“How Well Am I Doing?

”
Statement of Cash Flows
Chapter 15

© 2010 The McGraw-Hill Companies, Inc.

 Purpose of the Statement of Cash Flows

Are Why
Whyisisthere
thereaa
Arecash
cash flows
flows
sufficient difference
sufficienttoto difference
support between
betweennet
supportongoing
ongoing Can
net
operations? Canwe
wemeet
meet income
incomeandandnet
net
operations? our
ourobligations
obligations cash
cashflow?
flow?
to
tocreditors?
creditors?

Will
Willthe
thecompany
company
have
haveto toborrow
borrow Can
money Canwe wepay
pay
moneyto tomake
make dividends?
dividends?
needed
needed
investments?
investments?

McGraw-Hill/Irwin Slide 2
 Learning Objective 1

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

McGraw-Hill/Irwin Slide 3
 Cash

The term cash on the statement of cash flows refers

broadly to both currency and cash equivalents.

Currency and
Bank Accounts
Treasury
Bills

Cash
Money Market Commercial
Funds Paper
McGraw-Hill/Irwin Slide 4
 Constructing the Statement of Cash Flows Using Changes
in Noncash Balance Sheet Accounts

4. Changes in 3. Changes in
Capital Stock Liabilities

Net Cash
Flows for a
5. Dividends Period 2. Changes in
Paid to Noncash
Stockholders Assets

1. Net Income

McGraw-Hill/Irwin Slide 5
 Constructing the Statement of Cash Flows Using Changes
in Noncash Balance Sheet Accounts

McGraw-Hill/Irwin Slide 6
 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.

McGraw-Hill/Irwin Slide 7
 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.

McGraw-Hill/Irwin Slide 8
 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 customer
pays their bill.

When the customer pays the

bill, the company’s cash
increases.

McGraw-Hill/Irwin Slide 9
 Constructing the Statement of Cash Flows Using Changes
in Noncash Balance Sheet Accounts

Decreases in liability accounts

imply uses of cash.

Example:
Example: A A company
company
pays
pays aa note
note payable
payable held
held
by
by aa creditor.
creditor.

When the payment is made,

cash decreases.

McGraw-Hill/Irwin Slide 10
 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.)
Cash $ 71,000 $ 90,000 $ (19,000)
Accounts Receivable 23,000 40,000 (17,000)
Inventory 322,000 300,000 22,000
Land 68,000 100,000 (32,000)
Equipment 112,000 84,000 28,000
Accumulated Depr. (45,000) (39,000) 6,000
Accounts Payable (38,000) (27,000) 11,000
Salaries Payable (9,000) (14,000) (5,000)
Note Payable - Joe Doe - (50,000) (50,000)
Common Stock (500,000) (450,000) 50,000
Retained Earnings (4,000) (34,000) (30,000)
$ - $ -

McGraw-Hill/Irwin Slide 11
 A Simplified Statement of Cash Flows: An
Example

Additional
Additional Information:
Information:
 There was a net loss for the year of $27,000.
There was a net loss for the year of $27,000.
 Depreciation charges for the year were $6,000.
Depreciation charges for the year were $6,000.
 During the year, Ed sold land originally costing $32,000 for
During the year, Ed sold land originally costing $32,000 for
$32,000.
$32,000.
 During the year, Ed purchased equipment for $28,000.
During the year, Ed purchased equipment for $28,000.
 During the year, Ed paid dividends of $3,000 to the
During the year, Ed paid dividends of $3,000 to the
stockholders.
stockholders.
 Ed issued $50,000 of common stock to settle the note due to
Ed issued $50,000 of common stock to settle the note due to
Joe
JoeDoe.
Doe.

McGraw-Hill/Irwin Slide 12
 A Simplified Statement of Cash Flows: An
Example

Here is a summary of the sources

of cash for Ed’s Pizza Hut.

Ed's Pizza Hut

Sources of Cash
Decrease in A/R $ 17,000
Decrease in Land 32,000
Increase in A/P 11,000
Depreciation charges 6,000
Total sources of cash $ 66,000

McGraw-Hill/Irwin Slide 13
 A Simplified Statement of Cash Flows: An
Example

Here is a summary of the uses of

cash for Ed’s Pizza Hut.
Ed's Pizza Hut
Uses of Cash
Net loss $ 27,000
Increase in Inventory 22,000
Increase in Equipment 28,000
Increase in Salaries Payable 5,000
Dividends paid 3,000
Total uses of cash $ 85,000

The net cash flow for Ed’s Pizza Hut is ($19,000):

$66,000 in sources minus $85,000 in uses.
McGraw-Hill/Irwin Slide 14
 A Simplified Statement of Cash Flows
Ed's Pizza Hut
Sources of Cash
Decrease in A/R $ 17,000
This simplified
Decrease in Land 32,000 approach does
Increase in A/P 11,000 not follow the
Depreciation charges 6,000
Total sources of cash $ 66,000 format required
for external
Ed's Pizza Hut
Uses of Cash reporting
Net loss $ 27,000 purposes. It is
Increase in Inventory 22,000
Increase in Equipment 28,000
for illustrative
Increase in Salaries Payable 5,000 purposes only.
Dividends paid 3,000
Total uses of cash $ 85,000

McGraw-Hill/Irwin Slide 15
 Learning Objective 2

Classify transactions as
operating, investing, or
financing activities.

McGraw-Hill/Irwin Slide 16
 The Full-Fledged Statement of Cash Flows:
Operating Activities

Operating activities are

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

McGraw-Hill/Irwin Slide 17
 The Full-Fledged Statement of Cash Flows:
Investing Activities

Investing activities relate to

transactions involving the
acquiring or disposing of
noncurrent assets.

3. Lending money
1. Acquiring or
to another entity
selling property,
and subsequently
plant and
collecting on the
equipment
2. Acquiring or loan
selling securities

McGraw-Hill/Irwin Slide 18
 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
company’s owners.
3. Payment of
dividends (note
1. Issuing stock
that interest on
and purchasing
debt is classified
treasury stock
2. Issuing long- as an operating
term debt and activity)
repayment of debt.

McGraw-Hill/Irwin Slide 19
 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
McGraw-Hill/Irwin Slide 20
 The Full-Fledged Statement of Cash Flows: An
Overview

Operating Activities

Investing Activities
Reconciliation of the
beginning cash balance
Financing Activities with the ending cash
balance
Noncash Investing
and Financing
Activities
McGraw-Hill/Irwin Slide 21
 Operating Activities

Includes those activities that affect current

assets, current liabilities, or net income.
McGraw-Hill/Irwin Slide 22
 Operating Activities

Sources of cash are added to net

income and uses of cash are
deducted from net income.

McGraw-Hill/Irwin Slide 23
 Operating Activities

McGraw-Hill/Irwin Slide 24
 Operating Activities

McGraw-Hill/Irwin Slide 25
 Operating Activities

Depreciation and Amortization charges are added

back because they are decreases in noncash assets.

McGraw-Hill/Irwin Slide 26
 Operating Activities

Gains
Gainsare
are Losses
Lossesare
areadded.
added.
subtracted.
subtracted.

McGraw-Hill/Irwin Slide 27
 Investing Activities
Add:
Add: Proceeds
Proceedsfromfrom sale
sale of
ofland,
land,
buildings,
buildings, equipment,
equipment, or or other
other
noncurrent
noncurrentassets
assets $$ XXX
XXX
Receipt
Receiptof ofprincipal
principal from
from
investments
investments XXX
XXX
Less:
Less: Payments
Paymentsto to acquire
acquire land,
land,
buildings,
buildings, equipment,
equipment, or or other
other
noncurrent
noncurrentassets
assets (XXX)
(XXX)
Payments
Paymentsto to acquire
acquire
investments
investments (XXX)
(XXX)
Net
NetCash
Cash Flows
Flowsfrom
from Investing
Investing Activities
Activities $$ XXX
XXX

Includes
Includes transactions
transactions that
that involve
involve the
the
acquisition
acquisition or
or disposal
disposal of
of noncurrent
noncurrent assets.
assets.
McGraw-Hill/Irwin Slide 28
 Financing Activities
Add:
Add: Proceeds
Proceedsfrom
from borrowings
borrowings $$ XXX
XXX
Proceeds
Proceedsfrom
from issuing
issuing capital
capital
stock
stock XXX
XXX
Proceeds
Proceedsfrom
from sale
sale of
ofbonds
bonds XXX
XXX
Less:
Less: Principal
Principal payments
paymentson on
borrowed
borrowed funds
funds (XXX)
(XXX)
Payments
Paymentsrelated
related to
to bond
bond
maturities
maturities (XXX)
(XXX)
Dividend
Dividend payments
payments (XXX)
(XXX)
Net
NetCash
Cash Flows
Flowsfrom
from Financing
Financing Activities
Activities $$ XXX
XXX

Includes transactions involving receipts

from or payments to creditors and owners.
McGraw-Hill/Irwin Slide 29
 Other Issues: Gross or Net?
Example:
Example:
For investing and  Assume Macy’s purchases
Assume Macy’s purchases
financing activities, $50
$50million
millionininproperty
property
during
duringthe
theyear
yearand
andsells
sells
items on the other
otherproperty
propertyfor
for$30
$30
statement of cash million.
million.
 Instead of showing the net
Instead of showing the net
flows should be change
changeofof$20
$20million,
million,the
the
presented in gross company
companymust
mustreport
reportthe
the
gross
grossamounts
amountsof ofboth
both
amounts rather than transactions.
transactions.
in net amounts.

McGraw-Hill/Irwin Slide 30
 Other Issues: Direct Method or Indirect Method?

Two Formats for Reporting Operating Activities

Direct Method Indirect Method

Reports the Starts with

cash effects of accrual net
each operating income and
activity converts to
cash basis
No matter which format is used, the same amount of net
cash provided by operating activities is generated.
McGraw-Hill/Irwin Slide 31
 Learning Objective 3
Prepare a statement of
cash flows using the
indirect method to
determine the net cash
provided by operating
activities.

McGraw-Hill/Irwin Slide 32
 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.)
Cash $ 71,000 $ 90,000 $ (19,000)
Accounts Receivable 23,000 40,000 (17,000) Let’s revisit the
Inventory 322,000 300,000 22,000 comparative
Land 68,000 100,000 (32,000)
balance sheet
Equipment 112,000 84,000 28,000
Accumulated Depr. (45,000) (39,000) 6,000 account balances
Accounts Payable (38,000) (27,000) 11,000 for Ed’s Pizza Hut.
Salaries Payable (9,000) (14,000) (5,000)
Note Payable - Joe Doe - (50,000) (50,000)
Common Stock (500,000) (450,000) 50,000
Retained Earnings (4,000) (34,000) (30,000)
$ - $ -

McGraw-Hill/Irwin Slide 33
 A Full-Fledged Statement of Cash Flows:
An Example
Let’s also refresh our memory regarding the
following additional information.
 There
There was
was aa net
net loss
loss for
for the
the year
year of
of $27,000.
$27,000.
 Depreciation
Depreciation charges
charges forfor the
the year
year were
were $6,000.
$6,000.
 During
During the
the year,
year, Ed
Ed sold
sold land
land originally
originally costing
costing
$32,000
$32,000 for
for $32,000.
$32,000.
 During
During the
the year,
year, Ed
Ed purchased
purchased equipment
equipment for for
$28,000.
$28,000.
 During
During the
the year,
year, Ed
Ed paid
paid dividends
dividends ofof $3,000
$3,000 toto
the
the stockholders.
stockholders.
 Ed
Ed issued
issued $50,000
$50,000 of of common
common stockstock to
to settle
settle the
the
note
note due
due to
to Joe
Joe Doe.
Doe.
McGraw-Hill/Irwin Slide 34
 Preparing the Statement of Cash Flows: Step 1
Ed's Pizza Hut
Statement of Cash Flows Worksheet
Source Cash Flow Adjust- Adjusted Classifi-
Change or Use? Effect ments Effect cation
Assets (except cash and
cash equivalents)
Current assets
Accounts receivable
Inventory
Noncurrent assets
Land List each account
Equipment
Contra Assets, Liabilities, appearing on the
Contra assets
Accumulated depreciation comparative balance
Current liabilities
Accounts payable sheets except for cash
Salaries payable
Noncurrent liabilities
and cash equivalents
Notes payable
Stockholders' equity
and retained earnings.
Common stock
Retained earnings
Net loss
Dividends
Total (net cash flow) $ - $ - $ -

McGraw-Hill/Irwin Slide 35
 Preparing the Statement of Cash Flows: Step 2
Ed's Pizza Hut
Statement of Cash Flows Worksheet
Source Cash Flow Adjust- Adjusted Classifi-
Change or Use? Effect ments Effect cation
Assets (except cash and
cash equivalents)
Current assets
Accounts receivable $ (17,000)
Inventory 22,000
Noncurrent assets
Land (32,000)
Equipment 28,000
Contra Assets, Liabilities, Compute the change
Contra assets
Accumulated depreciation 6,000 from the beginning
Current liabilities
Accounts payable 11,000 balance to the ending
Salaries payable
Noncurrent liabilities
(5,000)
balance for each
Notes payable
Stockholders' equity
(50,000)
account.
Common stock 50,000
Retained earnings
Net loss (27,000)
Dividends 3,000
Total (net cash flow) $ - $ - $ -

McGraw-Hill/Irwin Slide 36
 Preparing the Statement of Cash Flows: Step 3
Ed's Pizza Hut
Statement of Cash Flows Worksheet
Source Cash Flow Adjust- Adjusted Classifi-
Change or Use? Effect ments Effect cation
Assets (except cash and
cash equivalents)
Current assets
Accounts receivable $ (17,000) Source
Inventory
Noncurrent assets
22,000 Use
Code each entry on
Land
Equipment
(32,000)
28,000
Source
Use
the worksheet as a
Contra Assets, Liabilities,
Contra assets
source or use of
Accumulated depreciation
Current liabilities
6,000 Source
cash.
Accounts payable 11,000 Source
Salaries payable (5,000) Use

{
Noncurrent liabilities
Notes payable (50,000) Use Recall that the transaction
Stockholders' equity involving the Notes Payable and
Common stock 50,000 Source Common Stock was noncash.
Retained earnings
Net loss (27,000) Use
Dividends 3,000 Use
Total (net cash flow) $ - $ - $ -

McGraw-Hill/Irwin Slide 37
 Preparing the Statement of Cash Flows: Step 4
Ed's Pizza Hut
Statement of Cash Flows Worksheet
Source Cash Flow Adjust- Adjusted Classifi-
Change or Use? Effect ments Effect cation
Assets (except cash and
cash equivalents)
Current assets
Accounts receivable $ (17,000) Source $ 17,000
Inventory 22,000 Use (22,000)
Noncurrent assets
Land
Equipment
(32,000)
28,000
Source
Use
32,000
(28,000)
Code sources
Contra Assets, Liabilities,
Contra assets
of cash as
Accumulated depreciation 6,000 Source 6,000 positive
Current liabilities
Accounts payable 11,000 Source 11,000 numbers and
Salaries payable (5,000) Use (5,000)
Noncurrent liabilities uses of cash
Notes payable (50,000) Use (50,000)
Stockholders' equity as negative
Common stock 50,000 Source 50,000
Retained earnings numbers.
Net loss (27,000) Use (27,000)
Dividends 3,000 Use (3,000)
Total (net cash flow) $ (19,000) $ - $ -

McGraw-Hill/Irwin Slide 38
 Preparing the Statement of Cash Flows: Step 5
Ed's Pizza Hut
Statement of Cash Flows Worksheet
Source Cash Flow Adjust- Adjusted Classifi-
Change or Use? Effect ments Effect
Make any
cation
Assets (except cash and necessary
cash equivalents)
Current assets adjustments,
Accounts receivable
Inventory
$ (17,000)
22,000
Source
Use
$ 17,000
(22,000)
-
-
$ 17,000
(22,000)
including
Noncurrent assets adjustments for
Land (32,000) Source 32,000 - 32,000
Equipment 28,000 Use (28,000) - (28,000)
gains and losses.
Contra Assets, Liabilities, The net effect of
Contra assets
Accumulated depreciation 6,000 Source 6,000 - 6,000 these should
Current liabilities
Accounts payable 11,000 Source 11,000 - 11,000
equal zero.
Salaries payable (5,000) Use (5,000) - (5,000)

{
Noncurrent liabilities
Notes payable (50,000) Use (50,000) 50,000 We need
- to make an adjustment
Stockholders' equity for the noncash transaction
Common stock 50,000 Source 50,000 (50,000) -
Retained earnings
relating to Notes Payable and
Net loss (27,000) Use (27,000) - (27,000) Common Stock.
Dividends 3,000 Use (3,000) - (3,000)
Total (net cash flow) $ (19,000) $ - $ (19,000)

McGraw-Hill/Irwin Slide 39
 Preparing the Statement of Cash Flows: Step 6
Ed's Pizza Hut
Statement of Cash Flows Worksheet
Source Cash Flow Adjust- Adjusted Classifi-
Change or Use? Effect ments Effect cation
Assets (except cash and
cash equivalents)
Current assets
Accounts receivable $ (17,000) Source $ 17,000 - $ 17,000 Operating
Inventory 22,000 Use (22,000) - (22,000) Operating
Noncurrent assets Classify
Land
Equipment
(32,000)
28,000
Source
Use
32,000
(28,000)
-
-
32,000
(28,000)
Investing
Investing each
Contra Assets, Liabilities,
Contra assets entry as
Accumulated depreciation
Current liabilities
6,000 Source 6,000 - 6,000 Operating
operating,
Accounts payable
Salaries payable
11,000
(5,000)
Source
Use
11,000
(5,000)
-
-
11,000
(5,000)
Operating
Operating
investing
Noncurrent liabilities
Notes payable (50,000) Use (50,000) 50,000 -
or
Stockholders' equity
Common stock 50,000 Source 50,000 (50,000) -
financing
Retained earnings
Net loss (27,000) Use (27,000) - (27,000) Operating
activity.
Dividends 3,000 Use (3,000) - (3,000) Financing
Total (net cash flow) $ (19,000) $ - $ (19,000)

McGraw-Hill/Irwin Slide 40
 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 $ (27,000)
Add: Decrease in A/R 17,000
Increase in A/P 11,000 Copy the data
Increase in Depr. Charges 6,000 from the
Less: Increase in Inventory (22,000) worksheet into
Decrease in Salaries Payable (5,000)
Net Cash Provided by Operating Activities (20,000)
the Statement of
Investing Activities Cash Flows
Proceeds from sale of Land 32,000 section by
Purchase of equipment (28,000)
section.
Net Cash Provided by Investing Activities 4,000
Financing Activities
Dividends paid (3,000)
Net change in cash (19,000)

McGraw-Hill/Irwin Slide 41
 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 $ (27,000)
Add: Decrease in A/R 17,000
Increase in A/P 11,000
Increase in Depr. Charges 6,000 Prepare a cash
Less: Increase in Inventory (22,000)
Decrease in Salaries Payable (5,000) reconciliation at
Net Cash Provided by Operating Activities (20,000) the bottom of the
Investing Activities
Proceeds from sale of Land 32,000
statement.
Purchase of equipment (28,000)
Net Cash Provided by Investing Activities 4,000
Financing Activities
Dividends paid (3,000)
Net change in cash (19,000)
Cash, beginning 90,000
Cash, ending 71,000
McGraw-Hill/Irwin Slide 42
 Example – Indirect Method
Ed's Pizza Hut
Statement of Cash Flows
For the Period Ending 3/31/2008
Operating Activities
Net Loss $ (27,000) In addition, on the
Add: Decrease in A/R 17,000 face of the
Increase in A/P 11,000
Increase in Depr. Charges 6,000
statement or in a
Less: Increase in Inventory (22,000) supplemental
Decrease in Salaries Payable (5,000) schedule, disclose
Net Cash Provided by Operating Activities (20,000)
Investing Activities the issuance of
Proceeds from sale of Land 32,000 $50,000 of stock
Purchase of equipment (28,000)
Net Cash Provided by Investing Activities 4,000
to a creditor, a
Financing Activities noncash financing
Dividends paid (3,000) activity.
Net change in cash (19,000)
Cash, beginning 90,000
Cash, ending 71,000
McGraw-Hill/Irwin Slide 43
 Interpretation of the Statement of Cash Flows

Examine the operating activities

section carefully.
 Ed’s Pizza Hut generated a negative net
cash provided by operating activities of
$20,000. 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.

McGraw-Hill/Irwin Slide 44
 Learning Objective 4

Compute free
cash flow.

McGraw-Hill/Irwin Slide 45
 Free Cash Flows

Free cash flow measures a company’s ability to

fund its capital expenditures and dividends from
its net cash provided by operating activities.

Net Cash Provided by Capital

Free Cash Flow =
Operating Activities
- Expenditures
- Dividends

McGraw-Hill/Irwin Slide 46
 Free Cash Flows

Free cash flow measures a company’s ability to

fund its capital expenditures and dividends from
its net cash provided by operating activities.
Net Cash Provided by Capital
Free Cash Flow =
Operating Activities
- Expenditures - Dividends
$ (51,000) = $ (20,000) - $ 28,000 - $ 3,000

McGraw-Hill/Irwin Slide 47
The Direct Method of Determining the Net
Cash Provided by Operating Activities

Appendix 15A

© 2010 The McGraw-Hill Companies, Inc.

 Learning Objective 5

Use the direct method to

determine the net cash
provided by operating
activities.
(Appendix 15A)

McGraw-Hill/Irwin Slide 49
 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.

Net cash provided by operating

activities under the direct method will
always agree with the amount
computed using the indirect method.

McGraw-Hill/Irwin Slide 50
 Similarities and Differences in Handling Data
Add (+) or
Deduct (-) to
Adjust to a
Revenue or Expense Item Cash Basis
Sales revenue (as reported)
Adjustments to a cash basis:
Increases in accounts receivable -
Adjustments for accounts
Decreases in accounts receivable +
that affect revenue are the
Cost of goods sold (as reported)
Adjustments to a cash basis: same in the direct and
indirect methods.
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 +
Adjustments for accounts
Decrease in prepaid expenses
Increase in accrued liabilities
-
-
that affect expenses are
Decrease in accrued liabilities
Period's depreciation, depletion and
+
-
handled in opposite ways
amortization charges
for the direct and indirect
Income tax expense (as reported)
Adjustments to a cash basis: methods.
Increase in accrued taxes payable -
Decrease in accrued taxes payable +
Increase in deferred income taxes -
Decrease in deferred income taxes +

McGraw-Hill/Irwin Slide 51
 Direct Method: Gains and Losses

Under the direct method,

no adjustments for gains
and losses on the sale of
assets are needed.

McGraw-Hill/Irwin Slide 52
 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.)
Cash $ 71,000 $ 90,000 $ (19,000)
Accounts Receivable 23,000 40,000 (17,000) Let’s revisit the
Inventory 322,000 300,000 22,000 comparative
Land 68,000 100,000 (32,000)
balance sheet
Equipment 112,000 84,000 28,000
Accumulated Depr. (45,000) (39,000) 6,000 account balances
Accounts Payable (38,000) (27,000) 11,000 for Ed’s Pizza Hut.
Salaries Payable (9,000) (14,000) (5,000)
Note Payable - Joe Doe - (50,000) (50,000)
Common Stock (500,000) (450,000) 50,000
Retained Earnings (4,000) (34,000) (30,000)
$ - $ -

McGraw-Hill/Irwin Slide 53
 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)

Let’s assume that Ed’s Pizza Hut

prepared this income statement.

McGraw-Hill/Irwin Slide 54
 The Direct Method: An Example

Step 1: Translate sales revenue into cash

collected from customers.

Sales (as reported) $ 1,000,000
Add: Decrease in accounts receivable 17,000
Cash collected from customers $ 1,017,000

McGraw-Hill/Irwin Slide 55
 The Direct Method: An Example

Step 2: Translate cost of goods sold into

cash disbursements for purchases.

Cost of goods sold (as reported) $ 750,000

Add: Increase in inventory 22,000
Less: Increase in accounts payable (11,000)
Cash paid for purchases $ 761,000

McGraw-Hill/Irwin Slide 56
 The Direct Method: An Example

Step 3: Translate operating expenses into

cash paid for operating expenses.

Operating expenses (as reported) $ 277,000

Add: Decrease in salaries payable 5,000
Less: Increase in depreciation (6,000)
Cash paid for operating expenses $ 276,000

No adjustment for income taxes is

required because Ed’s Pizza Hut has a net
loss of $27,000.
McGraw-Hill/Irwin Slide 57
 The Direct Method: An Example

Ed's Pizza Hut

Statement of Cash Flows
For the Period Ending 3/31/2008
Operating Activities
Notice that the
Cash received from customers $ 1,017,000 net cash
Cash paid for purchases (761,000)
Cash paid for operating expenses (276,000)
provided by
Net Cash Provided by Operating Activities (20,000) operating
Investing Activities
Proceeds from sale of land 32,000 activities agrees
Purchase of equipment
Net Cash Provided by Investing Activities
(28,000)
4,000
with that
Financing Activities computed using
Dividends paid (3,000)
Net change in cash (19,000)
the indirect
Cash, beginning 90,000 method.
Cash, ending $ 71,000

McGraw-Hill/Irwin Slide 58
 End of Chapter 15

McGraw-Hill/Irwin Slide 59