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How Well Am I Doing?

Statement of Cash Flows


Chapter Fifteen

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Purpose of the Statement of Cash Flows

Are cash flows sufficient to support ongoing operations?

Can we meet our obligations to creditors?

Why is there a difference between net income and net cash flow?

Will the company have to borrow money to make needed investments?

Can we pay dividends?

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Learning Objective 1

Classify changes in noncash balance sheet accounts as sources or uses of cash.

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Cash

Currency and Bank Accounts

The term cash on the statement of cash flows refers broadly to both currency and cash equivalents.
T-bills

Cash
Money Market Funds
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Commercial Paper
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Constructing the Statement of Cash Flows Using Changes in Noncash Balance Sheet Accounts

Changes in Capital Stock

Changes in Liabilities

Dividends Paid to Stockholders

Net Cash Flows for a Period

Changes in Noncash Assets

Net Income
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Constructing the Statement of Cash Flows Using Changes in Noncash Balance Sheet Accounts

ome ss es in noncash assets es in liabilities* es in capital stock ts ds paid to stockholders


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Sources Always Decreases Increases Increases

Uses Always Increases Decreases

Decreases Always Total sources - Total uses = Net cash f


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Constructing the Statement of Cash Flows Using Changes in Noncash Balance Sheet Accounts

Increases in noncash asset accounts imply uses of cash.


Example: Inventory is purchased on credit from a supplier. It is implied that cash was used to acquire the inventory.
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Constructing the Statement of Cash Flows Using Changes in Noncash Balance Sheet Accounts

Increases in liability accounts imply sources of cash.


Example: Inventory is purchased on credit from a supplier. It is implied that an increase in a payable has the effect of increasing cash available for other uses.
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Constructing the Statement of Cash Flows Using Changes in Noncash Balance Sheet Accounts

Decreases in noncash assets accounts imply sources of cash.


Example: Accounts receivable decreases when a company pays its bill. When the customer pays the bill, the companys cash increases.
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Constructing the Statement of Cash Flows Using Changes in Noncash Balance Sheet Accounts

Decreases in liability accounts imply uses of cash.


Example: A company pays a note payable held by a creditor. When the payment is made, cash decreases.

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A Simplified Statement of Cash Flows: An Example


Ed's Pizza Hut Comparative Balance Sheet Account Balances 3/31/2008 3/31/2007 Change DR (CR) DR (CR) Incr. (Decr.) $ 71,000 $ 90,000 $ (19,000) 23,000 40,000 (17,000) 350,000 300,000 50,000 68,000 100,000 (32,000) 84,000 84,000 (45,000) (39,000) 6,000 (38,000) (27,000) 11,000 (9,000) (14,000) (5,000) (50,000) (50,000) (500,000) (450,000) 50,000 (4,000) (34,000) (30,000) $ - $ Copyright 2008, The McGraw-Hill Companies, Inc.

Cash Accounts Receivable Inventory Land Equipment Accumulated Depr. Accounts Payable Salaries Payable Note Payable - Joe Doe Common Stock Retained Earnings

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A Simplified Statement of Cash Flows: An Example

Additional Information:
There was a net loss for the year of $27,000. Depreciation charges for the year were $6,000. During the year, Ed sold land originally costing $32,000 for $32,000. During the year, Ed paid dividends of $3,000 to the stockholders. Ed issued $50,000 of common stock to settle the note due to Joe Doe.

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A Simplified Statement of Cash Flows: An Example Here is a summary of the sources of cash for Eds Pizza Hut.
Ed's Pizza Hut Sources of Cash Decrease in A/R $ Decrease in Land Increase in A/P Depreciation charges Total sources of cash $

17,000 32,000 11,000 6,000 66,000

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A Simplified Statement of Cash Flows: An Example Here is a summary of the uses of cash for Eds Pizza Hut.
Ed's Pizza Hut Uses of Cash Net loss Increase in Inventory Increase in Salaries Payable Dividends paid Total uses of cash $ 27,000 50,000 5,000 3,000 85,000

The net cash flow for Eds Pizza Hut is ($19,000): $66,000 in sources minus $85,000 in uses.
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A Simplified Statement of Cash Flows


Ed's Pizza Hut Sources of Cash Decrease in A/R $ Decrease in Land Increase in A/P Depreciation charges Total sources of cash $

17,000 32,000 11,000 6,000 66,000

Ed's Pizza Hut Uses of Cash Net loss Increase in Inventory Increase in Salaries Payable Dividends paid Total uses of cash
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27,000 50,000 5,000 3,000 85,000

This simplified approach does not follow the format required for external reporting purposes. It is for illustrative purposes only.
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Learning Objective 2

Classify transactions as operating, investing, or financing activities.

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The Full-Fledged Statement of Cash Flows: Operating Activities

Operating activities are those activities that enter into the determination of net income.
Transactions affecting current assets Transactions affecting current liabilities Changes in noncurrent balance sheet accounts that directly affect net income

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The Full-Fledged Statement of Cash Flows: Investing Activities

Investing activities relate to transactions involving the acquiring or disposing of noncurrent assets.
Acquiring or selling property, plant and equipment Acquiring or selling securities Lending money to another entity and subsequently collecting on the loan

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The Full-Fledged Statement of Cash Flows: Financing Activities


Financing activities relate to transactions involving borrowing from creditors or repaying creditors and engaging in transactions with the companys owners.
Issuing stock and purchasing treasury stock Issuing long-term debt and repayment of debt. Payment of dividends (note that interest on debt is classified as an operating activity)

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The Full-Fledged Statement of Cash Flows: An Overview

Operating Activities: Net income Changes in current assets Changes in noncurrent assets that affect net income (e.g., depreciation) Changes in current liabilities (except for debts to lenders and dividends payable) Changes in noncurrent liabilities that affect net income Investing Activities: Changes in noncurrent assets that are not included in net income Financing Activities: Changes in the current liabilities that are debts to lenders rather than obligations to suppliers, employees, or the government Changes in noncurrent liabilities that are not included in net income Changes in capital stock accounts Dividends
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The Full-Fledged Statement of Cash Flows: An Overview

Operating Activities Investing Activities Financing Activities


Reconciliation of the beginning cash balance with the ending cash balance

Noncash Investing and Financing Activities


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Operating Activities
Net Income (Loss) Add: Decr. in Current Noncash Assets Incr. in Current Liabilities Depreciation Charges Losses Less: Incr. in Current Noncash Assets Decr. in Current Liabilities Gains Net Cash Flows from Operating Activities $ XXX XXX XXX XXX XXX (XXX) (XXX) (XXX) $ XXX

Includes those activities that enter into the determination of net income.
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Operating Activities

Sources of cash are added to net income and uses of cash are subtracted from net income.
Impact on Net Income Sources Uses Current Noncash Assets Current Liabilities Decreases Increases Increases Decreases

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Operating Activities
Net Income (Loss) Add: Decr. in Current Noncash Assets Incr. in Current Liabilities Depreciation Charges Losses Less: Incr. in Current Noncash Assets Decr. in Current Liabilities Gains Net Cash Flows from Operating Activities
Impact on Net Income Sources Uses Current Noncash Assets Current Liabilities
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$ XXX XXX XXX XXX XXX (XXX) (XXX) (XXX) $ XXX

Decreases Increases

Increases Decreases
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Operating Activities
Net Income (Loss) Add: Decr. in Current Noncash Assets Incr. in Current Liabilities Depreciation Charges Losses Less: Incr. in Current Noncash Assets Decr. in Current Liabilities Gains Net Cash Flows from Operating Activities
Impact on Net Income Sources Uses Current Noncash Assets Current Liabilities
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$ XXX XXX XXX XXX XXX (XXX) (XXX) (XXX) $ XXX

Decreases Increases

Increases Decreases
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Operating Activities
Net Income (Loss) Add: Decr. in Current Noncash Assets Incr. in Current Liabilities Depreciation Charges Losses Less: Incr. in Current Noncash Assets Decr. in Current Liabilities Gains Net Cash Flows from Operating Activities $ XXX XXX XXX XXX XXX (XXX) (XXX) (XXX) $ XXX

Depreciation and Amortization charges are added back to net income because they are decreases in noncash assets.
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Operating Activities
Net Income (Loss) Add: Decr. in Current Noncash Assets Incr. in Current Liabilities Depreciation Charges Losses Less: Incr. in Current Noncash Assets Decr. in Current Liabilities Gains Net Cash Flows from Operating Activities
Gains are subtracted from net income.
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$ XXX XXX XXX XXX XXX (XXX) (XXX) (XXX) $ XXX

Losses are added back to net income.


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Investing Activities
Add: Proceeds from sale of land, buildings, equipment, or other noncurrent assets Receipt of principal from investments Less: Payments to acquire land, buildings, equipment, or other noncurrent assets Payments to acquire investments Net Cash Flows from Investing Activities

$ XXX XXX

(XXX) (XXX) $ XXX

Includes transactions that involve the acquisition or disposal of noncurrent assets.


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Financing Activities
Add: Proceeds from borrowings Proceeds from issuing capital stock Proceeds from sale of bonds Less: Principal payments on borrowed funds Payments related to bond maturities Dividend payments Net Cash Flows from Financing Activities $ XXX XXX XXX (XXX) (XXX) (XXX) $ XXX

Includes transactions involving receipts from or payments to creditors and owners.


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Other Issues: Gross or Net?


Example:

For investing and financing activities, items on the statement of cash flows should be presented in gross amounts rather than in net amounts.
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Assume Macys purchases $50 million in property during the year and sells other property for $30 million. Instead of showing the net change of $20 million, the company must report the gross amounts of both transactions.
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Other Issues: Direct Method or Indirect Method? Two Formats for Reporting Operating Activities

Direct Method

Indirect Method Starts with accrual net income and converts to cash basis

Reports the cash effects of each operating activity

No matter which format is used, the same amount of net cash flows from operating activities is generated.
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Learning Objective 3

Prepare a statement of cash flows using the indirect method to determine the net cash provided by operating activities.
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A Full-Fledged Statement of Cash Flows: An Example


Ed's Pizza Hut Comparative Balance Sheet Account Balances 3/31/2008 3/31/2007 Change DR (CR) DR (CR) Incr. (Decr.) $ 71,000 $ 90,000 $ (19,000) 23,000 40,000 (17,000) 350,000 300,000 50,000 68,000 100,000 (32,000) 84,000 84,000 (45,000) (39,000) 6,000 (38,000) (27,000) 11,000 (9,000) (14,000) (5,000) (50,000) (50,000) (500,000) (450,000) 50,000 (4,000) (34,000) (30,000) $ - $ -

Cash Accounts Receivable Inventory Land Equipment Accumulated Depr. Accounts Payable Salaries Payable Note Payable - Joe Doe Common Stock Retained Earnings

Lets revisit the comparative balance sheet account balances for Eds Pizza Hut.

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A Full-Fledged Statement of Cash Flows: An Example Lets also refresh our memory regarding the following additional information.

Additional Information:
There was a net loss for the year of $27,000. Depreciation charges for the year were $6,000. During the year, Ed sold land originally costing $32,000 for $32,000. During the year, Ed paid dividends of $3,000 to the stockholders. Ed issued $50,000 of common stock to settle the note due to Joe Doe.
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Preparing the Statement of Cash Flows: Step 1


Ed's Pizza Hut Statement of Cash Flows Worksheet Source Cash Flow AdjustChange or Use? Effect ments Assets (except cash and Current assets Accounts receivable Inventory Noncurrent assets Land Equipment Contra Assets, Liabilities, Contra assets Accumulated depreciation Current liabilities Accounts payable Salaries payable Noncurrent liabilities Notes payable Stockholders' equity Common stock Retained earnings Net loss Dividends Total (net cash flow)
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Adjusted Effect

Classification

List each account appearing on the comparative balance sheets except for cash and cash equivalents and retained earnings.

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Preparing the Statement of Cash Flows: Step 2


Ed's Pizza Hut Statement of Cash Flows Worksheet Source Cash Flow AdjustChange or Use? Effect ments Assets (except cash and Current assets Accounts receivable Inventory Noncurrent assets Land Equipment Contra Assets, Liabilities, Contra assets Accumulated depreciation Current liabilities Accounts payable Salaries payable Noncurrent liabilities Notes payable Stockholders' equity Common stock Retained earnings Net loss Dividends Total (net cash flow)
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Adjusted Effect

Classification

(17,000) 50,000 (32,000) -

6,000 11,000 (5,000) (50,000) 50,000 (27,000) 3,000

Compute the change from the beginning balance to the ending balance for each account.

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Preparing the Statement of Cash Flows: Step 3


Ed's Pizza Hut Statement of Cash Flows Worksheet Source Cash Flow AdjustChange or Use? Effect ments Assets (except cash and Current assets Accounts receivable Inventory Noncurrent assets Land Equipment Contra Assets, Liabilities, Contra assets Accumulated depreciation Current liabilities Accounts payable Salaries payable Noncurrent liabilities Notes payable Stockholders' equity Common stock Retained earnings Net loss Dividends Total (net cash flow)
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Adjusted Effect

Classification

(17,000) Source 50,000 Use (32,000) Source -

6,000

Source

Code each entry on the worksheet as a source or use of cash.

11,000 Source (5,000) Use (50,000) 50,000 (27,000) 3,000 Use Source Use Use

Recall that the transaction involving the Notes Payable and Common Stock was noncash.

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Preparing the Statement of Cash Flows: Step 4


Ed's Pizza Hut Statement of Cash Flows Worksheet Source Cash Flow AdjustChange or Use? Effect ments Assets (except cash and Current assets Accounts receivable Inventory Noncurrent assets Land Equipment Contra Assets, Liabilities, Contra assets Accumulated depreciation Current liabilities Accounts payable Salaries payable Noncurrent liabilities Notes payable Stockholders' equity Common stock Retained earnings Net loss Dividends Total (net cash flow)
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Adjusted Effect

Classification

(17,000) Source 50,000 Use (32,000) Source -

17,000 (50,000) 32,000 -

6,000

Source

6,000 11,000 (5,000) (50,000) 50,000 (27,000) (3,000) (19,000)

11,000 Source (5,000) Use (50,000) 50,000 (27,000) 3,000 Use Source Use Use $

Code sources of cash as positive numbers and uses of cash as negative numbers.

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Preparing the Statement of Cash Flows: Step 5


Ed's Pizza Hut Statement of Cash Flows Worksheet Source Cash Flow AdjustChange or Use? Effect ments Adjusted Effect

Make any Classifinecessary cation

(17,000) Source 50,000 Use (32,000) Source -

17,000 (50,000) 32,000 -

17,000 (50,000) 32,000 -

on

6,000

Source

6,000 11,000 (5,000) (50,000)

50,000

11,000 Source (5,000) Use (50,000)


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{
-

6,000

adjustments, including adjustments for gains and losses. The net effect of these should equal zero.

We need to make an adjustment 11,000 the noncash transaction for relating to Notes Payable and (5,000) Common Stock.

Use

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Preparing the Statement- of$ Cash Flows: Step 6 (17,000) Source $ 17,000 17,000 Operating
50,000 Use (50,000) 32,000 (50,000) 32,000 Operating Investing (32,000) Source -

ion

6,000

Source

6,000 11,000 (5,000) (50,000) 50,000 (27,000) (3,000) (19,000) $

50,000 (50,000) -

6,000 11,000 (5,000) (27,000) (3,000) (19,000)

Operating Operating Operating

11,000 Source (5,000) Use (50,000) 50,000 (27,000) 3,000 Use Source Use Use $

Operating Financing

Classify each entry as operating, investing or financing activity.

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Preparing the Statement of Cash Flows: Step 7

Ed's Pizza Hut Statement of Cash Flows For the Period Ending 3/31/2008 Operating Activities Net Loss $ Add: Decrease in A/R Increase in A/P Increase in Depr. Charges Less: Increase in Inventory Decrease in Salaries Payable Net Cash Flow from Operations Investing Activities Proceeds from sale of Land Financing Activities Dividends paid Net change in cash

(27,000) 17,000 11,000 6,000 (50,000) (5,000) (48,000) 32,000 (3,000) (19,000)

Copy the data from the worksheet into the Statement of Cash Flows section by section.

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Preparing the Statement of Cash Flows: Step 8

Ed's Pizza Hut Statement of Cash Flows For the Period Ending 3/31/2008 Operating Activities Net Loss $ Add: Decrease in A/R Increase in A/P Increase in Depr. Charges Less: Increase in Inventory Decrease in Salaries Payable Net Cash Flow from Operations Investing Activities Proceeds from sale of Land Financing Activities Dividends paid Net change in cash Cash, beginning Cash, ending $
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(27,000) 17,000 11,000 6,000 (50,000) (5,000) (48,000) 32,000 (3,000) (19,000) 90,000 71,000

Prepare a cash reconciliation at the bottom of the statement.

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Example Indirect Method


Ed's Pizza Hut Statement of Cash Flows For the Period Ending 3/31/2008 Operating Activities Net Loss $ Add: Decrease in A/R Increase in A/P Increase in Depr. Charges Less: Increase in Inventory Decrease in Salaries Payable Net Cash Flow from Operations Investing Activities Proceeds from sale of Land Financing Activities Dividends paid Net change in cash Cash, beginning Cash, ending $
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(27,000) 17,000 11,000 6,000 (50,000) (5,000) (48,000) 32,000 (3,000) (19,000) 90,000 71,000

In addition, on the face of the statement or in a supplemental schedule, disclose the issuance of $50,000 of stock to a creditor, a noncash financing activity.
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Interpretation of the Statement of Cash Flows

Examine the operating activities section carefully.


Eds Pizza Hut generated a negative cash flow from operations of $48,000. This is usually a sign of fundamental difficulties. Ultimately, a positive cash flow is necessary to avoid liquidating assets or borrowing money to pay for day-to-day activities.

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The Direct Method of Determining the Net Cash Provided by Operating Activities
Appendix 15A

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Learning Objective 4

Use the direct method to determine the net cash provided by operating activities. (Appendix 15A)

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Computing Net Cash Provided by Operating Activities

The direct method computes net cash provided by operating activities by reconstructing the income statement on a cash basis from top to bottom.

Cash provided by operating activities under the direct method will always agree with the amount computed using the indirect method.
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Similarities and Differences in Handling Data


Revenue or Expense Item Sales revenue (as reported) Adjustments to a cash basis: Increases in accounts receivable Decreases in accounts receivable Cost of goods sold (as reported) Adjustments to a cash basis: Increase in merchandise inventory Decrease in merchandise inventory Increase in accounts payable Decrease in accounts payable Operating expenses (as reported) Adjustments to a cash basis: Increase in prepaid expenses Decrease in prepaid expenses Increase in accrued liabilities Decrease in accrued liabilities Period's depreciation, depletion and amortization charges Income tax expense (as reported) Adjustments to a cash basis: Increase in accrued taxes payable Decrease in accrued taxes payable Increase in deferred income taxes Decrease in deferred income taxes
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Add (+) or Deduct (-) to Adjust to a Cash Basis

+ +

Adjustments for accounts that affect revenue are the same in the direct and indirect methods.
Adjustments for accounts that affect expenses are handled in opposite ways for the direct and indirect methods.

+ + -

+ +
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Direct Method: Gains and Losses

Under the direct method, no adjustments for gains and losses on the sale of assets are needed.

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The Direct Method: An Example


Ed's Pizza Hut Comparative Balance Sheet Account Balances 3/31/2008 3/31/2007 Change DR (CR) DR (CR) Incr. (Decr.) $ 71,000 $ 90,000 $ (19,000) 23,000 40,000 (17,000) 350,000 300,000 50,000 68,000 100,000 (32,000) 84,000 84,000 (45,000) (39,000) 6,000 (38,000) (27,000) 11,000 (9,000) (14,000) (5,000) (50,000) (50,000) (500,000) (450,000) 50,000 (4,000) (34,000) (30,000) $ - $ -

Cash Accounts Receivable Inventory Land Equipment Accumulated Depr. Accounts Payable Salaries Payable Note Payable - Joe Doe Common Stock Retained Earnings

Lets revisit the comparative balance sheet account balances for Eds Pizza Hut.

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The Direct Method: An Example


Ed's Pizza Hut Income Statement For the Year Ended 3/31/2008 Sales $ 1,000,000 Cost of goods sold 750,000 Gross margin 250,000 Operating expenses 277,000 Net loss $ (27,000)

Lets assume that Eds Pizza Hut prepared this income statement.
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The Direct Method: An Example

Step 1: Translate sales revenue into cash collected from customers.

Sales (as reported) Add: Decrease in accounts receivable Cash collected from customers

$ $

1,000,000 17,000 1,017,000

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The Direct Method: An Example

Step 2: Translate cost of goods sold into cash disbursements for purchases.
Cost of goods sold (as reported) $ Add: Increase in inventory Less: Increase in accounts payable Cash paid for purchases $ 750,000 50,000 (11,000) 789,000

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The Direct Method: An Example

Step 3: Translate operating expenses into cash paid for operating expenses.
Operating expenses (as reported) Add: Decrease in salaries payable Less: Increase in depreciation Cash paid for operating expenses $ 277,000 5,000 (6,000) 276,000

No adjustment for income taxes is required because Eds Pizza Hut has a net loss of $27,000.
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The Direct Method: An Example


Ed's Pizza Hut Statement of Cash Flows For the Period Ending 3/31/2008 Operating Activities Cash received from customers $ 1,017,000 Cash paid for purchases (789,000) Cash paid for operating expenses (276,000) Net Cash Flow from Operations (48,000) Investing Activities Proceeds from sale of land 32,000 Financing Activities Dividends paid (3,000) Net change in cash (19,000) Cash, beginning 90,000 Cash, ending $ 71,000
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Notice that the net cash provided by operating activities agrees with that computed using the indirect method.
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End of Chapter 15

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