1. Chapter 14 The Statement of Cash Flows

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Learning Objectives
Identify the purposes of the statement of cash flows and distinguish among operating, investing, and financing cash flows
Prepare the statement of cash flows by the indirect method
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Learning Objectives
Use free cash flow to evaluate business performance
Prepare the statement of cash flows by the direct method (Appendix 14A)
Prepare the statement of cash flows by the indirect method using a spreadsheet (Appendix 14B)
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Learning Objective 1
Identify the purposes of the statement of cash flows and distinguish among operating, investing, and financing cash flows
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5. What Is the Statement of Cash Flows?
The statement of cash flows reports on a business’s cash receipts and cash payments for a specific period.
This statement does the following:
Reports on the cash flows of a business
Reports why cash increased or decreased during the period
Covers a span of time and is dated the same as the income statement
Up to this point, you have learned about three financial statements: the income statement, the statement of retained earnings, and the balance sheet. Each of these financial statements reports specific items about a company. The statement of cash flows reports on a business’s cash receipts and cash payments for a specific period.
This statement does the following:
Reports on the cash flow of a business—where cash came from (receipts) and how cash was spent (payments).
Reports why cash increased or decreased during the period.
Covers a span of time and is stated the same as the income statement—“Year Ended December 31, 2016,” for example.
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6. Purpose of the Statement of Cash Flows
The statement of cash flows explains why net income as reported on the income statement does not equal the change in the cash balance.
The statement of cash flows helps:
Predict future cash flows
Evaluate management
Predict ability to pay debts and dividends
The statement of cash flows explains why net income as reported on the income statement does not equal the change in the cash balance. In essence, the statement of cash flows is the link between the accrual-based income statement and the cash reported on the balance sheet.
The statement of cash flows helps do the following:
Predicts future cash flows. Past cash receipts and payments help predict future cash flows.
Evaluate management. Wise investment decisions help the business prosper, while unwise decisions cause the business to have problems. Investors and creditors use cash flow information to evaluate managers’ decisions.
Predict ability to pay debts and dividends. Lenders want to know whether they will collect on their loans. Stockholders want dividends on their investments. The statement of cash flows helps make these predictions.
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7. Classification of Cash Flows
There are three basic types of cash flows, and the statement of cash flows has a section for each:
Operating activities
Investing activities
Financing activities
There are three basic types of cash flows, and the statement of cash flows has a section for each:
Operating activities
Investing activities
Financing activities
Each section reports cash inflows (cash receipts coming into the company) and cash outflows (cash going out of the company) based on these three divisions.
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Operating Activities
Operating activities is the first section on the statement of cash flows.
This section reports on activities that create revenue or expense in the entity’s business.
This is often the most important category.
Operating activities is the first section on the statement of cash flows and is often the most important category. The operating activities section reports on activities that create revenue or expense in the entity’s business. It reflects the day-to-day operations of the business such as cash receipts (cash inflows) from customer for the sales of merchandise inventory and services and the cash outflow for purchases of merchandise inventory or payment of operating expenses. The operating activities section also includes cash receipts (cash inflows) for interest and dividend income and cash payments (cash outflows) for interest expense and income tax expense.
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Investing Activities
Investing activities is the second category listed on the statement of cash flows.
This section reports cash receipts and cash payments that increase or decrease long-term assets.
It includes the cash inflow from selling and the cash outflow from purchasing long-term assets.
Investing activities is the second category listed on the statement of cash flows. This section reports cash receipts and cash payments that increase or decrease long-term assets such as property, plant, equipment, notes receivable, and investments. It includes the cash inflow from selling and the cash outflow from purchasing these long-term assets. In addition, it includes the loaning (cash outflow) and collecting (cash inflow) of long-term notes receivable.
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Financing Activities
Financing activities is the last category listed on the statement of cash flows.
Financing activities include cash inflows and outflows involved in long-term liabilities and equity.
Financing activities include issuing stock, paying dividends, and buying and selling treasury stock.
The last category on the statement of cash flows is financing activities. Financing activities include cash inflows and outflows involved in long-term liabilities and equity. This includes issuing stock, paying dividends, and buying and selling treasury stock. It also includes borrowing money and paying off long-term liabilities such as notes payable, bonds payable, and mortgages payable.
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11. Classification of Cash Flows
Each section of the statement of cash flows affects a different part of the balance sheet. The operating activities section reports on how cash flows affect the current accounts—current assets and current liabilities. Investing activities affect the long-term assets. And the financing activities affect long-term liabilities and equity. Exhibit 14-1 shows the relationship between operating, investing, and financing cash flows and the various parts of the balance sheet.
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12. Non-cash Investing and Financing Activities
Companies make investments that do not require cash.
Such transactions are called non-cash investing and financing activities.
These activities appear as a separate schedule at the bottom of the statement of cash flows or in the notes to the financial statements.
The three sections of the statement of cash flows report only activities that involve cash. Companies also make investments that do not require cash. They also obtain financing other than cash. Such transactions are called non-cash investing and financing activities. Non-cash investing and financing activities are investing and financing activities that do not involve cash.
Example of these activities include the purchase of equipment financed by a long-term note payable or the contribution of equipment by a stockholder in exchange for common stock. These activities are not included in the statement of cash flows. Instead, they appear as a separate schedule at the bottom of the statement of cash flows or in the notes to the financial statements.
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13. Non-cash Investing and Financing Activities
Exhibit 14-2 summarizes the different sections of the statement of cash flows.
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14. Two Formats for Operating Activities
Indirect method
Starts with accrual income and adjusts to net cash
Uses account relationships to determine changes in cash
Direct method
Restates the income in terms of cash
Shows actual cash receipts and cash payments
There are two ways to format the operating activities section of the statement of cash flows:
The indirect method starts with net income and adjusts it to net cash provided by operating activities.
The direct method restates the income statement in terms of cash. The direct method shows all the cash receipts and all the cash payments from operating activities.
The indirect method and direct method use different computations but produce the same amount of net cash flow from operating activities. Both methods present investing activities and financing activities in exactly the same format. Only the operating activities section is presented differently between the two methods.
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Learning Objective 2
Prepare the statement of cash flows by the indirect method
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16. How Is the Statement of Cash Flows Prepared Using the Indirect Method?
Items needed:
Income statement for the current year
Balance sheet for current year
Balance sheet from prior year
Additional information based on review of transactions
To prepare the statement of cash flows, you need the income statement for the current year, as well as the balance sheet from the current and prior years. In addition, you need to review the transactions for some additional information. For illustrative purposes, we will use ShopMart, Inc., a fictitious retail store that sells electronics, home furnishings, home supplies, and more.
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17. How Is the Statement of Cash Flows Prepared Using the Indirect Method?
Prepare in five steps:
Complete the cash flows from operating activities.
Complete the cash flows from investing section.
Complete the cash flows from financing section.
Compute the change in cash.
Prepare a schedule for non-cash activities.
To prepare the statement of cash flows by the indirect method, we follow steps 1–5:
Step 1: Complete the cash flows from operating activities section using net income and adjusting for increases or decreases in current assets (other than cash) and current liabilities. Also adjust for gains and losses from long-term assets and non-cash expenses such as depreciation expense.
Step 2: Complete the cash flows from investing activities section by reviewing the long-term assets section of the balance sheet.
Step 3: Complete the cash flows from financing activities section by reviewing the long-term liabilities and equity sections of the balance sheet.
Step 4: Compute the net increase or decrease in cash during the year. The change in cash is the key reconciling figure for the statement of cash flows and must match the change in cash reported on the comparative balance sheet.
Step 5: Prepare a separate schedule reporting any non-cash investing and financing activities.
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18. How Is the Statement of Cash Flows Prepared Using the Indirect Method?
ShopMart’s comparative balance sheet is shown in Exhibit 14-3.
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19. How Is the Statement of Cash Flows Prepared Using the Indirect Method?
ShopMart’s income statement is shown in Exhibit 14-4.
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20. How Is the Statement of Cash Flows Prepared Using the Indirect Method?
Let’s apply these steps to show the operating activities of ShopMart:
Add back all non-cash expenses to the net income. Expenses such as Depreciation Expense, Amortization Expense, or Depletion Expense represent expenses that are not related to current cash flows.
Subtract accounting gains from net income. These gains (such as Gain on Sale of Land) are not cash flows that are related to operating activities, so their effect should be eliminated from net income.
Add accounting losses back to net income. These losses (such as Loss on Sale of Equipment) are not cash flows that are related to operating activities, so their effect should be eliminated from net income.
When current assets increase, we will treat that as a “use” of cash and subtract it from net income.
When current assets decrease, we will treat that as a “source” of cash and add it to net income.
When current liabilities increase, we will treat that as a “source” of cash and add the increase to net income.
When current liabilities decrease, we will treat that as a “use” of cash, and we will subtract the decrease from net income.
Exhibit 14-5 shows the completed statement of cash flows.
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21. Cash Flows from Operating Activities
When using the indirect method, the operating activities section begins with accrual-basis net income or loss, which needs to be adjusted to a cash number.
For example:
Sales on account generate revenues that increase net income, but the company has not yet collected cash from those sales.
Accrued expenses decrease net income, but the company has not yet paid cash.
When using the indirect method, the statement of cash flows operating activities section begins with net income (or net loss) because revenues and expenses, which affect net income, produce cash receipts and cash payments. Revenues bring in cash receipts, and expenses must be paid. But net income as shown on the income statement is accrual-based, and the cash flows (cash basis net income) do not always equal the accrual basis revenues and expenses. For example, sales on account generate revenues that increase net income, but the company has not yet collected cash from those sales. Accrued expenses decrease net income, but the company has not yet paid cash if the expenses are accrued.
To go from net income to cash flow from operating activities, we must make some adjustments to net income on the statement of cash flows. These additions and subtractions follow net income and are labeled Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities.
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22. Depreciation, Depletion, and Amortization Expenses
Depreciation, depletion, and amortization expenses are added back to net income to reconcile net income to net cash flow from operating activities.
Adjustments include adding back non-cash expenses such as depreciation, depletion, and amortization expenses. These expenses are added back to net income to reconcile net income to net cash flows from operating activities.
Depreciation does not affect cash as there is no Cash account in the journal entry (Depreciation Expense—Plant Assets, debit, Accumulated Depreciation—Plant Assets, credit). However, deprecation, like all the other expenses, decreases net income. Therefore, to go from net income to cash flows, we must remove depreciation by adding it back to net income.
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23. Gains and Losses on the Disposal of Long-Term Assets
Disposals from long-term assets create a gain or loss that must be removed from net income, which is in the operating activities section.
Disposals of long-term assets such as land and building are investing activities, and these disposals usually create a gain or a loss. The gain or loss is included in net income, which is already in the operating activities section of the statement of cash flows. The gain or loss must be removed from net income on the statement of cash flows, so the total cash receipts from the sale of the assets can be shown in the investing section.
Exhibit 14-4, ShopMart’s income statement, includes a gain on disposal of plant assets. The gain increased net income, so it is subtracted in the operating activities section.
On the other hand, a loss on the disposal of plant assets would decrease net income on the income statement, so the amount of the loss would be reversed to determine the net cash provided by operating activities on the statement of cash flows.
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24. Changes in Current Assets and Current Liabilities
Most current assets and current liabilities result from operating activities.
Most current assets and current liabilities result from operating activities. For example, accounts receivable result from sales, and merchandise inventory relates to cost of goods sold. Changes in the Current Assets and Current Liabilities accounts create adjustments to net income on the statement of cash flows, as follows:
An increase in a current asset other than cash causes a decrease in Cash.
A decrease in current assets other than cash causes an increase in Cash.
An increase in a current liability causes an increase in Cash.
A decrease in a current liability causes a decrease in Cash.
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25. Evaluating Cash Flows from Operating Activities
The operating activities section starts with accrual net income, and then adjustments are made to reconcile net income to net cash.
When all of the adjustments have been made to net income, you will be able to compute net cash flow from operating activities. Exhibit 14-5 shows how the cash flows from operating activities section might appear on ShopMart’s statement of cash flows.
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26. Evaluating Cash Flows from Operating Activities
The operating activities section (indirect method) always starts with accrual basis net income. Adjustments are then made to determine the cash basis net income. Exhibit 14-6 summarizes the adjustments made to reconcile net income to net cash provided by operating activities:
Add back all non-cash expenses to the net income. Expenses such as Depreciation Expense, Amortization Expense, or Depletion Expense represent expenses that are not related to current cash flows.
Subtract accounting gains from net income. These gains (such as Gain on Sale of Land) are not cash flows that are related to operating activities, so their effect should be eliminated from net income.
Add accounting losses back to net income. These losses (such as Loss on Sale of Equipment) are not cash flows that are related to operating activities, so their effect should be eliminated from net income.
When current assets increase, we will treat that as a “use” of cash and subtract it from net income.
When current assets decrease, we will treat that as a “source” of cash and add it to net income.
When current liabilities increase, we will treat that as a “source” of cash and add the increase to net income.
When current liabilities decrease, we will treat that as a “use” of cash, and we will subtract the decrease from net income.
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27. Cash Flows from Investing Activities
Investing activities affect long-term assets, such as:
Plant assets
Investments
Notes receivable
It is helpful to evaluate the T-accounts for each long-term asset to determine if there was an acquisition or disposal.
Investing activities affect long-term assets, such as plant assets, investments, and notes receivable. When computing investing cash flows, it is helpful to evaluate the T-accounts for each long-term asset. A T-account will show if there was an acquisition or disposal that happened during the year.
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28. Cash Flows from Investing Activities
Use the information available to determine the cash received from an asset disposal:
We need to determine the amount of cash received for the disposal of plant assets. Using the information provided, we can re-create the journal entry for the disposal and solve for the missing cash amount. We compute the cash receipt from the disposal as follows: Cash Received = Cost – Accumulated Depreciation + Gain – Loss. Using the figures from this example, the cash received is $50,000 ($55,000 – $15,000 + $10,000).
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29. Cash Flows from Investing Activities
Cash flows from investing activities includes the receipt from the disposal of plant assets as well as the purchase of plant assets.
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30. Cash Flows from Financing Activities
Financing activities affect the long-term liability and equity accounts:
Long-Term Notes Payable
Bonds Payable
Common Stock
Retained Earnings
Financing activities affect the long-term liability and equity accounts, such as Long-Term Notes Payable, Bonds Payable, Common Stock, and Retained Earnings. To determine the cash flows from financing activities, we need to review each of these accounts.
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31. Cash Flows from Financing Activities
If the amount of cash dividend payments is not readily available, the Retained Earnings account can be used to determine dividend payments.
The amount of dividend payments can be computed by analyzing the Retained Earnings account. Retained Earnings increases when companies earn net income. Retained Earnings decreases when companies have a net loss and when they declare dividends. We know from the income statement in Exhibit 14-4 that ShopMart earned net income of $40,000. ShopMart can’t have both net income and net loss for the same period; therefore, the missing value must be the amount of dividends ShopMart declared.
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32. Cash Flows from Financing Activities
Cash flows from financing activities includes the receipt of cash from the issuance of Notes Payable and Common Stock as well as payments for Notes Payable, purchases of Treasury Stock, and payment of Dividends.
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33. Net Change in Cash and Cash Balances
To complete the statement of cash flows, the net change in cash and its effect on the beginning cash balance must be shown. This represents the total change in cash for the period and reconciles the statement of cash flows. First, the net increase or decrease in cash is computed by combining the cash provided by or used for operating, investing, and financing activities.
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34. Non-cash Investing and Financing Activities
The last step is to prepare the non-cash investing and financing activities section.
The last step in preparing the statement of cash flows is to prepare the non-cash investing and financing activities section, as shown in Exhibit This section appears as a separate schedule of the statement of cash flows or in the notes to the financial statements.
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Learning Objective 3
Use free cash flow to evaluate business performance
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36. How Do We Use Free Cash Flow to Evaluate Business Performance?
Investors want to know how much cash a company can “free up” for new opportunities.
Free cash flow is the amount of cash available from operating activities after paying for planned investments in long-term assets and after paying dividends.
Throughout this chapter, we have focused on cash flows from operating, investing, and financing activities. Some investors want to know how much cash a company can “free up” for new opportunities. Free cash flow is the amount of cash available from operating activities after paying for planned investments in long-term assets and after paying dividends to shareholders. Free cash flow = Net cash provided by operating activities – Cash payments planned for investments in long-term assets – Cash dividends.
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37. How Do We Use Free Cash Flow to Evaluate Business Performance?
ShopMart expects net cash provided by operations of $200,000. It plans to spend $160,000 to modernize its retail facilities and pays $15,000 in cash dividends.
ShopMart’s free cash flow is $25,000: ($200,000 ‒ $160,000 ‒ $15,000)
Many companies use free cash flow to estimate the amount of cash that would be available for unexpected opportunities.
ShopMart’s free cash flow equals $25,000 ($200,000 ‒ $160,000 ‒ $15,000 ). If a good investment opportunity comes along, the company should have $25,000 cash available to invest.
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Learning Objective 4
Prepare the statement of cash flows by the direct method (Appendix 14A)
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39. How Is the Statement of Cash Flows Prepared Using the Direct Method?
The Financial Accounting Standards Board (FASB) prefers the direct method of reporting cash flows from operating activities.
This method provides clearer information about the sources and uses of cash than the indirect method.
Only the operating section differs between the two methods.
The Financial Accounting Standards Board (FASB) prefers the direct method of reporting cash flows from operating activities. The direct method provides clearer information about the sources and uses of cash than does the indirect method. Investing and financing cash flows are exactly the same presentation under both direct and indirect methods.
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40. Cash Flows from Operating Activities
Cash collections from customers:
When using the direct method, we take each line item of the income statement and convert it from accrual to cash basis. So, in essence, the operating activities section of the direct-method cash flow statement is really just a cash basis income statement.
The first item on the income statement is Sales Revenue. Sales Revenue represents the total of all sales, whether for cash or on account. The balance sheet account related to Sales Revenue is Accounts Receivable.
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Payments to Suppliers
Cash paid for inventory is calculated as follows:
Cash paid for operating expenses is calculated as follows:
Suppliers, also called vendors, are entities that provide the business with its merchandise inventory and essential services. The accounts related to supplier payments for merchandise inventory are Cost of Goods Sold, Merchandise Inventory, and Accounts Payable.
Cost of Goods Sold on the income statement was $156,000. Merchandise Inventory decreased from $145,000 at December 31, 2015, to $143,000 at December 31, Accounts Payable increased from $50,000 at December 31, 2015, to $90,000 at December 31, Cash paid for inventory is found by taking Cost of Goods Sold – Beginning Merchandise Inventory + Ending Merchandise Inventory + Beginning Accounts Payable – Ending Accounts Payable. Using the figures from this example: $156,000 – $145,000 + $143,000 + $50,000 – $90,000 = 114,000.
The accounts related to supplier payments for operating expenses are Other Operating Expenses and Accrued Liabilities. Cash paid for operating expenses is calculated as Other Operating Expenses + Beginning Accrued Liabilities – Ending Accrued Liabilities. Using the figures from this example, the cash paid for operating expenses was $21,000 ($16, ,000 – $5,000).
Adding them together, we get total cash paid to suppliers of $135,000 ($114,000 + $21,000).
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Payments to Suppliers
Payments to suppliers include all payments for the following:
Merchandise inventory
Operating expenses except employee compensation, interest, and income taxes
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43. Net Cash Provided by Operating Activities
To calculate net cash provided by operating activities using the direct method, we add all the cash receipts and cash payments.
Net cash provided by operating activities is $70,000, which is the same amount found under the indirect method.
To calculate net cash provided by operating activities using the direct method, we add all the cash receipts and cash payments described previously and find the difference. For ShopMart, total cash receipts were $290,000. Total cash payments were $220,000. So, net cash provided by operating activities is $70,000. If you refer to the indirect method statement of cash flows shown in Exhibit 14-5, you will find that it showed the same $70,000 for net cash provided by operating activities; only the method by which it was calculated was different.
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44. Net Cash Provided by Operating Activities
Exhibit 14A-1 shows the completed statement of cash flows using the direct method for operating activities.
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How Is the Statement of Cash Flows Prepared Using the Indirect Method and a Spreadsheet?
Most companies use a spreadsheet to prepare the statement of cash flows.
This statement starts with the beginning balance sheet and concludes with the ending balance sheet.
Columns labeled “Transaction Analysis” hold the data for the statement of cash flows.
This chapter discusses the uses of the statement of cash flows in decision making and shows how to prepare the statement using T-accounts. The T-account approach works well as a learning device. In practice, however, most companies face complex situations. In these cases, a spreadsheet can help in preparing the statement of cash flows.
The spreadsheet starts with the beginning balance sheet and concludes with the ending balance sheet. Two middle columns—one for debit amounts and the other for credit amounts—complete the spreadsheet. These columns, labeled “Transaction Analysis,” hold the data for the statement of cash flows. Accountants can prepare the statement directly from the lower part of the spreadsheet.
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How Is the Statement of Cash Flows Prepared Using the Indirect Method and a Spreadsheet?
The indirect method reconciles accrual basis net income to net cash provided by operating activities. Exhibit 14B-1 is the spreadsheet for preparing the statement of cash flows by the indirect method. Panel A shows the transaction analysis, and Panel B gives the information to prepare the statement of cash flows.
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How Is the Statement of Cash Flows Prepared Using the Indirect Method and a Spreadsheet?
The indirect method reconciles accrual basis net income to net cash provided by operating activities. Exhibit 14B-1 is the spreadsheet for preparing the statement of cash flows by the indirect method. Panel A shows the transaction analysis, and Panel B gives the information to prepare the statement of cash flows.
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