CHAPTER 3

INCOME FLOWS VERSUS CASH FLOWS:

UNDERSTANDING THE STATEMENT OF CASH FLOWS
Solutions to Questions, Exercises, Problems, and Teaching Notes to Cases
3.1 Need for a Statement of Cash Flows. The amount of revenue recognized equals
the amount of cash the firm expects to collect from customers. However, the firm
does not necessarily recognize the revenue at the time it receives the cash. It typically
recognizes revenue at the time of sale even though it has not yet collected cash
from customers. Likewise, the amount of expense recognized equals the cash disbursement
made for equipment, materials, labor, and so on. However, the firm
recognizes the expense when it consumes the services of these factor inputs, not
when it makes the cash expenditure. Thus, accrual accounting ignores the timing of
cash flows related to revenues and expenses, creating the need for a financial statement that
reports how revenues and expenses affect cash flows. Furthermore, the
income statement typically reports only a portion of the effects of investing and
financing each period. Depreciation expense is the portion of the cost of depreciable
assets allocated to the period. Interest expense is the portion of the cost of debt financing
allocated to the period. Reported amounts of depreciation for any particular
period usually do not equal the cash flows associated with acquisitions and sales of
depreciable assets during the period. Likewise, reported amounts of interest for any
period do not equal the cash flows associated with increases and decreases in debt
financing. Thus, the need arises for a separate financial statement that reports how
investing and financing activities affect cash flows beyond any affect on accrualbased net
income.
3.2 Requirement for Managers to Provide a Statement of Cash Flows. You can
always approximate a statement of cash flows given a balance sheet and income
statement. However, the key point is that this statement would just be a reasonable
approximation. There are numerous reasons why such an approximation would be
incorrect or imprecise. First, some information that is required may not actually be
disclosed on the balance sheet or income statement. For example, depreciation
expense is often not shown on the income statement separately. Similarly,
presentation of assets and liabilities often aggregates individual accounts that might
be necessary to uncover actual cash flows, like cash settlements for litigation for
example. Second, using changes in balance sheet accounts as an estimate of the
underlying difference between amounts included in earnings and actual cash flows is
affected by at least four sources of error: (i) acquisitions and divestitures, (ii) noncash
transactions, (iii) changes in contra accounts, and (iv) foreign currency translation.

Structure of the Statement of Cash Flows. The statement of cash flows reconciles
net income (at the top of the statement) to net change in cash (at the bottom). In
between, we first see the section for operating activities, followed by investing
activities and then financing activities. For a start-up firm, financing is the first type
of cash flows that will occur. After financing has occurred, the firm will then invest
in productive assets, which would be shown in the investing activities. Finally, after
investments in productive assets have been made, the firm will begin using and
generating operating cash flows. Thus, for a start-up firm, the cash flow activity
begins at the bottom (i.e., financing activities) and then works up through investing
activities to operating activities. In contrast, for a firm that is fully operational, it is
more straightforward to think first about the ability of the firm to generate operating
cash flows, then the use of those cash flows to fund investing activities and repay
providers of capital (i.e., financing activities). Occasionally, financing activities will
be engaged for investing activities, so the bottom two sections tend to operate
together conditional on realized cash flows from operations.
3.4 Articulation of the Statement of Cash Flows with Other Financial
Statements.
The statement of cash flows begins with net income (for firms using the indirect
method, which includes most firms), and net income is the summary bottom-line
performance measure from the income statement. The statement of cash flows culminates with
computed net change in cash and cash equivalents, which reconciles
with the beginning and ending balances of cash and cash equivalents on the balance
sheet. The balance sheet and income statement are linked through retained earnings,
which increases with net income (from the income statement).
3.5 Classification of Interest Expense. For many users, the explanation for why
interest expense is classified as an operating activity under U.S. GAAP is hard to understand
because it is clearly a cost of financing. In fact, of the seven members of the
FASB, three dissented to the requirement to include interest expense in operating
activities, arguing that costs of financing are a financing activity. Nevertheless, the
classification in the statement of cash flows parallels that in the income statement,
where interest on debt is an expense but payments on the principal amount of the
debt are not an expense, but a reduction in a liability. The overarching rule seems to
be that “if it’s in the income statement, it is operating.” The FASB considered the
classification of interest expense as a financing activity, but ultimately concluded
that “This Statement does, however, require that the amount of interest paid during
a period (net of amounts capitalized) be disclosed, which will permit users of financial
statements who wish to consider interest paid as a financing cash outflow to do
so” (para. 90 of SFAS No. 95). Note that IFRS permits companies to classify interest expense as
an operating or financing activity so long as the treatment is consistently followed.