Statement of Cash Flows: Indirect Method

Financial Statements

• A financial statement includes net income, depreciation, operating activities, and financing activities.

Statement of Cash Flows (Indirect Method)

• It will include Net income, depreciation, operating activities and financing activities.

Adjustments to Net Income for Cash Flows

• Increase in asset account means it will be deducted from net income.
• Increase in asset accounts represents cash paid out that is not on the income statement.
• Increase in prepaid expenses will be a deduction from net income.
• Amortization of premium on bonds payable reduces interest expense.
• It increases net income without increasing cash.
• The amortization must be deducted from net income.

Calculating Net Increase in Cash

• Net income is the starting point.
• Depreciation and amortization are noncash expenses which reduce net income to be added back to operating cash flow
• Decrease in accounts receivable are to be added means more collected than credit sales, increasing operating cash flow
• The increase in inventories needs to be subtracted as this is paid out from inventory not sold, decreasing operating cash flow
• Increase in accounts payable is to be added as not everything has yet been paid for, thus increasing operating cash flow.
• Increase in plant assets indicates purchase of plant assets, a decrease to cash and an investing cash flow. It is a cash outflow.
• The increase in contributed capital means cash increased from sale of shares and represents a financing cash inflow.
• Decrease in short-term notes payable means principal paid, which means cash was used. This is a financing cash outflow.

Depreciation Expense in Cash Flows (Indirect Method)

• Depreciation expense needs to be added back to net income to calculate cash flows from operating activities.
• It is a reduction to net income on the income statement but is not a cash expense.

Direct Method for Cash Flows

• It provides specific information about cash inflows and outflows from different operating activities.
• Examples; cash received from customers and cash paid to suppliers.
• Statement of cash flows discloses each transaction type separately. -It includes cash received from customers, paid to suppliers, paid for rent, paid for salaries, and more.

Sale of Fully Depreciated Asset

• A gain on the sale of an asset is reported in the income statement section of continuing operations in the year sold.

Credit Card Interest Impact

• Incurred credit card interest decreases equity because it is an expense that reduces income and retained earnings.
• Interest paid is an operating activity and is recorded as an operating cash outflow on the statement of cash flows.

Depreciation Methods and Cash Flows

• Using financial statements prepared for tax purposes rather than accrual accounting purposes will not affect cash flow amounts.
• Cash flow does not change based on reporting in financial statements, book, or tax purposes.
• Eliminating depreciation from net income is achieved by adding it back when calculating cash flow from operating activities.

Statement of Cash Flows and Dividends

• The payment of common share dividends is classified as a financing activity and is a use of cash.

Income Statement Formats

• A major difference is related to operating and non-operating data.
• In the single-step format all revenue/gains are reported together and all expenses/losses reported together
• In the multiple-step format, individual classes of operating revenues/expenses are reported with all other gains/losses.

Net Cash Flow from Operating Activities

• Amortization of a bond premium is a part of the calculation.

Indirect Method and Adjustments

• Adjusts net income to calculate cash flows from operations.
• The FASB doesn't encourage the use of the indirect method.

Reconciliation of Net Income

• Noncash activity is not included in the body of the statement of cash flows and should be disclosed in a supplemental schedule.
• Examples; purchase of land and building in exchange for a long-term note.

Operating Activity

• Income tax refund is viewed as operating

Dividends Paid

• Dividends paid is classified as a financing activity on the statement of cash flows

Statement of Cash Flows Disclosure

• Only cash transactions

Adjusting Net Cash Flows

• Cash paid to lenders for interest is an operating activity on the statement of cash flows.

Determining Net Cash Flows

• Amortization of bond premiums should be deducted from net income to determine net cash flows from operating activities.

Goodwill Impairment

• Impairment of goodwill reduces net income.
• It is a non-cash transaction that needs to be added back to net income in calculating net cash flows from operating activities.

Calculating Cash Flows (Indirect Method)

• Depreciation expenses, an increase in accounts payable, the gain from the sale of land (investing activity), Dividends paid are accounted for in determining total cash flows and cannot be included again in the computation.

Investing and Financing

• There are two investing activities: the payment for the purchase of machinery (a cash outflow) and the proceeds from the sale of the plant building (a cash inflow).
• There were also two financing activities: the proceeds from the issuance of preferred stock (a cash inflow) and the dividends paid on the preferred stock (a cash outflow).

Depreciation Expense Adjustment

• Because depreciation is a noncash expense, it shouldn't be included in the statement of cash flows.
• It is included in net income as deduction and must be reversed by adding it back to net income and calculate cash generated from operating activities

Interest Paid Report

• Under the direct method, the interest paid to bondholders is reported in the operating outflow section.

Adjusting Cash Flow

• Decrease in net receivables should increase net income under the indrect method
• A loss requires an adjustment to net income under the indirect method.
• Because it was a loss included in net income, but does not relate to an operating activity, it has to be added back to net income.

Determining Change in Balance

• All transactions that involve cash will be classified as either operating, investing, or financing activities, so this question is actually just asking what the change in the cash balance during the year was, which is the ending cash balance minus the beginning cash balance
• The correct answer cannot be calculated because not all the transactions that affect cash have been given, we just calculate starting and ending balance.

Statement of Cash Flows Intention

• The statement of cash flows provides information on the sources and uses of cash.
• When used with other financial statements, the statement of cash flows helps users in evaluating a firm's liquidity, solvency and financial flexibility.

Noncash Items

• The purchase of land and building in exchange for a long-term note is reported in the supplemental schedule of noncash investing and financing activities at the end of the statement of cash flows.

Financing Activities

• The purchase of treasury shares is classified as a financing activity.

Operating Activity

• Cash paid for interest is classified as an operating activity.

Operating Activities (Indirect Method)

• Increases in operating asset accounts and decreases in operating liability accounts and gains from investing and financing activities are deducted from net income.

Financial Flexibility

• Refers to the ability of a company to take actions that will alter the amounts and timing of its cash flows so that it is able to respond to unexpected needs and opportunities.

FASB Objectives

• According to the FASB conceptual framework, the objectives of financial reporting for business enterprises are based on the needs of investors and creditors in making decisions. Statement of Financial Accounting Concepts (SFAC) No. 8

FASB definition of Revenue

• Is inflows or other increases in assets or settlement of liabilities (or a combination of both) that result from delivering or producing goods, providing services, or performing other activities that constitute the entity's ongoing major or central operations
• Results from primary business operations.
• Revenue may result when an asset is increased or a liability is decreased
• Settlement of a company’s liabilities can occur by goods being delivered
• Prepayment for future work that decrease a liability through revenue

Historical Cost Convention

• Values all assets at their cost to the business, without any adjustment for depreciation.

Valuing Assets and Profits

• Historical cost convention tends to understate asset values
• Overstates profits in times of rising prices.

Historical Cost Concept

• Causes the value of assets on the financial statements to be understated since we're paying more for assets now than we were previously.

Going Concern Assumption

• The idea of going concern is the assumption that the company will continue to operate in the foreseeable future.

Financial Statements & Managers

• The financial statements included in the annual report to shareholders do not contain enough detail for internal managers in charge of operating activities

Tax Reporting and Cashflows

• A decrease in income taxes payable results in a decrease in cash flow.
• The indirect method adjusts income statement accounts to derive cash flow and a reduction of taxes results in lower cash for the company

Changes in Stockholder Equity

• Reconciliation of the beginning and ending balances in the Retained Earnings account
• Includes changes that happen throughout the accounting period

Solvency Definition

• Refers to a firm's ability to cover its liabilities with its assets. The cash balance at the end of the period does not help a user evaluate the company's continuing solvency.
• Cash flows from operating activities is the most important factor for solvency.

Income Statement elements*

• Statement of Financial Position is for shareholder equity

What about all those Statement of Cash Flow classifications?

Equity activities is NOT a classification on the State of Cash flows. The classification includes three things:

• Financing activities
• Investing activities
• Operating activities

Available-for-Sale Securities Disclosures

• Should be accounted for on the statement of cash flows as a(n) Investing activity

Statements of Cashflows Operating Activity

If a company has a decrease in accounts payable during the year, the statements of cashflows will look at this as operating.

Limitations to Statement of Financial Position

The statement of financial position, or balance sheet, does not report earnings for the enterprise at all. Earnings are reported on the income statement.

Financial Statement Impact on Sales

• When a fixed asset is sold for less than book value net profit will decrease

Statements of Cashflows Collections

• Only the collections for goods sold to customers are cash inflows from operating activities

Long-term Transactions and Cashflow Statements

• Acquisition of the long-term productive asset is $5,000 cash outflow for an investing activity,
• Obtaining the loan is a $10,000 cash inflow from a financing activity

Trillium Stock Transactions, Statements of Cashflows & Financing

The purchase of Trillium stock for $300,000 is the only investing activity payment of dividends and treasury stock transactions are both financing activities.

Bank Loans & Dividends

The $250,000 interest paid on the bank loan is the only operating activity noted. The dividends paid to shareholders are a financing activity and the purchase of equipment is an investment activity.

How much should be shown in the Financing Activities section?

Answer: Dividends paid ($200,000) and repurchase of the company's stock as treasury stock ($400,000) are transactions that should be classified as cash flows from financing activities on the company's cash flow statement. Interest on debt is classified as a cash flow from operating activities, not financing activities.

Operating Activity Net Cashflow Answer: Cash flow from financing activities included $800,000 cash inflow from sale of stock and $80,000 cash outflow for dividends. Net cash flow from financing activities was therefore $800,000 – $80,000 = $720,000.

Financial Activity Net Cashflow $2,800,000 cash received from the sale of available-for-sale securities is a cash inflow and cash paid for the acquisition of land is a cash outflow ($1,500,000). Both are investing activities. The net cash flow from investing activities is $2,800,000 – $1,500,000 = $1,300,000.

Calculating "Madden's cash inflow from operating activities for the current year is"

The net cash flow from operating activities, calculated using the indirect method, is: Net income $ 82,000 Minus: Gain on sale of equipment (given in problem) (10,000) Plus: Decrease in accounts receivable Minus: Increase in inventory Plus: Depreciation expense Minus: Decrease in accounts payable Net cash flow from operating activities 6,000 (12,000) 20,000 (3,000) $ 83,000

Calculate Cashflows (Indirect Method)?

Depreciation expense is added back to net income because it is a non-cash expense item.

Fair Value Accounting when is a Benefit?

Answer: $28 million in outstanding bonds trading at $98 would be reported at 98% of $28 million using fair value accounting, or $27,440,000. It would be to the firm's benefit to be able to report its liability at lower than nominal, or face, value.

Sell and General Expenses + Depreciation (Cashflow)

$1,110,000 Cash provided by operating activities is calculated as follows: Net income $ 870,000 Plus: Depreciation expenses 200,000 Minus: Gain on sale of equipment (40,000) Minus: Increase in current assets (100,000) Plus: Increase in current liabilities 150,000 Plus: Increase in long-term deferred tax liability 30,000 Cash provided by operating activities $1,110,000

Understand the indirect method for preparing the statement of cash flows. Learn how to adjust net income for depreciation, amortization, and changes in asset and liability accounts. Calculate the net increase in cash by considering these adjustments.