Investing Activities

LINE I1 - CASH FLOWS FROM INVESTING ACTIVITIES: This line merely identifies the section:

11 | Cash flows from investing activities: |

LINE I2 - CASH FLOWS FROM SALE OF LAND: Emerson sold land for $750,000 during the year:

12 | Sale of land $ 750,000 |

In actuality, it would be pretty easy to look up this transaction in the journal. The entry would look like this:

But, it is not necessary to refer to the journal. Notice that land on the balance sheet decreased by $600,000 ($1,400,000 - $800,000), and that the income statement included a $150,000 gain. Applying a little "forensic" accounting allows you to deduce that $600,000 in land was sold for $750,000, to produce the $150,000 gain.

LINE I3 - CASH FLOWS FROM PURCHASE OF EQUIPMENT: Emerson purchased equipment for $150,000 during the year:

I3 Purchase of equipment (150,000)

LINE I4 - NET CASH PROVIDED BY INVESTING ACTIVITIES: Emerson's overall investing activities generated $600,000 in cash during the year. This resulted from the net effects of disposing of land and purchasing equipment.

I4 Net cash provided by investing activities 600,000

Financing Activities

LINE F1 - CASH FLOWS FROM FINANCING ACTIVITIES: This line merely identifies the section:

F1 J Cash flows from financing activities:

LINE F2 - CASH PROCEEDS FROM ISSUING COMMON STOCK: This line reveals that $80,000 was received from issuing common stock.

F2 Proceeds from issuing stock $ 80,000

This cash inflow is suggested by the $10,000 increase in common stock ($910,000 - $900,000) and $70,000 increase in additional paid-in capital ($370,000 - $300,000).

LINE F3 - CASH OUTFLOW FOR DIVIDENDS: The statement of retained earnings reveals that Emerson declared $50,000 in dividends. Since there is no dividend payable on the balance sheet, one can assume that all of the dividends were paid during the year:

F3 Dividends on common (50,000)

LINE F4 - CASH OUTFLOW FOR REPAYMENT OF LONG-TERM LOAN: The balance sheet reveals a $900,000 decrease in long-term debt ($1,800,000 - $900,000). This represented a significant use of cash during the year:

F4 Repayment of long-term loans (900,000)

This line item reveals that Emerson has used much of the cash flow generated from operations and asset disposals to reduce the outstanding debt of the company.

LINE F5 - NET CASH USED IN FINANCING ACTIVITIES: Emerson's overall financing activities used $870,000 in cash during the year. The bulk of this outflow was attributable to debt repayment.

F5 Net cash used in financing activities (870,000)

Cash Flow Recap

LINE C1, C2, C3 - THE CHANGE IN CASH: Emerson's cash flow statement reveals a $530,000 increase in cash during the year ($800,000 from positive operating cash flow, $600,000 from positive investing cash flow, and $870,000 from negative financing cash flow). This change in cash is confirmed by reference to the beginning and ending cash balances on the balance sheet:

C1 Net increase in cash $ 530,000

C2 Cash balance at January 1, 20X5 170,000

C3 Cash balance at December 31, 20X5 $ 700 000

Noncash Investing/Financing Activities

LINE N1, N2 - NONCASH INVESTING AND FINANCING ACTIVITIES: Emerson issued $300,000 of preferred stock for a building. This falls into the special section for revealing the noncash investing and financing events:

N1 Noncash investing/financing activities:

N2 Issued preferred stock for building $ 300,000

Reconciliation of Income to Operating Cash Flows

The statement of cash flows just presented is specifically known as the "direct approach." The direct approach is the preferred approach. It is so named because the cash items entering into the determination of operating cash flow are specifically identified. In many respects, this presentation of operating cash flows resembles a cash basis income statement. An alternative "indirect" approach will be presented shortly. But first, be aware that companies who choose to use the direct approach must supplement the cash flow statement with a reconciliation of income to cash from operations:

Notice that this reconciliation starts with the net income, and adjusts to the $800,000 net cash from operations. Some explanation may prove helpful:

• Depreciation is added back to net income, because it reduced income but did not consume any cash.

• Gain on sale of land is subtracted, because it increased income, but is not related to operations (remember, it is an investing item and the "gain" is not the sales price).

• Increase in accounts receivable is subtracted, because it represents uncollected sales included in income.

• Decrease in inventory is added, because it represents cost of sales from existing inventory (not a new cash purchase). Increase in accounts payable is added, because it represents expenses not paid.

• Decrease in wages payable is subtracted, because it represents a cash payment for something expensed in an earlier period.

Now, this can get rather confusing. Let's try to simplify it a bit. First, you can probably see why depreciation is added back.

But, the gain is likely fuzzy. It must be subtracted because you are trying to remove it from the operating number; it increased net income, but it is viewed as something other than operating, and that is why it is backed out. Conversely, a loss on such a transaction would be added.

The increase in accounts receivable represents sales that increased income but not cash. That is why

Increases in current assets related to operations will be subtracted, but decreases will be added and, vice versa:

Increases in current liabilities related to operations will be added, but decreases will be subtracted

Examine this pattern, to satisfy yourself that it works for the inventory, accounts payable, and wages payable. Now, you can logically extend the pattern to most any other operating adjustment that pertains to a current asset or current liability.

As a reminder, this reconciliation of income to operating cash is intended to supplement the direct approach to the statement of cash flows. You will likely find the reconciliation in notes to the financial statements.