Financial Accounting

Eleventh Edition
Global Edition

Chapter 11
Cash Flows

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Course Overview
Details of common asset accounts:
➢Cash: Bank Reconciliation ✓
➢Receivables: Impairment & notes interests ✓
➢Inventory ✓
➢Property, plant and equipment ✓
Details of common liability accounts ✓
Details of equity ✓
Details of Statement of Cash Flow (This Lecture)

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Learning Objectives
11.1 Identify the purposes of the statement of cash flows
11.2 Distinguish among operating, investing, and financing
cash flow activities
11.3 Prepare cash flows from operating activities using the
indirect method
11.4 Prepare cash flows from investing activities
11.5 Prepare cash flows from financing activities
11.6 Prepare cash flows from operating activities using the
direct method
11.7 Evaluate a company’s ability to generate cash flows

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Learning Objective 11.1
Identify the purposes of the statement of cash flows

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Purposes of the Statement of Cash
Flows (1 of 2)
• Reports cash flows:
– Cash receipts
– Cash payments
– Covers a period of time (month, quarter, year)
– Typically the same time period as the Income
Statement

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Purposes of the Statement of Cash
Flows (2 of 2)
• Three purposes:
– Shows the relationship of net income to cash flows
– Evaluates management decisions
– Based on past performance
– Predicts future cash flows
– Past cash flows predict future cash flows

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Learning Objective 11.2
Distinguish among operating, investing, and financing
cash flow activities

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Distinguish Among Operating, Investing, and
Financing Cash Flow Activities (1 of 2)
Three Types of Business Activities
• Operating
– Net income: revenues, expenses, gains, and losses
– Plus: changes in current assets and liabilities
• Investing
– Changes in long-term assets
• Financing
– Changes in long-term liabilities and shareholders’
equity

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Exhibit 11-1 Major Classes of Cash Receipts and
Cash Payments on the Statement of Cash Flows

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Exhibit 11-2 How Operating, Investing, and
Financing Activities Affect the Balance Sheet

*Note that IFRS gives some flexibility on where to report certain items:
Interest payment – Operating or Financing
Interest received – Operating or Investing
Dividend payment – Operating or Financing
Dividend received – Operating or Investing

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Distinguish Among Operating, Investing, and
Financing Cash Flow Activities (2 of 2)
• Two Formats for Operating Activities
– Indirect Method → reconciles from net income to net
cash provided by operating activities (simpler, used by
more companies)
– Direct Method → Reports all cash receipts and cash
payments from operating activities (more complicated,
preferred by the IASB)

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Learning Objective 11.3
Prepare cash flows from operating activities using the
indirect method

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Prepare Cash Flows from Operating
Activities Using the Indirect Method (1 of 6)
Indirect Method: Start from net income, adjust for non-
cash & non-current transactions
To illustrate the statement of cash flows, we use The
Roadster Factory, Inc. (TRF), a dealer in auto parts for
sports cars. Using the comparative balance sheets for
20X6 and 20X7 and the income statement for 20X7,
prepare the statement of cash flows using the indirect
method.

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Exhibit 11-3: The Roadster Factory’s
Income Statement

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Exhibit 11-4 TRF’s Balance Sheet

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Exhibit 11-5 Template for Cash Flows from
Operating Activities: Indirect Method

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Prepare Cash Flows from Operating
Activities Using the Indirect Method (2 of 6)
Cash Flows from Operating Activities
• Step 1: Start with the net income from the income statement
(Exhibit 11-3)
• Step 2: Add depreciation, depletion, amortization expense;
deduct gains and losses on sale of long-term assets
• Step 3: Identify the changes in current assets and current
liabilities from the balance sheet (Exhibit 11-4)
• Step 4: Deduct increase or decrease in each current asset
(other than cash)
• Step 5: Deduct increase or decrease in each current liabilities

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Prepare Cash Flows from Operating
Activities Using the Indirect Method (3 of 6)
• Depreciation, Depletion, and Amortization
Expenses
– Added back to net income to convert net income to
cash flow
– No effect on cash, decreases net income
– Add-back cancels the deduction on the income
statement
The Roadster Factory, Inc. reports depreciation expense
on their income statement of $18,000 (Exhibit 11-6).

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Exhibit 11-6 Statement of Cash Flows: Operating
Activities by the Indirect Method (1 of 3)

*Dep Exp should be +18, not (18)

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Prepare Cash Flows from Operating
Activities Using the Indirect Method (4 of 6)
• Gains and Losses on the Sale of Long-Term
Assets
– An adjustment to net income
– Subtract gains from operating activities
– Add losses from operating activities
The Roadster Factory sold equipment with a gain of
$8,000.

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Exhibit 11-6 Statement of Cash Flows: Operating
Activities by the Indirect Method (2 of 3)

*Dep Exp should be +18, not (18)

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Prepare Cash Flows from Operating
Activities Using the Indirect Method (5 of 6)
Changes in Current Assets and Current Liabilities
• Deduct increase in noncash current assets
– Accounts Receivable increased by $15,000
– Prepaid Expenses increased by $1,000
• Add decrease in noncash current assets
– Inventory decreased by $3,000

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Prepare Cash Flows from Operating
Activities Using the Indirect Method (6 of 6)
Changes in Current Assets and Current Liabilities
• Add increase in current liabilities
– Accounts Payable increased by $34,000
• Deduct decrease in current liabilities
– Salary and Wages Payable decreased by $2,000
– Accrued Liabilities decreased by $2,000

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Exhibit 11-6 Statement of Cash Flows: Operating
Activities by the Indirect Method (3 of 3)

*Dep Exp
should be
+ 18, not
(18)

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Learning Objective 11.4
Prepare cash flows from investing activities

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Prepare Cash Flows from Investing
Activities (1 of 5)
Cash Flow from Investing Activities
• Transactions involving long-term assets
– PPE assets, long-term Investments, loans
• Increase represents purchase of long-term assets
– Decreases cash
• Decrease represents sale of long-term assets
– Increases cash

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Prepare Cash Flows from Investing
Activities (2 of 5)
• Computing Purchases and Sales of PPE
‒ Assume acquisition of PPE during the year is
$196,000, we can compute the sale of PPE.

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Prepare Cash Flows from Investing
Activities (3 of 5)
Computing Purchases and Sales of Investments,
and Loans and Collections

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Prepare Cash Flows from Investing
Activities (4 of 5)
Purchases and Sales of Investments, and Loans
and Collections

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Prepare Cash Flows from Investing
Activities (5 of 5)
Purchases and Sales of Investments, and Loans
and Collections

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Exhibit 12-7 Statement of Cash
Flows: Investing Activities

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Exhibit 11-8 Computing Cash Flows
from Investing Activities

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Learning Objective 11.5
Prepare cash flows from financing activities

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Prepare Cash Flows from Financing
Activities (1 of 5)
• Affect liabilities and stockholders’ equity
– Long-Term Debt, Share Capital, Additional Paid-in
Capital, and Retained Earnings
• Increases in liabilities & equity indicates increases in
cash
• Decreases in liabilities & equity indicates decreases in
cash

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Prepare Cash Flows from Financing
Activities (2 of 5)
Computing Issuance and Payments of Long-Term
Debt

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Prepare Cash Flows from Financing
Activities (3 of 5)
Computing Issuances of Shares and Purchases of
Treasury Shares

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Prepare Cash Flows from Financing
Activities (4 of 5)
Computing Dividend Declarations and Payments

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Exhibit 11-9 Statement of Cash
Flows: Investing Activities

Proceeds
should be
+ not ()

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Exhibit 11-10 Computing Cash Flows
from Financing Activities

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Exhibit 11-11 Statement of Cash
Flows: Indirect Method (operating)

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Prepare Cash Flows from Financing
Activities (5 of 5)
Noncash Investing and Financing Activities
Sometimes investing and financing activities may not
involve cash transactions. If the amount is large enough
(material) they may need footnote disclosures.

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Exhibit 11-12 Noncash Investing and
Financing Activities (All Amounts Assumed)

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Learning Objective 11.6
Prepare cash flows from operating activities using the
direct method

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Prepare Cash Flows from Operating
Activities Using the Direct Method (1 of 10)
• IAS 7 prefers the direct method
– Provides clearer information about the sources and
uses of cash
– Very small percentage of companies actually use
direct method
– Requires more computations than the indirect
method
– Investing and financing cash flows are unaffected
by the method used

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Prepare Cash Flows from Operating
Activities Using the Direct Method (2 of 10)
Compute Operating Cash Flows by the Direct Method
• Cash Receipts (Positive)
– Cash collections from customers
– Cash receipts of Interest and Dividends
– Other operating receipts
• Cash Payments (Negative)
– Payments to suppliers
– Payments to employees
– Payments of interest and income taxes
– Other operating expenses
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Prepare Cash Flows from Operating
Activities Using the Direct Method (3 of 10)
Cash Flows from Operating Activities
Depreciation, depletion, and amortization expenses are
not listed on the direct-method statement of cash flows
because they do not affect cash

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Exhibit 11-13 Direct Method of Computing Cash
Flows from Operating Activities

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Exhibit 11-14 TRF’s Income Statement

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Exhibit 11-15 TRF’s Balance Sheets

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Prepare Cash Flows from Operating
Activities Using the Direct Method (4 of 10)
Cash Collections from Customers

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Prepare Cash Flows from Operating
Activities Using the Direct Method (5 of 10)
Payments for Inventory

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Prepare Cash Flows from Operating
Activities Using the Direct Method (6 of 10)
Payments for Operating Expenses

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Prepare Cash Flows from Operating
Activities Using the Direct Method (7 of 10)
Payments for Operating Expenses

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Prepare Cash Flows from Operating
Activities Using the Direct Method (8 of 10)
Payments for Operating Expenses

Payments to Suppliers
Payments to suppliers = Payments for inventory + Payments for other operating expenses
$133,000 = $113,000 + $20,000

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Prepare Cash Flows from Operating
Activities Using the Direct Method (9 of 10)
Payments to Employees

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Prepare Cash Flows from Operating
Activities Using the Direct Method (10 of 10)

Collections from Customer 288

Interest revenue 2
Payments to Suppliers (133)
Payments to Employees (58)
Interest expenses (15)
Tax expenses (7)
Net cash provided by operating activities 77

Equals the amount from indirect method

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Learning Objective 11.7
Evaluate a company’s ability to generate cash flows

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Evaluate a Company’s Ability to
Generate Cash Flows (1 of 3)
Free Cash Flow

Cash available from operations after payments for investments:

Estimate of amount of excess cash available for the company’s use

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Evaluate a Company’s Ability to
Generate Cash Flows (2 of 3)
Cash Realization Ratio
– Measures amount of net profit reflected in actual cash
generated from operations
– Calculated as a ratio of CFO over net profit

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Exhibit 11-16 Cash Realization
Comparisons

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Evaluate a Company’s Ability to
Generate Cash Flows (3 of 3)
Examining Cash Flow Patterns
– Examined over a period of time, not just at the end of
one fiscal year
– For simple analysis, plot the cash flow patterns over a
number of years (refer to Singtel and Vodafone’s
example)

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Exhibit 11-17 Singtel’s Cash Flow
Patterns 2012–2016

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Exhibit 11-18 Vodafone’s Cash Flow
Patterns 2012–2016

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Chapter Summary
• The 3 types of cash flows are from operating, investing
,and financing activities
• Operating: Net income+

• The indirect method of preparing operating cash flow starts

from net income and make adjustment to non-cash
gain/loss & changes in current assets and liabilities
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Chapter Summary
• The direct method of preparing operating cash flow directly
record cash receipts and payments

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Chapter Summary
• The results from both method of preparing operating cash
flow are the same
• IAS 7 prefers direct method because the information is
clearer. However, indirect method is more commonly used
because it is easier to prepare
• Cash flow from investing and financing activities are
unaffected by the method chosen

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Course Overview
What is accounting? ✓
Why do we do accounting in the way that will be discussed
in this course? ✓
How do we do accounting?
➢The format: T-accounts & journal entries ✓
➢Accrual accounting: Adjusting entries ✓
➢Presenting Financial Statements ✓
➢Details of common accounts and cash flow ✓
How do we use accounting information? (Lecture 11)

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Course Overview
Financial Statement Analysis:
•Current Ratio •Times-interest-earned Ratio
•Receivable Turnover •Earnings per Ordinary Share
•Gross Profit •Return on (Common) Equity
•Inventory Turnover •Free Cash Flow
(Residence Period)
•Cash Realization Ratio
•Return on Assets
•Debt Ratio

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Homework Assignments
• S11-7 E11-33B
• Due 26 Nov, 11:59pm
• Upload to Blackboard
• Late submission is not accepted

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