CHAPTER

16 Statement of Cash
Flows
Accounting
26e

Warren
Reeve
Duchac
Learning Objectives

• LO1: Describe the cash flow activities

reported in the statement of cash flows.
• LO2: Prepare a statement of cash flows,
using the indirect method.
• LO3: Prepare a statement of cash flows,
using the direct method.
• LO4: Describe and illustrate the use of free
cash flow in evaluating a company’s cash
flow.

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Reporting Cash Flows (slide 1 of 4)

• The statement of cash flows reports a

company’s cash inflows and outflows for a
period.
• The statement of cash flows provides
useful information about a company’s
ability to do the following:
o Generate cash from operations
o Maintain and expand its operating capacity
o Meet its financial obligations
o Pay dividends

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Reporting Cash Flows (slide 2 of 4)

• The statement of cash flows is used by

managers in evaluating past operations
and in planning future investing and
financing activities.
• It is also used by external users such as
investors and creditors to assess a
company’s profit potential and ability to
pay its debt and pay dividends.

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Reporting Cash Flows (slide 3 of 4)

• The statement of cash flows reports cash flows

from three types of cash flow activities, as follows:
1. Cash flows from operating activities are the cash
flows from transactions that affect the net income of a
company.
 Example: Purchase and sale of merchandise by a retailer.
2. Cash flows from investing activities are the cash
flows from transactions that affect investments in the
noncurrent assets of the company.
 Example: Purchase and sale of fixed assets, such as
equipment and buildings.
3. Cash flows from financing activities are the cash
flows from transactions that affect the debt and equity
of the company.
 Example: Issuing or retiring equity and debt securities.

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Reporting Cash Flows (slide 4 of 4)

• The cash flows are reported in the

statement of cash flows as follows:

o The ending cash on the statement of cash

flows equals the cash reported on the
company’s balance sheet at the end of the
year.

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Sources and Uses of Cash

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Cash Flows from Operating Activities

• Cash flows from operating activities

reports the cash inflows and outflows from
a company’s day-to-day operations.
• Companies may select one of two
alternative methods for reporting cash
flows from operating activities in the
statement of cash flows:
o The direct method
o The indirect method
• Both methods result in the same amount
of cash flow from operating activities. They
differ in the way they report cash flows
from operating activities.
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Cash Flows from Operating Activities: The
Direct Method (slide 1 of 2)
• The direct method reports operating cash
inflows (receipts) and cash outflows (payments)
as follows:

o The primary operating cash inflow is cash received from

customers.
o The primary operating cash outflows are cash payments
for merchandise, operating expenses, interest, and
income tax payments.
o The cash received from operating activities less the
cash payments for operating activities is the net cash
flow from operating activities.
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Cash Flows from Operating Activities: The
Direct Method (slide 2 of 2)

• The primary advantage of the direct

method is that it directly reports cash
receipts and cash payments in the
statement of cash flows.
• Its primary disadvantage is that these data
may not be readily available in the
accounting records.
o Thus, the direct method is normally more costly
to prepare and, as a result, is used infrequently
in practice.

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Cash Flows from Operating Activities: The
Indirect Method (slide 1 of 2)
• The indirect method reports cash flows from
operating activities by beginning with net income
and adjusting it for revenues and expenses that
do not involve the receipt of cash or payment of
cash, as follows:

o The adjustments to reconcile net income to net cash

flow from operating activities include such items as
depreciation and gains or losses on fixed assets.
o Changes in current operating assets and liabilities such
as accounts receivable or accounts payable are also
added or deducted, depending on their effect on cash
flows.
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Cash Flows from Operating Activities: The
Indirect Method (slide 2 of 2)
• A primary advantage of the indirect
method is that it reconciles the differences
between net income and net cash flows
from operations.
• Because the data are readily available, the
indirect method is less costly to prepare
than the direct method.
o As a result, the indirect method of reporting
cash flows from operations is most commonly
used in practice.

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Cash Flow from Operations: Direct and Indirect
Methods—NetSolutions

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Cash Flows from Investing Activities

• Cash flows from investing activities show

the cash inflows and outflows related to
changes in a company’s long-term assets.
• Cash flows from investing activities are
reported on the statement of cash flows as
follows:

o Cash inflows from investing activities normally

arise from selling fixed assets, investments,
and intangible assets.
o Cash outflows normally include payments to
purchase fixed assets, investments, and
intangible assets.
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Cash Flows from Financing Activities

• Cash flows from financing activities show the cash

inflows and outflows related to changes in a
company’s long-term liabilities and stockholders’
equity.
• Cash flows from financing activities are reported
on the statement of cash flows as follows:

o Cash inflows from financing activities normally arise

from issuing long-term debt or equity securities.
 For example, issuing bonds, notes payable, preferred stock, and
common stock creates cash inflows from financing activities.
o Cash outflows from financing activities normally include
paying cash dividends, repaying long-term debt, and
acquiring
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Noncash Investing and Financing Activities

• A company may enter into transactions

involving investing and financing activities
that do not directly affect cash.
o For example, a company may issue common
stock to retire long-term debt.
• Because such transactions indirectly affect
cash flows, they are reported in a separate
section that usually appears at the bottom
of the statement of cash flows.

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Format of the Statement of Cash Flows

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Example Exercise Classifying Cash Flows

Identify whether each of the following would be reported as an

operating, investing, or financing activity in the statement of
cash flows:
a. Purchase of patent
• Investing
b. Payment of cash dividend
• Financing
c. Disposal of equipment
• Investing
d. Cash sales
• Operating
e. Purchase of treasury stock
• Financing
f. Payment of wages expense
• Operating
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part.
No Cash Flow Per Share

• Cash flow per share is computed as

follows:

• Cash flow per share should not be

reported on a company’s financial
statements for the following reasons:
o Users may misinterpret cash flow per share as
the per-share amount available for dividends.
o Users may misinterpret cash flow per share as
equivalent to (or better than) earnings per
share.
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Preparing the Statement of Cash Flows— The
Indirect Method (slide 1 of 2)

• The indirect method of reporting cash

flows from operating activities uses the
logic that a change in any balance sheet
account (including cash) can be analyzed
in terms of changes in other balance sheet
accounts:

o Thus, by analyzing changes in the liability,

stockholders’ equity, and noncash asset
accounts, any change in the cash account can
be indirectly determined:

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Preparing the Statement of Cash Flows— The
Indirect Method (slide 2 of 2)
• Under the indirect method, there is no
order in which the balance sheet accounts
must be analyzed. However, because net
income (or net loss) is a component of any
change in Retained Earnings, the first
account normally analyzed is Retained
Earnings.

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Income Statement and Comparative Balance
Sheet (slide 1 of 2)

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Income Statement and Comparative Balance
Sheet (slide 2 of 2)

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Retained Earnings

• The comparative balance sheet for Rundell

Inc. shows that retained earnings
increased $80,000 during the year. The
retained earnings account that follows
indicates how this change occurred:

o The net income of $108,000 is the first amount

reported in the Cash Flows from Operating
Activities section.
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Adjustments to Net Income (slide 1 of 10)

• The net income of $108,000 reported by

Rundell Inc. does not equal the cash flows
from operating activities for the period.
o This is because net income is determined using
the accrual method of accounting.
 Under the accrual method of accounting, revenues
and expenses are recorded at different times from
when cash is received or paid. Thus, under the
indirect method, adjustments to net income must be
made to determine cash flows from operating
activities.

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Adjustments to Net Income (Loss) Using the
Indirect Method

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Adjustments to Net Income (slide 2 of 10)

• Net income is normally adjusted to cash flows

from operating activities, using the following
steps:
o Step 1. Expenses that do not affect cash are added.
Such expenses decrease net income but not involve
cash payments and, thus, are added to net income.
o Step 2. Losses on the disposal of assets are added and
gains on the disposal of assets are deducted.
o Step 3. Changes in current operating assets and
liabilities are added or deducted as follows:
 Increases in noncash current operating assets are
deducted.
 Decrease in noncash current operating assets are added.
 Increases in current operating liabilities are added.
 Decreases in current operating liabilities are deducted.

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Example Exercise Adjustment to Net Income—Indirect
Method

Omni Corporation’s accumulated depreciation

increased by $12,000, while $3,400 of patent
amortization was recognized between balance sheet
dates. There were no purchases or sales of depreciable
or intangible assets during the year. In addition, the
income statement showed a gain of $4,100 from the
sale of land. Reconcile Omni’s net income of $50,000 to
net cash flow from operating activities.

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part.
Net Cash Flow From Operating Activities—
Indirect Method

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Adjustments to Net Income (slide 3 of 10)

• The next few slides will show how

Rundell’s net income is converted to cash
flows from operating activities of
$100,500.

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Adjustments to Net Income (slide 4 of 10)

• Step 1: Add depreciation of $7,000.

o Analysis: The comparative balance sheet
indicates that Accumulated Depreciation—
Building increased by $7,000. The following
account indicates that depreciation for the year
was $7,000 for the building:

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Adjustments to Net Income (slide 5 of 10)

• Step 2: Deduct the gain on the sale of land

of $12,000.
o Analysis: The income statement reports a gain
of $12,000 from the sale of land. The proceeds,
which include the gain, are reported in the
Investing section of the statement of cash
flows. Thus, the gain of $12,000 is deducted
from net income in determining cash flows
from operating activities.

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Adjustments to Net Income (slide 6 of 10)

• Step 3: Add and deduct changes in current

operating assets and liabilities excluding
cash.

o Accounts receivable (net): The $9,000 increase

is deducted from net income.
 This is because the $9,000 increase in accounts
receivable indicates that sales on account were
$9,000 more than the cash received from customers.
– Thus, sales (and net income) includes $9,000 that was
not received in cash during the year.
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Adjustments to Net Income (slide 7 of 10)

• Step 3: Add and deduct changes in current

operating assets and liabilities excluding
cash.

o Inventories: The $8,000 decrease is added to

net income.
 This is because the $8,000 decrease in inventories
indicates that the cost of merchandise sold exceeds
the cost of merchandise purchased during the year
by $8,000.
– In other words, the cost of merchandise sold includes
$8,000 of goods from inventory that were not
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purchased (used cash) during the year.
Adjustments to Net Income (slide 8 of 10)

• Step 3: Add and deduct changes in current

operating assets and liabilities excluding
cash.

o Accounts payable (merchandise creditors):

The $3,200 decrease is deducted from net
income.
 This is because a decrease in accounts payable
indicates that the cash payments to merchandise
creditors exceed the merchandise purchased on
account by $3,200.
– Therefore, the cost of merchandise sold is $3,200 less
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than the cash paid to merchandise creditors during the
Adjustments to Net Income (slide 9 of 10)

• Step 3: Add and deduct changes in current

operating assets and liabilities excluding
cash.

o Accrued expenses payable (operating

expenses): The $2,200 increase is added to
net income.
 This is because an increase in accrued expenses
payable indicates that operating expenses exceed
the cash payments for operating expenses by
$2,200.
– In other words, operating expenses reported on the
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Adjustments to Net Income (slide 10 of 10)

• Step 3: Add and deduct changes in current

operating assets and liabilities excluding
cash.

o Income taxes payable: The $500 decrease is

deducted from net income.
 This is because a decrease in income taxes payable
indicates that taxes paid exceed the amount of taxes
incurred during the year by $500.
– In other words, the amount reported on the income
statement for income tax expense is less than the
amount paid by $500.
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 Changes in Current Operating Assets
Example Exercise and Liabilities—Indirect Method (slide
1 of 2)

Victor Corporation’s current operating assets and

liabilities from the company’s comparative balance
sheet were as follows:

Adjust Victor’s net income of $70,000 for changes in

operating assets and liabilities to arrive at cash flows
from operating activities.

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part.
 Changes in Current Operating Assets
Example Exercise and Liabilities—Indirect Method (slide
2 of 2)

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part.
Example Exercise Cash Flows from Operating Activities—
Indirect Method

Omicron Inc. reported the following data:

Prepare the Cash Flows from Operating Activities section of the

statement of cash flows, using the indirect method.

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part.
Dividends (slide 1 of 2)

• The retained earnings account of Rundell

Inc. indicates cash dividends of $28,000
were declared during the year. However,
the following dividends payable account
indicates that only $24,000 of dividends
were paid during the year:

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Dividends (slide 2 of 2)

• Because dividend payments are a

financing activity, the dividend payment of
$24,000 is reported in the Financing
Activities section of the statement of cash
flows, as follows:

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Common Stock (slide 1 of 2)

• The common stock account of Rundell Inc. increased by $8,000,

and the paid-in capital in excess of par—common stock account
increased by $40,000, as follows:

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Common Stock (slide 2 of 2)

• These increases were from issuing 4,000

shares of common stock for $12 per share.
This cash inflow is reported in the
Financing Activities section as follows:

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Bonds Payable (slide 1 of 2)

• The Bonds Payable account of Rundell Inc.

decreased by $50,000, as follows:

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Bonds Payable (slide 2 of 2)

• This decrease is from retiring the bonds by

a cash payment for their face amount. This
cash outflow is reported in the Financing
Activities section as follows:

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Building (slide 1 of 2)

• The building account of Rundell Inc. increased by $60,000, and the

accumulated depreciation—building account increased by $7,000,
as follows:

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Building (slide 2 of 2)

• The purchase of a building for cash of

$60,000 is reported as an outflow of cash
in the Investing Activities section as
follows:

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Land (slide 1 of 2)

• The $45,000 decline in the land account of

Rundell Inc. was from two transactions, as
follows:

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Land (slide 2 of 2)

• The June 8 transaction is the sale of land

with a cost of $60,000 for $72,000 in cash.
The $72,000 proceeds from the sale are
reported in the Investing Activities section
as follows:

• The October 12 transaction is the

purchase of land for cash of $15,000. This
transaction is reported as an outflow of
cash in the Investing Activities section as
follows:

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Example Exercise Land Transactions on the Statement of
Cash Flows

Alpha Corporation purchased land for $125,000. Later

in the year, the company sold a different piece of land
with a book value of $165,000 for $200,000. How are
the effects of these transactions reported on the
statement of cash flows?

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part.
Statement of Cash Flows—Indirect Method

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Preparing the Statement of Cash Flows—The
Direct Method (slide 1 of 2)

• The direct method reports cash flows from

operating activities as follows:

o The Cash Flows from Investing and Financing

Activities sections of the statement of cash
flows are exactly the same under both the
direct and indirect methods.
o The amount of net cash flow from operating
activities is also the same, but the manner in
which it is reported is different.
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Preparing the Statement of Cash Flows—The
Direct Method (slide 2 of 2)
• The Cash Flows from Investing and Financing
Activities sections of the statement of cash flows
are exactly the same under both the direct and
indirect methods.
• The amount of net cash flow from operating
activities is also the same, but the manner in
which it is reported is different.
o Depreciation expense is not adjusted or reported as part
of cash flows from operating activities.
 This is because depreciation expense does not involve a cash
outflow.
o The gain on the sale of the land is also not adjusted and
is not reported as part of cash flows from operating
activities.
 This is because the cash flow from operating activities is
determined directly, rather than by reconciling net income. The
cashAll proceeds
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scanned, copied of the land
or duplicated, are
or posted reported
to a publicly as an
accessible website, in whole or in part.
Converting Income Statement to Cash Flows from
Operating Activities using the Direct Method

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Cash Received from Customers (slide 1 of 2)

• The income statement of Rundell Inc. (see

slide 22) reports sales of $1,180,000. To
determine the cash received from
customers, the $1,180,000 is adjusted for
any increase or decrease in accounts
receivable.

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Determining the Cash Received from Customers

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Cash Received from Customers (slide 2 of 2)

• The cash received from customers is

computed as follows:

o The increase of $9,000 in accounts receivable

during 2016 indicates that sales on account
exceeded cash received from customers by
$9,000.
 In other words, sales include $9,000 that did not
result in a cash inflow during the year.

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Example Exercise Cash Received from Customers—Direct
Method

Sales reported on the income statement were

$350,000. The accounts receivable balance declined
$8,000 over the year. Determine the amount of cash
received from customers.

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part.
Cash Payments for Merchandise (slide 1 of 2)

• The income statement of Rundell Inc. (see

slide 22) reports cost of merchandise sold
of $790,000. To determine the cash
payments for merchandise, the $790,000
is adjusted for any increases or decreases
in inventories and accounts payable.

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Determining the Cash Payments for Merchandise

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Cash Payments for Merchandise (slide 2 of 2)

• The cash payments for merchandise is computed

as follows:

o The $8,000 decrease in inventories indicates that the

merchandise sold exceeded the cost of the merchandise
purchased by $8,000.
 In other words, the cost of merchandise sold includes
$8,000 of goods sold from inventory that did not require a
cash outflow during the year.
o The $3,200 decrease in accounts payable indicates that
cash payments for merchandise were $3,200 more than
the purchases on account during 2016.

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Example Exercise Cash Payments for Merchandise—
Direct Method

The cost of merchandise sold reported on the income

statement was $145,000. The accounts payable balance
increased by $4,000, and the inventory balance
increased by $9,000 over the year. Determine the
amount of cash paid for merchandise.

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part.
Cash Payments for Operating Expenses (slide 1 of
2)

• The income statement of Rundell Inc. (see

slide 22) reports total operating expenses
of $203,000, which includes depreciation
expense of $7,000.
o Because depreciation expense does not require
a cash outflow, it is omitted from cash
payments for operating expenses.
• To determine the cash payments for
operating expenses, the other operating
expenses (excluding depreciation) of
$196,000 ($203,000 – $7,000) are
adjusted for any increase or decrease in
accrued expenses payable.
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Determining the Cash Payments for Operating
Expenses

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Cash Payments for Operating Expenses (slide 2 of
2)

• The cash payments for operating expenses

are computed as follows:

o The increase in accrued expenses payable

indicates that the cash payments for operating
expenses were $2,200 less than the amount
reported for operating expenses during the
year.

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Gain on Sale of Land

• The income statement for Rundell Inc. (see

slide 22) reports a gain of $12,000 on the
sale of land.
o The sale of land is an investing activity. Thus,
the proceeds from the sale, which include the
gain, are reported as part of the cash flows
from investing activities.

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Interest Expense (slide 1 of 2)

• The income statement of Rundell Inc. (see

slide 22) reports interest expense of
$8,000.
• To determine the cash payments for
interest, the $8,000 is adjusted for any
increases or decreases in interest payable.

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Determining the Cash Payments for Interest

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Interest Expense (slide 2 of 2)

• The comparative balance sheet of Rundell

(see slide 23) indicates no interest
payable.
o This is because the interest expense on the
bonds payable is paid on June 1 and December
31.
• Therefore, no adjustment of the interest
expense of $8,000 is necessary.

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Cash Payments for Income Taxes (slide 1 of 2)

• The income statement of Rundell Inc. (see

slide 22) reports income tax expense of
$83,000.
• To determine the cash payments for
income taxes, the $83,000 is adjusted for
any increases or decreases in income
taxes payable.

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Determining the Cash Payments for Income
Taxes

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Cash Payments for Income Taxes (slide 2 of 2)

• The cash payments for income taxes are

computed as follows:

• The $500 decrease in income taxes payable

indicates that the cash payments for income
taxes were $500 more than the amount reported
for income tax expense during 2016.

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Statement of Cash Flows—Direct Method

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Financial Analysis and Interpretation: Free
Cash Flow (slide 1 of 2)
• Free cash flow measures the operating
cash flow available to a company to use
after purchasing the property, plant, and
equipment (PP&E) necessary to maintain
current productive capacity.
• Free cash flow is computed as follows:

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Financial Analysis and Interpretation: Free
Cash Flow (slide 2 of 2)
• Positive free cash flow is favorable.
• A company that has free cash flow is able
to fund internal growth, retire debt, pay
dividends, and benefit from financial
flexibility.
• A company with no free cash flow is
unable to maintain current productive
capacity.
• Lack of free cash flow can be an early
indicator of liquidity problems.

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Example Exercise Free Cash Flow (slide 1 of 2)

Omnicron Inc. reported the following on the company’s

cash flow statement in 2016 and 2015:

Seventy-five percent of the net cash flow used for

investing activities was used to replace existing
capacity.
a. Determine Omnicron’s free cash flow.
b. Has Omnicron’s free cash flow improved or declined
from 2015 to 2016?
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part.
Example Exercise Free Cash Flow (slide 2 of 2)

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part.
Appendix: Spreadsheet (Work Sheet) for
Statement of Cash Flows—The Indirect Method
(slide 1 of 2)

• A spreadsheet (work sheet) may be used

in preparing the statement of cash flows.
However, whether or not a spreadsheet
(work sheet) is used, the concepts
presented in this chapter are not affected.

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Appendix: Spreadsheet (Work Sheet) for
Statement of Cash Flows—The Indirect Method
(slide 2 of 2)
• The steps in preparing this spreadsheet (work sheet) are as
follows:
o Step 1. List the title of each balance sheet account in the
Accounts column.
o Step 2. For each balance sheet account, enter its balance in
the two Balance columns. Place the credit balances in
parentheses.
o Step 3. Add both of the Balance columns, which should total
zero.
o Step 4. Analyze the change during the year in each noncash
account to determine its net increase (decrease) and classify
the change as affecting cash flows from operating activities,
investing activities, financing activities, or noncash investing
and financing activities.
o Step 5. Indicate the effect of the change on cash flows by
making entries in the Transactions columns.
o Step 6. After all noncash accounts have been analyzed, enter
the net increase (decrease) in cash during the period.
Step 7. Add the Debit and Credit Transactions columns. The
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End-of-Period Spreadsheet (Work Sheet) for
Statement of Cash Flows—Indirect Method

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