Depreciation

Information about cash flows can influence decision makers in many ways . For
example , if a company’s regular operations bring in more cash than it uses ,
investors will value the company higher than if property and equipment must be
sold to finance operations . Information about cash flow can help creditors
decide whether a company will have enough cash to pay its debts as they mature.


Management and investors use cash flow information to evaluate a company’s
ability to meet unexpected obligations . Cash flow information is also used to
evaluate company’s ability to take advantage of new business opportunities
that may arise. In November 1987, the FASB issued Statement of Financial
Accounting Standards “statement of cash flow ” This standard requires
businesses to include a statement of cash flow in all financial reports that
contain both a balance sheet and an income statement. The primary purpose of
this statement is to present information about a company’s cash receipts and
disbursements during the reporting period. Direct Method of Presenting Cash Flow
from Operating Activities When you prepare a statement of cash flow , the net
cash provided by operating activities can be calculated two different ways . One
is called Direct Method the other is Indirect Method .When the direct method is
used , you separately list each major class of operating cash receipts and each
major class of cash payments . Then the payments are subtracted from the
receipts to determine the net cash provided by operating activities. The FASB
encourage companies to use direct method. Indirect Method of Presenting Cash
Flow from Operating Activities The indirect method is not as informative as
direct method because it does not disclose the individual cash inflows and
outflows from operating activities. Instead the direct method discloses only the
net cash provided by operating activities . When the indirect method is used ,
the net income is listed first . Then it is adjusted for items that are
necessary to reconcile net income to the net cash provided by operating
activities . For example , you know that depreciation expense is subtracted in
the calculation of net income . But , depreciation expense does not involve a
current cash payment. Therefore, depreciation expense is added back to net
income in the process of reconciling net income to the net cash provided by
operating activities. Cash and Cash Equivalents In Statement of Financial
Accounting Standards , the FASB concluded that a statement of cash flow should
explain the difference between the beginning and the ending balances of cash and
cash equivalents. Prior to this new standard ,cash equivalents were generally
understood to be short term , temporary investments of cash . However , not all
short-term investments meet the FASB definition of cash equivalents . To qualify
as a cash equivalent , an investment must satisfy two criteria . These are: 1-
The investments must be readily convertible to a known amount of cash. 2- The
investments must be sufficiently close to its maturity date so that its market
value is relatively insensitive to interest rate changes. Classifying Cash
Transactions A statement of cash flow describes the changes in cash plus cash
equivalents. Therefore, cash payments to purchase cash equivalents and cash
receipts from selling cash equivalents are not reported on the statement. All
other cash receipts and payments are classified as operating , investing or
financing activities. Within each category , individual cash receipts and
payments are summarized and described in a manner that clearly presents the
general nature of the company’s cash transactions . Then , the summarized cash
receipts and payments within each category are netted against each other . A
category provides a net cash flow if the receipts in the category exceed the
payments . And if the payments in a category exceed the receipts , the category
is a net user of cash during the period. Operating Activities You should
recognize the operating activities generally include only transactions that
relate to the calculation of net income . However, some income statement items
are not related to the operating activities . As disclosed in a statement of
cash flows , operating activities involve the production or purchase of
merchandise and the sale of goods and services to customers . Operating
activities also include the expenditures related to administering the business.

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In fact , cash flow from operating activities include all cash flows from
transactions that are not defined as investing or financing activities . Cash
Flows from Operating Activities Cash Inflows Cash Outflows -Cash sales to
customers -Payments to employees for salaries and -Cash collections from credit
customers wages -Receipts of cash dividends from stock -Payments to suppliers of
goods and services investments in other entities -Payments to government
agencies for taxes -Refunds from suppliers fines and penalties -Cash collected
from a lawsuit -Interest payments, net of amounts capitalized -Receipts of
interest payments -Cash refunds to customers Investing Activities Transactions
that involve making and collecting loans or that involve purchasing and selling
plant assets , other productive assets , and investments are called investing
activities. Usually , investing activities involve the purchase or sale of
assets that are classified on the balance sheet as plant and equipment ,
intangible assets , or long term investments . However, the purchase and sale of
short term investments other than cash equivalents are also investing
activities. Cash Flows from Investing Activities Cash Inflows Cash Outflows
-Proceeds from selling assets -Payments to purchase assets -Proceeds from
collecting loans -Payments to acquire securities -Proceeds from selling
securities -Payments to acquire dept securities -Proceeds from sale of loans
made by -Payments in the form of loans made to other the enterprise parties
Financing Activities A companies transactions with its owners and long term
creditors are called financing activities. Also , financing activities include
borrowing cash on a short term basis. However, cash payments to settle credit
purchases of merchandise, whether on account or by note, are operating
activities. Payments of interest expense are also operating activities. Cash
Flows from Financing Activities Cash Inflows Cash Outflows -Proceeds from the
issuance of -Payments of dividends and other distributions securities to owners
-Proceeds from the issuance of -Payments to purchase treasury stock bonds and
notes payable -Repayments of cash loans -Proceeds from other short or long
-Payments of the principal amounts involved term borrowing transactions in long
term credit arrangements Preparing a Statement of Cash Flows The information you
need to prepare a statement of cash flow comes from a variety of sources . These
include comparative balance sheets at the beginning and the end of the
accounting period , an income statement for the period and a careful analysis of
each non cash balance sheet account . Grover Company (Example) Grover
Company’s December 31, 1989 and 1990 balance sheets and 1990 income statement
are illustrated. The objective is to prepare a statement of cash flow that
explains the $5000 increase in cash , based on these financial statements and
the additional information about 1990 transactions that follows: 1- All accounts
payable balances resulted from merchandise purchases . 2- Plant assets that cost
$70,000 were purchased by paying $10,000 cash and issuing $60,000 of bonds
payable to seller. 3- Plant assets with an original cost of $30,000 and
accumulated depreciation of $12,000 were sold for $12,000 cash. The result was a
$6,000 loss. 4 The proceeds from issuing 3,000 shares of common stock was
$15,000. 5- The $16,000 gain on retirement of bonds resulted from paying $18,000
to retire bonds with a book value of $34,000. 6- Cash dividends of $14,000 were
declared and paid. GROVER COMPANY Balance sheet December 31, 1990 and 1989 1990
1989 Assets Current Assets: Cash $ 17,000 $ 12,000 Accounts Receivable 60,000
40,000 Merchandise Inventory 84,000 70,000 Prepaid Expenses 6,000 4,000 Total
Current Assets $ 167,000 $ 126,000 Long Term Assets: Plant Assets $250,000
$210,000 Less: accumulated depreciation 60,000 190,000 48,000 162,000 Total
Assets: $357,000 $288,000 Liabilities Current Liabilities: Accounts Payable $
35,000 $ 40,000 Interest Payable 3,000 4,000 Income Taxes Payable 22,000 12,000
Total Current Liabilities $ 60,000 $ 56,000 Long Term Liabilities: Bonds Payable
90,000 64,000 Total Liabilities: $ 150,000 $ 210,000 Stockholders’ Equity
Contributed Capital: Common stock $10 par value $ 95,000 $ 80,000 Retained
earnings 112,000 88,000 Total stockholders’ equity 207,000 168,000 Total
liabilities and stockholders’ equity $ 357,000 $ 288,000 GROVER COMPANY Income
Statement For Year Ended December 31, 1990
Sales………………………………………………. $ 590,000 Cost of
goods sold……………………………….. $ 300,000 Wages and other
operating expenses…………. 216,000 Interest
expense………………………………….. 7,000 Income taxes
expense…………………………… 15,000 Depreciation
expense……………………………. 24,000 (562,000) Loss on sale of
plants……………………………. (6,000) Gain on retirement of
debt………………………. 16,000 Net
Income………………………………………… $ 38,000 Operating
Activities We begin the analysis by calculating the cash flows from operating
activities. In general, this involve adjusting the income statement items that
relate to operating activities for changes in their related balance sheet
accounts. Cash Received From Customers: Accounts receivable increased from
$40,000 to $60,000 , cash receipts from customers are equal to sales of $590,000
plus the $40,000 beginning balance less the $60,000 ending balance, or $570,000.


Cash received from customers = Sales – Increase in accounts receivable If the
balance of accounts receivable decreases Cash received from customers = Sales +
Decrease in accounts receivable $570,000 of cash Grover Company received from
customers is shown on the statement of cash flows as a cash inflow from
operating activities. Cash Payments For Merchandise: $14,000 increase in
merchandise inventory is added to cost of goods of $300,000 to get purchase of
$314,000. Purchases of $314,000 plus a beginning balance of $40,000 , less the
ending balance of $35,000 , equals each payments of $319,000 . + Increase in
merchandise inventory Purchases = Cost of goods sold – Decrease in merchandise
inventory And, + Decrease in accounts pay. Cash payments for merchandise =
Purchases – Increase in accounts pay. Grover Company’s payments of $319,000
for merchandise are reported on the statement of cash flows as a cash outflow
from operating activities. Cash Payments for Wages and Other Operating Expenses:
Prepaid expenses increased by $2,000 during the period , the cash payments for
wages and other operating expenses were $2,000 more than the reported expense.


Thus, the amount for wages and other operating expenses is $216,000 plus $2,000
or $218,000 If Grover Company’s balance sheets had shown accrued liabilities ,
you would also have to adjust the expense for the change in accrued liabilities.


Cash paid for Wages and +inc. prepaid exp. +dec. accrued liab. wages and other =
other operating operating expenses expenses – dec. prepaid exp. -inc. accrued
liab. Payments for Interest and Taxes: Interest payments were $8,000 and income
tax payments were $5,000 + decrease in related payable Cash Payment = Expense –
increase in related payable Investing Activities: Investing activities usually
refer to transactions that affect long term assets. Recall from the information
that was provided about Grover Company’s transactions that the company
purchased plant assets and also sold plant assets. Both of these activities are
investing activities. Purchase of plant assets: Grover Company purchase plant
assets that cost $70,000 by issuing $60,000 of bonds payable to the seller and
paying the $10,000 balance in cash. The $10,000 payment is reported as a cash
outflow on the statement of cash flows. Sale of Plant Assets: Grover Company
sold plant assets that cost $30,000 and were depreciated $12,000. The result of
sale was a loss of $6000 and a cash receipt of $12,000. This cash receipt is
reported on the statement of cash flows as a cash inflow from investing
activities. Financing Activities: Financing activities usually relate to a
company’s long term dept and stockholder’s equity accounts. In the
information about Grover Company, there were four transactions that involved
financing activities . One of these , the $60,000 issuance of bonds payable to
purchase plant assets. The remaining tree transactions were the retirement of
bonds , the issuance of common stock , and the payment of cash dividends.


Payment to Retire Bonds Payable: Grover Company’ December 31 ,1990, balance
sheet showed bonds payable of $34,000 . These were retired for $18,000 cash in
1990. The income statement reports the $16,000 difference as a gain. The
statement of cash flows shows the $18,000 payment as a cash outflow from
financing activities. Receipt from Common Stock Issuance: During 1990, Grover
Company issued 3000 shares of common stock for $5 per share. This $15,000 cash
receipt is reported on the statement of cash flow as a financing activity. Look
at the December 31, 1989, and 1990 balance sheets. Notice that the Common Stock
account balance increased from $80,000 at the beginning of 1990 to $95,000 at
the end of 1990. Thus, $15,000 stock issue reconciles the change in the Common
Stock account. Payment of Cash Dividends: According to the facts provided about
Grover Company’s transactions , cash dividend of $14,000 were paid during
1990. This payment is reported as a cash outflow from financing activities.


Also , note that the effects of this $14,000 payment and the reported net income
of $38,000 fully reconcile the beginning and ending balances of retained
earnings . GROVER COMPANY Statement of Cash Flows ( Direct Method ) For Year
Ended December 31, 1990 Operating Activities: Cash received from
customers……………………. $ 570,000 Cash provide by operating
activities……………… $ 570,000 Cash paid for merchandise
……………………….. (319,000) Cash paid for wages and other
expenses……….. (218,000) Interest paid
…………………………………………. (8,000) Income taxes
paid…………………………………… (5,000) Cash disbursed for
operating activities…………… (550,000) Net Cash Provided By Operating
Activities………… $ 20,000 Investing Activities: Receipt from sale of plant
asset……………………. $ 12,000 Payment to purchase plant
asset…………………… (10,000) Net Cash Used In Investing
Activities……………….. 2,000 Financing Activities: Payments to retire
bonds…………………………… $ (18,000) Proceeds from issuing
stock……………………….. 15,000 Dividends
paid……………………………………….. (14,000) Net Cash Provided
By Financing Activities…………. (17,000) Net Increase (decrease) In
Cash…………………….. $ 5,000 Cash and Cash Equivalents , beginning of
year……. $ 12,000 Cash and Cash Equivalents , end of year…………… $
17,000

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