Current accounting standards require that companies include a statement of cash flows among their consolidated financial reports. The main purpose of the statement of cash flows is to pro- vide information about the entity’s cash receipts and cash payments during a period. The state- ment is also designed to show why an entity’s net income is different from its operating cash flows. For a consolidated entity, the cash flows relate to the entire business combination including the parent and all of its subsidiaries.
The statement of cash flows allocates the consolidated entity’s overall change in cash dur- ing a period to three separate categories:
• Cash flows from operating activities.
• Cash flows from investing activities.
• Cash flows from financing activities.
The cash flows from operating activities can be shown using either the indirect approach or the direct approach. The indirect approach begins with consolidated net income and then adds and subtracts various items to adjust the accrual number to a cash flow amount. The direct ap- proach examines cash flows directly from distinct sources that typically include revenues, pur- chases of inventory, and cash payments of other expenses. However, firms using the direct approach must also supplement the statement with the calculation of cash flows from operat- ing activities using the indirect approach.
The consolidated statement of cash flows is not prepared from the individual cash flow statements of the separate companies. Instead, the consolidated income statements and bal- ance sheets are first brought together on the worksheet. The cash flows statement is then based on the resulting consolidated figures. Thus, this statement is not actually produced by consolidation but is created from numbers generated by the process. Because special ac- counting procedures are needed in the period when the parent acquires a subsidiary, we first discuss preparation of the consolidated statement of cash flows for periods in which an acquisition takes place, followed by statement preparation in periods subsequent to acquisition.
Acquisition Period Statement of Cash Flows
If a business combination occurs during a particular reporting period, the consolidated cash flow statement must properly reflect several considerations. For many business combinations, the following issues frequently are present:
Business Acquisitions in Exchange for Cash
Cash purchases of businesses are an investing activity. The net cash outflow (cash paid less subsidiary cash acquired) is reported as the amount paid in a business acquisition.9
Operating Cash Flow Adjustments
Keeping in mind that the focus is on the consolidated entity’s cash flows (not just the parent’s), consolidated net income is the starting point for the indirect calculation of consolidated oper- ating cash flows. Recall that consolidated net income includes only postacquisition subsidiary revenues and expenses. Therefore the adjustment to the accrual-based income number must also reflect only postacquisition amounts for the subsidiary. One important category of ad- justments to consolidated net income to arrive at cash flows from operations involves changes in current operating accounts. Intraperiod acquisitions require special consideration in calcu- lating changes in these current operating accounts.
For example, an increase in an accounts receivable balance typically indicates that a firm’s accrual-based sales exceed the actual cash collections for sales during a period.
LO4
Prepare a consolidated statement of cash flows.
9For acquisitions that do not involve cash, or only partially involve cash, the details of the acquisitions should be provided in a supplemental section of the statement of cash flows for “significant noncash investing and financing activities.”
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Therefore, in computing operating cash flows, the increase in accounts receivable are de- ducted from the sales amount (direct method) or the net income (indirect method). However, when an acquisition takes place, the change in accounts receivable will often include amounts from the newly acquired subsidiary. Because the consolidated entity recognizes only postacquisition subsidiary revenues, such acquired receivables do not reflect sales that have been made by the consolidated entity. Therefore any subsidiary acquisition-date cur- rent operating account balances must be removed from the change in accounts receivable calculation.
In fact, any changes in operating balance sheet accounts (accounts receivable, inventory, accounts payable, etc.) must be computed net of the amounts acquired in the combination. Use of the direct approach of presenting operating cash flows also reports the separate computa- tions of cash collected from customers and cash paid for inventory net of effects of any acquired businesses.
Excess Fair Value Amortizations
Any adjustments arising from the subsidiary’s revenues or expenses (e.g., depreciation, amor- tization) must reflect only postacquisition amounts. Closing the subsidiary’s books at the date of acquisition facilitates the determination of the appropriate current year postacquisition sub- sidiary effects on the consolidated entity’s cash flows.
Subsidiary Dividends Paid
The cash outflow from dividends paid by a subsidiary only leaves the consolidated entity when paid to the noncontrolling interest. Thus dividends paid by a subsidiary to its parent do not ap- pear as financing outflows. However, subsidiary dividends paid to the noncontrolling interest are a component of cash outflows from financing activities.
Intra-Entity Transfers
A significant volume of transfers between affiliated companies comprising a business combination often occurs. The resulting effects of intra-entity activities are eliminated in the preparation of consolidated statements. Likewise, the consolidated statement of cash flows does not include the impact of these transfers. Intra-entity sales and purchases do not change the amount of cash held by the business combination when viewed as a whole. Because the statement of cash flows is derived from the consolidated balance sheet and income statement, the impact of all transfers is already removed. Therefore, the proper presentation of cash flows requires no special adjustments for intra-entity trans- fers. The worksheet entries produce correct balances for the consolidated statement of cash flows.
Statement of Cash Flows in Periods Subsequent to Acquisition
The preparation of the consolidated statement of cash flows during periods of no acquisition is relatively uncomplicated. As before, consolidated net income is the starting point for the indirect calculation of consolidated operating cash flows. If the operating accounts are free from any effects of previous year’s acquisitions, no further special adjustments are required.
Because the consolidation process eliminates intra-entity balances, preparation of the operat- ing activity section of the statement of cash flows typically proceeds in a straightforward manner using the already-available consolidated income statement and balance sheet amounts.
Finally, subsidiary dividends paid to the noncontrolling interest are shown as a component of cash outflows from financing activities.
Consolidated Statement of Cash Flows Illustration
Assume that on July 1, 2011, Pinto Company acquires 90 percent of Salida Company’s out- standing stock for $774,000 in cash. At the acquisition date, the 10 percent noncontrolling
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Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues 261
interest has a fair value of $86,000. Exhibit 6.6 shows book and fair values of Salida’s assets and liabilities and Pinto’s acquisition-date fair-value allocation schedule.
At the end of 2011, the following comparative balance sheets and consolidated income statement are available:
PINTO COMPANY AND SUBSIDIARY SALIDA COMPANY Comparative Balance Sheets
Pinto Co. Consolidated January 1, 2011 December 31, 2011 Cash . . . $ 170,000 $ 431,000 Accounts receivable (net) . . . 118,000 319,000 Inventory . . . 310,000 395,000 Land . . . 250,000 370,000 Buildings (net) . . . 350,000 426,000 Equipment (net) . . . 1,145,000 1,380,000 Database . . . –0– 49,000 Total assets . . . $2,343,000 $3,370,000 Accounts payable . . . $ 50,000 $ 45,000 Long-term liabilities . . . 18,000 522,000 Common stock . . . 1,500,000 1,500,000
Noncontrolling interest . . . –0– 98,250
Retained earnings . . . 775,000 1,204,750 Total liabilities and equities . . . $2,343,000 $3,370,000 EXHIBIT 6.6
SALIDA COMPANY Book and Fair Values
July 1, 2011
Account Book Value Fair Value
Cash . . . $ 35,000 $ 35,000 Accounts receivable . . . 145,000 145,000 Inventory . . . 90,000 90,000 Land . . . 100,000 120,000 Buildings . . . 136,000 136,000 Equipment . . . 259,000 299,000 Database . . . –0– 50,000 Accounts payable . . . (15,000) (15,000) Net book value . . . $750,000 $ 860,000
PINTO’S ACQUISITION OF SALIDA Excess Fair Value over Book Value Allocation
July 1, 2011
Consideration transferred by Pinto . . . $ 774,000 Noncontrolling interest fair value . . . 86,000 Salida’s total fair value . . . $ 860,000 Salida’s book value . . . 750,000 Excess fair over book value . . . $ 110,000
To land . . . $ 20,000 To equipment (five-year life) . . . 40,000
To database (25-year life) . . . 50,000 110,000 –0–
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PINTO COMPANY AND SUBSIDIARY SALIDA COMPANY Consolidated Income Statement
For the Year Ended December 31, 2011
Revenues . . . $1,255,000 Cost of goods sold . . . $600,000
Depreciation . . . 124,000 Database amortization . . . 1,000
Interest and other expenses . . . 35,500 760,500 Consolidated net income . . . $ 494,500
Additional Information for 2011
• The consolidated income statement totals include Salida’s postacquisition revenues and expenses.
• During the year, Pinto paid $50,000 in dividends. On August 1, Salida paid a $25,000 dividend.
• During the year, Pinto issued $504,000 in long-term debt at par value.
• No asset purchases or dispositions occurred during the year other than Pinto’s acquisition of Salida.
In preparing the consolidated statement of cash flows, note that each adjustment derives from the consolidated income statement or changes from Pinto’s January 1, 2011, balance sheet to the consolidated balance sheet at December 31, 2011.
Depreciation and Amortization These expenses do not represent current operating cash out- flows and thus are added back to convert accrual basis income to cash provided by operating activities.
Increases in Accounts Receivable, Inventory, and Accounts Payable (net of acquisition) Changes in balance sheet accounts affecting operating cash flows must take into account amounts acquired in business acquisitions. In this case, note that the changes in Accounts Re- ceivable, Inventory, and Accounts Payable are computed as follows:
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Accounts Accounts Receivable Inventory Payable
Pinto’s balance 1/1/11 . . . $118,000 $310,000 $50,000 Increase from Salida acquisition . . . 145,000 90,000 15,000 Adjusted beginning balance . . . 263,000 400,000 65,000
Consolidated balance 12/31/11 . . . 319,000 395,000 45,000
Operating cash flow adjustment . . . $ 56,000 $ 5,000 $20,000
Acquisition of Salida Company The Investing Activities section of the cash flow statement shows increases and decreases in assets purchased or sold involving cash. The cash outflow from the acquisition of Salida Company is determined as follows:
Cash paid for 90 percent interest in Salida . . . $774,000 Cash acquired . . . (35,000)
Net cash paid for Salida investment . . . $739,000
Note here that although Pinto acquires only 90 percent of Salida, 100 percent of Salida’s cash is offset against the cash consideration paid in the acquisition in determining the investing cash outflow. Ownership divisions between the noncontrolling and controlling interests do not affect reporting for the entity’s investing cash flows.
Issue of Long-Term Debt Pinto Company’s issuance of long-term debt represents a cash inflow from financing activities.
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Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues 263
Dividends The dividends paid to Pinto Company owners ($50,000) combined with the dividends paid to the noncontrolling interest ($2,500) represent cash outflows from financing activities.
Based on the consolidated totals from the comparative balance sheets and the consolidated income statement, the following consolidated statement of cash flows is then prepared. Pinto chooses to use the indirect method of reporting cash flows from operating activities.
PINTO COMPANY AND SUBSIDIARY SALIDA COMPANY Consolidated Statement of Cash Flows
For the Year Ended December 31, 2011
Consolidated net income . . . $ 494,500 Depreciation expense . . . $ 124,000
Amortization expense . . . 1,000 Increase in accounts receivable (net of acquisition effects) . . . (56,000) Decrease in inventory (net of acquisition effects) . . . 5,000
Decrease in accounts payable (net of acquisition effects) . . . (20,000) 54,000 Net cash provided by operations . . . $ 548,500 Purchase of Salida Company (net of cash acquired)
Net cash used in investing activities . . . $(739,000) (739,000) Issue long-term debt . . . $ 504,000
Dividends . . . (52,500)
Net cash provided by financing activities . . . 451,500 Increase in Cash 1/1/11 to 12/31/11 . . . $ 261,000