BM2003

BASIC FINANCIAL STATEMENTS III

Statement of Cash Flows
The statement of cash flows simply shows the inflow and outflow of cash arising from the operating,
financing, and investing activities of the business.
According to Weygandt, Kimmel, and Kieso (2020), the statement of cash flow helps the users assess the
following:
1. The entity’s ability to generate future cash flows. By examining relationships between items in the
statement of cash flows, investors can make predictions of the amounts, timing, and uncertainty of
future cash flows better than they can from accrual-basis data.
2. The entity’s ability to pay dividends and meet obligations. If a company does not have adequate cash,
it cannot pay employees, settle debts, or pay dividends. Employees, creditors, and stockholders
should be particularly interested in this statement because it alone shows the flows of cash in a
business.
3. The reasons for the difference between net income and net cash provided (used) by operating
activities. Net income includes information on the success or failure of a business. However, some
financial statement users are critical on accrual-basis net income because it requires many estimates.
As a result, users often challenge the reliability of the number.
4. Cash investing and financing transactions during the period. By examining a company’s investing and
financing transactions, a financial statement reader can better understand why assets and liabilities
changed during the period.
Three (3) Activities in the Statement of Cash Flow
• Operating Activities - These are revenues and expenses transactions arising from the normal
operating cycle of the business. Examples of these activities are the sale of goods or services, interest
and dividends received, payment to suppliers, wages, taxes, interest for lenders, and other operating
expenses.
• Investing Activities - These are inflows and outflows of cash generated from transactions involving
fixed assets, investments, and sale of securities. Examples of these activities are acquisition and sale
of property, plant, and equipment, purchase, and sale of investment in debt or equity securities, loan
transaction to other entities.
• Financing Activities - These include transactions involving noncurrent liabilities and stockholders’
equity. Examples of these activities are the sale of common stocks, issuance of bonds, payment of
dividends to stockholders, and redemption of long-term debt.
Preparing Statement of Cash Flows
Companies prepare the statement of cash flows differently from the three (3) other basic financial
statements. First, it is not made from an adjusted trial balance. It requires detailed information concerning
the changes in account balances that occurred between two (2) points in time. An adjusted trial balance
will not provide the necessary data. Second, the statement of cash flows deals with cash receipts and
payments. As a result, the company adjusts the effects of the use of accrual accounting to determine cash
flows. The information to prepare this statement comes from three (3) sources (Weygandt, Kimmel, &
Kieso, 2018):

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• Comparative balance sheets - Information in the comparative balance sheets indicate the amount of
the changes in assets, liabilities, and stockholders’ equity from the beginning to the end of the period.
• Current income statement - Information in this statement helps determine the amount of net cash
provided or used by operating activities during the period.
• Additional information - Such information includes transaction data that are needed to determine
how cash was provided or used during the period.
Preparing the statement of cash flows from these data sources involves three (3) significant steps:
Step 1. Determine net cash provided/used by operating activities by converting net income from an
accrual basis to a cash basis. This step involves analyzing not only the current year’s income
statement but also comparative balance sheets and selected additional data.
Step 2. Analyze changes in noncurrent asset and liability accounts and stockholders’ equity accounts and
record as investing and financing activities, or disclose as noncash transactions. This step involves
analyzing comparative balance sheet data and selected additional information for their effects
on cash.
Step 3. Compare the net change in cash on the statement of cash flows with the change in the cash
account reported on the balance sheet to make sure the amounts agree. The difference between
the beginning and ending cash balances can be easily computed from comparative balance
sheets.
There are two (2) methods used in preparing the statement of cash flows - the indirect method and the
direct method. The only difference between the two (2) methods is on the part of operating activities.

Indirect Method
The indirect method begins the statement of cash flows with net income. Then, net income is adjusted for
items that do not affect cash. In effect, the net income is converted from accrual net income to cash flows
from operating activities.
OPERATING ACTIVITIES

𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 +⁄− 𝐴𝑑𝑗𝑢𝑠𝑡𝑚𝑒𝑛𝑡𝑠 ∗ = 𝑁𝑒𝑡 𝑐𝑎𝑠ℎ 𝑝𝑟𝑜𝑣𝑖𝑑𝑒𝑑 𝑜𝑟 𝑢𝑠𝑒𝑑 𝑏𝑦 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑖𝑒𝑠

*Typical types of adjustments

➢ Depreciation expense - It is a non-cash expense arising from the portion of property, plant, and
equipment’s cost that is being used up as of the specific period. In accrual accounting, it reduces net
income. The amount of depreciation deducted is added back to negate the effects of reduction to
bring the balance of net income to net cash provided by operating activities. This method also applies
to amortization.
For example, the DEF Company income statement reports depreciation expense amounting to
P25,000. Assuming that the net income in that year is P238,000. If there were no other non-cash
items, DEF then presents depreciation expense in the statement of financial position as follows:
Net income P238,000
Adjustment:
Depreciation expense 25,000
Net cash provided by operating activities P263,000

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➢ Gain or loss on disposal of plant assets - These are increases or decreases in net income brought by
the destruction or sale of plant assets. Since these transactions affect the net income, they are added
back (loss) and deducted (gain) to the net income to arrive at the adjusted balance of cash provided
by operating activities.
For example, the DEF Company income statement reports depreciation expense amounting to
P25,000. Assuming that the net income in that year is P2,380,000. Also, the company sold two (2) of
its major equipment. Equipment AX1001 costing P1,000,000 was sold for 1,050,000, while equipment
AX1002 with a cost of P1,280,000 was sold for P1,170,000. The company recorded no other noncash
items. DEF then reports the net cash provided by operating activities as follows:

Net income P2,380,000

Adjustment provided by operating
activities: Depreciation expense 250,000
Gain on disposal of equipment (AX001) (50,000)
Loss on disposal of equipment (AX002) 110,000
Net cash provided by operating activities P2,690,000
Note: Cash received on sale or disposal of plant assets is reported under the investing activities.
Always remember that only the gain or loss is recorded under the operating activities section of the
statement of financial position in any sale transaction of plant assets.
➢ Changes to Non-cash Current Assets and Current Liability Accounts – Accrual accounting recognizes
revenue when earned and records expenses when it is incurred. Since these two (2) accounts do not
usually coincide with the flow of cash, and it affects the current asset and current liability accounts,
an adjustment should be made to determine its impact on net income to arrive at the net cash
provided by operating activities.
o Changes in Non-cash Current Assets - Increases in current assets are deducted from net income,
whereas the decreases are added to arrive at net cash provided by operating activities.
o Changes in Current Liabilities - Increases in current assets are added to net income, whereas the
decreases are deducted to arrive at net cash provided by operating activities.
SUMMARY OF ADJUSTMENTS AND ITS IMPACT ON NET INCOME
Required
Type of Adjustment Accounts Affected Adjustment in
Net Income
Depreciation expense Add
Noncash charges
Amortization expense Add
Loss on disposal of plant assets Add
Gains and Losses
Gain on disposal of plant assets Deduct
Changes in Current Increase in the current asset account Deduct
Assets Decrease in the current asset account Add
Changes in Current Increase in current liability Add
Liabilities Decrease in current liability Deduct

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INVESTING AND FINANCING ACTIVITIES

As discussed, transactions affecting current assets and current liabilities are both reported under
operating activities. These are not the only accounts that can be found in the statement of financial
position as there are other accounts such as noncurrent assets, noncurrent liabilities, and shareholders’
or stockholders’ equity. These accounts are found in the following sections of the statement of cash flows:
➢ Cash flow from investing activities - These include transactions affecting the noncurrent assets of the
company.
Following the example on Page 3, DEF purchased land worth P1,100,000 by directly exchanging bonds
for land. Also, the company acquired an office building for P1,200,000 cash. The equipment increased
by P170,000. This increase is the result of the following transactions: (1) purchase of equipment of
P250,000, and (2) the sale of equipment AX003 for P40,000 costing P80,000. DEF would then report
the cash flow from operating and investing activities as follows:

Net income P2,380,000

Adjustment provided by operating activities:
Depreciation expense 250,000
Gain on disposal of equipment (AX001) (50,000)
Loss on disposal of equipment (AX002) 110,000
Loss on sale of equipment (AX003) 40,000
Net cash provided/ (used) by operating activities P2,730,000

Cash flows from investing activities

Purchase of building (1,200,000)
Purchase of equipment (250,000)
Sale of equipment 40,000
Net cash provided/ (used) by investing activities P(1,410,000)
Note: The purchase of land is not included even though it is an investing activity because it does not
involve cash.
➢ Cash flow from financing activities - These include transactions affecting the noncurrent liabilities and
shareholders’ equity of the company.
Using the information given in the previous example, DEF also reports an increase in the Common
Stock of P200,000. It is indicated that this increase was a result of an issuance of a new share of stocks.
Retained earnings are also increased by P2,090,000 during the year. This figure comes from the net
income amounting to P2,380,000 and dividends of P290,000. DEF company would then report its
statement of cash flows as follows:
DEF COMPANY
Statement of Cash Flows
For the Year Ended December 31, 2X20
Net income P2,380,000
Adjustment provided by operating activities:
Depreciation expense 250,000
Gain on disposal of equipment (AX001) (50,000)
Loss on disposal of equipment (AX002) 110,000
Loss on sale of equipment (AX003) 40,000 350,000
Net cash provided/ (used) by operating activities 2,730,000

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Cash flows from investing activities

Purchase of building (1,200,000)
Purchase of equipment (250,000)
Sale of equipment 40,000
Net cash provided/ (used) by investing activities (1,410,000)
Cash flows from financing activities
Issuance of common stock 200,000
Payment of dividends (290,000)
Net cash provided/ (used) by financing activities (90,000)
Net increase in cash 1,230,000
Cash balance, beginning (assumed) 1,500,000
Cash balance, end 2,730,000

Direct Method
The direct method simply records the actual cash inflows and outflow of the company, such as cash
receipts and payments. These cash flows are netted to arrive at the net cash provided or used in the
operating activities, then added to the balances of both investing and financing activities.

OPERATING ACTIVITIES

𝐶𝑎𝑠ℎ 𝑟𝑒𝑐𝑒𝑖𝑝𝑡𝑠 − 𝐶𝑎𝑠ℎ 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 = 𝑁𝑒𝑡 𝑐𝑎𝑠ℎ 𝑝𝑟𝑜𝑣𝑖𝑑𝑒𝑑 𝑜𝑟 𝑢𝑠𝑒𝑑 𝑏𝑦 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑖𝑒𝑠

➢ Cash receipts from customers – This is computed by deducting from the sales revenue any increase in
accounts receivable for the period. On the other hand, decreases in accounts receivable should be
added, as shown below:
𝐶𝑎𝑠ℎ 𝑟𝑒𝑐𝑒𝑖𝑝𝑡𝑠 𝑓𝑟𝑜𝑚 𝑐𝑢𝑠𝑡𝑜𝑚𝑒𝑟𝑠
= 𝑆𝑎𝑙𝑒𝑠 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 +⁄− 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑜𝑟 𝐷𝑒𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
➢ Cash payments to suppliers - This is computed by adjusting the reported cost of goods sold with any
increase or decrease of inventory to arrive at the total purchases for the year. Then, the balance of
the purchases account would then be adjusted by any changes in accounts payable, as shown below:
Cash payments to suppliers = Cost of goods sold (+ Increase in inventory/ - Decrease in inventory)
(+ Decrease in accounts payable / - Increase in accounts payable)

➢ Depreciation expense and loss on disposal of plant assets – These are not reported under the direct
method as it does involve actual outflow of cash. The same rule will also be applied to amortization
and bad debts expense.
➢ Cash payments for interest - The interest expense included in the statement of cash flows is also the
same with the amount included in the income statement.
➢ Cash payment for taxes – This is computed by adjusting the income tax expense with the decrease or
increase in income taxes payable, as shown below:
Cash payments for taxes = Income tax expense (+ Decrease in income taxes payable/ - Increase in
inventory)

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INVESTING AND FINANCING ACTIVITIES

The investing and financing activities are reported the same under both the direct and indirect methods.
These two (2) parts recognize only the transactions that include outflows or inflows of cash.

Free Cash Flow

The success of any business is dependent on its efficiency and effectiveness in producing its products, and
the level of trust they have from their stakeholders, especially customers and investors. Similar to the
saying “there is no such thing as free lunch,” those things are not free as it entails cost such as cost of
investing in new equipment (capital expenditures) and dividends. Those costs, when deducted to net cash
provided by operating activities, is called the free cash flow.

𝑭𝒓𝒆𝒆 𝒄𝒂𝒔𝒉 𝒇𝒍𝒐𝒘 = 𝑁𝑒𝑡 𝑐𝑎𝑠ℎ 𝑝𝑟𝑜𝑣𝑖𝑑𝑒𝑑 𝑜𝑟 𝑢𝑠𝑒𝑑 𝑏𝑦 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑖𝑒𝑠 − 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠 −
𝐶𝑎𝑠ℎ 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠

For example, the following are derived from the Statement of Cash Flows of The Twisted Lab Company:

The Twisted Lab Company

Statement of Cash Flows
For the Year Ended December 31, 2X20
Cash provided by operating activities P1,581,300
Cash flows from investing activities
Additions to property and equipment P(115,250)
Purchases of investments (2,862,500)
Sale of investments 1,485,000
Acquisitions of companies (505,600)
Maturities of investments 778,750
Other (19,700)
Cash used by investing activities (1,239,300)
Cash paid for dividends (319,250)

Required: Compute for The Twisted Lab Company free cash flow.

Solution:
Cash provided by operating activities P1,581,300
Less: Expenditures on property, plant, and equipment 115,250
Dividends paid 319,250
Free cash flow P1,146,800

References
Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2018). Accounting principles 13th Ed. New Jersey: John Wiley
& Sons.

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