CHAPTER FIVE

STATEMENT OF CASHFLOWS

USEFULNESS OF THE STATEMENT OF CASH FLOWS

Statement of Cash Flows: reports the cash receipts and cash
payments from operating, investing, and financing activities
during a period. Provides information to help assess:
- Entity’s ability to generate future cash flows.
- Entity’s ability to pay dividends and meet obligations.
- Reasons for difference between net income and net
cash provided (used) by operating activities.
- Cash investing and financing transactions during the
period.

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 CLASSIFICATION OF CASH FLOWS

 Operating, Investing, and Financing

1. Operating Activities: the cash effects of transactions that
create revenues and expenses. (Income Statement Items)
Cash inflows:
– From sale of goods or services.
– From interest received and dividends received.
• Cash outflows:
– To suppliers for inventory.
– To employees for wages.
– To government for taxes.
– To lenders for interest.
– To others for expenses.
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2. Investing Activities
 The purchase or disposal of investments and property, plant,
and equipment.
 Lending money and collecting the loans.
 (Long-Term Assets)
Cash inflows:
- From sale of property, plant, and equipment.
- From sale of investments in debt or equity securities of other
entities.
- From collection of principal on loans to other entities.
Cash outflows:
- To purchase property, plant, and equipment.
- To purchase investments in debt or equity securities of other
entities.
- To make loans to other entities.
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3. Financing Activities
 Obtaining cash from issuing debt and repaying the amounts
borrowed.
 Obtaining cash from stockholders, repurchasing shares, and
paying dividends.
 (Long-Term Liabilities and Stockholders’ Equity)
Cash inflows:
- From sale of common stock.
- From issuance of debt (bonds and notes).
Cash outflows:
- To stockholders as dividends.
- To redeem long-term debt or reacquire capital stock
(treasury stock).
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 SIGNIFICANT NONCASH ACTIVITIES

 Companies report noncash activities in either a

1. Separate schedule (bottom of the statement).
2. Separate note to the financial statements.
Examples include:
- Direct issuance of common stock to purchase assets.
- Conversion of bonds into common stock.
- Issuance of debt to purchase assets.
- Exchanges of plant assets.

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 FORMAT OF THE STATEMENT OF CASH FLOW

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 Prepare a statement of cash flows using the
indirect method.
 Statement of cash flows is prepared differently from the
three other basic financial statements.
– Three sources of information:
a) Comparative balance sheets: indicates the amount of
changes in asset, liability, and stockholders; equity accounts
from the beginning to the end of the period.
b) Current income statement: helps determine the amount
of net cash provided or used by operating activities during
the period.
c) Additional information: Such information includes
transaction data that are needed to determine how much
cash was provided or used during the period.
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 THREE MAJOR STEPS TO PREPARE THE
STATEMENT OF CASH FLOWS
Step 1: Determine net cash provided/used by operating
activities by converting net income from an accrual basis to a
cash basis.
Step 2: Analyze changes in noncurrent asset and liability
accounts and record as investing and financing activities, or
disclose as noncash transactions.
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.

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STEP 1: OPERATING ACTIVITIES

TWO METHODS: DIRECT AND INDIRECT.

THESE NOTES FOCUS ON INDIRECT.
– Companies favor the INDIRECT METHOD for two
reasons:
- Easier and less costly to prepare.
- Focuses on differences between net income and net
ash flow from operating activities.
– Both methods result in the SAME AMOUNT of cash flow
from operating activities.
– They differ in the way they report cash flows from
operating activities.

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 Cont’d…

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 INDIRECT METHOD

Steps for the Indirect Method

1. Start with NET INCOME (going to convert accrual net
income into cash from operations)
2. ADD (+) noncash expenses such as depreciation,
amortization, and depletion.
3. ADD (+ ) losses on sale of long-term assets.
4. DEDUCT (-) gains on sale of long-term assets.
5. Analyze changes to noncash CURRENT ASSET and
CURRENT LIABILITY ACCOUNTS.
A. DEDUCT increases in current asset account.
B.ADD decrease in current asset account.

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 Cont’d…
 Current Assets INCREASE , then you are going to DECREASE
Net Income. Current Assets DECREASE, then you are going
to INCREASE Net Income.
C. ADD increases in current liability account.
D. DEDUCT decrease in current liability account.
 Current Liabilities INCREASE , then you are going to
INCREASE Net Income. Current Liabilities DECREASE ,
then you are going to DECREASE Net Income

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 INDIRECT METHOD FOR OPERATING
ACTIVITIES SECTION (EXAMPLE PROBLEM)

 WB Company reported net income of ETB 190,000 for the

current year. Depreciation recorded on buildings and
equipment amounted to ETB 90,000 for the year. Balances
of the current asset and current liability accounts at the
beginning and end of the year are as follows:
End of Year Beginning of
Year
Cash ETB 120,000 Br.100,000
Accounts receivable 70,000 50,000
Inventory 50,000 80,000
Accounts payable 35,000 30,000

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 Cont’d…
Instructions
 Prepare the cash flows from the operating activities section
of the statement of cash flows using the indirect method.
 Net cash provided by operating activities is ETB 295,000
STEP 2: INVESTING ACTIVITIES
• Analyze changes in noncurrent asset and liability accounts
and record as investing and financing activities, or disclose
as noncash transactions.
• Think changes in Non-current (long-term) assets (Property,
plant, equipment, investments in stocks or bonds of other
entities, loans to other entities, and collection of a nontrade
receivable (excluding interest))

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 Cont’d…
 Decrease in cash
- Purchase of long-term assets (Ex: buildings, equipment,
land) Purchase of long-term investments, Lending money.
 (PAYING CASH which means CASH GOES DOWN)
 Increase in cash
- Sale of long-term assets (Ex: buildings, equipment,
land) Sale of long-term investments, Collection of
long-term loan
 (RECEIVING CASH which means CASH GOES UP)

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 Cont’d…
STEP 2 : FINANCING ACTIVITIES
 Think changes in long-term liabilities and shareholder’s
equity. Money obtained to run a business from loans (long-
term liabilities) or issuing stock (ownership in the company.)
 Decrease in Cash
- Payback long-term loans ,redemption of bonds
payable, purchase treasury stock (Buying back the
company’s own stock.), Payment of dividends
 (PAYING CASH which means CASH GOES DOWN)

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 Cont’d…
Increase in Cash
- Issuance or sale of common or preferred stock, issuance of
bonds payable or long-term notes payable
 (RECEIVING CASH which means CASH GOES UP)

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 Step 3: Finish Statement of Cash Flows

 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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 Cont’d…
***Noncash investing and financing activities like buying
equipment by issuing a note do not involve cash, but are still
important.
 They are shown on the bottom of the statement of cash
flows or in a disclosure note.
 Because such transactions indirectly affect cash flows, they
are reported in a separate section that usually appears at
the bottom of the statement of cash flows.

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 List of Noncash Investing and Financing
Activities
– Retirement of debt by issuing equity stock.
– Conversion of preferred stock to common stock.
– Lease of assets in a capital lease transaction.
– Purchase of long-term assets by issuing a note or bond.
– Exchange of noncash assets for other noncash assets.
– Purchase of noncash assets by issuing equity or debt

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 INDIRECT METHOD STATEMENT OF CASH FLOW COMPREHENSIVE EXAMPLE

The following information is available for Magic Corporation for

the year ended December 31, 2017
Collection of principal on long-term loan to a supplier $16,000

Acquisition of equipment for cash 10,000

Proceeds from the sale of long-term investment at book value 22,000

Issuance of common stock for cash 20,000

Depreciation expense 25,000
Redemption of bonds payable at carrying (book) value 34,000

Payment of cash dividends 6,000

Net income 30,000
Purchase of land by issuing bonds payable 40,000

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 In addition, the following information is available from
the comparative balance sheet for Magic at the end of
2017 and 2016:

Cash $148,000 $91,000

Accounts receivable (net) 25,000 15,000
Prepaid insurance 19,000 13,000
Total current assets $192,000 119,000
Accounts payable
$ 30,000 $19,000
Salaries and wages payable 6,000 7,000
Total current liabilities $ 36,000 $26,000

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Group Assignmnet 1 (10%)
Instructions
Prepare Magic’s statement of cash flows for the
year ended December 31, 20X7, using the
indirect method

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 Use the statement of cash flows to evaluate a
company.
Free cash flow: describes the cash remaining from
operations after adjustment for capital expenditures and
dividends.

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 Free Cash Flow Example
Information for two companies in the same industry,
Tucker Corporation and Wiggins Corporation, is
presented here.

Tucker Wiggins
Corporation Corporation
Cash provided by operating 140,000 $140,000
activities
Net earnings 200,000 200,000
Capital expenditures 60,000 90,000
Dividends paid 5,000 10,000

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 Instructions
Compute the free cash flow for each company.

 Tucker Corporation has a larger amount of cash remaining

than Wiggins Corporation after adjustment for capital
expenditures and dividend payments. Therefore, Tucker has
a greater cash-generating ability than Wiggins Corporation.

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 END OF CHAPTER FIVE !

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