Why Is Cash So Important? You can probably answer that question from your own experience. It takes cash to pay bills and to generate future income for a business. Businesses, such as Amazon.com, Inc., a retail Web site that sells everything from sporting equipment to household goods, closely monitors cash. Amazon.com is interested in where its cash came from (receipts) and how its cash is spent (payments). One way for Amazon.com to monitor its cash receipts and payments is by preparing a statement of cash flows. For example, on Amazon.com’s 2015 statement of cash flows, the corporation reported that it paid $4.5 million purchasing property and equipment and that it paid $273 million cash for income taxes
(net of refunds). It also reported that from 2014 to 2015 the corporation had an increase in cash of $1,333 million, even though net income was only $596 million. In this chapter, you learn what a statement of cash flows is and why it is useful to a business.
In addition, you learn how to prepare the statement and understand why companies and investors carefully monitor the statement of cash flows.
David National reviewed his company’s income statement with a confused look on his face. The statement reported a net profit of $20,000 for the past quarter.
David knew that sales had been increasing in his small sporting equipment retail shop, and he expected this trend to continue through the end of the year. But David didn’t understand why the income statement showed a profit. The company’s payroll clerk had called him earlier in the day and told him that there wasn’t enough cash in the bank to pay the employees’s monthly salaries. It didn’t make sense to David that the company could report a $20,000 profit on the income statement but not have enough cash to pay the payroll.
He figured that the newly hired accountant, Mark Maloney, must have made a mistake.
16The Statement of Cash Flows
Why Doesn’t the Business Have Any Cash?
David picked up the phone to call Mark. He had several questions to ask him. Why didn’t the company have any cash in the bank? How was the company using its cash? How could the company report a $20,000 profit but not have that much cash in the bank? Where did the cash received from customers go? After speaking with his accountant, David learned that the profit reported on the income statement didn’t represent cash and that it was important that he review the company’s statement of cash flows. The statement of cash flows, Mark told him, reports the cash receipts and cash payments of the business. It shows the sources and uses
of cash and helps answer the question “Where did the cash go?”
WHAT IS THE STATEMENT OF CASH FLOWS?
Up to this point, you have learned about three financial statements—t
he income statement, the statement of retained earnings, and the balance sheet.
Each of these financial statements reports specific items about a company. The income statement reports net income or net loss for the time period. The statement of retained earnings reports the changes in retained earnings during the time period, and the balance sheet reports a company’s financial position. None of these statements reports specifically on the changes in cash. When a comparative balance sheet for two periods is presented, it shows whether cash increased or decreased.
But the balance sheet does not show why cash increased or decreased. We need the statement of cash flows for that. The statement of cash flows reports on a business’s cash receipts and cash payments for a specific period. This statement does the following: Reports on the cash flows of a business—where cash came from (receipts) and how cash was spent (payments). tReports why cash increased or decreased during the period. tCovers a span of time and is dated the same as the income statement—“Year Ended December 31, 2018,” for example.
Purpose of the Statement of Cash Flows The statement of cash flows explains why net income as reported on the income statement does not equal the change in the cash balance. In essence, the statement of cash flows is the link between the accrual-based income statement and the cash reported on the balance sheet. How do people use cash flow information? The statement of cash flows helps do the following: Predict future cash flows. Past cash receipts and payments help predict future cash flows. Evaluate management. Wise investment decisions help the business prosper, while unwise decisions cause the business to have problems. Investors and creditors use cash flow information to evaluate managers’ decisions. tPredict ability to pay debts and dividends. Lenders want to know whether they will collect on their loans. Stockholders want dividends on their investments. The statement of cash flows helps make these predictions.
Learning Objective 1
Identify the purposes of the
statement of cash flows and
distinguish among operating,
investing, and financing cash flows
Statement of Cash Flows Reports on a business’s cash receipts and cash payments for a specific period.
Cash Flows Cash receipts and cash payments of a business.
1 Identify the purposes of the statement of cash flows and distinguish among operating, investing, and financing cash flows.
2 Prepare the statement of cash flows by the indirect method.
3 Use free cash flow to evaluate business performance.
4 Prepare the statement of cash flows by the direct method (Appendix 16A) 5 Prepare the statement of cash flows by the indirect method using a spreadsheet (Appendix 16B)
Chapter 16 Learning Objectives
The Statement of Cash Flows 835
Classification of Cash Flows There are three basic types of cash flow activities, and the statement of cash flows has a section for each: Operating activities tInvesting activities financing activities Each section reports cash inflows (cash receipts coming into the company) and cash outflows (cash payments going out of the company) based on these three divisions. Operating Activities Operating activities is the first section on the statement of cash flows and is often the most important category. The operating activities section reports on activities that create revenue or expense in the entity’s business. It reflects the day-to-day operations of the business such as cash receipts (cash inflows) from customers for the sales of merchandise inventory and services and the cash payments (cash outflows) for purchases of merchandise inventory or payment of operating expenses. The operating activities section also includes cash receipts (cash inflows) for interest revenue and dividend income and cash payments (cash outflows) for interest expense and income tax expense. Investing Activities Investing activities is the second category listed on the statement of cash flows.
This section reports cash receipts and cash payments that increase or decrease long-term assets such as property, plant, equipment, notes receivable, and investments. It includes the cash inflow from selling and the cash outflow for the purchase of these long-term assets. In addition, it includes the lending (cash outflow) and collection (cash inflow) of long-term notes receivable. Financing Activities The last category on the statement of cash flows is financing activities. Financing activities include cash inflows and outflows involved in long-term liabilities and equity. This includes issuing stock, paying dividends, and buying and selling treasury stock. It also includes borrowing money and paying off long-term liabilities such as notes payable, bonds payable, and mortgages payable. Each section of the statement of cash flows affects a different part of the balance sheet. The operating activities section reports on how cash flows affect the current accounts—current assets and current liabilities. Investing activities affect the long-term assets. And the financing activities affect long-term liabilities and equity. Exhibit 16-1 shows the relationship between operating, investing, and financing cash flows and the various parts of the balance sheet.
Operating Activities Activities that create revenue or expense in the entity’s business; a section of the statement of cash flows.
Investing Activities Activities that increase or decrease long-term assets; a section of the statement of cash flows.
Financing Activities Activities that increase or decrease long-term liabilities and equity; a section of the statement of cash flows.
Exhibit 16-1 | Operating, Investing, and Financing Cash Flows and the Balance Sheet Accounts
Current Assets
Long–term Assets
Current Liabilities
Long–term Liabilities
Equity
Operating Cash Flows
Investing Cash Flows
Operating Cash Flows
Financing Cash Flows
Cash paid for merchandise inventory = Cost of Goods Sold – Beginning Merchandise Inventory + Ending Merchandise Inventory + Beginning Accounts Payable –
Ending Accounts Payable = +156,000 – +145,000 + +143,000 + +50,000 – +90,000
= +114,000
Additional data follow: 1. The income statement for 2019 included the following items:
a. Net income, $417,000.
b. Depreciation expense for the year, $34,330.
c. Amortization on the bonds payable, $254.
2. There were no disposals of property, plant and equipment during the year.
All acquisitions of PP&E were for cash except the land, which was acquired by issuing preferred stock.
3. The company issued bonds payable with a face value of $210,000, receiving cash of $208,476. 4. The company distributed 4,000 shares of common stock in a stock dividend when the market value was $4.50 per share. All other dividends were paid in cash.
5. The common stock, except for the stock dividend, was issued for cash.
6. The cash receipt from the notes payable in 2019 is considered a financing
activity because it does not relate to operations.
Requirement Prepare the statement of cash flows for the year ended December 31, 2019,
using the indirect method.
Before you begin this assignment, review the Tying It All Together feature in the chapter.
It will also be helpful if you review Amazon.com, Inc.’s 2015 annual report (http://phx.corporate-ir.net/phoenix.zhtml?c=97664&p=irol-reportsAnnual).
Amazon.com, Inc. serves its customers through its retail Web sites, selling millions of unique products.
In addition, the company manufactures and sells electronic devices including Kindle e-readers and Fire tablets.
Amazon.com also offers Amazon Prime, a membership program that includes unlimited free shipping on items and access to unlimited streaming of
movies and TV episodes.
Requirements 1. Review Item 7 (Management’s Discussion and Analysis of Financial Condition and Results of Operations) included in the 2015 Annual Report. What does Amazon.com, Inc. state is the company’s financial focus? What are free cash flows and how does Amazon.com plan to increase its free cash flows? 2. Review the statement of cash flows for Amazon.com, Inc. What type of noncash adjustments to net income did Amazon.com report in 2015? 3. Review the 2015 statement of cash flows for Amazon.com, Inc. What was the net cash provided (used) for investing activities? What were the cash inflows and outflows related to this section? 4. Review the 2015 statement of cash flows for Amazon.com, Inc. What was the net cash provided (used) for financing activities? What were the cash inflows and outflows related to this section?
Tying It All Together Case 16-1
CHAPTER 16
The Statement of Cash Flows
899
Theater by Design and Show Cinemas are asking you to recommend their stock to your clients. Because Theater by Design and Show Cinemas earn about the same net income and have similar financial positions, your decision depends on their statement of cash flows, summarized as follows: > Decision Case 16-1
Theater by Design Show Cinemas
Net Cash Provided by Operating Activities $ 30,000 $ 70,000 Cash Provided by (Used for) Investing Activities: Purchase of Plant Assets $ (20,000) $ (100,000) Sale of Plant Assets 40,000 20,000 10,000 (90,000) Cash Provided by (Used for) Financing Activities: Issuance of Common Stock 0 30,000 Payment of Long-term Debt (40,000) 0 Net Increase (Decrease) in Cash $ 10,000 $ 10,000
Based on their cash flows, which company looks better? Give your reasons.
> Ethical Issue 16-1
Moss Exports is having a bad year. Net income is only $60,000. Also, two important overseas customers are falling behind in their payments to Moss, and Moss’s accounts receivable are ballooning. The company desperately needs a loan. The Moss Exports Board of Directors is considering ways to put the best face on the company’s financial statements. Moss’s bank closely examines cash flow from operating activities. Daniel Peavey, Moss’s controller, suggests reclassifying the receivables from the slow-paying clients as long-term.
He explains to the board that removing the $80,000 increase in accounts receivable from current assets will increase net cash provided by operations.
This approach may help Moss get the loan. Requirements
1. Using only the amounts given, compute net cash provided by operations, both without and with the reclassification of the receivables. Which reporting makes Moss look better?
2. Under what condition would the reclassification of the receivables be ethical? Unethical?
CHAPTER 16
Details about a company’s cash flows appear in a number of places in the annual report.
Use Target Corporation’s Fiscal 2015 Annual Report to answer the following questions.
Visit http://www.pearsonhighered.com/Horngren to view a link to Target Corporation’s Fiscal 2015 Annual Report. Requirements
1. Which method does Target use to report net cash flows from operating activities?
How can you tell?
2. Target earned net income during 2015. Did operations provide cash or use cash during 2015? Give the amount.
How did net cash provided by (used for) operations during 2015 compare with net income in 2015? 3. For the year ended January 30, 2016 (fiscal year 2015), did Target pay cash
dividends? If so, how much?
4. For the year ended January 30, 2016, did Target use cash to purchase property, plant,
and equipment? If so, how much?
Financial Statement Case 16-1
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