Statement of Cash Flows

CHAPTER 15

Managerial Accounting
Seventeenth edition

© 2021 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution
permitted without the prior written consent of McGraw Hill.
 5-2

Learning Objectives
LO15–1 Classify cash inflows and outflows as relating to
operating, investing, or financing activities

LO15–2 Prepare a statement of cash flows using the

indirect method to determine the net cash provided by
operating activities

LO15–3 Compute free cash flow

[LO15–4(Appendix 15A) Use the direct method to

determine the net cash provided by operating activities]
 External Reports
Income Statement

Balance Sheet
Statement of Cash Flows

The statement of cash flows highlights the major

activities that impact cash flows and, hence,
affect the overall cash balance

© McGraw Hill 15-3

 Purpose of the Statement of Cash Flows
Helps answer a variety of questions such as:
1. Are we generating sufficient cash flows from ongoing
operations to remain viable?
2. Can we pay our debts?
3. Can we pay our usual dividends?
4. Major reasons why net income and net cash flow differ?
5. To what extent will we have to borrow money in order
to make needed investments?

© McGraw Hill 15-4

 A Fundamental Principle
Δ Cash balance = Δ Noncash balance sheet accounts

This principle ensures that properly analyzing the

changes in all noncash balance sheet accounts always
quantifies the cash inflows and outflows that explain
the change in the cash balance.

© McGraw Hill 15-5

 A Review of Basic Equations
Basic Equation for Asset Accounts
Beginning balance + Debits – Credits = Ending balance

Basic Equation for Contra-Asset, Liability, and

Stockholders’ Equity Accounts
Beginning balance – Debits + Credits = Ending balance

© McGraw Hill 15-6

 Statement of Cash Flows: Key Concepts
The term cash on the statement of cash flows refers
broadly to both currency and cash equivalents.

Currency and bank accounts = Cash

Treasury bills, commercial paper, and money

market funds = Cash equivalents
[Short-term, liquid and safe investments]

© McGraw Hill 15-7

 Learning Objective 1
Classify cash inflows and outflows as
relating to:
Operating,
Investing
or
Financing activities

© McGraw Hill 15-8

 Organizing a Statement of Cash Flows 1

Operating Activities Revenue and expense

transactions that affect net
income.

Investing Activities Acquiring or disposing of

noncurrent assets.

Financing Activities Borrowing from and

repaying principal to
creditors and transactions
with stockholders.
These are US GAAP and IFRS reporting requirements for Cashflow statement organization
© McGraw Hill 15-9
 Organizing a Statement of Cash Flows 2

© McGraw Hill 15-10

 Operating Activities: Direct or Indirect
Method?
Direct Method Indirect Method

Reconstructs the income Accrual net income is

statement on a cash basis adjusted to a cash basis;
from top to bottom used by 99%

Both methods result in the exact same amount of cash

provided by operating activities
[Indirect Method is compulsory, Direct Method optional]

© McGraw Hill 15-11

 Indirect Method: 3-Step Process
Step 1: Add depreciation charges to net income.

Step 2: Analyze net changes in noncash balance

sheet accounts.
Step 3: Adjust for gains and losses.

© McGraw Hill 15-12

 Step 1: Add Depreciation Charges 1

Accumulated depreciation is a noncash balance

sheet account and we must adjust net income for all
the changes in the noncash balance sheet accounts
that have occurred during the period.

Basic Equation for Contra-Asset, Liability, and

Stockholders’ Equity Accounts
Beginning balance – Debits + Credits = Ending balance

© McGraw Hill 15-13

 Step 1: Add Depreciation Charges 2

Account Activity for Accumulated Depreciation

Beginning balance $300

Ending balance $500
Accumulated depreciation of equipment sold $70

Basic Equation for Contra-Asset, Liability, and

Stockholders’ Equity Accounts
Beginning balance – Debits + Credits = Ending balance
$300 – $70 + Credits = $500
Credits = $500 – $300 + $70
Credits = $270
© McGraw Hill 15-14
 Step 2: Analyze Net Changes in Noncash
Balance Sheet Accounts
Increase in Decrease in
Account Account
Balance Balance
Current Assets
Accounts receivable Subtract Add
Inventory Subtract Add
Prepaid expenses Subtract Add
Current Liabilities
Accounts payable Add Subtract
Accrued liabilities Add Subtract
Incomes taxes payable Add Subtract

© McGraw Hill 15-15

 Step 3: Adjust for Gains and Losses
Under US GAAP & IFRS, gains and losses must be
included in the investing activities section of the
statement of cash flows
Gains and losses:
- removed from net income in the operating
activities section
- Added to the investing activities section:
• Subtract gains
• Add losses
© McGraw Hill 15-16
 Investing & Financing Activities – Gross
Cash Flows 1

US GAAP & IFRS require investing and financing sections

of the statement of cash flows disclose gross cash flows

Increase in Decrease in
Account Balance Account Balance
Noncurrent Assets (Investing activities)
Property, plant, and equipment Subtract Add
Long-term investments Subtract Add
Loans to other entities Subtract Add

© McGraw Hill 15-17

 Investing and Financing Activities – Gross
Cash Flows 2

Increase in Decrease in
Account Balance Account Balance
Liabilities and Stockholders’ Equity
(Financing activities)
Bonds payable Add Subtract
Common stock Add Subtract
Retained earnings * *

* Requires further analysis to quantify cash dividends paid.

© McGraw Hill 15-18

 Property, Plant, and Equipment
Account Activity for Property, Plant, and Equipment

Beginning balance $1,000 Original cost of equipment sold $100

Ending balance $1,800 Accumulated depreciation of
equipment sold $70
Cash proceeds from sale Gain on the sale of equipment
of equipment $40 (included in net income) $10

Basic Equation for Asset Accounts

Beginning balance + Debits – Credits = Ending balance
$1,000 + Debits – $100 = $1,800
Debits = $1,800 – $1,000 + $100
Debits = $900 (cash outflow)
Report $40 cash inflow. Report $900 cash outflow.
© McGraw Hill 15-19
 Retained Earnings
Account Activity for
Retained Earnings
Beginning balance $2,000
Ending balance $3,000
Net income $1,200

Basic Equation for Contra-Asset, Liability, and Stockholders’ Equity Accounts

Beginning balance – Debits + Credits = Ending balance
$2,000 – Debits + $1,200 = $3,000
$3,200 = $3,000 + Debits
Debits = $200 (cash outflow – Cash Dividend)

Report $1,200 net income in Report $200 dividends paid in

operating activities. financing activities.

© McGraw Hill 15-20

 Summary of Key Concepts 1

© McGraw Hill 15-21

 Summary of Key Concepts 2

© McGraw Hill 15-22

Guided Example
 Learning Objective 2
Prepare a statement of cash flows using the
indirect method to determine the net cash
provided by operating activities.

© McGraw Hill 15-25

 Apparel, Inc. Financial Statements 1

Apparel, Inc.
Income Statement
(US Dollars in millions)

Sales $3,638
Cost of goods sold 2,469
Gross margin 1,169
Selling and administrative expenses 941
Net operating income 228
Nonoperating items: Gain on sale of store 3
Income before taxes 231
Income taxes 91
Net income $ 140

© McGraw Hill 15-26

 Apparel, Inc. Financial Statements 2

Apparel, Inc.

Comparative Balance Statement

(dollars in millions)

Ending Beginning
Balance Balance Change
Assets
Current assets:
Cash and cash equivalents $ 91 $ 29 +62
Accounts receivable 637 654 −17
Inventory 586 537 +49
Total current assets 1,314 1,220
Property, plant, and equipment 1,517 1,394 +123
Less accumulated depreciation 654 561 +93
Net property, plant, and equipment 863 833
Total assets $2,177 $2,053

© McGraw Hill 15-27

 Apparel, Inc. Financial Statements 3

Ending Beginning
Balance Balance Change
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable $ 264 $ 220 +44
Accrued liabilities 193 190 +3
Income taxes payable 75 71 +4
Total current liabilities 532 481
Bonds payable 479 520 −41
Total liabilities 1,011 1,001
Stockholders’ equity:

Common stock 157 155 +2

Retained earnings 1,009 897 +112
Total stockholders’ equity 1,166 1,052
Total liabilities and stockholders’ equity $2,177 $2,053

© McGraw Hill 15-28

 An Example of a Statement of Cash Flows
In addition to the FS provided, assume the following:
1. Company sold a store that had an original cost of $15 million
and accumulated depreciation of $10 million. The cash
proceeds from the sale were $8 million. The gain on the sale
was $? million.
2. The company did not issue any new bonds during the year.
3. The company did not repurchase any of its own common
stock during the year.
4. The company paid a cash dividend during the year.

© McGraw Hill 15-29

 Operating Activities – Step 1
Accumulated Depreciation: The first step in computing Apparel’s net cash
provided by operating activities is to add depreciation to net income.

Basic Equation for Contra-Asset, Liability, and Stockholders’ Equity Accounts

Beginning balance – Debits + Credits = Ending balance
$561M – $10M + Credits = $654M
Credits = $654M – $561M + $10M
Credits = $103M

© McGraw Hill 15-30

 Operating Activities – Step 2
The second step is to analyze net changes in noncash balance sheet
accounts that impact net income.

© McGraw Hill 15-31

 Operating Activities – Step 3
The third step in computing Apparel’s net cash provided by operating activities is
to adjust for gains and losses included in net income.
Apparel, Inc.
Income Statement
Sales $3,638
Cost of goods sold 2,469
Gross margin 1,169
Selling and administrative expenses 941
Net operating income 228
Nonoperating items: Gain on sale of store 3
Income before taxes 231
Income taxes 91
Net income $ 140

© McGraw Hill 15-32

 Operating Activities
Apparel, Inc.
(dollars in millions)

Operating Activities
Net income $140
Adjustments to convert net income to a cash basis:
Depreciation 103
Decrease in accounts receivable 17
Increase in inventory (49)
Increase in accounts payable 44
Increase in accrued liabilities 3
Increase in income taxes payable 4
Gain on sale of store (3) 119
Net cash provided by (used in) operating activities $259

© McGraw Hill 15-33

 Investing Activities
Basic Equation for Asset (PPE) Accounts
Beginning balance + Debits – Credits = Ending balance
$1,394M + Debits – $15M = $1,517M
Debits = $1,517M – $1,394M + $15M
Debits = $138M (cash outflow)

Report $8 million cash inflow. Report $138 million cash outflow.

© McGraw Hill 15-34

 Financing Activities

Basic Equation for Contra-Asset, Liability, and Stockholders’ Equity Accounts

Beginning balance – Debits + Credits = Ending balance
$897M – Debits + $140M = $1,009M
$1,037M = $1,009M + Debits
Debits = $28M (cash outflow) Dividends

Access the text alternative for slide images.

© McGraw Hill 15-35

 Apparel, Inc. – Statement of Cash Flows 1

Apparel, Inc.
Statement of Cash Flows–Indirect Method
(dollars in millions)
Operating Activities
Net income $140
Adjustments to convert net income to a cash basis:
Depreciation 103
Decrease in accounts receivable 17
Increase in inventory (49)
Increase in accounts payable 44
Increase in accrued liabilities 3
Increase in income taxes payable 4
Gain on sale of store (3) 119
Net cash provided by (used in) operating activities 259

© McGraw Hill 15-36

 Apparel, Inc. – Statement of Cash Flows 2

Investing Activities
Additions to property, plant, and equipment (138)
Proceeds from sale of store 8
Net cash provided by (used in) operating activities (130)
Financing Activities
Retirement of bonds payable (41)
Issuance of common stock 2
Cash dividends paid (28)
Net cash provided by (used in) financing activities (67)
Net increase in cash and cash equivalents 62
Beginning cash and cash equivalents 29
Ending cash and cash equivalents $ 91

© McGraw Hill 15-37

 Seeing the Big Picture

© McGraw Hill 15-38

 Interpreting the Statement of Cash Flows
A statement of cash flows should be evaluated in the
context of a company’s specific circumstances:
• Company Lifecycle: startup, growth, mature, declining
• But exceptions!

Useful information can also be derived by

examining the relationships among numbers, eg:
• Cashflow margin of $0.07 per sale (259/3638)
• Net Operating Cash to Current Liabilities: 259 to 532
• Investing vs Depreciation: 138 to 103
© McGraw Hill 15-39
Guided Example
 Learning Objective 3
Compute free cash flow.

© McGraw Hill 15-43

 Free Cash Flows 1

Free cash flow measures a company’s ability to

fund its capital expenditures and dividends from
its net cash provided by operating activities

Net cash provided by Capital

Free cash flow = − − Dividends
operating activities expenditures

© McGraw Hill 15-44

 Free Cash Flows 2

Free cash flow measures a company’s ability to

fund its capital expenditures and dividends from
its net cash provided by operating activities.
Net cash provided by Capital
Free cash flow = − − Dividends
operating activities expenditures
$93 = $259 − $138 − $28

• Positive FCF: Co generated enough Operating Cash to fund capital expenditure

and dividend payments
• Negative FCF: Co needed to obtain cash from other sources (borrowing, issuing
common stock) to fund capital expenditure and dividend payments
• Interpretation depends on Lifecycle and Market conditions

© McGraw Hill 15-45

 Earnings Quality
Managers generally perceive that earnings are of higher
quality when the earnings are:
1. Not unduly influenced by inflation,
2. Computed using conservative accounting principles and
estimates, and
3. Correlated with net cash provided by operating activities.

Otherwise, net income influenced by other factors: non-

operational (eg non-recurring) or aggressive accounting

© McGraw Hill 15-46

 Summary
• Cashflow Statement organized into 3 sections for external reporting:
operating, investing, and financing activities
• Net cash from operating activities is an important measure
• Indicates how successful a company is in generating continuing cash
• Indirect method of computing net operating cash is a 3-step process:
1. Add depreciation to net income
2. Analyze net changes in balance sheet accounts that impact net income
3. Adjust for gains or losses included in the income statement.
• Investing & Financing sections of CF statement reports gross amounts
• CF statement summarizes net increases/decreases in cash & equivalents
during the period, which explains the change in the cash balance
• Interpretation of operating activities is greatly enhanced and should be
contextualised
© McGraw Hill 15-47
 End of Chapter 15

© 2021 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution
permitted without the prior written consent of McGraw Hill.
Guided Example

Exercise 15-5
Changes in various accounts and gains and losses on the sale of assets during the year for
Trysten Company are given below:

Item Amount
Accounts receivable $ 40,000 increase
Inventory $150,000 decrease
Prepaid expenses $ 4,000 decrease
Accounts payable $ 57,000 decrease
Accrued liabilities $ 6,000 decrease
Income taxes payable $ 13,500 increase
Sale of equipment $ 4,000 loss
Sale of long-term investments $ 16,000 gain
Required:
Prepare an answer sheet using the following column headings:
Item Amount Add Subtract

For each item, place an X in the Add or Subtract column to indicate whether the dollar amount
should be added to or subtracted from net income under the indirect method when computing
the net cash provided by operating activities for the year.
[LO2]