BA213: Chapter 14—Statement of Cash Flows

Study Objectives:1. Indicate the usefulness of the statement of cash flows.2. Distinguish among operating, investing, and financing activities.3. Prepare a statement of cash flows using the indirect method.4. Analyze the statement of cash flows.5. Prepare a statement of cash flows using the direct method

I. The Statement of Cash Flows. The three basic financial statements (comparative balance sheets, income statement, and retained earnings statement) do not show detailed summary of the net change in cash as a result of operating, investing, and financing activities during the period.

A. INDICATE THE PURPOSE OF THE STATEMENT OF CASH FLOWS.

1. The primary purpose of the statement of cash flows (SCF) is to provide information about an entity’s cash receipts and cash payments during a period.

2. A secondary objective is to provide information about its:a) Operating (profit-making activities of the enterprise),b) Investing (purchase and sale of long-term assets), and c) financing activities of an entity during a period (obtaining resources needed

to pay for long-term assets and repay borrowed money from creditors and owners).

3. It provides answers to the following simple, but important, questions about an enterprise:a) Where did the cash come from during the period?b) What was the cash used for during the period?c) What was the change in the cash balance during the period?

B. MEANING AND USEFULNESS OF “CASH FLOWS”1. The SCF is usually prepared using cash and cash equivalents as its basis. Cash

equivalents are short-term, highly liquid investments that are both:a) readily convertible to known amounts of cash, andb) so near to their maturity that their market value is relatively insensitive to

changes in interest rates.2. USEFULNESS: The information in the SCF should help investors, creditors and

others assess the following aspects of the firm’s financial position:a) The entity’s ability to generate future cash flows.b) The entity’s ability to pay dividends and meet obligations.c) The reasons for the difference between net income and net cash provided

(used) by operating activities. NET INCOME is not the same as CASH PROVIDED BY OPERATING ACTIVITIES. The differences between net income and net cash provided by operating activities are illustrated by

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the results of the companies shown from annual reports for the same fiscal year.

d) The cash investing and financing transactions during the period to better understand why assets and liabilities changed during the period.

C. CLASSIFICATION OF CASH FLOWS. TYPICAL RECEIPTS AND PAYMENTS CLASSIFIED BY ACTIVITY and Classification of Cash Receipts and Payments:

1. Distinguish among operating, investing, and financing activities. Transactions and other events characteristic of each kind of activity are as follows:a) Operating activities include the cash effects of transactions that create revenues

and expenses. They thus enter into the determination of net income.b) Investing activities include

1) acquiring and disposing of investments and productive long-lived assets, and

2) lending money and collecting the loans.c) Financing activities include

1) obtaining cash from issuing debt and repaying the amounts borrowed, and

2) obtaining cash from stockholders and providing them with a return on their investment.

2. The category of operating activities is the most important because it shows the cash provided by company operations and generally considered to be the best measure of a company’s ability to generate sufficient cash to continue as a going concern.

3. Note the following general guidelines:a) Operating activities involve income determination (income statement) items.

Operating activities generally relate to changes in current assets and current liabilities.

b) Investing activities involve cash flows resulting from changes in investments and long-term asset items.

c) Financing activities involve cash flows resulting from changes in long-term liability and stockholders’ equity items.

d) Test your understanding of classification of activities by indicating the classification in the statement of cash flows for each of the following and check the bottom of the lecture notes for the answers:1) Proceeds from the sale of investment falls under____________.2) Disbursement for the purchase of treasury stock ___________.3) Loan to another corporation _______________.4) Proceeds from an insurance policy for a building destroyed by

fire____________________.5) Proceeds from winning a lawsuit_______________.

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6) Receipt of interest from an investment in bonds_____________.7) Payment of dividends__________________.8) Sale of merchandise for cash________________.9) Cash collected on an accounts receivable_________________.10) Paid an accounts payable_____________________.11) Converting bonds into common stock________________.12) Purchased equipment issuing a long-term note_____________.

D. SIGNIFICANT NONCASH ACTIVITIES—Not all of a company’s significant activities involve cash. 1. Examples of significant noncash activities are:

a) Direct issuance of common stock to purchase assets.b) Conversion of bonds into common stock.c) Direct issuance of debt to purchase assets.d) Exchange of plant assets.

2. Significant financing and investing activities that do not affect cash are NOT reported in the body of the SCF. Such activities are reported in either:a) a separate schedule at the bottom of the SCF orb) in a separate note or supplementary schedule to the financial statements.

3. The reporting of these noncash activities in a separate schedule or the notes satisfies the disclosure principle and materiality concept (see chapter 6, pages 368-9 in textbook that the disclosure principle holds that a company should report enough information for outsiders to make knowledgeable decisions about the company and that the materiality concept states that a company must perform strictly proper accounting only for items that are significant to the business’s financial situation.

E. FORMAT OF THE STATEMENT OF CASH FLOWS1. The general format of the SCF is the 3 activities previously discussed – operating,

investing, and financing – plus the significant noncash investing and financing activities. To help remember, use the acronym, OIF, “O, IF I could just remember the three sections of the SCF.” FORMAT OF THE STATEMENT OF CASH FLOWS to see the following sections:a) Cash flows from operating activitiesb) Cash flows from investing activitiesc) Cash flows from financing activitiesd) Net increase (decrease in cash)e) Noncash investing and financing activities

2. SAMPLE STATEMENT OF CASH FLOWS that:a) The individual inflows and outflows from investing, and financing

activities are always reported separately so that the investing and financing activities of the enterprise will not be obscured.

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b) The operating section also shows the inflows and outflows separately. But the operating depends on the method used (Direct or Indirect) to prepare the statement as discussed later.

c) Statement of Cash Flows illustrations shows the cash inflows first of each activity and then the cash outflows of each activity with examples of inflows and outflows for each.

3. Note examples of the Statement of Cash Flows that the reported operating, investing, and financing activities result either net cash provided or used by each activity as follows:a) Provided by indicates that cash receipts are greater than cash payments.b) Used by indicated that cash payments are greater than cash receipts.

F. PREPARING THE STATEMENT OF CASH FLOWS1. The SCF is prepared differently from the 3 other basic financial

statements.a) FIRST: It is NOT prepared from the adjusted trial balance.b) SECOND: The SCF deals with cash receipts and payments, so the

accrual concept is NOT used in the preparation of the SCF .2. The information to prepare this statement usually comes from 3 sources:

Comparative balance sheet —two years balances sheets are used to determine the amount of changes in assets, liabilities, and stockholders’ equities.

Current income statement —helps determine the amount of cash provided or used by operating activities as mentioned previously operating activities are those that enter into the determination of net income.

Additional information —such as transaction data that are needed to determine how cash was provided and used during the period.

3. INFORMATION SOURCES FOR ACTIVITIES:a) For OPERATING ACTIVITIES—analyze income statement items and

changes in noncash current asset and current liability items.b) For INVESTING ACTIVITIES—analyze increases and decreases in

noncurrent asset items.c) For FINANCING ACTIVITIES—analyze increases and decreases in

noncurrent liability and stockholders’ equity items.4. Preparing the statement of cash flows from these data sources involves

three major steps:

Step 1: Determine net cash provided/used by operating activities by converting net income from an accrual basis to a cash basis. This step involves:a) Analyzing not only the current year’s income statement but also

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b) Comparative balance sheets and selected additional data.

Step 2: Analyze changes in noncurrent asset and liability accounts and record as investing and financing activities, or as significant noncash transactions. This step involves analyzing comparative balance sheet data and selected additional information for their effects on cash.

Step 3: Compare the net change in cash on the statement of cash flows with the change in the cash account reported on the balance sheet to make sure the amounts agree. The difference between the beginning and ending cash balance can be easily computed from comparative balance sheets.

H. INDIRECT AND DIRECT METHODS—CONVERTING NET INCOME TO NET CASH PROVIDED (USED) BY OPERATING ACTIVITIES. In order to determine net cash provided/used by operating activities, NET INCOME must be converted from accrual basis to cash basis. This conversion may be accomplished by 1) the indirect method or 2) the direct method.1. Both Methods arrive at the same total amount for “Net cash provided by

operating activities.” They differ in disclosing the items that comprise the total amount.

2. The indirect method (A method of reporting net cash flows from operations that involves converting accrual-basis net income to cash basis) is used extensively in practice. The indirect is favored by companies for 2 reasons: 1) it is easier to prepare and 2) it focuses on the differences between net income and net cash flow from operating activities. It is called the indirect method as it does not directly show where cash came from (Cash receipts) or where cash went to (Cash payments:a) (1) Begins with net income and adjusts for income statement items that did

not affect cash.b) (2) Reconciles net income to net cash provided (used) by operating

activities.3. The direct method (A method of reporting net cash flows from

operations that shows the major classes of cash receipts and payments for a period of time). It is called the direct method as it does directly show where cash came from (Cash receipts) or where cash went to (Cash payments).a) The FASB has expressed a preference for the direct method, but

allows the use of either method. This is the method that I used when preparing the SCF for my clients as they could understand this method better as indicated the direct source of cash receipts and cash payments.

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b) When the direct method is used, the net cash flow from operating activities as computed using the indirect method MUST ALSO BE REPORTED IN A SEPARATE SCHEDULE so it requires more work and probably why the indirect method is favored by majority of companies.

c) The DIRECT METHOD:1) Adjusts each item on the income statement from the accrual basis to

the cash basis.2) Major classes of operating receipts and cash payments are

reported.

II. PREPARING A STATEMENT OF CASH FLOWS: INDIRECT METHOD. The comparative balance sheets, the income statement, and additional information are used to illustrate and explain the indirect method of preparing the SCF:A. Step 1: Operating Activities—DETERMINE NET CASH

PROVIDED/USED BY OPERATING ACTIVITIES BY CONVERTING NET INCOME FROM AN ACCRUAL BASIS TO A CASH BASIS:1. WHY net income MUST be converted to net cash provided by operating

activities: Under GAAP, most companies use the accrual basis of accounting which

requires:a) Revenues to be recorded when earned which may include credit

sales that have not yet been collected in cash andb) Expenses to be recorded when incurred which may include

expenditures that have not been paid in cash.c) Thus under accrual basis of accounting, net income is not the same

as net cash provided by operating activities and therefore under the indirect method, net income must be adjusted to convert certain items to the cash basis.

Three type of adjustments to convert net income to net cash provided by operating activities:1) Add back noncash expenses and losses that result from

investing and financing activities, such as depreciation expense, amortization, or depletion. The indirect method (or reconciliation method) starts with net income and converts it to net cash provided by operating activities. In other words, the indirect method adjusts net income for items that affect reported net income but do not affect cash. Noncash charges in the income statement are added back to net income. OPERATING

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ACTIVITIES—INDIRECT ADJUSTMENTS FOR NONCASH ITEMS.a) Note that Noncash charges are ADDED TO NET INCOME as

these reduce net income but DO NOT REDUCE CASH. Example are: Depreciation expense Amortization expense of intangible assets and

amortization of bond discounts. Depletion expense Loss on sale of plant assets

b) The adjustment for depreciation and the adjustment for loss on sale of equipment which are ADDED TO NET INCOME to arrive at cash from operating activities.

2) Deduct gains that result from investing and financing activities—ADJUSTMENT FOR NONCASH ITEMS:a) Note that the gain on sale of equipment is DEDUCTED

FROM NET INCOME as these noncash credits increase net income but DO NOT INCREASE CASH. The actual amount of cash received from the sale is reported as a source of cash in the investing activities section of the statement of cash flows.

b) Examples of noncash credits which are DEDUCTED from net income are: Gain on sale of plant assets Gains on retirement of debt Amortization of bond premium

3) Analyze changes to noncash current asset and current liability accounts. Reconcile net income to net cash provided (used) by operating income by identifying adjustments to net income with current asset and current liability accounts other than cash—INDIRECT METHOD ADJUSTMENT FOR CURRENT ASSETS AND LIABILITIES. Some Rules of Thumb:

If current assets decrease, they are added to net income (because more cash is coming in than going out like with accounts receivable or cash is not being used to purchase more such as inventories, supplies, prepaid insurance, etc.).

If current assets increase, they are deducted from net income (because not collecting as much cash from accounts receivable as they are increasing or more cash is being used to purchase more inventories than selling

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them or supplies, prepaid insurance, etc. than using them).

If current liabilities increase, they are added to net income (as not using cash to pay off the liabilities as they are increasing).

If current liabilities decrease, they are deducted from net income (as using cash to pay off the liabilities as they are decreasing).

4) CASH FLOWS FROM OPERATING ACTIVITIES—INDIRECT METHOD PROBLEM DATA showing an example of the preparation of the operating activities section of the SCF:

The section begins with the net income. Next the adjustments to reconcile net income to net cash

provided by operating activities:a. Noncash charges are added to net income—

depreciation expense.b. Noncash credits are deducted from net income—like

gain on sale of land.c. Decreases in current assets are added to net income

—such as decrease in accounts receivable.d. Increases in current assets are deducted from net

income—like an increase in prepaid rent or an increase in inventory.

e. Increases in current liabilities are added to net income—like an increase in accounts payable or an increase in interest payable.

f. Decreases in current liabilities are deducted from net income—like a decrease in taxes payable.

2. The presentation of net cash provided by operating activities—indirect method:a) A decrease in accounts receivable are added to net income. When

accounts receivable decrease during the year, revenues on an accrual basis are lower than are revenues on a cash basis. In other words, operations of the period caused revenues to increase, but not all of these revenues resulted in an increase in cash. Increases in revenues had to result in an increase in accounts receivable. To convert net income into net cash provided by operating activities, a decrease in accounts receivable must be added to net income.

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b) Note that an increase in merchandise inventory or prepaid expenses are deducted from net income because if these items are increasing, that the cost of merchandise inventory, supplies, prepaid insurance, etc., purchased exceeds the cost of goods sold, supplies expense, insurance expense, etc., shown on the income statement. Another way to look at this is that more cash is being expended for merchandise inventory, supplies, insurance as these items are increasing than being sold or used as these items are INCREASING. Therefore, the INCREASE must be DEDUCTED FROM net income.

c) An increase in accounts payable is added to net income. When current liabilities increase during the year, expenses on an accrual basis shown on the income statement are higher than they are on a cash basis.. To adjust net income to net cash provided by operating activities, an increase must be added to net income.

d) A decrease in income taxes payable is subtracted from net income. When current liabilities decrease during the year, expenses on an accrual basis shown on the income statement are lower than they are on a cash basis. That means that more cash is expended for expenses than shown on the income statements. Therefore, a decrease in income taxes payable is deducted from net income.

3. Summary of conversion to net cash provided by operating activities—indirect method. Three type of adjustments required to convert net income to net cash provided by operating activities:

a) (1) Noncash charges such as depreciation, amortization, and depletion are added to net income.

b) (2) Losses are added to net income and gains are deducted from net income.

c) (3) Changes in noncash current asset and current liability are summarized as follows:1) Increases in current assets are deducted from net income.2) Decreases in current assets are added to net income.3) Increases in current liabilities are added to net income.4) Decreases in current liabilities are deducted from net income.

B. Step 2: Determine net cash provided/used by investing and financing activities —ANALYZE CHANGES IN NONCURRENT ASSET AND LIABILITY ACCOUNTS AND RECORD AS INVESTING AND FINANCING ACTIVITIES, OR AS NONCASH INVESTING AND FINANCING ACTIVITIEIS by analyzing comparative balance sheets data and selected additional information. You should assume that ANY UNEXPLAINED DIFFERENCES IN NONCURRENT ACCOUNTS INVOLVE CASH.1. From the comparative balance sheets:

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a) Increase in land : An example of additional information that the land purchase was through the issuance of bonds payable does NOT affect cash but is a significant noncash investing and financing activity that must be disclosed in a separate schedule.

b) Increase in building : An example of additional information that an office building was acquired for cash and would be shown in the investing section.

c) Increase in equipment : An example of two transactions from the purchase and sale of equipment show on two line items on the Statement of Cash Flows.

d) Increase in Bonds Payable : An example of additional information that the land purchase was through the issuance of bonds payable that does NOT affect cash but is a significant noncash investing and financing activity that must be disclosed in a separate schedule.

e) Increase in Common Stock : An example of additional information that the issuance of common stock for cash and would be shown in the financing section.

f) Increase in Retained Earnings : The following factors account for this increase.1) Net income increases Retained Earnings.2) Additional information may indicate that the company declared and paid a

cash dividend.3) The increase due to net income is reported in the operating activities

section.4) The cash dividend paid is reported in the financing activities section.

This analysis can also be made directly from the Retained Earnings account.

2. STATEMENT OF CASH FLOWS:a) Operating activities with total positive amount uses the words,

“provided by” to give the total amount of “Net cash flows provided by operating activities.”

b) In the investing and financing activities sections, positive numbers indicate cash inflows (receipts), and negative numbers indicate cash outflows (payments).

c) Investing activities with a total negative has the words, “used by” to give the total amount of “Net cash flows used by investing activities.”

d) Financing activities with a total negative uses the words, “used by” to give the total amount of “Net cash flows used by financing activities.

III. Prepare a Statement of Cash Flows using the Direct Method:A. Step 1: Operating Activities—DETERMINE NET CASH

PROVIDED/USED BY OPERATING ACTIVITIES BY CONVERTING NET INCOME FROM AN ACCRUAL BASIS TO A CASH BASIS: Under the DIRECT METHOD, net cash provided by operating

activities is computed by:

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1. Adjust each item on the income statement from the accrual basis to the cash basis

2. Major classes of operating cash receipts and cash payments are reported.

3. To simplify and condense the operating activities section, only major classes (suppliers, employees, operating expenses, interest, and taxes) of operating cash receipts and cash payments are reported. a) The difference between cash receipts and cash payments is

the net cash provided by operating activities.b) Cash Receipts from Customers :

1) The income statement reports revenues from customers.2) To determine the amount of cash receipts, the decrease in accounts

receivable is added to sales revenues.3) Conversely, an increase in accounts receivable is deducted from

sales revenues, since cash receipts from customers is less than sales revenues.

4) The formula to calculate the cash receipts from customersRevenues

from sales

+ Decrease accounts receivableor = Cash receipts from customers

- Increase accounts receivableFor an example, accounts receivable decreased $3,000, so that cash receipts from customers were $978,000, calculated as follows:Revenues from sales + Increase in A/R = Cash receipts from customers

$975,000 + $3,000 = $978,0005) Cash receipts from customers may also be determined from an

analysis of Accounts.c) The formula to calculate the cash payments to suppliers where the

major expenditure is for the purchase of merchandise inventory:

Cost of Goods Sold

+ Increase in inventories

= Cash Payment to Suppliers

or- Decrease in inventories

AND+ Decrease in accounts payable

or- Increase in accounts payable

1. An example of a company reported cost of goods sold on its income statement of $660,000. To determine purchases, cost of goods sold must be adjusted for the change in inventory. An increase (decrease) in inventory is added to (deducted from) cost of goods sold to arrive at purchases. The company’s inventory increased $10,000. Cash

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payments to suppliers are then determined by adjusting purchases for the change in accounts payable. An accounts payable increase (decrease) is deducted from (added to) purchases. Thus to combine the two adjustments calculated with the formula as shown as follows:

COGS + Inc. in Inventory + Dec. in A/P = Cash Payments to Suppliers

$660,000 + $10,000 + $8,000 = $678,0002. Cash payments to suppliers may also be determined from an analysis

of Accounts Payable. The formula to calculate the cash payments for operating expenses:

Operating Expenses other

than depreciation

+ Increase in prepaid expenses

=Cash Payments for Operating Expenses

or- Decrease in prepaid expenses

AND+ Decrease in accrued liabilities

or- Increase in accrued liabilities

3. Operating expenses of $176,000 were reported on an income statement. To convert operating expenses to cash payments for operating expenses, the decrease in prepaid expenses of $2,000 must be deducted from operating expenses. An increase in prepaid expenses would be added to operating expenses. The decrease in accrued expenses of $5,000 must be added, while an increase would be deducted.

4. The formula to compute cash payments for operating expenses—direct method where the number for a company example shown as follows:

Operating Expenses

- Dec. in Prepaid Expenses

+ Dec. in Accrued Expenses Payable

= Cash Payments for Operating Expenses

$176,000 - $2,000 + $5,000 = $179,000

d) The formula to calculate the cash payments for interest expense:

Interest Expense

+ Decrease in interest payable=or Cash paid for interest

- Increase in interest payable

e) The formula to calculate the cash payments for dividends:Cash

Dividends Declared

+ Decrease in dividends payable =or Cash paid for dividends

- Increase in dividends payable

f) The formula to calculate the cash payments for income taxes:

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Income Tax

Expense

+ Decrease in income tax payable=or Cash payments for income tax

- Increase in income tax payableA company example: there is an increase income taxes payable of $12,000. Therefore the amount shown for income tax expense on the income statement is adjusted for the cash payments of income taxes as follows:

Income Tax Expense - Increase in Inc. Taxes Payable

= Cash payments for income taxes

$36,000 - $12,000 = $24,000

B. STEP 2: DETERMINE NET CASH PROVIDED/USED BY INVESTING AND FINANCING ACTIVITIES:

a) Increase in land . Note from the additional information that the land purchase was through the issuance of common stock that does NOT affect cash but is a significant noncash investing and financing activity that must be disclosed in a separate schedule.

b) Increase in equipment . An example of two transactions from the purchase and sale of equipment shown on two line items shown on the Statement of Cash Flows in the cash flows from investing activities section.

c) Increase in Bonds Payable . The additional information indicated that bonds were issued for cash and is reported in the Cash flows from financing activities.

d) Increase in Common Stock . If additional information that the land purchase was through the issuance of common stock that does NOT affect cash but is a significant noncash investing and financing activity that must be disclosed in a separate schedule.

e) The reasons for the net increase in Retained Earnings are determined by analysis:1) Net income increased Retained Earnings.2) The additional information may indicate that a cash dividend was

declared and paid.3) The adjustment of revenues and expenses to arrive at net

cash provided by operating activities was done in Step 1 above while the cash dividend paid is reported in the financing activities section. This analysis can also be made directly from the Retained Earnings account.

C. Step 3: Net Change in Cash—COMPARE THE NET CHANGE IN CASH ON THE STATEMENT OF CASH FLOWS WITH THE CHANGE IN THE CASH ACCOUNT REPORTED ON THE BALANCE SHEET TO MAKE SURE THE AMOUNTS AGREE:

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1. An example indicates that the net change in cash during the period was an increase of $32,000.

2. This should agree with the change in Cash account reported on the balance sheet.

IV. Using Cash Flows to Evaluate a Company.A. In the statement of cash flows, cash provided by operating activities is intended to

indicate the cash-generating capability of the company.B. Analysts have noted, however, that cash provided by operating activities fails

to take into account that a company must invest in new fixed assets just to maintain its current level of operations. Companies also must at least maintain dividends at current levels to satisfy investors.

C. A measurement to provide additional insight regarding a company’s cash generating ability is free cash flow which describes the cash remaining from operations after adjustment for capital expenditures and dividends.

D. The formula for free cash flow applying to the Microsoft Corporation’s Statement of Cash Flows as follows in millions:

Cash Provided by Operations - Capital

Expenditures - Cash Dividends = Free Cash Flow

$14,626 - 1,109 - 1,729 = $11,788E. This free cash flow of $11,788 billion is a tremendous amount of cash generated in a

single year which is available for the acquisition of new assets, the retirement of stock or debt, or the payment of dividends.

ANSWERS TO CLASSIFCATION OF ACTIVITIES:1. Investing2. Financing3. Investing4. Investing5. Operating6. Operating7. Financing8. Operating9. Operating10. Operating11. Noncash investing and financing 12. Noncash investing and financing

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