) The main idea of investing and financing activities is the position of investments in fixed assets, and the position of fund mobilization and repayment 7/17/2006 Nguyen Tan Binh Nguyễn Tấn Bình 26 13 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4a Calculating Cash Flows from Investing and Financing Activities (cont.) Analyze items on balance sheet for investing and financing activities: An increase in cash (an inflow) from: An increase in liabilities or owners’ equity A decrease in non-cash assets A decrease in cash (an outflow) from: A decrease in liabilities or owners’ equity An increase in non-cash assets 7/17/2006 Nguyễn Tấn Bình 27 Calculating Cash Flows from Investing and Financing Activities (cont.) A change in fixed assets usually is A purchase of fixed assets A liquidation of fixed assets Depreciation expense Net Change = Purchases – Sales – Depr During Period Data on Bo Ho Company: Net Change: Sales (at Book Value): Depreciation during Period: Purchases during Period: 7/17/2006 Nguyen Tan Binh 260 (=480 – 220) 10 17 287 (=260+10+17) Nguyễn Tấn Bình 28 14 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4a Calculating Cash Flows from Investing and Financing Activities (cont.) A change in owners’ equity usually is A new stock issue Net income Dividends Net Change = New Issue + Net Income – Dividends Data on Bo Ho Company Net Change in OE: Net Income during 2004: Dividends Paid during 2004: New Stock Issue: 7/17/2006 102 (= 417 – 315) 23 19 98 (=102 – 23 + 19) Nguyễn Tấn Bình 29 Non-cash Investing and Financing Activities Non-cash activities have no impact on cash, and hence, not appear on the statement of cash flows Remember, cash flows from investing and financing activities are prepared under the direct method; that is, they are actually received and paid Readers still want to know this information These items will be shown as endnotes to the statement of cash flows, or on a separate statement 7/17/2006 Nguyen Tan Binh Nguyễn Tấn Bình 30 15 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4a Preparing the Statement of Cash Flows Indirect Method In addition to the direct method of calculating cash flows from operations, the indirect method is also used The indirect method proves to be better in valuation of income quality The indirect method adjusts net income to account the net cash flow from operating Through adjustments, impacts on net cash flow from operating are more clearly shown 7/17/2006 Nguyễn Tấn Bình 31 Adjusting Net Income to Account the Net Cash Flow from Operating The indirect method starts with net income Plus and minus changes in current assets and current debt (which make net income and net cash flow different) If a firm uses the direct method, the national accounting standard commission often asks for an additional use of indirect method 7/17/2006 Nguyen Tan Binh Nguyễn Tấn Bình 32 16 Principles of accounting Fulbright Economics Teaching Program 2005-2006 Lecture 4a Adjusting Net Income to Account the Net Cash Flow from Operating (cont.) Adjustments include Depreciation is added back to net income because it reduces income on the income statement, but cash is not actually disbursed An increase in current (non-cash) assets leads to a decrease in cash from operating, so it is adjusted by subtracting from net income A decrease in current (non-cash) assets leads to an increase in cash from operating, so it is adjusted by adding to net income 7/17/2006 Nguyễn Tấn Bình 33 Adjusting Net Income to Account the Net Cash Flow from Operating (cont.) Adjustments include (cont.) An increase in liabilities leads to an increase in cash from operating, so it is adjusted by adding to net income A decrease in liabilities leads to a decrease in cash from operating, so it is adjusted by subtracting from net income 7/17/2006 Nguyen Tan Binh Nguyễn Tấn Bình 34 17 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4a Adjusting Net Income to Account the Net Cash Flow from Operating (cont.) The general principle of addition and subtraction to adjust net income in the indirect method is as same as in the direct method, namely, to adjust line by line on the income statement Remember the cash equation ∆Cash = ∆Liabilities + ∆Owners’ Equity – ∆Non-cash Assets 7/17/2006 35 Nguyễn Tấn Bình Adjusting Net Income to Account the Net Cash Flow from Operating (cont.) Calculating cash flow from operating for Bo Ho Company Net Income $23 Adjustments for net income to calculate cash flow from operating Depreciation Increase in Accounts Receivable Increase in Inventory Increase in Accounts Payable Increase in Salaries Payable Net Impact (increase and decrease) Net Cash Flow from Operating 7/17/2006 Nguyen Tan Binh Nguyễn Tấn Bình $ 17 (20) (40) 68 21 46 $ 69 36 18 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4a Adjusting Net Income to Account the Net Cash Flow from Operating (cont.) As discussed, depreciation is the allocation of the historical cost over the future accounting periods Depreciation is not a disbursement flow; it is a noncash expense Depreciation is added back to net income to account the net cash flow from operating, simply because it has been subtracted when we calculating net income on the income statement Deprecation is also not a cash receipt flow 7/17/2006 37 Nguyễn Tấn Bình Adjustments Addition of non-cash losses (or expenses) Depreciation (for fixed assets), amortization (for intangible assets), depletion (for natural resources) Losses from non-operating activity Subtraction of non-cash profits (or revenues) Profits from non-operating activity Adjustments for changes in current assets and current debt (generally called working capital) related to operating Changes in current assets # Less Increase # Plus Decrease 7/17/2006 Nguyen Tan Binh Changes in current debt @ Plus Increase @ Less Decrease Nguyễn Tấn Bình 38 19 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4a Adjustments (cont.) Profits (losses) from non-cash operating not belong to the firm’s main operating activity, but are shown on the income statement, and hence, affect the net income These profits (losses) should be subtracted from (added to) net income, because they have been recorded in the other activity (investing and financing) These profits (losses) are reflected in the other activities (investing or financing), so they should be adjusted to avoid from being double recorded on the same statement of cash flows 7/17/2006 Nguyễn Tấn Bình 39 Adjustments (cont.) Ben Thanh Company sells a piece of land for 50 million in cash; its acquisition cost is 75 million; the firm has a loss of 25 million How does this loss affect the cash flow from operating on the statement of cash flow? 7/17/2006 Nguyen Tan Binh Nguyễn Tấn Bình 40 20 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4a Adjustments (cont.) The firm’s net income has included the 25 million loss, but this is not an operating activity The cash flow of 50 million (with the loss imbedded) is shown in the category of cash flow from investing The 25 million loss should be added back to net income as an adjustment, to avoid double recording on the statement of cash flow 7/17/2006 Nguyễn Tấn Bình 41 More Discussion on the Statement of Cash Flows Two items usually shown on the statement of cash flow in the indirect method: Profits or losses from sales of fixed assets (investing) Profits or losses from debt payment before due (financing) 7/17/2006 Nguyen Tan Binh Nguyễn Tấn Bình 42 21 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4a Profits/losses from sales of fixed assets As discussed, these profits (losses) should be subtracted from (or added to) the net income to adjust the net cash flow from operating They are not from operating, but included in net income, and hence, should be subtracted 7/17/2006 Nguyễn Tấn Bình 43 Profits/losses from debt payment before due Borrowing and paying debt are a financing activity, but the profits (losses) from debt payment before due have been shown in the net income These profits (losses) should be adjusted as same as those from sales of fixed assets 7/17/2006 Nguyen Tan Binh Nguyễn Tấn Bình 44 22 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4a Statement of Cash Sources and Uses Bo Ho Company The statement of cash sources and uses is the precursor of the statement of cash flows; it looks like a “random collection” of plus and minus signs (changes in the balance sheet items) Simply A change in liabilities and owners’ equity, or a decrease in assets generates cash A decrease in liabilities and owners’ equity, or an increase in assets uses cash 7/17/2006 45 Nguyễn Tấn Bình Statement of Cash Sources and Uses Bo Ho Company Cash Sources - Increase in Accounts Payable - Increase in Salaries Payable - Increase in Long-term Debt - Increase in Owners’ Equity - Decrease in Cash Balance Total Cash Uses - Increase in Accounts Receivable - Increase in Inventory - Increase in Fixed Assets (net) Total 7/17/2006 Nguyen Tan Binh Nguyễn Tấn Bình 68 21 120 102 320 20 40 260 320 46 23 Principles of accounting Fulbright Economics Teaching Program 2005-2006 Lecture 4a Statement of Cash Sources and Uses Bo Ho Company Cash Sources - Increase in Accounts Payable - Increase in Salaries Payable - Increase in Long-term Debt - Increase in Owners’ Equity - Decrease in Cash Balance Total Cash Uses - Increase in Accounts Receivable - Increase in Inventory - Increase in Fixed Assets (net) Total 68 21 120 102 320 20 40 260 320 Transactions are recorded on the basis of double-entry accounting, hence, the cash sources and uses always equal 7/17/2006 47 Nguyễn Tấn Bình Nothing to worry about the cash flow statement It is only the matter of the two operations Subtraction! Addition!! 7/17/2006 Nguyen Tan Binh Addition! Subtraction!! Nguyễn Tấn Bình 48 24 Principles of accounting Fulbright Economics Teaching Program 2005-2006 Lecture 4a References Horngren – Sundem – Elliott Introduction to Financial Accounting, 8th Edition, Prentice Hall, 2002 Stickney – Weil Financial Accounting, 8th Edition, The Dryden Press, 1997 Nguyen Tan Binh Ke toan quan tri, Nha Xuat ban Dai hoc Quoc gia Tp.HCM, 2003 7/17/2006 Nguyen Tan Binh Nguyễn Tấn Bình 49 25 ... Program 2005-2006 Principles of accounting Lecture 4a Statement of Cash Sources and Uses Bo Ho Company The statement of cash sources and uses is the precursor of the statement of cash flows; it looks... measure the results of business activities The statement of cash flows concerns with the net cash flow generated from business activities 7/17/2006 Nguyễn Tấn Bình Preparing the Statement of Cash Flows. .. Principles of accounting Lecture 4a Direct Method Step 1: Look at the change in the balance from the beginning to the end of period These numbers are often shown at the end of the cash flow statement