4-1

Topic 4 -- Statement of Cash

Flows: Effects Operating, Investing,
Financing Activities on Cash Flows

FINANCIAL ACCOUNTING
AN INTRODUCTION TO CONCEPTS,
METHODS, AND USES
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Learning Objectives

1. Understand why using the accrual basis of

accounting creates the need for a statement of
cash flows.
2. Understand the types of transactions that
result in cash flows.
3. Develop an ability to prepare a statement of
cash flows from a comparative balance sheet
and income statement.
4. Develop an ability to analyze the statement of
cash flows.
4-3 1. Overview of the
Statement of Cash Flows

The statement of cash flows …

(a) explains the reasons for a change in cash.
(b) classifies the reasons for the change as an
operating, investing or financing activity.
(c) reconciles net income with cash flow from
operations.
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Classification of Cash Flows

1. Operations -- cash flows related to selling goods

and services; that is, the principle business of
the firm.
2. Investing -- cash flows related to the acquisition
or sale of noncurrent assets.
3. Financing -- long term and short term cash
flows related to liabilities and owners’ equity;
dividends are a financing cash outflow.
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Example of
a Statement
of Cash
Flows

Exhibit 4.1
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Components of the Statement of Cash Flows

Cash received from Cash paid for

cash flow
Operations sale of goods - operating goods = from operations
and services and services

+-
Cash received from Cash paid for ac-
cash flow
Investing sales of investments - quisition of invest- = from investing
and PP&E ments and PP&E

Cash paid for

+-
Cash received from
dividends and cash flow
Financing issue of debt or - reacquisition of = from financing
capital stock
debt or capital stock
=
Figure 4.1 Net change in cash
for the period
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2. Preparing the Statement of Cash Flows

Firms could prepare the cash flow statement

directly from the cash account. Most, however,
find it more efficient to prepare the cash flow
statement from the balance sheet and income
statement.
(a) Direct and indirect methods.
(b) Algebraic formulation will present the
underlying concept of the cash flow statement.
(c) Two approaches to producing the cash flow
statement: columnar worksheet and t-account
worksheet.
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2.a. Direct and Indirect Methods

 Direct method of presentation calculates cash

flow from operations by subtracting cash
disbursements to supplies, employees, and
others from cash receipts from customers.
 The indirect method calculates cash flow from
operations by adjusting net income for
noncash revenues and expenses.
 Most firms present their cash flows using the
indirect method.

Copyright  2000 by Harcourt Inc. All rights reserved.

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2.b. Algebraic Formulation

Recall the basic accounting equation:

Assets = Liabilities + Shareholders’ Equity
or A = L + SE
Assets are either cash (C) or not (N$A), so
C + N$A = L + SE
 C +  N$A =  L +  SE
Where  means the change in the balance,
Rearranging gives the basic equation for the
statement of cash flows:
 C =  L +  SE -  N$A
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2.b. Algebraic Formulation (Cont.)

 C =  L +  SE -  N$A
 The change in cash,  C, is the increase or
decrease in the cash account.
 This amount must equal changes in liabilities
plus changes in shareholders’ equity minus
changes in assets other than cash.
 Thus, we can identify the causes in the change
in the cash account by studying the changes in
non-cash accounts.
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2.c. Two Approaches to
Producing the Cash Flow Statement

The basic formula can be implemented using

either of two approaches:
1. Columnar worksheet-- changes in balance
sheet accounts are classified by definition
using a multicolumn worksheet.
2. T-Account worksheet -- changes are classified
by analysis of the t-accounts.
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2.c.1. Columnar Worksheet

 Works well for relatively simple situations

involving few transactions.
 Enhances understanding of the cash flow
statement.
 Does not work as well as the T-account
method when the number and complexity of
transactions increases.
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2.c.1. Columnar Worksheet (Cont.)

Begin with a comparative balance sheet.

1. Compute the change in each balance sheet
account.
2. Classify each change as operating, investing or
financing activity.
2. Make any needed adjustments (for example,
for a sale of a long-lived asset).
4. Recast the classified changes in the form of a
cash flow statement.
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Noncash Expenses

 Noncash expenses, such as depreciation

expense, are added back.
 Not truly sources of cash, even though they
are associated with cash inflows; rather, a
reversal of the accrual process that required
the expenses to be recognized without regard
for the cash flow.
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Changes in Specific Accounts

increase decrease
If noncash assets If noncash assets
Non- are increased, are decreased,
cash then cash was spent, then they provided cash
Assets so cash is an outflow, so cash is an inflow,
so negative sign. so positive sign.
If liab. or S.E. If liab. or S.E.
Liabilities increased, then cash decreased, then cash
and was obtained, was spent,
Shareholders’ so cash in an inflow, so cash in an outflow,
Equity so positive sign. so negative sign.
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2.c.2. T-account Worksheet

 The columnar works well when the change in each

balance sheet account affects only one of the three
types of activities. It becomes cumbersome for more
complex (and realistic) situations.
 The T-account approach is a direct extension of T-
accounts - facilitates analysis of a transaction which
involves more than one activity.
 For example, the change in Retained Earnings can be
due to both net income (operating activity) and
dividends (financing activity).
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2.c.2. T-account Worksheet

1. Obtain beginning and ending balance sheets.

2. Prepare a T-account worksheet with a master
account, cash, divided into operating,
investing and financing sections.
3. Explain the change in the master cash account
by reconstructing the original entries in a
summary form.
4. Make any necessary adjustments.
5. Recast the master account in the format of a
cash flow statement.
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2.c.2. T-account Worksheet (Cont.)

Various Balance Sheet Accounts Cash

beginning beginning
balance balance
nnnnnn
3. this
ending part of the
balance 2. these are Operations
nnnnnn
offset by an cash
1. adjustments are opposite entry account
Investing becomes
made to all balance in the cash
sheet accounts to account. the cash
Financing flow
bring the beginning
balance to the ending statement.
ending
balance.
balance
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3. Effects of a Sale of
a Long-Term Assets on Cash Flows

 A few transactions complicate the derivation of

a cash flow statement from a comparative
balance sheet, for example, the sale of a long-
term (or fixed) asset.
 Recall the journal entry for the sale of an asset:

Cash nnnn
Accumulated Depreciation nnnn
Asset nnnn
Gain (or loss) on sale nnnn
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3. Sale of an Asset (Cont.)
 Each of the four parts of the above journal entry
require an adjustment in the cash flow statement.
 The first line, cash, adds a line to the investing section.
 The second line, a debit to accumulated depreciation,
increases the depreciation expense above the change in
the change in the accumulated depreciation account.
 The third line, a credit to the asset, increases the
amount of cash invested in long-lived assets above the
change in the fixed asset accounts.
 The fourth line, a gain or loss, is reversed out in the
operating sections since this is not a cash flow.
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Comparison of Cash Flow to Net Income
 Net income is an accrual based concept and purports to show
the long-term.
 Cash flows purport to show the short term.
 Consider the outlook for both short-term and long-term and
consider that each is either good or poor.
 A strong growing firm would show both good long-term and
good short-term outlooks.
 A failing firm would show both poor long-term and poor short
term outlooks.
 What about a firm with good cash flows (short-term) but poor
net income (long-term)?
 What about a firm with poor cash flows (short-term) but good
net income (long-term)?
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4. An International Perspective

 The International Accounting Standards Board

(IAS No. 7) recommends but does not require a
statement of cash flows.
 An approximation to a cash flow statement can
be prepared from a comparative balance sheet
with some additional information.
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Summary
 The statement of cash flows is presented. It
reports the effects on cash flows of a firm’s
operating, investing and financing activities.
 Information in this statement helps in
understanding:
1. How operations affect liquidity,
2. The level of capital expenditures needed to
support growth, and
3. The major changes in financing.
 Two methods are presented to produce a cash
flow statement from a comparative balance
sheet.