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Effects Operating, Investing, Financing Activities on Cash Flows


Learning Objectives1. Understand why using the accrual basis of accounting to prepare the balance sheet and income statement creates the need for a statement of cash flows. 2. Understand the types of transactions that result in cash flows from operating, investing, and financing activities. 3. Develop an ability to prepare a statement of cash flows from a comparative balance sheet and income statement.

Learning Objectives1. Distinguish between the direct and indirect methods of reporting and analyzing cash flows from operations. 2. Develop an ability to analyze the statement of cash flows, including the relation among cash flows from operating , investing, and financing activities for businesses in various stages of their growth.

Chapter Outline1. 2. 3. Need for a Statement of Cash Flows Overview of the Statement of Cash Flows Preparing the Statement of Cash Flows Direct and indirect methods T-account approach 4. An international perspective 5. Using Information in the Statement of Cash Flows 6. Ethical Issues and The Statement of Cash Flows Chapter Summary

Statement of Cash FlowsThe statement of cash flows b)

explains the reasons for a change in cash. classifies the reasons for the change as an operating, investing or financing activity. reconciles net income with cash flow from operations.




Three Classifications of Cash Flowscash flows related to selling goods and services; that is, the principle business of the firm.

2. Investing cash flows related to the acquisition or sale of noncurrent assets.

3. Financing long term and short term cash flows related to liabilities and owners equity; dividends are a financing cash outflow.

Example of a Statement of Cash Flows Exhibit 4.1

Preparing the Statement of Cash FlowsFirms could prepare the cash flow statement directly from the cash account. Most, however, find it more efficient to prepare the cash flow statement from the balance sheet and income statement. b) Direct and indirect methods. c) Algebraic formulation will present the underlying concept of Statement of cash flows. d) There are two approaches to producing the cash flow statement: columnar worksheet and t-account worksheet.

Define Direct and Indirect Method

Direct methodof presentation calculates cash flow from operations by subtracting cash disbursements to supplies, employees, and others from cash receipts from customers.

The indirect methodcalculates cash flow from operations by adjusting net income for noncash revenues and expenses.

Most firms present their cash flows using the indirect method.

Algebraic FormulationRecall the basic accounting equation: Assets = Liabilities + Shareholders Equity or A = L + SE Assets are either cash (C) or non cash assets (N$A), so C + N$A = L + SE C + N$A = L + SE Where means the change in the balance, Rearranging gives the basic equation for the statement of cash flows: C = L + SE - N$A

Algebraic Formulation (Cont.)C = L + SE - N$A

The change in cash, C, is the increase or decrease in the cash account. This amount must equal changes in liabilities plus changes in shareholders equity minus changes in assets other than cash. Thus, we can identify the causes in the change in the cash account by studying the changes in non-cash accounts.

Two Approaches to Producing the Cash Flow StatementThe basic formula can be implemented using either of two approaches:

Columnar worksheet -- changes in balance sheet accounts are classified by definition using a multicolumn worksheet. T-Account worksheet -- changes are classified by analysis of the t-

Columnar Worksheet

Works well for relatively simple situations involving few transactions. Enhances understanding of the cash flow statement. Does not work as well as the Taccount method when the number and complexity of transactions increases.

Columnar Worksheet (Cont.)Begin with a comparative balance sheet.2.

Compute the change in each balance sheet account. Classify each change as operating, investing or financing activity. Make any needed adjustments (for example, for a sale of a long-lived asset). Recast the classified changes in the form of a cash flow statement.




Noncash Expenses

Noncash expenses, such as depreciation expense, are added back. Items that are truly not sources of cash, even though they are associated with cash inflows; rather, a reversal of the accrual process that required the expenses to be recognized without regard for the cash flow.

Changes in Specific Accountsincrease Noncash Asset s Liabilities and Shareholders Equity If noncash assets are increased, then cash was spent, so cash is an outflow, negative sign. If liab. or S.E. increased, then cash was obtained, so cash in an inflow, positive sign. decrease If noncash assets are decreased, then they provided cash so cash is an inflow, positive sign. If liab. or S.E. decreased, then cash was spent, so cash in an outflow, negative sign.

T-account Worksheet

The columnar works well when the change in each balance sheet account affects only one of the three types of activities. It becomes cumbersome for more complex (and realistic) situations. The T-account approach is a direct extension of T-accounts - facilitates analysis of a transaction which involves more than one activity. For example, the change in Retained Earnings can be due to both net income (operating activity) and dividends (financing activity).

T-account Worksheet1. Obtain beginning and ending balance sheets. 2. Prepare a T-account worksheet with a master account, cash, divided into operating, investing and financing sections. 3. Explain the change in the master cash account by reconstructing the original entries in a summary form. 4. Make any necessary adjustments. 5. Recast the master account in the format of a cash flow statement.

T-account Worksheet (Cont.)Various Balance Sheet Accounts Cash beginning balance beginning balance

###### ending Operations 2. these are balance #### offset by an opposite entry Investing 1. adjustments are made to all balance in the cash Financing account. sheet accounts to bring the beginning balance to the ending balance. ending balance

3. this part of the cash account becomes the cash flow statement.

Effects of Sale of Long-Term Assets on Cash Flows

A few transactions complicate the derivation of a cash flow statement from a comparative balance sheet, for example, the sale of a long-term (or fixed) asset. Recall the journal entry for the sale of an asset:

Cash Accumulated Depreciation Asset Gain (or loss) on sale

### ### ### ###

Sale of an Asset (Cont.)

Each of the four parts of the above journal entry require an adjustment in the cash flow statement. The first line, cash, adds a line to the investing section. The second line, a debit to accumulated depreciation, increases the depreciation expense above the change in the change in the accumulated depreciation account. The third line, a credit to the asset, increases the amount of cash invested in long-lived assets above the change in the fixed asset accounts. The fourth line, a gain or loss, is reversed out in the operating sections since this is not a cash flow.

Comparison of Cash Flow to Net Income

Net income is an accrual based concept and purports to show the long-term. Cash flows purport to show the short term. Consider the outlook for both short-term and long-term and consider that each is either good or poor. A strong growing firm would show both good long-term and good short-term outlooks. A failing firm would show both poor long-term and poor short term outlooks. What about a firm with good cash flows (shortterm) but poor net income (long-term)? What about a firm with poor cash flows (shortterm) but good net income (long-term)?

An International Perspective

The International Accounting Standards Board (IAS No. 7) recommends but does not require a statement of cash flows. An approximation to a cash flow statement can be prepared from a comparative balance sheet with some additional information.

Chapter Summary

The statement of cash flows is presented. It reports the effects on cash flows of a firms operating, investing and financing activities. This information helps understand:1. How operations affect liquidity, 2. The level of capital expenditures needed to support growth, and 3. The major changes in financing.

Two methods are presented to produce a cash flow statement from a comparative balance sheet.