PREVIEW OF CHAPTER 23

ACCT2110 Intermediate Accounting II Week 11

Copyright ©2020 John Wiley & Sons, Inc. 1

Statement of Cash Flows Learning Objective 1
Describe the usefulness
and format of the
Primary purpose: statement of cash flows.

To provide information about a company’s

cash receipts and cash payments in a period.
Secondary objective:
To provide cash-basis information about the
company’s operating, investing, and financing
activities.
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Usefulness of the Statement of Cash Flows
Provides information to help assess:
1.Entity’s ability to generate future cash flows.
2.Entity’s ability to pay dividends and meet obligations.
3.Reasons for the difference between net income and
net cash flow from operating activities.
4.Cash and non-cash investing and financing
transactions during the period.

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Classifications of Cash Flows

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Classification of Typical Cash Inflows and Outflows
Operating Activities

ILLUSTRATION 23.1

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Classification of Typical Cash Inflows and Outflows
Investing and Financing Activities

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Cash and Cash Equivalents
The basis recommended by the I ASB for the statement of
cash flows is actually “cash & cash equivalents.” Cash
equivalents are short-term, highly liquid investments that
are both:
•Readily convertible to known amounts of cash, &
•So near their maturity that they present insignificant risk
of changes value in (e.g., due to changes in interest rates).
Only investments with original maturities of 3 months or
less qualify under this definition.

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Format of the Statement of Cash Flows

ILLUSTRATION 23.2

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 Preparing the Statement of Cash Flows
Three Sources of Information:
1.Comparative statements of financial position.
2.Current income statement data. Learning Objective 2
3.Selected transaction data. Prepare a statement
Three Major Steps: of cash flows.
Step 1. Determine change in cash.
Step 2. Determine net cash flow from operating activities.
Step 3. Determine net cash flows from investing and
financing activities.

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Illustrations—Tax Consultants Inc.
Illustration: Tax Consultants Inc. started on January 1,
2022, when it issued 60,000 shares of $1 par value
common stock for $60,000 cash. The company rented its
office space, furniture, and equipment, and performed
tax consulting services throughout the first year.
The comparative statements of financial position at the
start & end of the year 2022 appear in Illustration 23.3.
Illustration 23.4 shows the income statement &
additional information for Tax Consultants.

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Comparative Statements of Financial Position, Tax
Consultants Inc., Year 1

ILLUSTRATION 23.3

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Income Statement, Tax Consultants Inc., Year 1

ILLUSTRATION 23.4

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Step 1: Determine the Change in Cash

ILLUSTRATION 23.3

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Step 2: Determine the Net Cash Flow from
Operating Activities

• Company must determine revenues and

expenses on a cash basis.
• Eliminate the effects of income statement
transactions that do not result in an increase or
decrease in cash.
• Convert net income to net cash flow from
operating activities through either a direct
method or an indirect method.

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Net Income versus Net Cash Flow from Operating
Activities

ILLUSTRATION 23.5

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Increase in Accounts Receivable—Indirect Method
skip
Accounts receivable increased by $36,000 (from $0 to
$36,000) during the year.

ILLUSTRATION 23.6

When the Accounts Receivable balance increases, cash receipts

are lower than revenue earned under the accrual basis.

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Increase in Accounts Payable—Indirect Method
Accounts payable increased by $5,000 during the year.
When accounts payable increase in the year, expenses on an
accrual basis exceed those on a cash basis.
skip

ILLUSTRATION 23.7
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 Step 3: Determine Net Cash Flows from Investing and
Financing Activities
After Tax Consultants has computed the net cash from operating activities,
next is to determine whether any other changes in the statement of
financial position accounts caused an increase or decrease in cash.
An examination of the remaining statement of financial position accounts
for Tax Consultants shows increases in both ordinary shares & retained
earnings. The Share Capital—Ordinary increase of $60,000 resulted from
the issuance of ordinary shares for cash. The issuance of ordinary shares
is reported in the statement of cash flows as a receipt of cash from a
financing activity.
Two items caused the retained earnings increase of 20,000:
1.Net income of $34,000 increased retained earnings.
2.Declaration of $14,000 of dividends decreased retained earnings.

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Statement of Cash Flows, Tax Consultants Inc., Year 1

ILLUSTRATION 23.8

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Comparative Statements of Financial Position, Tax
Consultants Inc., Year 2

ILLUSTRATION 23.9
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Income Statement, Tax Consultants Inc., Year 2

ILLUSTRATION 23.10
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Step 1: Determine the Change in Cash, Year 2

ILLUSTRATION 23.9

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Decrease in Accounts Receivable, Year 2

ILLUSTRATION 23.9

Accounts receivable decreased during the period because cash

receipts (cash-basis revenues) are higher than revenues
reported on an accrual basis.
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Increase in Prepaid Expenses, Year 2

ILLUSTRATION 23.9

When prepaid expenses (assets) increase during a period, expenses on

an accrual-basis income statement are lower than they are on a cash-
basis income statement.

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 Increase in Accounts Payable, Year 2

ILLUSTRATION 23.9

Like the increase in 2022, Tax Consultants must add the 2023 increase of $35,000 in
accounts payable to net income, to convert to net cash flow from operating activities.
The company incurred a greater amount of expense than the amount of cash it
disbursed.

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Increase in Accumulated Depreciation, Year 2

ILLUSTRATION 23.9
Tax Consultants’ depreciation expense of $21,000 (also represented by the increase in
accumulated depreciation) is a non-cash charge; the company adds it back to net
incomeed, to arrive at net cash flow from operating activities. The $21,000 is the sum
of the $11,000 depreciation on the building and $10,000 depreciation on the
equipment.

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Computation of Net Cash Flow from Operating
Activities, Year 2—Indirect Method

ILLUSTRATION 23.11

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Step 3: Determine Net Cash Flow from Investing and
Financing Activities, Year 2

After you have determined the items affecting

net cash provided by operating activities, the
next step involves analyzing the remaining
changes in the statement of financial position
accounts.

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Increase in Land

ILLUSTRATION 23.9

The company purchased land for $70,000 during the period. The
transaction is a cash outflow, reported as an investing activity.
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Increase in Building

ILLUSTRATION 23.9

The company acquired an office building for $200,000 cash. This

transaction is a cash outflow, reported in the investing section.

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Increase in Equipment

ILLUSTRATION 23.9
An increase in equipment of $68,000 resulted because the company used cash to purchase
equipment. This transaction is a cash outflow, reported in the investing section.

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Increase in Bonds Payable

ILLUSTRATION 23.9

The Bonds Payable account increased $150,000. Cash received from the issuance of
these bonds represents an inflow of cash from a financing activity.

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Increase in Retained Earnings, Year 2

ILLUSTRATION 23.9
Retained earnings increased $116,000 during the year. Two factors explain this
increase: (1) net income of $134,000 increased retained earnings, and (2) dividends
of 18,000 decreased retained earnings.

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Statement of Cash Flows, Tax Consultants Inc., Year 2

ILLUSTRATION 23.12

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Sources of Information for the Statement of Cash
Flows
1. Comparative statements of financial position.
2. An analysis of the Retained Earnings account.
3. All changes that have passed through cash or
have resulted in an increase or decrease in
cash.
4. Write-downs, amortization charges, and
similar “book” entries, such as depreciation,
because they have no effect on cash.

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Indirect Method—Additional Adjustments
Relatively +ve Relatively -ve to
to cash flow cash flow

Reduce Op
income, no cash
paid

Means to
pay cash
OR no
cash
received

ILLUSTRATION 23.17

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Direct Method —An Example
Learning Objective 3
Contrast the direct and indirect methods of calculating net cash flow from operating
activities.

ILLUSTRATION 23.19
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Direct Method—An Example (continued)
Drogba’s December 31, 2022, income statement and
additional information are as follows.

ILLUSTRATION 23.20

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Major Classes of Cash Receipts and Payments

Relatively
Relatively
less cash
more cash

ILLUSTRATION 23.21
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Operating Activities—Direct Method
Cash Receipts from Customers
Accounts receivable increased €15,000. Thus, cash
receipts from customers are computed as follows.

-ve to cash
ILLUSTRATION 23.22

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Operating Activities—Direct Method
Cash Payments to Suppliers
Drogba SA reported cost of goods sold of €450,000 on its
income statement. In 2022, Drogba’s inventory increased
€160,000. The company computes purchases as follows.

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Operating Activities—Direct Method
Cash Payments to Suppliers (continued)
Drogba determines cash payments to suppliers by
adjusting purchases for the change in accounts payable.

+ve to cash

ILLUSTRATION 23.23

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Operating Activities—Direct Method
Cash Payments for Operating Expenses
Drogba reported operating expenses of €160,000 on its
income statement. To determine the cash paid for operating
expenses, it must adjust this amount for any changes in
•prepaid expenses and
•accrued expenses payable. - ve to cash
+ ve to cash

ILLUSTRATION 23.24

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Operating Activities—Direct Method
Cash Payments for Income Taxes
The income statement for Drogba shows income tax expense of
€48,000. This amount equals the cash paid. How do we know
that? Because the comparative statement of financial position
indicated no income taxes payable at either the beginning or end
of the year. Cash paid for income taxes is computed by taking the
expense and adjusting by the change in the payable.

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 Summary of Net Cash Flow from Operating
Activities—Direct Method
ILLUSTRATION
23.25

ILLUSTRATION 23.26

Direct
Method

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Reconciliation of Net Income to Net Cash Provided
by Operating Activities, 2022
When companies use the direct method they are required to
provide in a separate schedule the reconciliation of net income
to net cash provided by operating activities.

ILLUSTRATION 23.27

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Adjustments to Net Income
Depreciation, Amortization and Postretirement Benefit Costs
Learning Objective 4
Discuss special problems in preparing a
statement of cash flows.
Depreciation and Amortization
•Amortization of limited-life intangible assets.
•Amortization of bond discount or premium.
Postretirement Benefit Costs
•Company must adjust net income by the
difference between cash paid and the expense
reported.

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Adjustments to Net Income
Changes in Deferred Income Taxes and Equity Method of Accounting

Changes in Deferred Income Taxes

•Affect net income but have no effect on cash.
Equity Method of Accounting
•Net increase in the investment account does not
affect cash flows.
•Company must deduct the net increase from net
income to arrive at net cash flow from operating
activities.

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 Adjustments to Net Income- Losses and Gains
1. Losses and Gains
2. A loss is added to net income to compute net cash flow from
operating activities because the loss is a noncash charge in
the income statement.
3. Company reports a gain in the statement of cash flows as
part of the cash proceeds from the sale of equipment under
investing activities, thus it deducts the gain from net income
to avoid double-counting—once as part of net income and
again as part of the cash proceeds from the sale.

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Adjustments to Net Income
Share-Based Compensation

Share-Based Compensation
•Cash is not affected by recording the expense.
•The company must increase net income by the
amount of compensation expense from share
options in computing net cash flow from
operating activities.

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Accounts Receivable (Net)
Up to this point, we assumed no allowance for doubtful accounts—
a contra account—to offset accounts receivable. However, if a
company needs an allowance for doubtful accounts, how does the
allowance affect the company’s determination of net cash low rom
operating activities? Assume that Redmark AG reports net income
of €40,000. It has the following accounts receivable balances.

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ILLUSTRATION 23.28 51
Accounts Receivable (Net) Indirect Method
One method of presenting this information in the statement of
cash flows:

ILLUSTRATION 23.29

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Net Approach to Allowance for Doubtful
Accounts—Indirect Method
Alternate method (net approach) of presenting this information
in the statement of cash flows:

ILLUSTRATION 23.30

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Accounts Receivable (Net) Direct Method
Company should not net Allowance for Doubtful Accounts
against Accounts Receivable.

ILLUSTRATION 23.31

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Accounts Receivable (Net) Direct Method (continued)
If Redmark deducts the €9,000 increase in accounts receivable (net) from sales for the
year, it would report cash sales at €91,000 (€100,000 − €9,000) and cash payments for
operating expenses at €60,000. Both items would be misstated: Cash sales should be
reported at €85,000 (€100,000 − €15,000), and total cash payments for operating
expenses should be reported at €54,000 (€60,000 − €6,000).

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Other Working Capital Changes
Some changes in working capital, although they affect
cash, do not affect net income.
•Purchase of short-term non-trading equity securities.
•Issuance of a short-term non-trade note payable for
cash.
•Cash dividend payable.

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Net Losses
Illustration: If the net loss is £50,000 and the total amount of
charges to add back is £60,000, then net cash provided by
operating activities is £10,000.

ILLUSTRATION 23.33

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Disclosures
Significant Non-Cash Transactions
Common noncash transactions that a company should report
or disclose:
1.Acquisition of assets by assuming liabilities (including
finance lease obligations) or by issuing equity securities.
2.Exchanges of non-monetary assets.
3.Refinancing of long-term debt.
4.Conversion of debt or preference shares to ordinary shares.
5.Issuance of equity securities to retire debt.

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Learning Objective 5
Explain the use of worksheet in preparing a statement of cash flows.
A worksheet involves the following steps.
Step 1. Enter the statement of financial position accounts and
their beginning and ending balances in the statement of
financial position accounts section.
Step 2. Enter the data that explain the changes in the
statement of financial position accounts and their effects on
the statement of cash flows in the reconciling columns of the
worksheet.
Actual practice at work, not
Step 3. Enter the increase or decrease in cash on the cash line
examined
and at the bottom of the worksheet. This entry should enable
the totals of the reconciling columns to be in agreement.

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Update the course outline
Week 11 classwork
E23-3, E23-16
 
Week 11 homework
^ P23-2, additional exercise

End
End of
of Chapter
Chapter