- Discuss and show how to prepare a Statement of Cash Flows using the indirect method - Explain how to interpret the statement of cash flows [SLIDE 1] Recall from your financial accounting course that the accrual basis of accounting recognizes revenue when earned, and expenses when incurred, regardless of when cash is exchanged. Conversely, the cash basis of accounting recognizes revenue when cash is received and expenses when cash is paid, regardless of when goods or services are exchanged. The income statement, balance sheet, and statement of owners' equity are all created using the accrual basis of accounting. However, the statement of cash flows is based on cash flows only, and thus adjustments must be made to convert accrual basis information to a cash basis. As we begin to prepare a Statement of Cash Flows, several pieces of information are required to make adjustments:

Balance sheets for the end of last year and the end of the current year are needed to calculate the amount of change in each balance sheet account. These changes in balance sheet accounts are needed to prepare certain parts of the statement of cash flows.
Income statement information for the current year is needed as the starting point for converting net income from an accrual basis to a cash basis, which is shown in the operating activities section of the statement of cash flows.
Other information is needed to complete the statement of cash flows, such as cash dividends paid and the original cost of long-term investments sold.

With this information, we have four steps required to complete the statement of cash flows:

Prepare the operating activities section by converting net income from an accrual basis to a cash basis. This step can be done using one of two methods: the direct method or the indirect method. We are focusing on the indirect method, which begins with net income from the income statement and makes several adjustments related to changes in current assets, current liabilities, and other items to arrive at cash provided by operating activities(or used by operating activities if the result is a cash outflow). Cash provided by operating activities represents net income on a cash basis. It tells the reader how much cash was received from the daily operations of the business.
Prepare the investing activities section by presenting cash activity for noncurrent assets. This step focuses on the effect changes in noncurrent assets have on cash. Noncurrent asset balances found on the balance sheet, coupled with other information (i.e., cash proceeds from sale of equipment) are used to perform this step.
Prepare the financing activities section by presenting cash activity for noncurrent liabilities and owners' equity. This step focuses on the effect that changes in noncurrent liabilities and owners' equity have on cash. Noncurrent liabilities and owners' equity balances found on the balance sheet, coupled with other information (e.g., cash dividends paid), are used to perform this step.
Reconcile the change in cash. Each section of the statement of cash flows described in steps 1, 2, and 3, will show the total cash provided by (increase) or used by (decrease) the activity. Step 4 simply confirms that the net of these changes equates to the change in cash on the balance sheet.

Now that we have the steps to creating a statement of cash flows, we will begin with the operating section. Our example is Ivy Company and the balance sheet, income statement and additional information are provided on the slide and listed below.

Ivy Company Comparative Balance Sheet December 31, 2009, and 2008
	2009	2008
Assets
Cash	$4	$11
Accounts receivable	310	230
Inventory	160	195
Prepaid expenses	8	6
Plant and equipment	500	420
Accumulated depreciation	(85)	(70)
Long-term investments	31	38
Total assets	$928	$830
Liabilities and Stockholders' Equity
Accounts payable	$300	$225
Accrued liabilities	70	80
Bonds payable	195	170
Deferred income taxes	71	63
Common stock	160	200
Retained earnings	132	92
Total liabilities and stockholders' equity	$928	$830

Ivy Company Income Statement For the Year Ended December 31, 2009
Sales		$750
Cost of goods sold		450
Gross margin		300
Selling and administrative expenses		223
Net operating income		77
Nonoperating items:
Gain on sale of investments	$5
Loss on sale of equipment	2	3
Income before taxes		80
Income taxes		24
Net income		$56

During 2008, the company sold some equipment for $18 that had cost $30 and on which there was accumulated depreciation of $10. In addition, the company sold long-term investments for $12 that had cost $7 when purchased several years ago. Cash dividends totaling $16 were paid during 2008. [SLIDE 2] We will be using the indirect method to prepare the operating activities section. The starting point using the indirect method is net income. This amount comes from the income statement, which was prepared using the accrual basis of accounting. In order to convert net income to a cash basis, several adjustments are necessary to provide an amount related only to daily operating activities of the business. If the resulting adjusted amount is a cash inflow, it is called cash provided by operating activities; if it is a cash outflow, it is called cash used by operating activities. We will use the three step method discussed earlier to prepare the operating activities section:

Add depreciation charges to net income
Analyze net changes in noncash balance sheet accounts that impact net income
Adjust for gains and losses included on the income statement

The first adjustment to net income involves adding back expenses that do not affect cash (often called noncash expenses). For example, the accrual basis of accounting deducts depreciation expense in calculating net income, even though depreciation expense does not involve cash. Thus to convert net income to a cash basis, depreciation expense is added back to net income. For our example, this would mean adding back $25 and the calculation follows (remember, accumulated depreciation is a contra asset): Basic Equation for Contra-Asset, Liability, and Stockholders' Equity Accounts Beginning balance - Debits + Credits = Ending balance 70 -10 + ADJ = 85 ADJ = 85 – 70 + 10 ADJ = 15 + 10 ADJ = 25 We have $70 as the beginning balance and we sold an asset that had $10 in accumulated depreciation. We take the ending balance of $85 and make the adjustments by subtracting the $70 and adding back the $10 to get the cash flow adjustment of $25. One thought to remember here is: because depreciation is added back to net income on the statement of cash flows, some people erroneously conclude that a company can increase its cash flow by simply increasing its depreciation expense. This is false; a company cannot increase its net cash provided by operating activities by increasing its depreciation expense. If it increases its depreciation expense by X dollars, then net income will decline by X dollars and the amount of the adjustment in step one of this process will increase by X dollars. The decline in net income and the increase in the amount of the adjustment in step one exactly offset each other, resulting in zero impact on the net cash provided by operating activities. Once we have adjusted for depreciation, the next step is to analyze net changes in noncash balance sheet accounts that impact net income. Notice that changes in all current asset accounts (Accounts Receivable, Inventory, and Prepaid Expenses) result in the same type of adjustment to net income. If an asset account balance increases during the period, then the amount of the increase is subtracted from net income. If an asset account balance decreases during the period, then the amount of the decrease is added to net income. The current liability accounts (Accounts Payable, Accrued Liabilities, and Income Taxes Payable) are handled in the opposite fashion. If a liability account balance increases, then the amount of the increase is added to net income. If a liability account balance decreases, then the amount of the decrease is subtracted from net income. Keep in mind that the purpose of these adjustments is to translate net income to a cash basis. The third step in computing the net cash provided by operating activities is to adjust for gains/losses included in the income statement. Under U.S. GAAP and IFRS rules, the cash proceeds from the sale of noncurrent assets must be included in the investing activities section of the statement of cash flows. To comply with these rules, the gains and losses pertaining to the sale of noncurrent assets must be removed from net income as reported in the operating activities section of the statement of cash flows. To make this adjustment, subtract gains from net income and add losses to net income in the operating activities section. While not a requirement, a worksheet using the balance sheet accounts may be helpful to assist with where to post adjustments on a cash flow statement. The one below is for our example:

	Change	Source or Use?	Cash Flow Effect	Adjustments	Adjusted Effect	Classification
Assets (except cash and cash equivalents) Current assets:
Accounts receivable	80	Use	(80)		(80)	Operating
Inventory	(35)	Source	35		35	Operating
Prepaid expenses	2	Use	(2)		(2)	Operating
Noncurrent assets:
Plant and equipment	80	Use	(80)	(30)	(110)	Investing
Long-term investments	(7)	Source	7	(7)	-	Investing
Liabilities, Contra assets, and Stockholders' Equity Contra assets:
Accumulated depreciation	15	Source	15	10	25	Operating
Current liabilities:
Accounts payable	75	Source	75		75	Operating
Accrued liabilities	(10)	Use	(10)		(10)	Operating
Noncurrent liabilities:
Bonds payable	25	Source	25		25	Financing
Deferred income taxes	8	Source	8		8	Operating
Stockholders' equity:
Common stock	(40)	Use	(40)		(40)	Financing
Retained earnings:
Net income	56	Source	56		56	Operating
Dividends	(16)	Use	(16)		(16)	Financing
Additional entries:
Proceeds from sale of equipment				18	18	Investing
Loss on sale of equipment				2	2	Operating
Proceeds from sale of long-term Investments				12	12	Investing
Gain on sale of long-term Investments				(5)	(5)	Operating
Total			(7)	-	(7)

This worksheet shows the change in the account balance, whether the change represents a source or use of cash, the effect on cash flow, any adjustments, the adjusted effect to the cash flow statement, and where on the statement of cash flows the adjustment belongs. From this information, we can complete the operating section of the statement of cash flows as follows:

Operating activities:
Net income		$56
Adjustments to convert net income to a cash basis:
Depreciation charges for the year	25
Increase in accounts receivable	(80)
Decrease in inventory	35
Increase in prepaid expenses	(2)
Increase in accounts payable	75
Decrease in accrued liabilities	(10)
Gain on sale of investments	(5)
Loss on sale of equipment	2
Increase in deferred income taxes	8	48
Net cash provided by operating activities		$104

We have only selected the items from the worksheet that should be included in the operating activities section of the statement of cash flows. Next, we will review the items for the investing section. [SLIDE 3] U.S. GAAP and IFRS require that the investing and financing sections of the statement of cash flows disclose gross cash flows. The gross method of reporting cash flows is NOT used in the operating activities section of the statement of cash flows, where debits and credits are netted against each other. To compute gross cash flows for the investing and financing activities sections of the statement of cash flows, you'll begin by calculating the changes in the balance of each applicable balance sheet account. As with the current assets, when a noncurrent asset account balance (including Property, Plant, and Equipment; Long-Term Investments; and Loans to Other Entities) increases, it signals the need to subtract cash outflows in the investing activities section of the statement of cash flows. If the balance in a noncurrent asset account decreases during the period, then it signals the need to add cash inflows. The liability and equity accounts (Bonds Payable and Common Stock) are handled in the opposite fashion. If a liability or equity account balance increases, then it signals a need to add cash inflows to the financing activities section of the statement of cash flows. If a liability or equity account balance decreases, then it signals a need to subtract cash outflows. As we continue with our example, we have summarized the balance sheet items below that affect the investing and financing sections of the statement of cash flows below.

	Change	Source or Use?	Cash Flow Effect	Adjustments	Adjusted Effect	Classification
Assets (except cash and cash equivalents) Noncurrent assets:
Plant and equipment	80	Use	(80)	(30)	(110)	Investing
Long-term investments	(7)	Source	7	(7)	-	Investing
Liabilities, Contra assets, and Stockholders' Equity Noncurrent liabilities:
Bonds payable	25	Source	25		25	Financing
Common stock	(40)	Use	(40)		(40)	Financing
Retained earnings:
Dividends	(16)	Use	(16)		(16)	Financing
Additional entries
Proceeds from sale of equipment				18	18	Investing
Proceeds from sale of long-term Investments				12	12	Investing

With this information, our statement of cash flows section for investing and financing would look like the below:

Investing activities:
Proceeds from sale of long-term investments	$12
Proceeds from sale of equipment	18
Additions to plant and equipment	(110)
Net cash used for investing activities		(80)
Financing activities:
Increase in bonds payable	25
Decrease in common stock	(40)
Cash dividends	(16)
Net cash used for financing activities		(31)

The last step is the reconciliation to the cash balance. [SLIDE 4] The final step is to show that the change in cash on the statement of cash flows agrees with the change in cash on the balance sheet as shown at the bottom of the completed statement of cash flows. The following formula is used to calculate the net change in cash: Net change in cash and cash equivalents = Net cash provided by (used in) operating activities + Net cash provided by (used in) investing activities + Net cash provided by (used in) financing activities Our reconciliation of cash shows (in summary):

Net cash provided by operating activities	$104
Net cash used for investing activities	(80)
Net cash used for financing activities	(31)
Net decrease in cash	$(7)
Cash, January 1, 2009	11
Cash, December 31, 2009	$4

As you can see, our cash balance reconciles to the December 31, 2009 balance on the balance sheet. Our change between January 1, 2009 and December 31, 2009 was a decrease of $7. Subtracted from the January 1 beginning balance, we arrive at the $4 balance at December 31. [SLIDE 5] Managers can derive many useful insights by studying the statement of cash flows. A statement of cash flows should be evaluated in the context of a company's specific circumstances. A company with growing sales would understandably have an increase in its accounts receivable, inventory, and accounts payable balances. On the other hand, if a company with declining sales has increases in these account balances, it could signal trouble. Useful information can also be derived by examining the relationships among the numbers. For example, some managers study their company's trends in cash flow by comparing the net cash provided by operating activities to sales. The goal is to continuously increase the operating cash flows earned per sales dollar. Managers can also compare the additions to property, plant, and equipment in the investing activities section of the statement of cash flows to the depreciation included in the operating activities section of the statement. If the additions to property, plant and equipment are consistently less than depreciation, it suggests the company is not investing enough money to maintain its noncurrent assets. Free cash flow can be derived from the statement of cash flows. It measures a company's ability to fund its capital expenditures and dividends from its net cash provided by operating activities minus capital expenditures and minus dividends. A positive number indicates that the company generated enough cash flow from it operating activities to fund its capital expenditures and dividend payments. A negative number suggests that the company needed to obtain cash from other sources, such as borrowing money from lenders or issuing shares of common stock, to fund its investments in property, plant, and equipment and its dividend payments. The formula for free cash flow is: Free cash flow = Net cash provided by operating activities - Capital expenditures – Dividends In addition to free cash flow, managers and investors often look at the relationship between net income and net cash provided by operating activities to help assess the extent to which a company's earnings truly reflects operational performance. Managers generally perceive that earnings are of higher quality, or more indicative of operational performance, when the earnings:

Are not unduly influenced by inflation
Are computed using conservative accounting principles and estimates
Are correlated with net cash provided by operating activities

When a company's net income and net cash provided by operating activities move in tandem with one another (in other words, are correlated with one another), it suggests that earnings result from changes in sales and operating expenses. Conversely, if a company's net income is steadily increasing and its net cash provided by operating activities is declining, it suggests that net income is being influenced by factors unrelated to operational performance, such as nonrecurring transactions or aggressive accounting principles and estimates.