chapter 12 Statement of Cash Flows

Financial Accounting
10e
Libby • Libby • Hodge
Learning Objectives
After studying this chapter, you should be able to:

12-1 Classify cash flow statement items as part of net cash flows from
operating, investing, and financing activities.
12-2 Report and interpret cash flows from operating activities using
the indirect method.
12-3 Analyze and interpret the quality of income ratio.
12-4 Report and interpret cash flows from investing activities.
12-5 Analyze and interpret the capital acquisitions ratio.
12-6 Report and interpret cash flows from financing activities.
12-7 Understand the format of the cash flow statement and additional
cash flow disclosures.

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12-2
Understanding the Business

Positive cash flows permit a company to . . .

Pay
Pay
dividends
dividends to
to Expand
Expand its
its
owners.
owners. operations.
operations.

Take
Take
advantage
advantage of
of Replace
Replace
investment
investment worn
worn assets.
assets.
opportunities.
opportunities.

Some
SomeWall
WallStreet
Streetanalysts
analystsconsider
considerititimportant
importanttoto
understand
understandthe
thevarious
varioussources
sourcesand
anduses
usesof ofcash
cashthat
thatare
are
associated
associatedwith
withbusiness
businessactivity.
activity.

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12-3
Learning Objective 12-1
12-1 Classify cash flow statement items as part of net cash flows from
operating, investing, and financing activities.

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12-4
What is cash?

The definition of cash includes cash and cash

equivalents.

Cash equivalents are short-term, highly liquid

investments that are both
 Readily convertible into known amounts
of cash and
 So near to maturity there is little risk that
their value will change if interest rates
change.
Generally, only investments with original
maturities of three months or less qualify as
cash equivalents

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12-5
Classifications of the Statement of Cash Flows

Cash inflows and outflows directly related

Operating Activities
to earnings from normal operations.

Cash inflows and outflows related to the

acquisition or sale of productive facilities
Investing Activities and investments in the securities of other
companies.

Cash inflows and outflows related to

Financing Activities external sources of financing (owners and
creditors) for the enterprise.

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12-6
Exhibit 12.1

Consolidated
Statement of
Cash Flows

The ending cash

balance should
agree with the
balance sheet.

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12-7
Direct Method vs. Indirect Method

Two Formats for Reporting Cash Flow from Operating Activities

Direct Method Indirect Method

Reports the cash effects of Starts with accrual net

each operating activity income and converts to
cash flow from operating
activities

The cash flows from operating activities are always the same,
regardless of whether the direct or indirect method is used.

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12-8
Cash Flows from Operating Activities

Inflows
Inflows
Cash
Cashreceived
receivedfrom:
from:
 Customers
Customers
 Dividends and interest on
Dividends and interest on
investments
investments + Inflows
Cash
CashFlows
Flows
from
fromOperating
Operating
Outflows
Outflows Activities
Activities
Cash
Cashpaid
paidfor:
for:
 Purchase of services
Purchase of services
(electricity,
(electricity,etc.)
for resale
for resale
etc.)and
andgoods
goods _ Outflows
 Salaries and wages
Salaries and wages
 Income taxes
Income taxes
 Interest on liabilities
Interest on liabilities

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12-9
Cash Flows from Investing Activities

Inflows
Inflows
Cash
Cashreceived
receivedfrom:
from:
 Sale or disposal of property,
Sale or disposal of property,
plant,
plant,and
andequipment
equipment
 Sale or maturity of investments
Sale or maturity of investments
ininsecurities
securities + Inflows
Cash
CashFlows
Flowsfrom
from
Investing
Investing
Outflows Activities
Activities
Outflows
Cash
Cashpaid
paidfor:
for:
 Purchase of property, plant, and
Purchase of property, plant, and
equipment
_ Outflows
equipment
 Purchase of investments in
Purchase of investments in
securities
securities

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12-10
Cash Flows from Financing Activities

Inflows
Inflows
Cash
Cashreceived
receivedfrom:
from:
 Borrowings on notes, mortgages,
Borrowings on notes, mortgages,
bonds,
bonds,etc.,
etc.,from
fromcreditors
creditors
 Issuing stock to owners
Issuing stock to owners
+ Inflows
Cash
CashFlows
Flowsfrom
from
Financing
Financing
Activities
Activities
Outflows
Outflows
Cash
Cashpaid
paidfor:
_ Outflows
for:
 Repayment of principal to creditors
Repayment of principal to creditors
(excluding
(excludinginterest,
interest,which
whichisisan
an
operating activity)
operating activity)
 Repurchasing stock from owners
Repurchasing stock from owners
 Dividends to owners
Dividends to owners

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12-11
Net Increase (Decrease) in Cash
The combination of the net cash flows from operating, investing, and
financing activities must equal the net increase or decrease in cash.

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12-12
Relationships to the Balance Sheet and Income Statement (1
of 2)

Information
Informationneeded
neededto
toprepare
prepareaastatement
statementofofcash
cashflows:
flows:


Comparative
Comparativebalance
balancesheets
sheets
 A complete income statement
 A complete income statement
 Additional details concerning selected accounts
 Additional details concerning selected accounts

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12-13
Relationships to the Balance Sheet and Income Statement (2
of 2)
Preparation and understanding of the cash flow statement focuses
on the changes in the balance sheet accounts.

ΔΔCash Liabilities++ΔΔStockholders’
Cash==ΔΔLiabilities Stockholders’––ΔΔNoncash
Noncash
Equity
Equity Assets
Assets

Derives from . . .

Assets Liabilities++Stockholders’
Assets==Liabilities Stockholders’Equity
Equity

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12-14
Exhibit 12.2
Selected Cash Transactions and Their Effects on Other Balance Sheet Accounts

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Exhibit 12.3
Comparative Balance Sheet

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Exhibit 12.3
Current Income Statement

Under the indirect method, the statement of cash flows

begins with net income from the income statement.

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Learning Objective 12-2
12-2 Report and interpret cash flows from operating activities using
the indirect method.

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12-18
Reporting and Interpreting Cash Flows from Operating
Activities

The
Theindirect
indirectmethod
methodadjusts
adjustsnet
netincome
incomeby
by
eliminating
eliminatingnoncash
noncashitems.
items.

++Losses
Lossesand
and––Gains
Gains
Cash
CashFlows
Flows
Net
Net from
from
Income
Income Operating
Operating
Activities
Activities
++Noncash
Noncash +/−
+/−Changes
Changesinin
expenses
expensessuch
suchas
as current
currentassets
assetsand
and
depreciation
depreciationand
and current
currentliabilities.
liabilities.
amortization.
amortization.
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12-19
Adjustment for Gains and Losses

Cash received from the sale or disposal of long-term assets is classified as

investing cash inflow. Gains/losses on the income statement, if any, are
subtracted from/added to net income in order to compute cash flow from
operating activities.

Gains must be subtracted from net

Gains
income to avoid double counting the gain.

Losses must be added to net income to

Losses
avoid double counting the loss.

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12-20
Exhibit 12.4 (1 of 2)
Schedule for Net Cash Flow from Operating Activities, Indirect Method

Step
Step11
Adjust
Adjustnet
netincome
incomefor
fordepreciation
depreciationand
andamortization
amortization
expense
expense and gains and losses on sale of investingassets.
and gains and losses on sale of investing assets.
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Exhibit 12.4 (2 of 2)
Schedule for Net Cash Flow from Operating Activities, Indirect Method

Step
Step22
Adjust
Adjustnet
netincome
incomefor
forchanges
changesinin
current
currentassets
assetsand
andcurrent
currentliabilities.
liabilities.
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Change in Accounts Receivable

• Sales on account increase the balance in accounts receivable,

and collections from customers decrease the balance.
• The balance sheet indicates an increase in accounts receivable
of $10,273 for the period, which means that cash collected from
customers is lower than revenue.
• To convert to cash flows from operating activities, the amount
of the increase (the amount of sales over and above collections)
must be subtracted from net income. (A decrease is added.)

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12-23
Change in Inventory

• The balance sheet indicates that inventory increased by $5,433,

which means that the amount of purchases is more than the
amount of merchandise sold.
• The increase (the extra goods purchased) must be subtracted from
net income to convert to cash flow from operating activities. (A
decrease is added.)

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12-24
Change in Prepaid Expenses

• The balance sheet indicates a $2,603 increase in prepaid expenses,

which means that new cash prepayments are more than the
amount of expenses.
• The increase (the extra prepayments) must be subtracted from net
income. (A decrease is added.)

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12-25
Change in Accounts Payable

• The balance sheet indicates accounts payable increased by

$8,709, which means that cash payments were less than
purchases on account.
• This increase (the extra purchases on account) must be added
to net income. (A decrease is subtracted.)

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12-26
Change in Accrued Expenses

• The balance sheet indicates accrued expenses increased by

$2,883, which indicates that cash paid for the expenses is less
than accrual basis expenses.
• The increase (the lower cash paid) must be added to net
income. (A decrease is subtracted.)

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12-27
Summary
We can summarize the typical additions and subtractions that are
required to reconcile net income with cash flow from operating
activities as follows:

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12-28
Classification of Interest on the Cash Flow
Statement
International
Perspective—
U.S. GAAP and IFRS differ in the cash flow statement IFRS
treatment of interest received and interest paid.

Interest Received Interest Paid

U.S. GAAP Operating Operating

IFRS Operating or Investing Operating or Financing

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12-29
Interpreting Cash Flows from Operating Activities

A common rule of thumb followed by financial and credit analysts is to

avoid firms with rising net income but falling cash flow from operations.

Investors will not invest in a company if they do not believe that cash
generated from operations will be available to pay them dividends or
expand the company.

Creditors will not lend money if they do not believe that cash
generated from operations will be available to pay back the loan.

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12-30
Learning Objective 12-3
12-3 Analyze and interpret the quality of income ratio.

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12-31
Quality of Income Ratio
KEY RATIO ANALYSIS

Cash Flow from

Operating Activities
$$$
Quality of Income
=
Ratio Net Income

In general, this ratio measures the portion of income that was

generated in cash. All other things equal, a higher quality of
income ratio indicates greater ability to finance operating and
other cash needs from operating cash inflows.

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12-32
Fraud and Cash Flows from Operations (1 of 2)
QUESTION OF ETHICS

The cash flow statement often gives outsiders the

first hint that financial statements may contain
$$$
errors and irregularities.

Unethical managers sometimes attempt to reach earnings

targets by manipulating accruals and deferrals of revenues
and expenses to inflate income. Because these adjusting
entries do not affect the cash account, they have no effect
on the cash flow statement.

A growing difference between net income and cash flow

from operations can be a sign of such manipulations.

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12-33
Fraud and Cash Flows from Operations (2 of 2)
QUESTION OF ETHICS

Investors Chronicle reported on an $$$

accounting fraud at a commercial credit
company, suggesting the following:

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12-34
Learning Objective 12-4
12-4 Report and interpret cash flows from investing activities.

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12-35
Reporting and Interpreting Cash Flows from Investing
Activities
Related Balance
Sheet Account(s) Investing Activity Cash Flow Effect
Property, plant, and Purchase of property, Outflow
equipment and intangible plant, and equipment or
assets (patents, etc.) intangible assets for cash
Sale of property, plant, and Inflow

equipment or intangible
assets for cash
Short- or long-term Outflow
investments (stocks and Purchase of investment
bonds of other companies) securities for cash Inflow
Sale (maturity) of
investment securities for
Remember that: cash
• Only purchases paid for with cash or cash equivalents are included.
• The amount of cash that is received from the sale of assets is included,
regardless of whether the assets are sold at a gain or loss.
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12-36
Exhibit 12.1
(1 of 5)

We must report
individually the
cash used to
purchase
equipment and
the cash proceeds
received from the
sale of equipment.

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12-37
Exhibit 12.1
(2 of 5)

Although short-term
investments is a
current asset, it is
reported in the
investing section on
the statement of cash
flows. The company
purchased short-term
investments for $1,463.
They company also
sold short-term
investments for $2,011,
an amount equal to
their net book value.

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12-38
Learning Objective 12-5
12-5 Analyze and interpret the capital acquisitions ratio.

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12-39
Capital Acquisitions Ratio
KEY RATIO ANALYSIS

$$$
Capital Cash Flow from Operating Activities
Acquisitions =
Ratio Cash Paid for Property, Plant,
and Equipment

In general, this ratio reflects the portion of purchases of property, plant,

and equipment financed from operating activities. A high ratio indicates
less need for outside financing for current and future expansions.

A high ratio benefits the company because:

• it provides the company opportunities for strategic acquisitions
• it avoids the cost of additional debt
• it reduces the risk of bankruptcy that comes with additional leverage
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12-40
Free Cash Flow
FINANCIAL ANALYSIS

Managers and analysts calculate free cash flow

as a measure of a firm’s ability to pursue long-
$$$
term investment opportunities.

Free Cash Flow = Cash Flow from Operating Activities

– Dividends – Capital Expenditures

Any positive free cash flow is available for additional capital

expenditures, investments in other companies, and mergers and
acquisitions without the need for external financing or reductions
in dividends to shareholders.

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12-41
Learning Objective 12-6
12-6 Report and interpret cash flows from financing activities.

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12-42
 Reporting Cash Flows from Financing Activities
Related Balance
Sheet Account(s) Financing Activity Cash Flow Effect
Short-term debt (notes Borrowing cash from banks Inflow
payable) or other financial
institutions
Repayment of loan Outflow
principal
Long-term debt Issuance of bonds for cash Inflow
Repayment of bond Outflow
principal
Common stock and Issuance of stock for cash Inflow
additional paid-in capital Repurchase (retirement) of Outflow
stock with cash
Retained earnings Payment of cash dividends Outflow

Remember that:
• Cash repayments of principal are cash flows from financing activities.
• Interest payments are cash flows from operating activities.
• Dividend payments are cash flows from financing activities.
• If debt or stock is issued for other than cash, it is not included in this section.
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12-43
Exhibit 12.1
(3 of 5)

Cash received from

issuance of long-
term debt.

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12-44
Exhibit 12.1
(4 of 5)

Cash received from

issuing common
stock.

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12-45
Exhibit 12.1
(5 of 5)

Retained earnings
increased by $38,398
due to the combined
effect of $107,045 of
income and $68,647 in
dividends declared and
paid.

Retained Earnings Analysis

April 30, 2016 $ 188,926

Add net income 107,045
Less dividends (68,647)
April 29, 2017 $ 227,324

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12-46
Interpreting Cash Flows from Financing Activities

The long-term growth of a company is normally financed from

three sources:
1. Internally generated funds (cash from operating activities)
2. The issuance of stock
3. Money borrowed on a long-term basis

The statement of cash flows shows how management has

elected to fund its growth. This information is used by
analysts who wish to evaluate the capital structure and
growth potential of a business.

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Learning Objective 12-7
12-7 Understand the format of the cash flow statement and additional
cash flow disclosures.

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12-48
Completing the Statement and Additional Disclosures

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Supplemental Cash Flow Information

Two additional required cash flow disclosures are normally

listed at the bottom of the statement or in the notes.
1. Noncash investing and financing activities, such as the
purchase of a building with a mortgage given by the
former owner.
2. Cash paid for interest and cash paid for income taxes
(for companies that use the indirect method)

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Chapter Supplement A: Reporting Cash Flows from
Operating Activities—Direct Method

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Chapter Supplement B: Adjustment for Gains and Losses on
Sale of Long-Term Assets—Indirect Method
The Operating Activities section of the cash flow statement prepared using
the indirect method may include an adjustment for gains and losses on the
sale of long-term assets reported on the income statement.

If property, plant, and equipment with an original cost of $10,000 and

accumulated depreciation of $4,000 is sold for $8,000 cash, the following
entry is made.

$8,000 Investing
$2,000
cash flow
subtraction in the
Operating section

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Chapter Supplement C: T-Account Approach (Indirect
Method)
Based on the idea that changes in cash must equal the sum of the
changes in all other balance sheet accounts, we can use T-accounts to
analyze cash flows as follows:

1. Determine the change in each balance sheet account. From this

year’s ending balance, subtract this year’s beginning balance (i.e., last
year’s ending balance).

2. Identify the cash flow category or categories to which each account

relates.

3. Create schedules that summarize operating, investing, and financing

cash flows.

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Exhibit 12.9
T-Account Approach to Preparing the Statement of Cash Flows (Indirect Method)

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Exhibit 12.9
T-Account Approach to Preparing the Statement of Cash Flows (Indirect Method)

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