Chapter Five

Statement of Cash Flows revisited

The statement of cash flows is a required component of financial statements.
BASICS OF CASH FLOW REPORTING- Purpose of the Statement of Cash Flows:

The statement of cash flows is one of the five financial statements required by GAAP. The other four
required financial statements are:

1. Income Statement

2. Retained Earnings Statement or Statement of Stockholders’ Equity

3. Balance Sheet

4. Statement of Comprehensive Income

The statement of cash flows answers one question the other four financial statements do not: how did
the company generate, and spend, its cash?

Measurement of Cash Flows

Cash flows are defined to include both cash (monies in checking accounts and bank savings accounts)
and cash equivalents. Cash equivalents include:

• Money market funds

• Highly-liquid investments with original maturities of less than 3 months, such as bank certificates of
deposit and U.S. Treasury bills.

Classification of Cash Flows

The Statement of Cash Flows shows cash inflows and cash outflows, organized into three different
business activities. These three business activities are summarized below.

Name of activity Accounts analyzed What the activity presents

Operating activities Operating assets and liabilities. The net cash flows generated, or
These include most current asset used, by the business in their
and liability accounts. core operations. We will use the
indirect method of presenting
operating activities. This method
reconciles net income to net
cash flow from operating
activities.
Investing activities Long-term assets The cash inflows and outflows
from sales and purchases of
long-term assets, such as
equipment, patents, and long-
term investments.

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Financing activities Long-term liabilities and The cash inflows and outflows
stockholders’ equity. from issuance of debt;
repayment of debt; issuance of
stocks; dividends paid; and stock
repurchases.

Noncash investing and Financing Activities :

Businesses sometime engage in transactions not affecting cash. For example, a business can purchase
equipment by issuing a long-term note payable to the vendor. In this case, cash is not affected, and this
transaction would not be reported in the body of the statement of cash flows. This transaction, referred
to as a noncash investing and financing activity, would instead be disclosed either at the bottom of the
statement of cash flows or in a note to the financial statements.

CASH FLOWS FROM OPERATING ACTIVITIES

Using the indirect method of reporting operating activities: Nearly all companies report operating
activities using the indirect method. This is because the indirect method is easier to compute.

The following template should prove helpful to you in preparing the operating activities of the
statement of cash flows using the indirect method.

Net Income……………………………………………………………………………………………………………………………... $XXX

Adjustments to reconcile net income to net cash provided by operating activities:

Decrease in operating assets **………………………………………………………………………………………………….. X

Increase in operating liabilities +……………………………………………………………………………………………………X
Increase in operating assets ** …………………………………………………………………………………………………….(X)
Decrease in operating liabilities +………………………………………………………………………………………………… (X)
Depreciation Expense……………………………………………………………………………………………………………………. X
Loss on sale of assets or debt retirement………………………………………………………………………………………. X Gain
on sale of assets or debt retirement…………………………………………………………………………………….. (X) Net
Cash Provided by Operating Activities………………………………………………………………………………….. $XXXX

**Examples: A/R, Inventory, prepaid assets, and trading securities.

+ Examples: A/P, accrued liabilities, and unearned rent; excludes dividends payable.

If the indirect method is used, income taxes paid and interest paid must be disclosed in a footnote to
the financial statements.

For example, assume Michelle Company reported the following for its most recent fiscal year:

Net income, $200,000

Depreciation expense, $50,000

Increase in accounts receivable, $10,000

Decrease in merchandise inventory, $2,000

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Increase in prepaid expenses, $1,000

Decrease in accounts payable, $9,000

Increase in wages payable, $3,000

Loss on sale of equipment, $1,000

The operating activities would report the following, using the indirect method:

Cash flows from operating activities:

Net income……………………………………………………………………………………………………………….. $200,000

Adjustments to reconcile net income to net cash provided by operating activities:

Increase in accounts receivable………………………………………………………………………………… (10,000)

Decrease in merchandise inventory………………………………………………………………………………2,000

Increase in prepaid expenses………………………………………………………………………………………… (1,000)

Decrease in accounts payable…………………………………………………………………………………………(9,000)

Increase in wages payable………………………………………………………………………………………………..3,000

Depreciation expense……………………………………………………………………………………………………….50,000

Loss on sale of equipment……………………………………………………………………………………………….. 1,000

Net cash provided by operating activities………………………………………………………………………………… $236,000

CASH FLOWS FROM INVESTING ACTIVITIES - Investing activities include cash inflows from: • Sale of
long-term assets

• Sale of investments (except trading securities)

• Collections of notes receivable Investing activities include cash outflows from: • Purchase of long-term
assets

• Purchase of investments (except trading securities)

• Loaning cash to others

 Obtaining the data for the investing activities section involves three steps:

1. Calculate the increase or decrease in the long-term asset accounts

2. Reconstruct the changes in the accounts

3. Report their effects in the investing activities

As an example, assume the balance of Equipment for Michelle Company was $100,000 at the beginning
of the year, and $120,000 at the end of the year. We can say Equipment increased by $20,000 during the
year.

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However, a detailed reconstruction of Equipment revealed the following:

Equipment, beginning of year………………. $100,000

Purchases of equipment………………………. 30,000

Sales of equipment……………………………… (10,000)

Equipment, end of year……………………………………………………. $120,000

The equipment sold had an original cost of $10,000 and accumulated depreciation of $4,000, so its book
value was $6,000. Assuming the equipment was sold for $5,000, a loss of $1,000 on sale of equipment
was incurred.

The investing activities section for Michelle Company would report the following:

Cash flows from investing activities:

Cash received from sale of equipment…………………………… $5,000

Cash paid for purchase of equipment………………………………. (30,000)

Net cash used in investing activities………………………………………………….. (25,000)

The loss on sale of equipment of $1,000 would be added to net income in operating activities.

CASH FLOWS FROM FINANCING ACTIVITIES

Financing activities include cash inflows from:

• Issuing stock

• Issuing debt

Financing activities include cash outflows from:

• Purchasing treasury stock

• Retiring stock by purchase

• Debt payments

• Dividend payments

For example, if a company issued stock for $50,000 but repaid debt of $20,000, the financing activities
section would report the following.

Cash flows from financing activities:

Cash received from issuing stock……………………. $50,000

Cash paid to retire debt…………………………………… (20,000)

Net cash provided by financing activities…………………………………….. 30,000

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PROVING CASH BALANCES

After preparing the operating, investing and financing activities of the statement of cash flows, one final
step remains. We must report the beginning and ending balances of cash and cash equivalents, and
prove that the net change in cash is explained by summing the operating, investing, and financing
activities.

Assume the beginning of year cash balance for Michelle Company was $100,000, and the end of year
cash balance was $341,000. The net increase in cash would be $241,000. Michelle Company’s statement
of cash flow, once completed, would appear as follows.

Cash flows from operating activities:

Net income…………………………………………………………………………………………………………….$200,000

Adjustments to reconcile net income to net cash provided by operating activities:

Increase in accounts receivable………………………………………………………………………………… (10,000)

Decrease in merchandise inventory……………………………………………………………………………2,000

Increase in prepaid expenses………………………………………………………………………………………(1,000)

Decrease in accounts payable……………………………………………………………………………………….(9,000)

Increase in wages payable……………………………………………………………………………………………3,000

Depreciation expense……………………………………………………………………………………………………50,000

Loss on sale of equipment……………………………………………………………………………………………1,000

Net cash provided by operating activities………………………………………………………………………………….. $236,000

Cash flows from investing activities:

Cash received from sale of equipment……………………………………………………………………… $5,000

Cash paid for purchase of equipment……………………………………………………………………….. (30,000)

Net cash used in investing activities……………………………………………………………………………………………. (25,000)

Cash flows from financing activities:

Cash received from issuing stock……………………………………………………………………………….. $50,000

Cash paid to retire debt……………………………………………………………………………………………… (20,000)

Net cash provided by financing activities………………………………………………………………………………………. 30,000

Net increase in cash…………………………………………………………………………………………………………………….. 241,000

Cash and cash equivalents at prior year-end……………………………………………………………………………….. 100,000
Cash and cash equivalents at current year-end…………………………………………………………………………. $341,000

 The cash and cash equivalents balance at current year-end must agree with the balance for cash
and cash equivalents reported on the balance sheet.

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 Example #1
The following information was taken from the financial records of the XYZ Company.

End of Year Beginning of Year Change

Cash $ 23,500 $ 37,400 (13,900)
Accounts receivable 84,500 80,350 4,150
(net)
Inventories 100,200 94,300 5,900
Prepaid expenses 4,970 5,300 (330)
Accounts payable 71,400 68,900 2,500
(creditors)
Salaries Payable 5,320 6,450 (1,130)
Net Income reported on the income statement for the current year was $134,800. Depreciation expense
recorded on buildings and equipment was $27,400 for the year.

Required: Using the indirect method prepare the Cash Flows from Operating Activities section of the
Statement of Cash Flows.

Solution #1
Net Income………………………………………………………………………………………………… $134,800
Add: Decrease in prepaid expenses…………………………………….. $ 330
Increase in Accounts Payable………………………………………… 2,500
Depreciation Expense……………………………………………………. 27,400 30,230
165,030
Deduct: Increase in Accounts Receivable……………………………… $ 4,150
Increase in Inventories……………………………………………….. 5,900
Decrease in Salaries Payable……………………………………….. 1,130 11,180
Net Cash Flows from Operating Activities…………………………………. $153,850

Investing Activities: Investing Activities include events and transactions that affect long-term assets.
For example, the journal entry to record the sale of land with a cost of $100,000 for $120,000 would be:

Cash……………………………………. 120,000

Land………………………………………………..100,000

Gain on sale……………………………………. 20,000

The effect of this transaction is to reduce long-term assets by $100,000. On the statement of cash flows,
the cash proceeds are reported as an inflow in the investing activities section and the gain is deducted
from net income in the operating activities section as noted above.

 If equipment were purchased for $75,000, the journal entry would be:

Equipment…………………………………. 75,000

Cash………………………………………………. 75,000

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  The $75,000 would be reported as a use of cash in the investing section. The Investing Activities
section would appear as follows:
Cash inflows from:
Sale of Long-term Assets:
 Property, Plant or Equipment
 Intangible assets
 Investments
Less: Cash outflows from:
Purchase of Long-term Assets
 Property, Plant or Equipment
 Intangible assets
 Investments

=Net Cash Flows from Investing Activities

Example #2: The following information was taken from the financial records of the XYZ Company.

a) Net income was $189,500 for the period.

b) Purchased 10,000 shares of common stock at $15 per share for the treasury.

c) Sold equipment with a carrying value of $32,500 at a gain of $6,000.

d) Purchased land and a building worth $450,000 by signing a ten-year note.

e) Issued $1,000,000 in bonds at par.

f) The beginning and ending retained earnings account balances were $418,000 and $534,000,
respectively. There were no prior period adjustments.

g) Wrote a check for $648,000 for the purchase of machinery.

h) Sold long-term investments in stocks with a cost of$50,000 at a loss of $17,500.

i) Cash dividends were declared and paid during the period.

Required: Prepare the net cash flows from investing activities.

Solution #2

Investing Activities:

 Cash received from sale of equipment:

$32,000 – 6,000 = $38,500

 Cash received from sale of investments:

$50,000 – 17,500 = 32,500

 Cash paid for machinery (648,000)

Net cash flows from investing activities ($577,000)

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 Financing Activities- Financing Activities include events and transactions that affect long-term
liabilities and equity other than net income.

For example, the journal entry to record the issuance of bonds with a face value of $100,000 would
be:

Cash………………………….. 100,000

Bonds payable………………….. 100,000

 The effect of this transaction is to increase long-term liabilities by $100,000. On the

statement of cash flows, the cash proceeds are reported as an inflow in the financing
activities section.

If the bonds are subsequently retired at 101,000, the journal entry would be:

Loss on retirement……………………… 1,000

Bonds payable……………………………... 100,000

Cash………………………………………………………. 101,000

The effect of this transaction is to reduce long-term liabilities by $100,000. On the statement of cash
flows, the cash spent is reported as an outflow in the financing activities section and the loss is
added to net income in the operating activities section as noted above.

Dividends paid are also included in the financing activities section. Dividends paid are not part of the
operating activities section because dividends do not appear in the income statement. They are
reported in the financing activities section because they relate to the equity section of the balance
sheet and cash flows from changes in equity are reported in this section.

Whenever the beginning balance does not equal the ending balance for dividends payable, the
dividends paid will have to be calculated using the following formula:

Beginning balance + dividends declared - ending balance = dividends paid

If the beginning balance equals the ending balance for dividends payable or there are no beginning
and ending balances for dividends payable, then the dividends paid equals the dividends declared.

The Financing Activities section would appear as follows:

Cash inflows from: Issuing debt or equity securities

 Issuing bonds o Issuing Stocks (Common and Preferred)

 Reissuing Treasury Stocks
 Issuing other long-term debts (mortgage payable, notes payable)

Less: Cash outflows from: Retiring debts, repurchasing equity securities and paying dividends

 Payments to retire bonds

 Payments to retire other long-term debts
 Payments for Dividends

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  Payments to purchase Treasury Stock

=Net Cash Flows from Financing Activities

Again, Non-cash Financing and Investing Activities, such as issuing stock to retire bonds, are reported in
a separate schedule that appears after the bottom of the Statement of Cash Flows.

Example #3

The following information was taken from the financial records of the XYZ Company.

a) Net income was $189,500 for the period.

b) Purchased 10,000 shares of common stock at $15 per share for the treasury.

c) Sold equipment with a carrying value of $32,500 at a gain of $6,000.

d) Purchased land and a building worth $450,000 by signing a ten-year note payable.

e) Issued $1,000,000 in bonds at par.

f) The beginning and ending retained earnings account balances were $418,000 and $534,000,
respectively. There were no prior period adjustments during the period.

g) Wrote a check for $648,000 for the purchase of machinery.

h) Sold long-term investments in marketable securities with a $50,000 carrying value, at a loss of
$17,500.

i) Cash dividends were declared and paid during the period

Required: Prepare the net cash flows from financing activities section of the Statement of Cash Flows.

Solution #3

Financing Activities:

Cash paid to purchase treasury stock:

(10,000 shares x $15) = ($150,000)

Cash received from sale of bonds 1,000,000

Cash paid for dividends:

($418,000 + 189,500 - 534,000) = (73,500)

Net cash flows from financing activities ……………… $776,500

Practice Problem #1

The following information was taken from the financial records of the W Company.

End of Year Beginning of Year

cash $345,000 $386,000

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A/receivable 554,300 567,800
inventory 693,000 672,400
Prepaid expense 27,000 24,000
A/ payable 510,000 527,400
Wage payable 39,500 36,000

The net income reported on the income statement for the current year was $465,000, which included a
gain on sale of investments of $3,000. Depreciation expense recorded on store equipment for the year
amounted to $99,800.

Required: Using the indirect method prepare the operating activities section

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