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ACCOUNTING FOR MANAGERSACCOUNTING FOR MANAGERSStatement of Cash Flows
ACCOUNTING FOR MANAGERSACCOUNTING FOR MANAGERSStatement of Cash Flows
Effects Operating, Investing, Financing Activities on Cash Flows
PUTTU GURU PRASADFACULTY MEMBER
Learning ObjectivesLearning Objectives
1. Understand why using the accrual basis 1. Understand why using the accrual basis of accounting to prepare the balance of accounting to prepare the balance sheet and income statement creates the sheet and income statement creates the need for a statement of cash flows.need for a statement of cash flows.
2.2. Understand the types of transactions Understand the types of transactions that result in cash flows from operating, that result in cash flows from operating, investing, and financing activities.investing, and financing activities.
3.3. Develop an ability to prepare a Develop an ability to prepare a statement of cash flows from a statement of cash flows from a comparative balance sheet and income comparative balance sheet and income statement.statement.
1. Understand why using the accrual basis 1. Understand why using the accrual basis of accounting to prepare the balance of accounting to prepare the balance sheet and income statement creates the sheet and income statement creates the need for a statement of cash flows.need for a statement of cash flows.
2.2. Understand the types of transactions Understand the types of transactions that result in cash flows from operating, that result in cash flows from operating, investing, and financing activities.investing, and financing activities.
3.3. Develop an ability to prepare a Develop an ability to prepare a statement of cash flows from a statement of cash flows from a comparative balance sheet and income comparative balance sheet and income statement.statement.
Learning ObjectivesLearning Objectives
4.4. Distinguish between the direct and Distinguish between the direct and indirect methods of reporting and indirect methods of reporting and analyzing cash flows from operations. analyzing cash flows from operations.
5.5. Develop an ability to analyze the Develop an ability to analyze the statement of cash flows, including the statement of cash flows, including the relation among cash flows from relation among cash flows from operating , investing, and financing operating , investing, and financing activities for businesses in various activities for businesses in various stages of their growth.stages of their growth.
4.4. Distinguish between the direct and Distinguish between the direct and indirect methods of reporting and indirect methods of reporting and analyzing cash flows from operations. analyzing cash flows from operations.
5.5. Develop an ability to analyze the Develop an ability to analyze the statement of cash flows, including the statement of cash flows, including the relation among cash flows from relation among cash flows from operating , investing, and financing operating , investing, and financing activities for businesses in various activities for businesses in various stages of their growth.stages of their growth.
Chapter OutlineChapter Outline
1. Need for a Statement of Cash Flows1. Need for a Statement of Cash Flows
2. Overview of the Statement of Cash Flows2. Overview of the Statement of Cash Flows
3.3. Preparing the Statement of Cash FlowsPreparing the Statement of Cash Flows– Direct and indirect methodsDirect and indirect methods– T-account approachT-account approach
4.4. An international perspectiveAn international perspective
5.5. Using Information in the Statement of Cash Using Information in the Statement of Cash FlowsFlows
6.6. Ethical Issues and The Statement of Cash Ethical Issues and The Statement of Cash FlowsFlows
Chapter SummaryChapter Summary
1. Need for a Statement of Cash Flows1. Need for a Statement of Cash Flows
2. Overview of the Statement of Cash Flows2. Overview of the Statement of Cash Flows
3.3. Preparing the Statement of Cash FlowsPreparing the Statement of Cash Flows– Direct and indirect methodsDirect and indirect methods– T-account approachT-account approach
4.4. An international perspectiveAn international perspective
5.5. Using Information in the Statement of Cash Using Information in the Statement of Cash FlowsFlows
6.6. Ethical Issues and The Statement of Cash Ethical Issues and The Statement of Cash FlowsFlows
Chapter SummaryChapter Summary
Statement of Cash FlowsStatement of Cash Flows
The statement of cash flows … The statement of cash flows …
a)a) explains the reasons for a change in explains the reasons for a change in cash.cash.
b)b) classifies the reasons for the classifies the reasons for the change as an operating, investing change as an operating, investing or financing activity.or financing activity.
c)c) reconciles net income with cash reconciles net income with cash flow from operations.flow from operations.
The statement of cash flows … The statement of cash flows …
a)a) explains the reasons for a change in explains the reasons for a change in cash.cash.
b)b) classifies the reasons for the classifies the reasons for the change as an operating, investing change as an operating, investing or financing activity.or financing activity.
c)c) reconciles net income with cash reconciles net income with cash flow from operations.flow from operations.
Three Classifications of Cash Three Classifications of Cash FlowsFlows
1.1. OperationsOperations – – cash flows related to selling goods and cash flows related to selling goods and services; that is, the principle business of the services; that is, the principle business of the firm.firm.
2. 2. InvestingInvesting – – cash flows related to the acquisition or sale of cash flows related to the acquisition or sale of noncurrent assets.noncurrent assets.
3. 3. FinancingFinancing – – long term and short term cash flows related to long term and short term cash flows related to liabilities and owners’ equity; dividends are a liabilities and owners’ equity; dividends are a financing cash outflow.financing cash outflow.
1.1. OperationsOperations – – cash flows related to selling goods and cash flows related to selling goods and services; that is, the principle business of the services; that is, the principle business of the firm.firm.
2. 2. InvestingInvesting – – cash flows related to the acquisition or sale of cash flows related to the acquisition or sale of noncurrent assets.noncurrent assets.
3. 3. FinancingFinancing – – long term and short term cash flows related to long term and short term cash flows related to liabilities and owners’ equity; dividends are a liabilities and owners’ equity; dividends are a financing cash outflow.financing cash outflow.
Example Example of a of a
Statement Statement of Cash of Cash FlowsFlows
Exhibit 4.1Exhibit 4.1
Preparing the Statement of Cash Preparing the Statement of Cash FlowsFlows
Firms could prepare the cash flow statement Firms could prepare the cash flow statement directly from the cash account. Most, directly from the cash account. Most, however, find it more efficient to prepare however, find it more efficient to prepare the cash flow statement from the balance the cash flow statement from the balance sheet and income statement.sheet and income statement.
a)a) Direct and indirect methods.Direct and indirect methods.b)b) Algebraic formulation will present the Algebraic formulation will present the
underlying concept of Statement of cash underlying concept of Statement of cash flows.flows.
c)c) There are two approaches to producing There are two approaches to producing the cash flow statement: columnar the cash flow statement: columnar worksheet and t-account worksheet.worksheet and t-account worksheet.
Firms could prepare the cash flow statement Firms could prepare the cash flow statement directly from the cash account. Most, directly from the cash account. Most, however, find it more efficient to prepare however, find it more efficient to prepare the cash flow statement from the balance the cash flow statement from the balance sheet and income statement.sheet and income statement.
a)a) Direct and indirect methods.Direct and indirect methods.b)b) Algebraic formulation will present the Algebraic formulation will present the
underlying concept of Statement of cash underlying concept of Statement of cash flows.flows.
c)c) There are two approaches to producing There are two approaches to producing the cash flow statement: columnar the cash flow statement: columnar worksheet and t-account worksheet.worksheet and t-account worksheet.
Define Direct and Indirect MethodDefine Direct and Indirect Method Direct methodDirect method
of presentation calculates cash flow from of presentation calculates cash flow from operations by subtracting cash disbursements to operations by subtracting cash disbursements to supplies, employees, and others from cash supplies, employees, and others from cash receipts from customers.receipts from customers.
The indirect methodThe indirect method calculates cash flow from operations by adjusting calculates cash flow from operations by adjusting net income for noncash revenues and expenses.net income for noncash revenues and expenses.
Most firms present their cash flows using Most firms present their cash flows using the indirect method.the indirect method.
Direct methodDirect method of presentation calculates cash flow from of presentation calculates cash flow from operations by subtracting cash disbursements to operations by subtracting cash disbursements to supplies, employees, and others from cash supplies, employees, and others from cash receipts from customers.receipts from customers.
The indirect methodThe indirect method calculates cash flow from operations by adjusting calculates cash flow from operations by adjusting net income for noncash revenues and expenses.net income for noncash revenues and expenses.
Most firms present their cash flows using Most firms present their cash flows using the indirect method.the indirect method.
Algebraic FormulationAlgebraic Formulation
Recall the basic accounting equation:Recall the basic accounting equation:Assets = Liabilities + Shareholders’ EquityAssets = Liabilities + Shareholders’ Equity
or or A = L + SEA = L + SEAssets are either cash (C) or non cash Assets are either cash (C) or non cash
assets (N$A), soassets (N$A), soC + N$A = L + SEC + N$A = L + SE
C + C + N$A = N$A = L + L + SE SEWhere Where means the change in the balance, means the change in the balance,Rearranging gives the basic equation for Rearranging gives the basic equation for
the statement of cash flows:the statement of cash flows:
C = C = L + L + SE - SE - N$A N$A
Recall the basic accounting equation:Recall the basic accounting equation:Assets = Liabilities + Shareholders’ EquityAssets = Liabilities + Shareholders’ Equity
or or A = L + SEA = L + SEAssets are either cash (C) or non cash Assets are either cash (C) or non cash
assets (N$A), soassets (N$A), soC + N$A = L + SEC + N$A = L + SE
C + C + N$A = N$A = L + L + SE SEWhere Where means the change in the balance, means the change in the balance,Rearranging gives the basic equation for Rearranging gives the basic equation for
the statement of cash flows:the statement of cash flows:
C = C = L + L + SE - SE - N$A N$A
Algebraic Formulation (Cont.)Algebraic Formulation (Cont.)C = C = L + L + SE - SE - N$A N$A
The change in cash, The change in cash, C C, , is the increase is the increase or decrease in the cash account.or decrease in the cash account.
This amount must equal changes in This amount must equal changes in liabilities liabilities plusplus changes in shareholders’ changes in shareholders’ equity equity minusminus changes in assets other changes in assets other than cash.than cash.
Thus, we can identify the causes in the Thus, we can identify the causes in the change in the cash account by studying change in the cash account by studying the changes in non-cash accounts.the changes in non-cash accounts.
C = C = L + L + SE - SE - N$A N$A
The change in cash, The change in cash, C C, , is the increase is the increase or decrease in the cash account.or decrease in the cash account.
This amount must equal changes in This amount must equal changes in liabilities liabilities plusplus changes in shareholders’ changes in shareholders’ equity equity minusminus changes in assets other changes in assets other than cash.than cash.
Thus, we can identify the causes in the Thus, we can identify the causes in the change in the cash account by studying change in the cash account by studying the changes in non-cash accounts.the changes in non-cash accounts.
Two Approaches to Producing Two Approaches to Producing the Cash Flow Statementthe Cash Flow Statement
The basic formula can be The basic formula can be implemented using either of two implemented using either of two approaches:approaches:
1.1. Columnar worksheet -Columnar worksheet -- changes in - changes in balance sheet accounts are balance sheet accounts are classified by definition using a classified by definition using a multicolumn worksheet.multicolumn worksheet.
2.2. T-Account worksheetT-Account worksheet -- changes -- changes are classified by analysis of the t-are classified by analysis of the t-accounts.accounts.
The basic formula can be The basic formula can be implemented using either of two implemented using either of two approaches:approaches:
1.1. Columnar worksheet -Columnar worksheet -- changes in - changes in balance sheet accounts are balance sheet accounts are classified by definition using a classified by definition using a multicolumn worksheet.multicolumn worksheet.
2.2. T-Account worksheetT-Account worksheet -- changes -- changes are classified by analysis of the t-are classified by analysis of the t-accounts.accounts.
Columnar WorksheetColumnar Worksheet
Works well for relatively simple Works well for relatively simple situations involving few transactions.situations involving few transactions.
Enhances understanding of the cash Enhances understanding of the cash flow statement.flow statement.
Does not work as well as the T-Does not work as well as the T-account method when the number account method when the number and complexity of transactions and complexity of transactions increases.increases.
Works well for relatively simple Works well for relatively simple situations involving few transactions.situations involving few transactions.
Enhances understanding of the cash Enhances understanding of the cash flow statement.flow statement.
Does not work as well as the T-Does not work as well as the T-account method when the number account method when the number and complexity of transactions and complexity of transactions increases.increases.
Columnar Worksheet (Cont.)Columnar Worksheet (Cont.)
Begin with a comparative balance sheet.Begin with a comparative balance sheet.
1.1. Compute the change in each balance Compute the change in each balance sheet account.sheet account.
2.2. Classify each change as operating, Classify each change as operating, investing or financing activity.investing or financing activity.
3.3. Make any needed adjustments (for Make any needed adjustments (for example, for a sale of a long-lived example, for a sale of a long-lived asset).asset).
4.4. Recast the classified changes in the Recast the classified changes in the form of a cash flow statement.form of a cash flow statement.
Begin with a comparative balance sheet.Begin with a comparative balance sheet.
1.1. Compute the change in each balance Compute the change in each balance sheet account.sheet account.
2.2. Classify each change as operating, Classify each change as operating, investing or financing activity.investing or financing activity.
3.3. Make any needed adjustments (for Make any needed adjustments (for example, for a sale of a long-lived example, for a sale of a long-lived asset).asset).
4.4. Recast the classified changes in the Recast the classified changes in the form of a cash flow statement.form of a cash flow statement.
Noncash ExpensesNoncash Expenses
Noncash expenses, such as Noncash expenses, such as depreciation expense, are added depreciation expense, are added back. back.
Items that are truly not sources of Items that are truly not sources of cash, even though they are cash, even though they are associated with cash inflows; associated with cash inflows; rather, a reversal of the accrual rather, a reversal of the accrual process that required the process that required the expenses to be recognized without expenses to be recognized without regard for the cash flow.regard for the cash flow.
Noncash expenses, such as Noncash expenses, such as depreciation expense, are added depreciation expense, are added back. back.
Items that are truly not sources of Items that are truly not sources of cash, even though they are cash, even though they are associated with cash inflows; associated with cash inflows; rather, a reversal of the accrual rather, a reversal of the accrual process that required the process that required the expenses to be recognized without expenses to be recognized without regard for the cash flow.regard for the cash flow.
Changes in Specific AccountsChanges in Specific Accounts
If noncash assetsare increased,
then cash was spent,so cash is an outflow,
negative sign.
If noncash assetsare increased,
then cash was spent,so cash is an outflow,
negative sign.
If noncash assetsare decreased,
then they provided cashso cash is an inflow,
positive sign.
If noncash assetsare decreased,
then they provided cashso cash is an inflow,
positive sign.
If liab. or S.E.increased, then cash
was obtained,so cash in an inflow,
positive sign.
If liab. or S.E.increased, then cash
was obtained,so cash in an inflow,
positive sign.
If liab. or S.E.decreased, then cash
was spent,so cash in an outflow,
negative sign.
If liab. or S.E.decreased, then cash
was spent,so cash in an outflow,
negative sign.
Non-cash Assets
Non-cash Assets
Liabilitiesand Shareholders’Equity
Liabilitiesand Shareholders’Equity
increaseincrease decreasedecrease
T-account WorksheetT-account Worksheet The columnar works well when the change in The columnar works well when the change in
each balance sheet account affects only one each balance sheet account affects only one of the three types of activities. It becomes of the three types of activities. It becomes cumbersome for more complex (and realistic) cumbersome for more complex (and realistic) situations.situations.
The The T-account approachT-account approach is a direct extension is a direct extension of T-accounts - facilitates analysis of a of T-accounts - facilitates analysis of a transaction which involves more than one transaction which involves more than one activity.activity.
For example, the change in For example, the change in Retained EarningsRetained Earnings can be due to both net income (operating can be due to both net income (operating activity) and dividends (financing activity).activity) and dividends (financing activity).
The columnar works well when the change in The columnar works well when the change in each balance sheet account affects only one each balance sheet account affects only one of the three types of activities. It becomes of the three types of activities. It becomes cumbersome for more complex (and realistic) cumbersome for more complex (and realistic) situations.situations.
The The T-account approachT-account approach is a direct extension is a direct extension of T-accounts - facilitates analysis of a of T-accounts - facilitates analysis of a transaction which involves more than one transaction which involves more than one activity.activity.
For example, the change in For example, the change in Retained EarningsRetained Earnings can be due to both net income (operating can be due to both net income (operating activity) and dividends (financing activity).activity) and dividends (financing activity).
T-account WorksheetT-account Worksheet1.1. Obtain beginning and ending balance Obtain beginning and ending balance
sheets.sheets.
2.2. Prepare a T-account worksheet with a Prepare a T-account worksheet with a master account, cash, divided into master account, cash, divided into operating, investing and financing sections.operating, investing and financing sections.
3.3. Explain the change in the master cash Explain the change in the master cash account by reconstructing the original account by reconstructing the original entries in a summary form.entries in a summary form.
4.4. Make any necessary adjustments.Make any necessary adjustments.
5.5. Recast the master account in the format of Recast the master account in the format of a cash flow statement.a cash flow statement.
1.1. Obtain beginning and ending balance Obtain beginning and ending balance sheets.sheets.
2.2. Prepare a T-account worksheet with a Prepare a T-account worksheet with a master account, cash, divided into master account, cash, divided into operating, investing and financing sections.operating, investing and financing sections.
3.3. Explain the change in the master cash Explain the change in the master cash account by reconstructing the original account by reconstructing the original entries in a summary form.entries in a summary form.
4.4. Make any necessary adjustments.Make any necessary adjustments.
5.5. Recast the master account in the format of Recast the master account in the format of a cash flow statement.a cash flow statement.
T-account Worksheet (Cont.)T-account Worksheet (Cont.) Cash
beginningbalance Operations
Investing Financing
endingbalance
Various Balance Sheet Accounts
beginningbalance endingbalance
######
####
1. adjustments are made to all balance sheet accounts to bring the beginning balance to the ending balance.
2. these are offset by an opposite entry in the cash account.
3. this part of the cash account becomes the cash flow statement.
Effects of Sale of Long-Term Assets Effects of Sale of Long-Term Assets on Cash Flowson Cash Flows
A few transactions complicate the derivation of A few transactions complicate the derivation of a cash flow statement from a comparative a cash flow statement from a comparative balance sheet, for example, the sale of a long-balance sheet, for example, the sale of a long-term (or fixed) asset.term (or fixed) asset.
Recall the journal entry for the sale of an asset:Recall the journal entry for the sale of an asset:
A few transactions complicate the derivation of A few transactions complicate the derivation of a cash flow statement from a comparative a cash flow statement from a comparative balance sheet, for example, the sale of a long-balance sheet, for example, the sale of a long-term (or fixed) asset.term (or fixed) asset.
Recall the journal entry for the sale of an 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.)Sale of an Asset (Cont.) Each of the four parts of the above journal entry Each of the four parts of the above journal entry
require an adjustment in the cash flow statement.require an adjustment in the cash flow statement. The first line, cash, adds a line to the investing section.The first line, cash, adds a line to the investing section. The second line, a debit to accumulated depreciation, The second line, a debit to accumulated depreciation,
increases the depreciation expense above the change increases the depreciation expense above the change in the change in the accumulated depreciation in the change in the accumulated depreciation account.account.
The third line, a credit to the asset, increases the The third line, a credit to the asset, increases the amount of cash invested in long-lived assets above the amount of cash invested in long-lived assets above the change in the fixed asset accounts.change in the fixed asset accounts.
The fourth line, a gain or loss, is reversed out in the The fourth line, a gain or loss, is reversed out in the operating sections since this is not a cash flow.operating sections since this is not a cash flow.
Each of the four parts of the above journal entry Each of the four parts of the above journal entry require an adjustment in the cash flow statement.require an adjustment in the cash flow statement.
The first line, cash, adds a line to the investing section.The first line, cash, adds a line to the investing section. The second line, a debit to accumulated depreciation, The second line, a debit to accumulated depreciation,
increases the depreciation expense above the change increases the depreciation expense above the change in the change in the accumulated depreciation in the change in the accumulated depreciation account.account.
The third line, a credit to the asset, increases the The third line, a credit to the asset, increases the amount of cash invested in long-lived assets above the amount of cash invested in long-lived assets above the change in the fixed asset accounts.change in the fixed asset accounts.
The fourth line, a gain or loss, is reversed out in the The fourth line, a gain or loss, is reversed out in the operating sections since this is not a cash flow.operating sections since this is not a cash flow.
Comparison of Cash Flow to Net Comparison of Cash Flow to Net IncomeIncome
Net income is an accrual based concept and Net income is an accrual based concept and purports to show the long-term.purports to show the long-term.
Cash flows purport to show the short term.Cash flows purport to show the short term. Consider the outlook for both short-term and Consider the outlook for both short-term and
long-term and consider that each is either good long-term and consider that each is either good or poor.or poor.
A strong growing firm would show both good A strong growing firm would show both good long-term and good short-term outlooks.long-term and good short-term outlooks.
A failing firm would show both poor long-term A failing firm would show both poor long-term and poor short term outlooks.and poor short term outlooks.
What about a firm with good cash flows (short-What about a firm with good cash flows (short-term) but poor net income (long-term)?term) but poor net income (long-term)?
What about a firm with poor cash flows (short-What about a firm with poor cash flows (short-term) but good net income (long-term)?term) but good net income (long-term)?
Net income is an accrual based concept and Net income is an accrual based concept and purports to show the long-term.purports to show the long-term.
Cash flows purport to show the short term.Cash flows purport to show the short term. Consider the outlook for both short-term and Consider the outlook for both short-term and
long-term and consider that each is either good long-term and consider that each is either good or poor.or poor.
A strong growing firm would show both good A strong growing firm would show both good long-term and good short-term outlooks.long-term and good short-term outlooks.
A failing firm would show both poor long-term A failing firm would show both poor long-term and poor short term outlooks.and poor short term outlooks.
What about a firm with good cash flows (short-What about a firm with good cash flows (short-term) but poor net income (long-term)?term) but poor net income (long-term)?
What about a firm with poor cash flows (short-What about a firm with poor cash flows (short-term) but good net income (long-term)?term) but good net income (long-term)?
An International PerspectiveAn International Perspective
The International Accounting The International Accounting Standards Board (IAS No. 7) Standards Board (IAS No. 7) recommends but does not require recommends but does not require a statement of cash flows.a statement of cash flows.
An approximation to a cash flow An approximation to a cash flow statement can be prepared from a statement can be prepared from a comparative balance sheet with comparative balance sheet with some additional information.some additional information.
The International Accounting The International Accounting Standards Board (IAS No. 7) Standards Board (IAS No. 7) recommends but does not require recommends but does not require a statement of cash flows.a statement of cash flows.
An approximation to a cash flow An approximation to a cash flow statement can be prepared from a statement can be prepared from a comparative balance sheet with comparative balance sheet with some additional information.some additional information.
Chapter SummaryChapter Summary The statement of cash flows is presented. The statement of cash flows is presented.
It reports the effects on cash flows of a It reports the effects on cash flows of a firm’s operating, investing and financing firm’s operating, investing and financing activities.activities.
This information helps understand:This information helps understand:
1.1. How operations affect liquidity,How operations affect liquidity,
2.2. The level of capital expenditures needed to The level of capital expenditures needed to support growth, andsupport growth, and
3.3. The major changes in financing.The major changes in financing.
Two methods are presented to produce a Two methods are presented to produce a cash flow statement from a comparative cash flow statement from a comparative balance sheet.balance sheet.
The statement of cash flows is presented. The statement of cash flows is presented. It reports the effects on cash flows of a It reports the effects on cash flows of a firm’s operating, investing and financing firm’s operating, investing and financing activities.activities.
This information helps understand:This information helps understand:
1.1. How operations affect liquidity,How operations affect liquidity,
2.2. The level of capital expenditures needed to The level of capital expenditures needed to support growth, andsupport growth, and
3.3. The major changes in financing.The major changes in financing.
Two methods are presented to produce a Two methods are presented to produce a cash flow statement from a comparative cash flow statement from a comparative balance sheet.balance sheet.
