Chapter 12 – The Statement of Cash Flows

Cash Flows and Accrual Accounting

• All external parties have an interest in a company’s cash flows.
− Stockholders need some assurance that enough cash is being generated from operations to pay
dividends and to invest in the company’s future.
− Creditors want to know if cash from operations is sufficient to repay their loans along with
interest.
• A company’s cash position can increase or decrease over a period, and it can report a net profit or
a net loss, in the following four possible combinations:
1. A company can report an increase in cash and a net profit.
2. A company can report a decrease in cash and a net profit.
3. A company can report an increase in cash and a net loss.
4. A company can report a decrease in cash and a net loss.
• A company with a profitable year does not necessarily increase its cash position, nor does a
company with an unprofitable year always experience a decrease in cash.

Purpose of the Statement of Cash Flows

• Statement of cash flows: the financial statement that summarizes an entity’s cash receipts and
cash payments during the period from operating, investing, and financing activities.
• The statement of cash flows reports the changes in cash over a period of time and, most
importantly, explains those changes.

Reporting Requirements for a Statement of Cash Flows

• First, the statement must be prepared on a cash basis. Second, the cash flows must be classified
into three categories: Operating, Investing and Financing.

The Definition of Cash: Cash and Cash Equivalents

• The purpose of the statement of cash flows is to provide information about a company’s cash
inflows and outflows.
• Cash equivalent: an item readily convertible to a known amount of cash with a maturity to the
investor of three months or less.
• Commercial paper (short-term notes issued by corporations), money market funds, and Treasury
bills are examples of cash equivalents.

• The investment in stock of another company is considered a significant activity and thus is
reported on the statement of cash flows.
Classification of Cash Flows
• For the statement of cash flows, companies are required to classify activities into three categories:
operating, investing, or financing.
• Some companies end their statement of cash flows with the figure for the net increase or decrease
in cash and cash equivalents and do not report the beginning and ending balances in cash and cash
equivalents directly on the statement of cash flows.

Operating Activities
• Operating activities: activities concerned with the acquisition and sale of products and services.
• The statement of cash flows reflects a company’s operating activities on a cash basis.

Investing Activities
• Investing activities: activities concerned with the acquisition and disposal of long-term assets.
• Replacing worn-out plant and equipment and expanding the existing base of long-term assets are
essential to all businesses. Cash is paid for these acquisitions, often called capital expenditures.
• Sales of long-term assets such as plant and equipment are not generally a significant source of
cash. These assets are acquired to be used in producing goods and services or to support this
function, rather than to be resold, as is true for inventory.
• The acquisition of one company by another is an important investing activity.

Financing Activities
• Financing activities: activities concerned with the raising and repaying of funds in the form of debt
and equity.
• The repurchase of a company’s own stock and the repayment of borrowings are important cash
outflows to be reported in the Financing Activities section of the statement.

Summary of the Three Types of Activities

• The cash flows from operating activities are the cash effects of transactions that enter into the
determination of net income.
• Cash flows from operating activities usually relate to an increase or decrease in a current asset or
in a current liability.
• Investing activities normally relate to long-term assets on the balance sheet.
• Financing activities usually relate to either long-term liabilities or stockholders’ equity accounts.
Noncash Investing and Financing Activities
• Occasionally, companies engage in important investing and financing activities that do not affect
cash.

Two Methods of Reporting Cash Flow from Operating Activities

• Companies use one of two methods to report the amount of cash flow from operating activities –
direct and indirect method.
• Direct method: for preparing the Operating Activities section of the statement of cash flows, the
approach in which cash receipts and cash payments are reported.
• Indirect method: for preparing the Operating Activities section of the statement of cash flows, the
approach in which net income is reconciled to net cash flow from operations.
• The FASB prefers the direct method, but it is used much less frequently than the indirect method.

• The net increase in Accounts Receivable must be deducted from sales to find cash collected.
• The amount of cash provided by operating activities is the same under the two methods.
• The remainder of the statement of cash flows is the same regardless of which method is used.
• The only difference between the two methods is in the Operating Activities section of the
statement.
• In the indirect method, the increase in Accounts Receivable for the period is deducted from net
income on the statement because the increase indicates that the company sold more during the
period than it collected in cash.
• In the indirect method, the increase in Accounts Payable for the period is added back to net
income on the statement because the increase indicates that the company paid less during the
period than it recognized in expense on the income statement.

How the Statement of Cash Flows is Put Together

An Approach to Preparing the Statement of Cash Flows: Direct
Method
1. Set up three schedules with the following headings:
a. Cash Flows from Operating Activities
b. Cash Flows from Investing Activities
c. Cash Flows from Financing Activities
2. Determine the cash flows from operating activities. This requires analyzing each item on the
income statement and in the Current Asset and Current Liability accounts. As cash flows are
identified in this analysis, they are entered on the schedule of cash flows from operating activities.
3. Determine the cash flows from investing activities. This requires analyzing the Long-Term Asset
accounts and any additional information provided. As cash flows are identified in this analysis, they
are entered on the schedule of cash flows from investing activities. Any significant noncash
activities are entered on a supplemental schedule.
4. Determine the cash flows from financing activities. This requires analyzing the Long-Term Liability
and Stockholders’ Equity accounts and any additional information provided. As cash flows are
identified in this analysis, they are entered on the schedule of cash flows from financing activities.
Any significant noncash activities are entered on a supplemental schedule.
• The cash effects of changes in current accounts are reported in the Operating section.
• Changes relating to long-term asset accounts are reported in the Investing section.
• Changes relating to long-term liabilities and stockholders’ equity are reported in the Financing
section.

Schedule of Cash Flow from Operating Activities

• You can calculate cash collections from customers using the formula:
Beginning Accounts Receivable + Sales Revenue – Cash Collections = Ending Accounts Receivable
• Interest Revenue must not include interest receivables amount (which can be seen from current
assets).
• Cost of goods sold represents the cost of the inventory sold during the period, not the amount
purchased; we must analyze the Inventory account to determine the purchases of the period;
amount of purchases is not the same as the cash paid to suppliers because purchases are normally
on account; we must analyze the Accounts Payable account to determine the cash payments.
Beginning Inventory + Purchases – Cost of Goods Sold = Ending Inventory
Beginning Accounts Payable + Purchases – Cash Payments = Ending Accounts Payable
• Salaries and Wages cash payments can be calculated using the formula:
Beginning Salaries and Wages Payable + Salaries and Wages Expense – Cash Payments to
Employees = Ending Salaries and Wages Payable
• Depreciation of tangible long-term assets, amortization of intangible assets, and depletion of
natural resources are different from most other expenses in that they have no effect on cash flow.
• Cash payments for insurance expenses can be calculated using the formula:
Beginning Prepaid Insurance + Cash Payments for Insurance – Insurance Expense = Ending
Prepaid Insurance
• The FASB decided in favor of classification of interest as an operating activity because, unlike
dividends, it appears on the income statement.
• Cash payments regarding income taxes can be calculated with the formula:
Beginning Income Tax Payable + Income Tax Expense – Cash Payments for Taxes = Ending
Income Taxes Payable
Schedule of Cash Flow from Investing Activities
• The purchase of long-term assets is reported in this section as an outflow of cash.
• Any cash received from the sale of a long-term asset is reported in the Investing Activities section
of the statement of cash flows.
• The only related cash flows for depreciation expense are from the purchase and sale of these long-
term assets, and these are reported in the Investing Activities of the statement of cash flows.
Beginning Accumulated Depreciation + Depreciation Expense – Accumulated Depreciation on
Assets Sold = Ending Accumulated Depreciation
• When an asset is purchased on a note payable: the issuance of the note is a financing activity, and
the acquisition of land is an investing activity; because no cash was involved, the transaction is
reported in a separate schedule instead of directly on the statement of cash flows.
• Acquisitions of new plant and equipment are important investing activities.
Beginning property and equipment + Acquisitions – Disposals = Ending property and equipment

Schedule of Cash Flow from Financing Activities

• These activities generally involve long-term liabilities and stockholders’ equity.
• Any cash paid to retire a long-term liability is reported in the Financing Activities section of the
statement of cash flows.
• When a company has to pay more in cash to settle a debt than the book value of the debt (in case
of bonds), it reports a loss.
• The increase in Cash from an issuance of capital stock is presented as a cash inflow in the Schedule
of Cash Flows from Financing Activities.
• We can determine the amount of cash dividends using the formula:
Beginning retained earnings + Net income – Cash dividends = Ending retained earnings
An Approach to Preparing the Statement of Cash Flows: Indirect
Method
Reconcile Net Income to Net Cash Flows from Operating Activities
• The purpose of the Operating Activities section of the statement changes when the indirect
method is used.
• Instead of reporting cash receipts and cash payments, the objective is to reconcile net income to
net cash flow from operating activities.
• We start with the assumptions that all revenues and gains reported on the income statement
increase cash flow and that all expenses and losses decrease cash flow.
• For accounts receivable, because net income includes sales (as opposed to cash collections), the
net increase/decrease must be deducted to adjust net income to cash from operations.
• Because the gain/loss on sale of asset is included in the net income figure, it must be deducted to
determine cash from operations.
• Net changes in inventory and accounts payable are added back to the net income.
• A decrease in salaries and wages payable is deducted from the net income.
• Depreciation is a non-cash expense hence it must be added back to the net income. The same
holds true for amortization of intangible assets and depletion of natural resources.
• Net decrease in prepaid insurance and taxes payable is added back to the net income amount.
• Loss on retirement of bonds is added back to the net income under operating activities.

Summary of Adjustments to Net Income under the Indirect Method

Comparison of Direct and Indirect Methods

• The amount of cash provided by operating activities is the same under both methods.
• If a company uses the indirect method, it must separately disclose two important cash payments:
income taxes paid and interest paid.
• Advocates of the direct method believe that the information provided with this approach is
valuable in evaluating a company’s operating efficiency.
• The information presented in the Operating Activities section of the statement under the direct
method is certainly user-friendly.
• Advocates of the indirect method argue two major points:
1. The direct method reveals too much about a business by telling readers the amount of cash
receipts and cash payments from operations.
2. The indirect method focuses attention on the differences between income on an accrual basis
and a cash basis.
• If a company uses the direct method, it must present a separate schedule to reconcile net income
to net cash from operating activities.
The Use of Cash Flow Information
• Many investors focus on cash flow from operations rather than net income as their key statistic.
• The statement of cash flows provides investors, analysts, bankers, and other users with a valuable
starting point as they attempt to evaluate a company’s financial health.

Creditors and Cash Flow Adequacy

• Bankers and other creditors are especially concerned with a company’s ability to meet its principal
and interest obligations.
• Cash flow adequacy is a measure that gauges the cash that a company has available to meet future
debt obligations after paying taxes and interest costs and making capital expenditures.
Cash Flow from Operating Activities - Capital Expenditures
Cash Flow Adequacy =
Average Amount of Debt Maturing over Next Five Years
• The numerator of the ratio is determined by deducting capital expenditures, as they appear in the
Investing Activities section of the statement, from cash flow from operating activities. A disclosure
required by the SEC provides the information needed to calculate the denominator of the ratio.

Stockholders and Cash Flow per Share

• One measure of the relative worth of an investment in a company is the ratio of the stock’s market
price per share to the company’s earnings per share (price/earnings ratio).
• But many stockholders and Wall Street analysts are even more interested in the price of the stock
in relation to the company’s cash flow per share.
• Cash flow for purposes of this ratio is normally limited to cash flow from operating activities.