CHAPTER 12

Purpose of the Statement of Cash Flows

The statement of cash flows is considered a major financial statement, as are the
income statement, balance sheet, and statement of stockholders' equity. The
statement of cash flows provides a great deal of information and answers certain
questions that the other three statements do not. Its presentation is required
whenever an income statement is prepared. The statement of cash flows shows
the effects on cash and cash equivalents of the operating, investing, and
financing activities of a company for an accounting period.

The principal purpose of the statement of cash flows is to provide information

about a company's cash receipts and cash payments during an accounting
period. The secondary purpose of the statement of cash flows is to provide
information about a company's operating, investing, and financing activities
during the period.

Classification of Cash Flows

The statement of cash flows categorizes cash receipts and cash payments as
operating, investing, and financing activities.

• Operating activities include receiving cash from customers for the sale of
goods and services, receiving interest and dividends on loans and
investments, and making cash payments for wages, goods and services
purchased, interest, and taxes.

• Investing activities include purchasing and selling long-term assets and

marketable securities (other than cash equivalents), as well as making
and collecting on loans.

• Financing activities include issuing and buying back capital stock, as well
as borrowing and repaying loans on a short- or long-term basis (issuing
bonds and notes). Dividends paid are also included in this category, but
the repayment of accounts payable or accrued liabilities is not.

Significant Non-Cash Activities

The statement of cash flows should be accompanied by a schedule of non-cash
investing and financing transactions. Such transactions represent simultaneous
investing and financing activities that do not, however, result in an inflow or
outflow of cash.
These activities include:

• the issuance of stock for assets;

• the conversion of bonds into stock;
• the issuance of debt for assets; and
• the exchange of plant assets

Format Of The Statement of Cash Flows

The cash flows from operating activities always appears first. It is followed by the
investing activities section and then the financing activities section. In the formal
statement of cash flows, individual cash inflows and outflows from investing and
financing activities are shown separately in their respective categories. (e.g.,
inflows from sale of plant assets is reported separately from outflows from
investing in plant assets).

The Corporate Life Cycle

All products go through a series of phases called the product life cycle, and a
corporation’s cash flow reflects these phases. The phases (in order of their
occurrence) are often referred to as follows:

• Introductory Phase. During this phase, the corporation is likely to have a

cash deficit in its operations because the product’s sales are small and the
promotional expenses are great. There may also be a great deal of
expenditures for research and development activities. During this phase,
the corporation is likely to have a deficit in its investing activities because it
is spending a great deal on investing in plant assets. These deficits will be
covered through financing transactions.

• Growth Phase. During this phase, the sales revenue will increase.
Despite this, the growth in its inventories and supplies and the need to
increase the amount of credit offered to customers represent a significant
need for cash in a corporation’s operations. This phase is usually
characterized by additional spending on research and development
activities. During this phase, there is still a significant need for
investments in plant assets. All of these needs will still require a cash
infusion from financing transactions.

• Maturity Phase. A product in this phase is often referred to as a “cash

cow.” A company’s operations should produce cash flow, and there is a
shrinking demand for investments in plant assets. As a result of the
foregoing, there is little need for a cash infusion from financing
transactions.
 • Decline Phase. During this phase cash from operations decreases.
Cash from investing may become positive as the company liquidates
unneeded plant assets. Again there is little need for cash infusions from
financing transactions.

Usefulness of the Statement of Cash Flows

Investors and creditors may use the statement of cash flows to assess such
things as the company's ability to generate positive future cash flows, its ability to
pay its liabilities, its ability to pay dividends, and its need for additional financing.
Management uses the statement of cash flows (among other things) to assess
the business's debt-paying ability, determine its dividend policy, and plan its
investing and financing needs.

The Statement of Cash Flows also provides useful information to investors

regarding the following:

• The Quality of Income. Corporations may appear to be very profitable, but

the accruals may not be accompanied by the receipt of cash. The Cash
Flow Statement can be useful in determining whether the cash flows from
operations match the financial picture painted by the Income Statement or
whether cash from financing is being used to mask problems with a
corporation’s operations.

• Investments. The Statement of Cash Flows is the only place where a

corporation’s investment in plant assets is detailed. This can be very
important in determining whether a corporation is poised to continue to
grow in the future.

Preparing The Statement of Cash Flows

To prepare the statement, one needs a comparative balance sheet, the current
income statement, and additional information about transactions affecting non-
current accounts during the period.

The four steps in statement preparation are:

• determining cash flows from operating activities,

• determining cash flows from investing activities,
• determining cash flows from financing activities, and
• presenting all this information in the form of a statement of cash flows.

Indirect and Direct Methods

Cash flows from operating activities may be determined using either the direct
method or the indirect method. The choice of which method to use only affects
the calculation of the Cash Flow From Operations. There is no difference in the
Cash Flow From Investing Activities and the Cash Flow From Financing
Activities.

The direct and indirect methods produce the same results, and both are
considered GAAP. The FASB, however, recommends the direct method,
accompanied by a separate schedule (the indirect method) reconciling net
income to net cash flows. Despite this, the indirect method is used by
approximately 99% of all companies. When the direct method is used, the net
cash flow from operating activities as computed using the indirect method must
also be reported in a separate schedule.

With the Direct Method, the cash flow from operations is calculated directly (from
scratch). With the Indirect Method, however, the cash flow from operations is
calculated by taking the net income of the company and then making
adjustments. These adjustments are required because net income is calculated
using the accrual method, and we are interested only in cash receipts reduced by
cash disbursements (the cash method). These adjustments include:

• Adding back expenses that were deducted from net income but did not
cost anything (e.g., depreciation expense, amortization expense, and
depletion expense);
• Taking out capital gains and losses that do not relate to operations (e.g.,
sale of plant assets);
• Taking out expenses that were accrued but not yet paid (e.g., income
taxes accrued but not paid in the current year)
• Taking out expenditures that cost cash but were not expensed this year
(e.g., the purchase of inventory that was not sold or supplies that were not
used up, and the payment of prepaid expenses still outstanding at the end
of the year);
• Taking out income that was accrued but not yet received (e.g., credit sales
where the account receivable is still outstanding, accrued interest not yet
received); and
• Adding back cash receipts that were not treated as income (e.g.,
customers payments of accounts receivable that were generated in a prior
year)

Because of its widespread use, we will focus on the Indirect Method.

Indirect Method
Consider the balance sheet equation:

Assets = Liabilities + Owner’s Equity

Cash + Curr. Assets + LT Assets = Curr. Liab. + LT Liab. + Equity
∆ Cash + ∆ Curr. Assets + ∆ LT Assets = ∆ Curr. Liab. + ∆ LT Liab. + ∆ Equity
∆ Cash = -∆ Curr. Assets - ∆ LT Assets + ∆ [Link].+ ∆ LT Liab. + ∆ Equity

So cash changes in the opposite way from other assets and the same way as
liabilities and equity.

With the Indirect Method we assume that a change in a balance sheet account is
matched by a change in cash. This is true for every change in the balance sheet
accounts except for changes due to non-cash transactions (e.g., the purchase of
an asset in exchange for stock).

As a general rule, the changes for the following balance sheet accounts are
assumed to affect the following activities:

Activity Changes In These Accounts Fall Within The Activity In Question

Operations Current Assets

Current Liabilities
Net Income and Loss
Also add back non cash expenses like depreciation

Investing Long Term Assets

Financing Long Term Liabilities

Stockholder’s Equity (excluding Net Income)

Illustration of the Indirect Method

We are going to use the T-Account approach to the Indirect Method. It is a very
simple approach to use because:

• You mechanically go through every balance sheet account; and

• You note every change with an equal amount of debits and credits.

Because of these characteristics, it is difficult to skip an item.

A company has the following financial statements for the current and last years:

Balance Sheet

Assets Current Year Last Year

Cash $164,800 $ 50,000
Accounts Receivable 165,200 200,000
Merchandise Inventory 350,000 450,000
Prepaid Rent 2,000 3,000
Furniture and Fixtures 148,000 144,000
Accumulated Depreciation Furniture and Fixtures (42,000) (24,000)
------------- --------------
Total Assets $788,000 $823,000
======= ========
Liabilities
Accounts Payable $143,400 $200,400
Income Taxes Payable 1,400 4,400
Notes Payable (Long-Term) 40,000 20,000
Bonds Payable 100,000 200,000
Equity
Common Stock ($20 par value) 240,000 200,000
Paid-In Capital in Excess of Par Value 181,440 121,440
Retained Earnings 81,760 76,760
-------------- --------------
Total Liabilities & Equity $788,000 $823,000
======== ========
 Income Statement

Net Sales $1,609,000

Cost of Goods Sold (1,127,800)
----------------
Gross Margin $ 481,200

Operating Expenses (including Depreciation Expense

(449,400)
of $46,800)
----------------
Income From Operations $ 31,800

Other Income/Expense
Gain on Sale of Furniture and Fixtures $ 7,000
Interest Expense (23,200)
------------
Total Other Income/Expense (16,200)
----------------
Income Before Income Taxes $ 15,600
Income Tax Expense (4,600)
----------------
Net Income $ 11,000
=========

Additional information for the current year:

• Furniture and fixtures that cost $35,600 with accumulated depreciation of

$28,800 were sold at a gain of $7,000.
• Furniture and fixtures were purchased in the amount of $39,600.
• A $20,000 note payable was paid and $40,000 was borrowed on a new
note.
• Bonds Payable in the amount of $100,000 were converted into 2,000
shares of common stock.
• $6,000 in cash dividends were declared and paid.
From the Above Information, we can produce the following Statement of Cash
Flows:

Statement of Cash Flows

Cash Flows From Operating Activities

Net Income $11,000
Adjustments To Reconcile Net Income To Net Cash
Provided By Operating Activities:
Depreciation Expense $46,800
Decrease in Accounts Receivable 34,800
Decrease in Inventories 100,000
Decrease in Prepaid Expenses 1,000
Decrease in Accounts Payable -57,000
Decrease in Taxes Payable -3,000
Gain on Furniture and Fixtures -7,000
Total Adjustments 115,800
Net Cash Provided By Operating Activities: $126,600

Cash Flows From Investing Activities

Sale of Furniture and Fixtures 13,800
Purchase of Furniture and Fixtures -39,600
Net Cash Used By Investing Activities: -25,800

Cash Flows From Financing Activities

Issue Notes Payable 40,000
Payment of Dividends -6,000
Payment of Notes Payable -20,000
Net Cash Provided By Financing Activities: 14,000

Net Increase In Cash: 114,800

Cash At Beginning of Period: 50,000
Cash At End of Period: $164,800

Non-Cash Investing and Financing Activities:

Conversion of Bonds Into Common Stock: $100,000

We will now produce the information that you need to construct this Statement.
Using the T-Account approach you create a T-account for every account on the
Balance Sheet (except Cash). In each T-account, indicate the change in the
asset from last year to the current year. For example, if an asset has increased
by $8,000. Then place $8,000 on the debit side of that asset’s T-Account.
Similarly, if a liability has increased by $6,000, then place $6,000 on the credit
side of that liability’s T-Account.

In the above example, you would set up the following T-Accounts:

The Accounts Receivable have decreased by $34,800. This would be

represented by a credit to the Accounts Receivable T-Account:

Accounts Receivable
$34,800

The Merchandise Inventory has decreased by $100,000:

Merchandise Inventory
$100,000

The Prepaid Rent has decreased by $1,000:

Prepaid Rent
$1,000

The Furniture and Fixtures have increased by $4,000:

Furniture & Fixtures

$4,000

The Accumulated Depreciation has increased by $18,000. Remember that this is

a contra-asset account and it has a credit balance:

Accumulated Depreciation
$18,000
The Accounts Payable have decreased by $57,000:

Accounts Payable
$57,000

The Income Taxes Payable have decreased by $3,000:

Income Taxes Payable

$3,000

The Notes Payable have increased by $20,000:

Notes Payable
$20,000

The Bonds Payable have decreased by $100,000:

Bonds Payable
$100,000

The Common Stock has increased by $40,000:

Common Stock
$40,000

The Additional Paid-In Capital has increased by $60,000:

Additional Paid-In Capital

$60,000
The Retained Earnings has increased by $5,000:

Retained Earnings
$5,000

All of these figures above the line drawn in each T-Account represents the total
change in the account and we must now duplicate it below the line in each
account.

Except for the non-cash transactions, we will explain the change with a
corresponding entry in a large Cash T-Account that has been divided into three
parts for Operations, Investing, and Financing:

Cash
Operations

Investing

Financing

With the Indirect Method, we will work from the Net Income from the Income
Statement. The Net Income increased the Corporation’s Retained Earnings.
The Net Income is also the basis for the calculation of Cash Flow From
Operations. So, we enter the Net Income ($11,000) as a credit to Retained
Earnings (It increased Retained Earnings) and a debit to Cash (It increased
Cash). Thus we have equal debits and credits:

Retained Earnings
$5,000
$11,000
 Cash
Operations Net Income $11,000

Next, look at the additional information. We are told that $6,000 in cash dividends
were declared and paid. Dividends reduce Retained Earnings (debit), and the
payment of a cash dividend is an outflow of Cash. Thus, Cash is reduced
(credit). We have equal debits and credits of $6,000:

Retained Earnings
$5,000
$6,000 $11,000
============== ==============

If you net the credit of $11,000 (Net Income) and debit of $6,000 (Dividends), we
have explained how Retained earnings had a net increase of $5,000. The
payment of a dividend involves equity, and therefore should be recorded as a
financing transaction. Having explained the change in Retained Earnings, we
draw a double line below the account to show that we are finished with this
account.

Cash
Operations Net Income $11,000

Investing

Financing Pay Dividends $6,000

Look at the Additional Information again. We see that Bonds Payable in the
amount of $100,000 were converted into 2,000 shares of common stock. With a
bond conversion, you take the carrying value of the bonds off the balance sheet,
and issue stock for the exact amount of the carrying value.

D. Bonds Payable $100,000

Cr. Common Stock $40,000
Additional Paid-In Capital 60,000
The 2,000 shares of common stock have a par value of $20. So, $40,000 is
placed in Common Stock and the remainder of the carrying value of the bonds is
placed in Additional Paid-In Capital.

Bonds Payable
$100,000
$100,000
============= ==============

Common Stock
$40,000
$40,000
============= =============

Additional Paid-In Capital

$60,000
$60,000
=============== =============

We have now explained all of the changes to Bonds Payable, Common Stock
and Additional Paid-In Capital, and we are through with these accounts.

Cash was not involved in this transaction, and the transaction will appear in the
schedule of non-cash transactions.

Look at the Additional Information again. We see that a $20,000 note payable
was paid and $40,000 was borrowed on a new note. Take each of these items
separately.

The payment of the $20,000 promissory note is a decrease to Notes Payable

(Debit of $20,000) and a decrease to Cash (Credit of $20,000). The payment of
a Note Payable involves a Long-Term Liability and therefore involves a financing
transaction. We have equal debits (Notes Payable) and credits (Cash) of
$20,000:

Notes Payable
$20,000
$20,000
 Cash
Operations Net Income $11,000

Investing

Financing Pay Dividends $6,000

Pay Notes Payable $20,000

The borrowing of $40,000 increases Notes Payable (credit) and Cash (debit).
Because it involves a Long-Term Liability, it is a financing transaction:

Notes Payable
$20,000
$20,000 $40,000
============ =============

Cash
Operations Net Income $11,000

Investing

Financing Issue Notes Payable $40,000 Pay Dividends $6,000

Pay Notes Payable $20,000

We have explained the change in Notes Payable.

Look at the Additional Information. Furniture and fixtures were purchased in the
amount of $39,600. This is an increase to Furniture and Fixtures (debit) and a
decrease in Cash (credit). The purchase involves Long-Term Assets and thus is
an investing transaction:

Furniture & Fixtures

$4,000
$39,600
 Cash
Operations Net Income $11,000

Investing Purchase of Furniture $39,600

Financing Issue Notes Payable $40,000 Pay Dividends $6,000

Pay Notes Payable $20,000

From the Income Statement, we can see that the depreciation expense for the
current year is $46,800. Depreciation Expense increases Accumulated
Depreciation (credit). Depreciation does not cost any cash, but under the accrual
method, it reduced Net Income. The purpose of the Indirect Method is to convert
the accrual method Net Income into a cash method Net Income. Thus, we want
to increase Cash From Operations by the amount of Depreciation Expense.

If you have trouble with this logic, remember that we need an equal amount of
debits and credits. You know that Depreciation Expense increases Accumulated
Depreciation with a credit. So, Cash needs a debit of $46,800.

Accumulated Depreciation
$18,000
$46,800

Cash
Operations Net Income $11,000
Plus Depreciation $46,800
Investing Purchase of Furniture $39,600
Financing Issue Notes Payable $40,000 Pay Dividends $6,000
Pay Notes Payable $20,000

Look at the Additional Information. Furniture and fixtures that cost $35,600 with
accumulated depreciation of $28,800 were sold at a gain of $7,000. Note the
journal entry from that sale:

D. Cash $13,800
Accumulated Depreciation 28,800
Cr. Furniture and Fixtures $35,600
Gain 7,000
You want to do this journal entry to the T-Accounts noted in the journal entry:

Accumulated Depreciation
$18,000
$28,800 $46,800
============= ============

Furniture & Fixtures

$4,000
$39,600 $35,600
============= ============

The debit to Cash for $13,800 is a cash inflow from the sale of a Long-Term
Asset, which is an investing activity. We received $13,800 from that sale. The
$13,800 sales price includes the gain from the sale. But the gain is part of Net
Income, which appears under Operations. You are counting the gain twice –
Once in Operations and Once in Investing. You take the credit to gain and place
it in operations to take the gain out of the Net Income. (The Credit will offset the
Net Income, which is a Debit to Cash From Operations.)

Cash
Operations Net Income $11,000 Furniture Gain $7,000
Plus Depreciation $46,800

Investing Sale of Furniture $13,800 Purchase of Furniture $39,600

Financing Issue Notes Payable $40,000 Pay Dividends $6,000

Pay Notes Payable $20,000

We have explained the changes to Furniture & Fixtures and Accumulated

Depreciation.

The only accounts left unexplained are the current assets and current liabilities.
These changes to the accounts are entered below the line in each T-Account and
an offsetting debit or credit is entered to Cash Flow From Operations:

Accounts Receivable
$34,800
$34,800
=============== =============
 Merchandise Inventory
$100,000
$100,000
============== =============

Prepaid Rent
$1,000
$1,000
============== =============

Accounts Payable
$57,000
$57,000
=============== =============

Income Taxes Payable

$3,000
$3,000
=============== =============

Cash
Operations
Net Income $11,000 Furniture Gain $7,000
Depreciation $46,800 Decrease in A/P $57,000
Decrease in A/R $34,800 Decrease in Tax Pay $3,000
Decrease in Inven. $100,000
Decrease in Prep. Rent $1,000
Cash Flow From Operations: $126,600
Investing
Sale of Furniture $13,800 Purchase of Furniture $39,600
Cash Flow From Investing: -$25,800
Financing
Issue Notes Payable $40,000 Pay Dividends $6,000
Pay Notes Payable $20,000
Cash Flow From Financing: $14,000
Total Cash Flow For Current Year: $114,800
Plus: Beginning Balance of Cash: $50,000
Ending Balance of Cash: $164,800

The Direct Method

Under the direct method, (net) cash flows from operating activities are
determined by taking cash receipts from sales, adding interest and dividends
received, and deducting cash payments for purchases, operating expenses,
interest, and income taxes.

Free Cash Flow

Interpreting the Statement of Cash Flows includes examining important
relationships such as cash-generating efficiency and free cash flow.

• Cash-generating efficiency is the ability of a company to generate cash

from operations.
• Free cash flow is the cash available for new projects. It is the cash
remaining after current operating commitments, such as commitments for
operations, interest, income taxes, dividends, and net capital
expenditures, have been met.

Free Cash Flow = Cash From Operations - Capital Expenditures.- Dividends

Financial Statement Analysis

Cash From Operations is used to evaluate a corporation’s liquidity and solvency.

Current Cash Debt Coverage Ratio

When examining a corporation’s ability to pay its debts in the short term
(liquidity), financial analysts look at the Current Cash Debt Coverage Ratio. In
this ratio, you divide a corporation’s cash from operations by average current
liabilities:

Cash Flow From Operations

--------------------------------------
Average Current Liabilities

Cash Debt Coverage Ratio

When examining a corporation’s ability to pay its debts in the long-term

(solvency), financial analysts look at the Cash Debt Coverage Ratio. In this ratio,
you divide a corporation’s cash from operations by average total liabilities:

Cash Flow From Operations

--------------------------------------
Average Total Liabilities