INCOME FLOWS vs.

CASH FLOWS: UNDERSTANDING THE STATEMENT OF CASH FLOWS

PURPOSE OF THE STATEMENT OF CASH FLOWS lending institutions and shareholders.
Statement of Cash Flow assists users in CASH FLOWS ACTIVITIES AND FIRM'S LIFE
understanding the cash inflows and outflows that CYCLE
support a firm’s primary activities. A helpful framework for intuitively grasping the
An oversimplification of the statement of cash information conveyed through the organization of
flows is that it reports all of the sources and uses of cash flows involves the product life cycle concept
cash during a period. from economics and marketing. Individual products
The statement of cash flows: (like goods or services) move through four phases:
➔ reconciles the change in cash on the balance (1) introduction, (2) growth, (3) maturity, and (4)
sheet and net income reported in the income decline.
statement.
➔ is logically organized in three sections
(operating activities, investing activities, and
financing activities), which correspond to the
primary pursuits necessary to generate profits.
Provides information about cash flows to and
from entities, such as customers, suppliers,
creditors, and investors, with whom the firm
conducts business.
➔ assists analysts with numerous other tasks,
such as uncovering accounting discretion,
calculating free cash flows and identifying
other information unavailable elsewhere in the
financial reports.
Cash Flow vs. Net Income
A firm’s cash flows will differ from net income each
period because:
● cash receipts from customers do not
necessarily occur in the same period revenue
is recognized.
● cash expenditures do not necessarily occur in A Firm’s Life Cycle: Revenues
the same period expenses are recognized. The top graph shows the pattern of revenues
● cash inflows and outflows from investing and throughout the four phases, which typically follows a
financing activities do not immediately flow period of growth, peaking during maturity, and a
through the income statement. subsequent decline as customers switch to
Recall that a primary objective in preparing an income alternatives. Obviously, the length of these phases
statement is the matching of economic resources and the steepness of the revenue curve vary by type
used or consumed (expenses) during the period with and success of a product.
economic resources earned (revenues) during the A typical firm provides numerous products or
period. Under accrual accounting, the timing of the services, so the applicability of the theory and
inflow and outflow of cash is ignored. However, cash evidence for single products is more difficult when
is essential for operating, investing, and financing firms are diversified across numerous products at
activities. different stages of their life cycle. Nevertheless, these
Cash Flows and Financial Analysis patterns are descriptive of firm performance over time
1. Identify the Economic Characteristics of a Business as they introduce new products and discontinue older
2. Identify the Strategy of the Firm; ones.
3. Identify Non Recurring, Unusual Items and Provide A Firm’s Life Cycle: Net Income
Insight into the Use of Accounting Discretion by The middle panel of Exhibit 3.1 shows the trend of
Managers; net income over the life cycle of a product or firm. Net
4. Analyze Probability and Risk; losses usually occur in the introduction and early
5. Prepare Forecasted Financial Statements; and growth phases because revenues are less than the
6. Value the Firm. cost of designing and launching new products. Then,
THE RELATIONS AMONG THE CASH FLOWS net income peaks during the maturity phase, followed
ACTIVITIES by a decline.
Operating activities include all activities directly A Firm’s Life Cycle: Cash Flows
involving the production and delivery of goods or The lower panel of Exhibit 3.1 shows the cash flows
services; from operating, investing, and financing activities
Investing activities section chronicles expenditures during the four life cycle phases. As with revenues,
for (and proceeds from dispositions of) assets, such the length of phases and steepness of the net income
as equipment and joint ventures, that are intended to and cash flow curves vary depending on the success
be used to generate cash flows. Also included in the and sustainability of a product or a firm’s operations
investing section are cash flows related to and strategy.
acquisitions and divestitures. ➔ During the initial introduction of a product or
Financing activities summarizes cash received from business, revenues are minimal; therefore, net
(or returned to) capital providers such as banks, other income and net cash flows from operating and
investing activities are typically low or
 INCOME FLOWS vs. CASH FLOWS: UNDERSTANDING THE STATEMENT OF CASH FLOWS
negative, and the firm relies heavily on cash ● Such large increases in capital expenditures
flows from financing activities. are seen as a signal of management
➔ As the growth phase accelerates, operations bullishness about future growth.
become profitable and begin to generate ● Finally, as is typical of rapidly growing
cash. companies, growth in cash flows frequently is
➔ As products and businesses move through the not enough to fuel the investments required to
maturity phase, the cash flow pattern changes sustain growth, so Black Diamond realizes
dramatically. Operations become profitable substantial inflows of capital through financing
and generate substantial positive cash flows activities, which are approximately $40 million
because of market acceptance of the product in both 2011 and 2012.
and a leveling off of working capital needs and
asset acquisitions. Also, with revenues Growth firms typically have increasing profits or
leveling off, firms invest to maintain rather decreasing losses, positive cash flows from
than increase productive capacity. operations, negative cash flows for investing
➔ During the decline phase, cash flows from activities, and positive cash flows from financing
operations and investing activities taper off as activities.
customers become satiated or switch to
alternative products, thus decreasing sales. At Cedar Fair L.P. (Maturity Phase)
this point, firms use cash flows to repay Founded in 1983 in Sandusky, Ohio, Cedar Fair L.P.
outstanding debt from the introduction and is among the largest amusement park companies in
growth phases and can pay dividends or the world.
repurchase common stock from equity
investors. The company’s statement of cash flows (Exhibit 3.4)
FOUR COMPANIES: FOUR DIFFERENT STAGES exhibits the typically large positive cash flows from
OF THE LIFE CYCLE operating activities and negative cash flows for both
investing and financing activities.
Advanced Cell Technology, Inc. (Introduction
Phase) ● The company generates large and persistent
net income ($101.9 million in 2012, up from
Advanced Cell Technology (OTC BB: ACTC) $65.3 million in 2011) and enormous cash
The company’s statements of cash flows for flows from operating activities ($285.9 million
2010–2012 (Exhibit 3.2) show the typical pattern of a in 2012).
firm in the introduction phase. ● With such large amounts generated by cash
flows from operating activities, the company
❖ The negative cash flows from both operating relied very little on external financing; instead,
and investing activities, funded by large it tended to pay large distributions to partners
positive cash flows from financing activities. (the company is a partnership) and pay down
❖ The large net losses ($72.8 million in 2011 lines of credit and term debt.
and $28.5 million in 2012). ● Also, Cedar Fair continued to use significant
❖ The large and negative cash flows from cash for investing activities (a net total of
operating activities (negative $14.6 million for $80.2 million in 2012).
2012). ● Indeed, the company believes that annual
❖ The source of the cash flows—primarily park attendance is strongly affected by the
financing activities. introduction of new rides and attractions each
Start-up firms typically have negative profits, year, explaining the continuing investment
negative cash flows from operations, negative cash activities.
flows for investing activities, and positive cash flows ● In contrast to Advanced Cell Technology
from financing activities. above, where the balance of cash has been
steadily depleted, Cedar Fair has seen an
Black Diamond Group (Growth Phase) increase in cash on hand from $9.8 million in
2010 to $78.8 million at the end of 2012.
Black Diamond
The statement of cash flows in Exhibit 3.3 shows Mature firms typically have large positive profits, large
typical characteristics of a growth firm. positive cash flows from operations, stable cash flows
from investing activities, and negative cash flows from
● First, profits are increasing, as net income financing activities.
grew approximately 16% from $41.0 million to
$47.4 million in 2012. Warner Music Group (Decline Phase)
● Even more impressive, cash flows from Exhibit 3.5 shows the statement of cash flows for
operations increased 50%, from $68.8 million Warner Music Group during its final years before
to $103.5 million. being acquired by a private company.
● At the same time, capital expenditures
increased substantially, which increased the Like other music content companies, Warner Music
cash used for investing activities from $85.2 Group suffered as the music industry experienced a
million to $164.0 million. distribution transformation with the development of
 INCOME FLOWS vs. CASH FLOWS: UNDERSTANDING THE STATEMENT OF CASH FLOWS
digital music and other delivery platforms like Internet Net cash flows for a period should equal the change
streaming. As is typical of a firm in decline, Warner in cash for the period.
Music Group: Financial Accounting Standards Board (FASB)’s
Codification Topic 230 and International
● Reported a string of net losses (increased Accounting Standards Board (IASB)’s
from $51 million to $145 million between 2008 International Accounting Standard 7
and 2010). - Define cash flows in terms of their effect on
● Generated positive cash flows from the balance of cash and cash equivalents.
operations, but at a substantially decreasing
rate (declined from $304 million to $150 Cash equivalents
million). - Include highly liquid short-term investments
● Investing activities appeared volatile (negative that are readily convertible into cash. Both
in 2008 and 2010, but positive in 2009 as the U.S. GAAP and IFRS indicate that a maturity
company disposed of certain investments). date of three months or less would generally
● Raised very little capital from external qualify short-term investments as cash
financing sources, (other than a simultaneous equivalents.
issuance and higher retirement of debt in - Treasury bills
2009). - Commercial paper
Decline firms typically have decreasing profits or - Money market funds
increasing losses, declining cash flows from On the statement of cash flows, the net cash flows
operations, low or positive cash flows for investing equal the (net) sum of cash flows provided by or
activities, and negative cash flows from financing used for operating, investing, and financing
activities. activities.

Understanding the relations among Income The Operating Section of the Statement of Cash
Statement, Balance Sheet and Statement of Cash Flows
Flows
Cash flows from operating activities
Accrual accounting - First section of the statement of cash flows.
- Unreliable because managers can so easily - Most important, because it provides
manipulate it. information on the firm’s core activities.
- Auditors, regulators, boards of directors, the - These activities include cash received from
press, and activist investors restrict such selling goods and services to customers offset
nefarious behavior. by cash paid to suppliers, employees,
- Goes beyond measurement of cash flows to governments, and other providers of goods
measure economic inflows and outflows. and services.
The statement of cash flows, although quite - Where an analyst can gather information
useful, merely undoes the accrual accounting that about the quality of earnings.
transformed cash flows into balance sheets and - An analysis of the timing of cash flows in the
income statements. operating section exposes the drivers of
reported profitability on the income statement,
The statement of cash flows is closely tied to net which can sometimes raise red flags for
income, but serves several additional roles. You need earnings manipulation.
an understanding of the following three relations to
be able to interpret the statement of cash flows: The Operating Section: Format Alternatives
1. The overall relations among the net cash Under U.S. GAAP and IFRS
flows from operating, investing, and financing - Firms may present cash flows from operations
activities in one of two formats: the direct method or
2. The relation between the change in the cash the indirect method.
balance on the balance sheet and the net Direct method
changes reflected on the statement of cash - Preferred by both the FASB and IASB
flows - Lists individual classes of cash receipts and
3. The specific relation between net income and cash payments, such as cash collected from
cash flows from operations customers, cash paid to suppliers, and cash
paid to employees.
The Relation between Cash Balances and Net
Cash Flows Indirect method
- Reconciles reported net income to cash flows
Primary purpose of the statement of cash flows from operations by ‘‘undoing’’ non-cash
- Provide financial statement users with (accrual) components of earnings.
information about a firm’s cash receipts and Despite a preference for the direct method by
payments that cause the change in the cash standard setters, almost all companies report cash
balance on the balance sheet. flows using the indirect method.
Accounting in its simplest form: In 2011
Beginning Cash + Cash Receipts – Cash
Expenditures = Ending Cash Balance
 INCOME FLOWS vs. CASH FLOWS: UNDERSTANDING THE STATEMENT OF CASH FLOWS
- Accounting Trends & Techniques (AICPA) - These adjustments affect current period net
surveyed 500 firms and identified only 5 that income, but do not affect current period cash
used the direct method. flows, so must be ‘adjusted out’ of the starting
The reluctance to report under the direct method point of the statement of cash flows—net
seems to be based on practicality, because the income.
FASB and IASB require that firms using the direct - As an example, consider depreciation
method also provide a separate schedule for the expense. Depreciation expense reduces net
reconciliation between net income and operating income, but it is a non-cash expense. Thus, in
cash flows (in other words, an indirect method reconciling net income to cash flows from
operating section). operations, non-cash expenses such as
depreciation must be added back to net
income.
DIRECT METHOD: Working capital adjustments
- Adjustments for changes in operating working
capital accounts during the period.
- Common adjustments include increases and
decreases in accounts receivable,
inventories, and accounts payable.

Non-Working Capital Adjustments

➢ Depreciation and amortization expense
- Reduces net property, plant, and
equipment and net income.
- However, depreciation expense does
not require an operating cash outflow
in the period of the expense.
- Cash flows paid out for depreciable
assets are classified as investing
activities in the year of acquisition.
➢ Bad debt expense
- Like depreciation and amortization
expense for fixed and intangible
assets, bad debt expense reduces
net accounts receivable and net
income.
- However, bad debt expense is a
non-cash expense, so must be added
back to net income, similar to
depreciation and amortization.
➢ Deferred tax expense
- Firms recognize deferred tax assets
INDIRECT METHOD: and/or deferred tax liabilities on the
balance sheet when they use different
methods of accounting for financial
reporting and income tax reporting.
- The total amount of income tax
expense, including both current and
deferred components, will differ from
the amount of income taxes owed or
payable for the fiscal year (from the tax
return).
- Thus, firms must add back the excess
of income tax expense over income
taxes owed for the year (approximated
The Operating Section: Adjustments for the by current tax expense).
Indirect Method ➢ Employee stock option compensation
Calculation of cash flows from operations - Stock-based compensation, such as
- The indirect method involves two types of employee stock options that permit
adjustments to net income—working capital employees to purchase shares of the
and non-working capital adjustments. firm’s common stock for less than their
market value, is recognized as an
Common non-working capital adjustments expense on the income statement.
- Depreciation, amortization, deferred taxes,
and gains/losses on asset dispositions.
INCOME FLOWS vs. CASH FLOWS: UNDERSTANDING THE STATEMENT OF CASH FLOWS
- This expense reduces net income and of time an employee will realize
increases a shareholders’ equity postretirement benefits, the growth in
account, but it does not affect cash the cost of those benefits, and the
flows. return on investments set aside to
- Because the expense does not use cover those future costs).
cash, firms add back stock-based - As a result, companies with defined
compensation expense to net income benefit plans adjust net income for the
when computing cash flows from net difference between the expense
operations. and cash transactions.
➢ Gains and losses ➢ Excess tax benefits from share-based
- Companies that sell an item of compensation plans
property, plant, or equipment report the - Companies are required to expense an
full cash proceeds with the investing estimate of the fair value of stock
activities on the statement of cash options granted to employees over the
flows. vesting period. This expense lowers
income, resulting in lower tax expense.
➢ Equity method income - When an employee exercises stock
- Firms holding investments of 20–50% options, she will owe taxes on the
of the common shares in another difference between the stock price at
entity generally use the equity the time of exercise and the amount
method to account for the she has to pay to exercise the option
investment. (the strike price).
- The statement of cash flows usually
shows a subtraction from net income ➢ Impairment and restructuring-related
for the investor’s share of the charges
investee’s earnings and an addition for - Write-offs and write-downs of
the dividends received. assets reduce net income through
- Often, firms will simply report the net of impairment charges, but there are
these two amounts. usually no associated cash
transactions.
➢ Noncontrolling interests - Thus, impairment charges must be
- Firms with subsidiaries sometimes do added back to net income in the
not own 100% of those subsidiaries. computation of operating cash flows.
- Although the parent controls the - Similarly, restructuring charges are
operations of the subsidiaries, other estimated and the associated cash
investors have a non controlling or flows generally follow later.
minority interest. - Thus, restructuring charges appear as
- The parent consolidates 100% of the add backs to income, and the actual
subsidiaries assets, liabilities, and cash payments for restructuring
income, but shows deductions for the appear as subtractions from income in
noncontrolling interest. the operating section.
➢ Other comprehensive income
- As discussed in prior chapters, other Operating Working Capital Adjustments
comprehensive income represents The second type of adjustment used to reconcile net
non-cash adjustments to certain income to cash flows from operations involves
financial securities, foreign changes in the working capital (current asset and
currency gains/losses, and various current liability) accounts.
postretirement benefit items. Accounts receivable. Revenue recognition is based
- Thus, such amounts would also be on the economics of a sale rather than the realization
added back to net income. of cash. Unless a customer pays in cash, recognition
- However, most companies accomplish of revenue increases accounts receivable.
this by starting with net income in the Inventories. Two features of inventory accounting
statement of cash flows, rather than lead to adjustments to net income in computing
comprehensive income. operating cash flows. When inventory balances
➢ Employee-related costs such as pensions increase, the cash flow statement subtracts this
- There are two types of pension amount because it does imply a cash outlay. Similarly,
plans—defined contribution and when inventory balances decrease, the cash flow
defined benefit. statement includes a positive adjustment because the
- Defined benefit plans may give rise to decrease is expensed as cost of goods sold, but
large differences between pension some of this amount relates to inventory that was
expense and actual cash flows, but paid for in a prior reporting period.
this is not true for defined contribution Prepaid expenses. Prepaid expenses are simply
plans (for example, numerous cash payments that have yet to be expensed.
estimates are required for the length of Increases in prepaid expenses indicate cash
time an employee will work, the length payments in excess of amounts recognized as
expenses in computing net income; decreases in
 INCOME FLOWS vs. CASH FLOWS: UNDERSTANDING THE STATEMENT OF CASH FLOWS
prepaid expenses represent amounts that were the consolidated parent can change the balances of
expensed but for which there was no equivalent assets and liabilities, which is a non-cash change.
simultaneous cash flow.
Accounts payable and accrued expenses. An The Relation between Net Income and Cash Flows
increase in current liabilities for accounts payable and from Operations
accrued operating expenses means that a firm did not
use as much cash for inventory purchases and
operating expenses as the amounts appearing on the
income statement.
Income taxes payable. Firms typically do not pay all
taxes due for a particular year during that year. Some
taxes paid within a year relate to taxes due for the
preceding year; some taxes due for the current year
are paid the following year.
Other current assets and liabilities. In addition to
the working capital accounts discussed previously,
there are other current accounts such as marketable
securities, short-term investments, commercial paper,
and other short-term borrowings. The cash flows Preparing the Statement of Cash Flows
pertaining to these items are shown in investing
(marketable securities, short-term investments) or Algebraic Formulation
financing activities (commercial paper, short-term
borrowings). Assets = Liabilities + Shareholders’ Equity

Why Do Adjustments Rarely Equal the Changes in This equality holds for balance sheets at the
Assets and Liabilities on the Balance Sheet? beginning and end of each period. If you subtract the
The reconciling adjustments throughout the statement amounts on the balance sheet at the beginning of the
of cash flows relate to non-cash accounts on the period from the corresponding amounts on the
balance sheet, but it is rare that changes in the actual balance sheet at the end of the period, you obtain the
balance sheet accounts equal the reconciling following equality for changes (∆) in balance sheet
adjustments on the statement of cash flows. amounts:
1. Acquisitions and divestitures. If a company
acquires another firm for cash, that cash flow ∆ Assets = ∆ Liabilities + ∆ Shareholders’ Equity
appropriately shows up in the investing section of the
statement of cash flows. Acquisitions often result in You can now expand the change in assets as
the acquiring company taking over various current follows:
assets and liabilities of the acquiree, like receivables,
inventory, and payables. These current assets and ∆ Cash + ∆ Non-Cash Assets = ∆ Liabilities +
liabilities will be included in the consolidated balance ∆ Shareholders’ Equity
sheet at the end of the year. However, it would be
inappropriate to let the change in the balance sheet Rearranging terms,
totals show up as an adjustment in the operating
section of the statement of cash flows, as this would ∆ Cash = ∆ Liabilities + ∆ Shareholders’ Equity –
result in double counting. ∆ Non-Cash Assets
2. Non-cash transactions. Non-cash transactions
include non-cash acquisitions using common stock, Example:
the acquisition of assets under lease agreements,
asset exchanges, financed asset acquisitions or
settlement of liabilities, debt-for-equity swaps, and
other transactions which increase or decrease assets,
liabilities, or equities, but do not involve the exchange
of cash.
3. Changes in contra accounts. Some assets, like
accounts receivable and fixed assets, include contra
accounts. If those assets are shown net on the
balance sheet, then changes in the contra accounts
can also cause the change on the balance sheet to
not match the adjustments in the operating section of
the statement of cash flows.
4. Foreign currency translation. Globally diversified
companies have assets and liabilities located in many
countries and frequently denominated in various
currencies. When consolidated balance sheets are
prepared, the translation of current assets and
liabilities from the local currency into the currency of
 INCOME FLOWS vs. CASH FLOWS: UNDERSTANDING THE STATEMENT OF CASH FLOWS
Cash Collected from Customers = Sales – ∆
Accounts Receivable

2. Marketable Securities
- Firms typically acquire marketable securities
when they temporarily have excess cash and
sell these securities when they need cash.
3. Inventories
- Purchases of inventory during a period equal
cost of goods sold plus the change in
Rearrange terms : inventory.

4. Other Current Assets

To link the above decomposition of the balance sheet - Other current assets typically include
equation into the format of the statement of cash prepayments for various operating costs, such
flows, partition non-cash assets and liabilities into as insurance and rent.
working capital and non-working capital components. 5. Investments in Securities
- The Investments in Securities account can
change for the following reasons:

Rearranging terms,

6. Property, Plant, and Equipment

- Cash flows related to purchases and sales of
The rearrangement of the familiar balance fixed assets are classified as investing
sheet equation (and use of simplifying assumptions) activities.
yields the intuitive equation above, which figuratively 7. Accumulated Depreciation
maps into the information on the statement of cash - The amount of depreciation expense
flows. recognized each period reduces net income
but does not use cash. Thus, add back
depreciation expense on line.. This treatment
Classifying Changes in Balance Sheet Accounts is appropriate because depreciation expense
is not a cash flow (ignoring income tax
consequences).
8. Intangible Assets
- Intangible assets on the balance sheet include
patents, copyrights, goodwill, and similar
assets. A portion of the change in these
accounts represents amortization, which
requires an addback to net income when
computing cash flows from operations.
9. Accounts Payable
- Under the assumption that all accounts
payable are due to suppliers from which the
firm makes purchases, the cash outflow for
accounts payable equals inventory purchases
during the period minus the change in
accounts payable.

10. Notes Payable

1. Accounts Receivable - Notes Payable is the account generally used
- Cash collections from customers during a when a firm engages in short-term borrowing
period equal sales for the period plus from a bank or another financial institution.
accounts receivable at the beginning of the 11. Current Portion of Long-Term Debt
period minus accounts receivable at the end - The change in the current portion of long-term
of the period, or alternatively, sales minus the debt during a period equals (a) the
change in accounts receivable. reclassification of long-term debt from a
noncurrent liability to a current liability (that is,
 INCOME FLOWS vs. CASH FLOWS: UNDERSTANDING THE STATEMENT OF CASH FLOWS
debt that the firm expects to repay within one - Other comprehensive income represents only
year of the balance sheet date) minus (b) the non-cash adjustments (that is, gains and
current portion of long-term debt actually losses that have not been realized).
repaid during the period.
12. Other Current Liabilities Illustration of the Preparation Procedure
- Firms generally use this account for Based on the data for Footloose Shoe Store, the
obligations related to goods and services used procedure for preparing the statement of cash flows is
in operations other than purchases of illustrated in Exhibit 3.15. In addition to the balance
inventories. Thus, changes in other current sheet data shown there, net income was $16,634 for
liabilities appear as operating activities. Year 2.
13. Long-Term Debt
This account changes for the following reasons: Possible combinations of net changes in cash,
● Issuance of new long-term debt liabilities, shareholders’ equity, and non-cash assets
● Reclassification of long-term debt from a can be described as follows:
noncurrent to a current liability (current portion
of long-term debt)
● Retirement of long-term debt
● Conversion of long-term debt to preferred or
common stock
14. Deferred Income Taxes
- Income taxes are currently payable equal
income tax expense [included on line (18) as
a negative element of net income] plus or
minus the change in deferred taxes during the
period. Thus, changes in deferred income
taxes appear as an operating activity.
15. Other Noncurrent Liabilities
- This account includes unfunded pension and
retirement benefit obligations, long-term
deposits received, and other miscellaneous
long-term liabilities. Changes in these types of
obligations are operating activities, absent
information to the contrary.
16, 17, and 19. Common Stock, Additional Paid-in
Capital, and Treasury Stock
- These accounts change when a firm issues
new common stock or repurchases and retires
outstanding common stock, and they appear
as financing activities. The Additional Paid-in Thus, changes in liabilities and shareholders’ equity
Capital account also changes when firms have the same directional effect on cash, whereas
recognize compensation expenses related to changes in non-cash assets have the opposite
stock options. This is a non-cash expense directional effect.
that, like depreciation, requires an addback to
net income to compute cash flows from You classify the change in each account as an
operations. operating, investing, or financing activity because you
18. Retained Earnings have no information that more than one activity
- Retained earnings increase by the amount of caused the change in the account. Observe the
net income and decrease with the declaration following inferences for Year 2:
of dividends each period. 1. Operating activities were a net source of cash
for the period. Cash flows from operations
approximately equal net income. Footloose
Shoe Store increased its inventories but
- Net income is an operating activity, and reduced accounts payable.
dividends are a financing activity. 2. Cash flows from operations were more than
20. Accumulated Other Comprehensive Income sufficient to finance the increase in property,
- Recall that accumulated other comprehensive plant, and equipment.
income is a component of shareholders’ 3. Footloose Shoe Store used the cash derived
equity and includes various fair value gains from operations in excess of capital
and losses that have not been realized. expenditures to repay long-term debt.

Net Income + Other Comprehensive Income = Exhibit 3.16 presents the statement of cash flows for
Comprehensive Income Footloose Shoe Store for Year 2 using the amounts
taken from the worksheet in Exhibit 3.15. The far right
columns of Exhibits 3.15 and 3.16 provide
 INCOME FLOWS vs. CASH FLOWS: UNDERSTANDING THE STATEMENT OF CASH FLOWS
cross-references for clarifying how the worksheet is Several features of MicroStrategy’s original operating
used to prepare the statement of cash flows. section of the statement of cash flows stand out;
1. Although net income can legitimately exceed
cash flows from operations, especially for
growth firms, it is a red flag for accounting
quality issues because of managerial
discretion necessary in the reporting of
non-working capital and working capital.
2. The existence of negative cash flows from
operations but positive net income represents
a situation in which managers may be keenly
interested in reporting profits rather than
losses, increasing incentives to adopt
aggressive accounting practices.
3. The magnitude of the working capital
adjustments exceeds that of non-working
capital adjustments, which indicates that the
accounting for working capital accounts has
an elevated importance for the level of
reported earnings.
USEFULNESS OF THE STATEMENT OF CASH
FLOWS FOR ACCOUNTING AND RISK ANALYSIS Clearly, the financial statements as originally reported
contained clues investors could have used to raise
Accruals represent the non-cash accounting concerns about the quality of earnings possibly being
adjustments that are employed to prepare income low.
statements and balance sheets, such as recognizing In addition to the analysis of accounting quality, the
sales on account, accruing expenses incurred but not statement of cash flows is use- ful for liquidity and
paid, and so on. credit risk analysis.

MicroStrategy is a provider of software that enables

businesses to conduct transaction data through
various channels and to examine information about
customers, partners, and supply chains.

The most important point made in Exhibit 3.17 is that

regardless of the accounting practices (before or after
restatement), the cash flows do not change.