STATEMENT OF CASH FLOWS

Indirect Method

Mohamed Farouk Hafez, Ph. D.

Chapter
17-1
 Preparing the Statement of Cash Flows

Indirect and Direct Methods

Companies favor the indirect
method for two reasons:
1. It is easier and less costly
to prepare, and
2. It focuses on the
differences between net
income and net cash flow
from operating activities.

Chapter
17-2
 Preparing the Statement of Cash Flows
Indirect Demonstration
Method Problem

Chapter
17-3
 Preparing the Statement of Cash Flows
Indirect Demonstration
Method Problem

Chapter
17-4
 Preparing the Statement of Cash Flows
Demonstration
Problem

Additional information for 2008:

1. The company declared and paid a $29,000 cash dividend.
2. Issued $110,000 of long-term bonds in direct exchange for land.
3. A building costing $120,000 and equipment costing $25,000 were purchased for cash.
4. The company sold equipment with a book value of $7,000 (cost $8,000, less accumulated
depreciation $1,000) for $4,000 cash.
5. Issued common stock for $20,000 cash.
6. Depreciation expense was comprised of $6,000 for building and $3,000 for equipment.
Chapter
17-5
 Preparing the Statement of Cash Flows –
Indirect Method

Step 1: Operating Activities

Determine net cash provided/used by operating
activities by converting net income from an accrual
basis to a cash basis.

Common adjustments to Net Income (Loss):

Add back non-cash expenses (depreciation and
amortization expense).
Deduct gains and add losses.
Changes in current assets and current liabilities.
Chapter
17-6
 Step 1: Operating Activities

Depreciation Expense
Although depreciation expense reduces net income, it
does not reduce cash. Depreciation is a noncash
charge. The company must add it back to net income.

Cash flows from operating activities:

Net income $ 145,000
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation expense 9,000
Net cash provided by operating activities $ 154,000

Chapter
17-7
 Operating Activities

Loss on Sale of Equipment

Because companies report as a source of cash in the
investing activities section the actual amount of cash
received from the sale:

Any loss on sale is added to net income in the

operating section.

Any gain on sale is deducted from net income in

the operating section.

Chapter
17-8
 Operating Activities

Loss on Sale of Equipment

Cash flows from operating activities:

Net income $ 145,000
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation expense 9,000
Loss on sale of equipment 3,000
Net cash provided by operating activities $ 157,000

Chapter
17-9
 Operating Activities

Changes to Noncash Current Asset Accounts

When the Accounts Receivable balance decreases, cash
receipts are higher than revenue earned under the
accrual basis.
Accounts Receivable

1/1/08 Balance 30,000 Receipts from customers 517,000

Revenues 507,000

12/31/08 Balance 20,000

Therefore, the company adds to net income the amount

of the decrease in accounts receivable.

Chapter
17-10
 Operating Activities

Changes to Noncash Current Asset Accounts

Cash flows from operating activities:

Net income $ 145,000
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation expense 9,000
Loss on sale of equipment 3,000
Decrease in accounts receivable 10,000
Net cash provided by operating activities $ 167,000

Chapter
17-11
 Operating Activities

Changes to Noncash Current Asset Accounts

When the Inventory balance increases, the cost of
merchandise purchased exceeds the cost of goods sold.

Merchandise Inventory

1/1/08 Balance 10,000 Cost of goods sold 150,000

Purchases 155,000

12/31/08 Balance 15,000

As a result, cost of goods sold does not reflect cash

payments made for merchandise. The company deducts
from net income this inventory increase.
Chapter
17-12
 Operating Activities

Changes to Noncash Current Asset Accounts

Cash flows from operating activities:

Net income $ 145,000
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation expense 9,000
Loss on sale of equipment 3,000
Decrease in accounts receivable 10,000
Increase in inventory (5,000)
Net cash provided by operating activities $ 162,000

Chapter
17-13
 Operating Activities

Changes to Noncash Current Asset Accounts

When the Prepaid Expense balance increases, cash paid
for expenses is higher than expenses reported on an
accrual basis. The company deducts the decrease from
net income to arrive at net cash provided by operating
activities.

If prepaid expenses decrease, reported expenses are

higher than the expenses paid.

Chapter
17-14
 Operating Activities

Changes to Noncash Current Asset Accounts

Cash flows from operating activities:

Net income $ 145,000
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation expense 9,000
Loss on sale of equipment 3,000
Decrease in accounts receivable 10,000
Increase in inventory (5,000)
Increase in prepaid expenses (4,000)
Net cash provided by operating activities $ 158,000

Chapter
17-15
 Operating Activities

Changes to Noncash Current Liability Accounts

When Accounts Payable increases, this means the
company received more in goods than it actually paid for.
The increase is added to net income to determine net
cash provided by operating activities.

When Income Tax Payable decreases, this means the

income tax expense reported on the income statement
was less than the amount of taxes paid during the period.
The decrease is subtracted from net income to
determine net cash provided by operating activities.
Chapter
17-16
 Operating Activities

Changes to Noncash Current Liability Accounts

Cash flows from operating activities:

Net income $ 145,000
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation expense 9,000
Loss on sale of equipment 3,000
Decrease in accounts receivable 10,000
Increase in inventory (5,000)
Increase in prepaid expenses (4,000)
Increase in accounts payable 16,000
Decrease in income taxes payable (2,000)
Net cash provided by operating activities $ 172,000

Chapter
17-17
 Operating Activities

Summary of Conversion to Net

Cash Provided by Operating
Activities—Indirect Method

Chapter
17-18
 Step 2: Investing and Financing Activities
From the additional information, the company purchased land
of $110,000 by issuing long-term bonds. This is a significant
noncash investing and financing activity that merits disclosure
in a separate schedule.
Land
1/1/08 Balance 20,000
Issued bonds 110,000
12/31/08 Balance 130,000

Bonds Payable
1/1/08 Balance 20,000
For land 110,000
12/31/08 Balance 130,000
Chapter
17-19
 Investing and Financing Activities
Partial statement
Net cash provided by operating activities 172,000
Cash flows from investing activities:
Purchase of building (120,000)
Purchase of equipment (25,000)
Sale of equipment 4,000
Net cash used by investing activities (141,000)
Cash flows from financing activities:
Issuance of common stock 20,000
Payment of cash dividends (29,000)
Net cash used by financing activities (9,000)
Net increase in cash 22,000
Cash at beginning of period 33,000
Cash at end of period $ 55,000

Disclosure: Issuance of bonds to purchase land $ 110,000

Chapter
17-20
 Investing and Financing Activities

From the additional information, the company acquired

an office building for $120,000 cash. This is a cash
outflow reported in the investing section.

Building

1/1/08 Balance 40,000

Office building 120,000

12/31/08 Balance 160,000

Chapter
17-21
 Investing and Financing Activities
Partial statement
Net cash provided by operating activities 172,000
Cash flows from investing activities:
Purchase of building (120,000)
Purchase of equipment (25,000)
Sale of equipment 4,000
Net cash used by investing activities (141,000)
Cash flows from financing activities:
Issuance of common stock 20,000
Payment of cash dividends (29,000)
Net cash used by financing activities (9,000)
Net increase in cash 22,000
Cash at beginning of period 33,000
Cash at end of period $ 55,000

Disclosure: Issuance of bonds to purchase land $ 110,000

Chapter
17-22
 Investing and Financing Activities
The additional information explains that the equipment
increase resulted from two transactions: (1) a purchase of
equipment of $25,000, and (2) the sale for $4,000 of
equipment costing $8,000.

Equipment

1/1/08 Balance 10,000 Equipment sold 8,000

Purchase 25,000

12/31/08 Balance 27,000

Cash 4,000
Journal Accumulated depreciation 1,000
Entry Loss on sale of equipment 3,000
Equipment 8,000
Chapter
17-23
 Statement
Cash flows from operating activities:
Net income $ 145,000

of Cash
Adjustments to reconcile net income to net cash
provided by operating activities:

Flows
Depreciation expense 9,000
Loss on sale of equipment 3,000
Decrease in accounts receivable 10,000
Increase in inventory (5,000)
Indirect Increase in prepaid expenses (4,000)

Method
Increase in accounts payable 16,000
Decrease in income taxes payable (2,000)
Net cash provided by operating activities 172,000
Cash flows from investing activities:
Purchase of building (120,000)
Purchase of equipment (25,000)
Sale of equipment 4,000
Net cash used by investing activities (141,000)
Cash flows from financing activities:
Issuance of common stock 20,000
Payment of cash dividends (29,000)
Net cash used by financing activities (9,000)
Net increase in cash 22,000
Cash at beginning of period 33,000
Cash at end of period $ 55,000
Chapter
17-24
 Investing and Financing Activities

The additional information notes that the increase in

common stock resulted from the issuance of new shares.

Common Stock

1/1/08 Balance 50,000

Shares sold 20,000

12/31/08 Balance 70,000

Chapter
17-25
 Investing and Financing Activities
Partial statement
Net cash provided by operating activities 172,000
Cash flows from investing activities:
Purchase of building (120,000)
Purchase of equipment (25,000)
Sale of equipment 4,000
Net cash used by investing activities (141,000)
Cash flows from financing activities:
Issuance of common stock 20,000
Payment of cash dividends (29,000)
Net cash used by financing activities (9,000)
Net increase in cash 22,000
Cash at beginning of period 33,000
Cash at end of period $ 55,000

Disclosure: Issuance of bonds to purchase land $ 110,000

Chapter
17-26
 Investing and Financing Activities
Retained earnings increased $116,000 during the year. This
increase can be explained by two factors: (1) Net income of
$145,000 increased retained earnings. (2) Dividends of
$29,000 decreased retained earnings

Retained Earnings

1/1/08 Balance 48,000

Dividends 29,000 Net income 145,000

12/31/08 Balance 164,000

Chapter
17-27
 Statement
Cash flows from operating activities:
Net income $ 145,000

of Cash
Adjustments to reconcile net income to net cash
provided by operating activities:

Flows
Depreciation expense 9,000
Loss on sale of equipment 3,000
Decrease in accounts receivable 10,000
Increase in inventory (5,000)
Indirect Increase in prepaid expenses (4,000)

Method
Increase in accounts payable 16,000
Decrease in income taxes payable (2,000)
Net cash provided by operating activities 172,000
Cash flows from investing activities:
Purchase of building (120,000)
Purchase of equipment (25,000)
Sale of equipment 4,000
Net cash used by investing activities (141,000)
Cash flows from financing activities:
Issuance of common stock 20,000
Payment of cash dividends (29,000)
Net cash used by financing activities (9,000)
Net increase in cash 22,000
Cash at beginning of period 33,000
Cash at end of period $ 55,000
Chapter
17-28
 Using Cash Flows to Evaluate a Company

Free Cash Flow

Free cash flow describes the cash remaining from

operations after adjustment for capital expenditures
and dividends.

Chapter
17-29