CHAPTER 14

Statement ofCash Flows

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Chapter Opening

To make informed investment and credit decisions,financial statement users need informationto help them asses the amounts, timing and

uncertainty of a company’s prospective cash flows.

To make informed investment and credit decisions,financial statement users need informationto help them asses the amounts, timing and

uncertainty of a company’s prospective cash flows.

The statement of cash flows reportshow a company obtained and spentcash during an accounting period.

The statement of cash flows reportshow a company obtained and spentcash during an accounting period.

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Learning Objective

LO1LO1

To identify the typesof business eventsthat are reported inthe three sectionsof the statement of

cash flows

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Reporting Format for the Statement of Cash Flows

The Statement of Cash Flows must include the following three sections, as defined in FASB Statement 95:

The Statement of Cash Flows must include the following three sections, as defined in FASB Statement 95:

Operating Activities

Investing Activities

Financing Activities

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Cash Flows from

Operating Activities

Cash Flows from

Operating Activities

Cash Flows fromOperating Activities

Inflows Receipts from sales. Commissions and fees. Interest and dividends

received.

Inflows Receipts from sales. Commissions and fees. Interest and dividends

received.

Outflows Payments for inventory. Salaries and wages. Operating expenses Interest on liabilities. Taxes.

Outflows Payments for inventory. Salaries and wages. Operating expenses Interest on liabilities. Taxes.

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Cash Flows from

Investing Activities

Cash Flows from

Investing Activities

Cash Flows fromInvesting Activities

Inflows Selling property, plant, and

equipment. Selling investment securities. Collecting loans.

Inflows Selling property, plant, and

equipment. Selling investment securities. Collecting loans.

Outflows Purchasing property, plant,

and equipment. Purchasing investment

securities. Lending to others.

Outflows Purchasing property, plant,

and equipment. Purchasing investment

securities. Lending to others.

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Cash Flows from

Financing Activities

Cash Flows from

Financing Activities

Cash Flows fromFinancing Activities

Inflows Borrowing. Issuing stock.

Inflows Borrowing. Issuing stock.

Outflows Repaying debt (excluding

interest). Purchasing treasury stock. Paying dividends.

Outflows Repaying debt (excluding

interest). Purchasing treasury stock. Paying dividends.

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Significant noncash investing and financing transactions must be reported separately.

Example: Issuing common stock in exchange for land.

Significant noncash investing and financing transactions must be reported separately.

Example: Issuing common stock in exchange for land.

Noncash Investing and Financing Transactions

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Cash flows from operating activities

can be prepared using either the direct method or

the indirect method.

Cash flows from operating activities

can be prepared using either the direct method or

the indirect method.

Let’s look at the direct method first.

Let’s look at the direct method first.

Cash Flows fromOperating Activities

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Learning Objective

LO2LO2

To convertaccount balances

from accrual to cash

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Accrual basis revenue includes sales that did not result in cash inflows.

Cash received from customers can be computed as follows:

Cash received from customers

Cash received from customers

Decrease in receivablesDecrease in receivables

Increase in receivablesIncrease in receivables

+

–

=

=

Net salesNet sales

Converting from Accrual to Cash-Basis Accounting

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Learning Objective

LO3LO3

To use theT-account method toprepare a statement

of cash flows

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14-14Converting from Accrual to Cash-Basis Accounting

We will use T-accounts toanalyze changes in accounts.

Let’s look at an example.

We will use T-accounts toanalyze changes in accounts.

Let’s look at an example.

The Accounts Receivable balance was $1,200 on The Accounts Receivable balance was $1,200 on 12/31/04 and $1,000 on 12/31/05. If accrual 12/31/04 and $1,000 on 12/31/05. If accrual Sales Revenue for 2005 was $20,600, what Sales Revenue for 2005 was $20,600, what

were cash receipts from sales?were cash receipts from sales?

The Accounts Receivable balance was $1,200 on The Accounts Receivable balance was $1,200 on 12/31/04 and $1,000 on 12/31/05. If accrual 12/31/04 and $1,000 on 12/31/05. If accrual Sales Revenue for 2005 was $20,600, what Sales Revenue for 2005 was $20,600, what

were cash receipts from sales?were cash receipts from sales?

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14-15Converting from Accrual to Cash-Basis Accounting

1,200

20,600

1,000

12/31/04 Balance

12/31/05 Balance

Accrual Sales Revenue

Accounts Receivable

Cash receipts = $20,800

$1,200 + $20,600 - $1,000$1,200 + $20,600 - $1,000

The Accounts Receivable balance was $1,200 on The Accounts Receivable balance was $1,200 on 12/31/04 and $1,000 on 12/31/05. If accrual 12/31/04 and $1,000 on 12/31/05. If accrual Sales Revenue for 2005 was $20,600, what Sales Revenue for 2005 was $20,600, what

were cash receipts from sales?were cash receipts from sales?

The Accounts Receivable balance was $1,200 on The Accounts Receivable balance was $1,200 on 12/31/04 and $1,000 on 12/31/05. If accrual 12/31/04 and $1,000 on 12/31/05. If accrual Sales Revenue for 2005 was $20,600, what Sales Revenue for 2005 was $20,600, what

were cash receipts from sales?were cash receipts from sales?

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14-16Converting from Accrual to Cash-Basis Accounting

The Salaries Payable balance was $900 on 12/31/04 and $1,000 on 12/31/05. If accrued Salaries Expense for 2005 was $2,700, what

amount of cash was paid for salaries?

The Salaries Payable balance was $900 on 12/31/04 and $1,000 on 12/31/05. If accrued Salaries Expense for 2005 was $2,700, what

amount of cash was paid for salaries?

Now let’s use T-account analysis for a liability account with anaccrued expense.

Now let’s use T-account analysis for a liability account with anaccrued expense.

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14-17Converting from Accrual to Cash-Basis Accounting

12/31/04 Balance

12/31/05 Balance

Accrued Salaries Expense

Salaries Payable

Cash payments =

900

2,700

1,000

$2,600

$900 + $2,700 - $1,000$900 + $2,700 - $1,000

The Salaries Payable balance was $900 on 12/31/04 and $1,000 on 12/31/05. If accrued Salaries Expense for 2005 was $2,700, what

amount of cash was paid for salaries?

The Salaries Payable balance was $900 on 12/31/04 and $1,000 on 12/31/05. If accrued Salaries Expense for 2005 was $2,700, what

amount of cash was paid for salaries?

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Now that we have seen the T-account method of

analysis, let’s use it to prepare a Direct Method Statement of Cash Flows

for New South Corporation.

We will begin with by analyzing changes in

balance sheet accounts.

Direct Method

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Direct MethodAdditional Information

The corporation sold equipment for $300 cash during the year. The equipment had an original cost of $1,500 and accumulated depreciation of $1,100 at the time of sale.

The corporation issued a $2,500 mortgage note in exchange for land during the year.

There was a $1,500 cash dividend paid during the year.

Additional Information The corporation sold equipment for $300 cash

during the year. The equipment had an original cost of $1,500 and accumulated depreciation of $1,100 at the time of sale.

The corporation issued a $2,500 mortgage note in exchange for land during the year.

There was a $1,500 cash dividend paid during the year.

Let’s get started analyzing the accounts. First, we willreview the T-account analysis that we completed earlier.

Then we will analyze the remaining balance sheet accounts starting with the current accounts.

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12/31/04 Balance

12/31/05 Balance

Accrual sales revenue

Accounts Receivable

Cash receipts = $20,800

1,200

20,600

1,000

12/31/04 Balance

12/31/05 Balance

Accrued salaries expense

Salaries Payable

Cash Payments = $2,600

900

2,700

1,000

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12/31/04 Balance

12/31/05 Balance

Cost of Goods Sold

Inventory

Purchases =

8,200

10,500

8,900

12/31/04 Balance

12/31/05 Balance

Purchases

Accounts Payable

Cash Payments =

1,100

11,200

800

$11,200

$11,500

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12/31/04 Balance

12/31/05 Balance

Interest Revenue

Interest Receivable

Cash receipts =300

700

400

12/31/04 Balance

12/31/05 Balance

Interest Expense

Interest Payable

Cash payment =

500

400

300

$600

$600

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12/31/04 Balance

12/31/05 Balance

Insurance Expense

Prepaid Insurance

Cash payment =

1,400

600

1,100

12/31/04 Balance

12/31/05 Balance

Rent Revenue

Unearned Rent

Cash receipt =

1,600 2,400

600

$300

$1,400

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12/31/04 Balance

12/31/05 Balance

Other Operating Expenses

Other Operating Expenses Payable

Cash payment =

1,300

1,400

1,500

$1,200

Now that we have analyzed the current accounts and found the cash receipts and cash payments related to

operations, we are ready to prepare the Cash Flow from Operating Activities portion of the Statement of

Cash Flows.

Now that we have analyzed the current accounts and found the cash receipts and cash payments related to

operations, we are ready to prepare the Cash Flow from Operating Activities portion of the Statement of

Cash Flows.

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14-28Cash Flow fromOperating Activities

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Now, let’s continue to use the T-account analysis for the remaining noncurrent balance sheet accounts.

Direct Method

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12/31/04 Balance

12/31/05 Balance

Marketable Securities

Cash paid =

3,500

5,100

$1,600

12/31/04 Balance

12/31/05 Balance

Land

Mortgage issued for land =

6,000

8,500

$2,500

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12/31/04 Balance

12/31/05 Balance

Equipment

4,600 1,500

5,400

Equipment sale

Cash paid for equipment = $2,300

After completing the analysis of noncurrentassets, we are ready to prepare the Cash

Flow from Investing Activities portionof the Statement of Cash Flows.

After completing the analysis of noncurrentassets, we are ready to prepare the Cash

Flow from Investing Activities portionof the Statement of Cash Flows.

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14-32Cash Flow fromInvesting Activities

Next, we will analyze noncurrent liabilities and equity so that we can

prepare the Cash Flow from Financing Activities portion of the Statement of

Cash Flows.

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12/31/04 Balance

12/31/05 Balance

Mortgage Payable

Mortgage issued for Land =

-

2,500

12/31/04 Balance

12/31/05 Balance

Bonds Payable

Cash paid to retire bonds =

4,000

1,000

$2,500

$3,000

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12/31/04 Balance

12/31/05 Balance

Common Stock

Cash received from stocksale =

8,000

10,000

After completing the analysis of noncurrentliabilities and equity, we are ready to prepare

the Cash Flow from Financing Activitiesportion of the Statement of Cash Flows.

$2,000

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14-35Cash Flow fromFinancing Activities

Next, we will put the three sections together to completethe Statement of Cash Flows.

Third item of additional information.

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New South CorporationStatement of Cash Flows

For the Period Ending December 31, 2005

Cash Flows from Operating Activities 6,600$

Cash Flows from Investing Activities (3,600)

Cash Flows from Financing Activities (2,500)

Net Cash Flows for the Period 500$

Add: Beginning Cash Balance 400

Ending Cash Balance 900$

Noncash Investing and Financing Activities

Issue of Mortgage for Land 2,500$

Notice that the Ending Cash Balance on the Statement of Cash Flows agrees with the

12/31/05 Cash balance on the Balance Sheet.

Notice that the Ending Cash Balance on the Statement of Cash Flows agrees with the

12/31/05 Cash balance on the Balance Sheet.

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Learning Objective

LO4LO4

To explain how theindirect method differsfrom the direct method

in reporting cashflow from operating

activities.

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Now let’s look at the Indirect Method that is used

by over 95% of all companies.

Indirect Method

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A Comparison of the Directand Indirect Methods

Net cash flow is the same for both methods. The Direct Method provides more detail about

cash from operating activities. The investing and financing sections for the two

methods are identical.

Net cash flow is the same for both methods. The Direct Method provides more detail about

cash from operating activities. The investing and financing sections for the two

methods are identical.

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Net Income

Net Income

Cash Flows from Operating

Activities

Cash Flows from Operating

Activities

Indirect Method

Changes in current assets and current liabilities as shown on the following table.

Changes in current assets and current liabilities as shown on the following table.

+ Losses and - Gains

+ Losses and - Gains

+ Noncash expenses such as depreciation and

amortization.

+ Noncash expenses such as depreciation and

amortization.

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Use this table when adjusting Net Incometo Cash Flow from Operations.

Use this table when adjusting Net Incometo Cash Flow from Operations.

Indirect Method

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We will use the Indirect Method to prepare the Cash

Flows from Operating Activities for the New South

Corporation.

First, we will review the Balance Sheet and Income Statement for New South

Corporation.

Indirect Method

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The Indirect Method begins with Net Income, which is then adjusted for the non-cash items included in

net income.

For New South Corporation, the only non-cash items are depreciation and a loss.

The Indirect Method begins with Net Income, which is then adjusted for the non-cash items included in

net income.

For New South Corporation, the only non-cash items are depreciation and a loss.

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(Remember, we showed the balance sheets a few slides earlier.)

To complete the Cash Flow from Operating Activities section, we must examine comparative balance sheets

to determine the changes in current assets and current liabilities from the beginning of the period to

the end of the period.

To complete the Cash Flow from Operating Activities section, we must examine comparative balance sheets

to determine the changes in current assets and current liabilities from the beginning of the period to

the end of the period.

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Statement of Cash Flows Indirect Method Example

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Remember that when we prepared the operating section using the Direct Method, we also arrived at Net Cash Flow

from Operating Activities of $6,600.

Remember that when we prepared the operating section using the Direct Method, we also arrived at Net Cash Flow

from Operating Activities of $6,600.

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Because the investingand financing sectionsare identical with eithermethod of preparation,

we will not repeatthose sections of the

statement.

Indirect Method

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Learning Objective

LO5LO5

To explain how thestatement of cash

flows could misleaddecision makers if notinterpreted with care

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The Financial Analyst

A rapidly growingcompany might be short of

cash in spite of largereported net income.

Because accruals anddeferrals affect operating income,cash flow from operating activities

may be stable thanoperating income.

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The Financial Analyst

The statement focusesattention on:

Ability to generate cashfrom its operations.

Management of currentassets and current liabilities.

Expenditures forlong-term assets.

Amount received fromexternal financing.

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End of Chapter 14