Chapter 12 – Statement of Cash Flows
12-1
CHAPTER 12
STATEMENT OF CASH FLOWS
Learning Objectives and Related Assignment Materials
Learning Objectives
Mini-
Exercises
Exercises
Problems
Alternate
Problems
Cases and
Projects
1. Classify cash flow statement items as
part of net cash flows from operating,
investing, and financing activities.
1, 3
1, 2, 3, 4,
5
1, 2
1, 2
4, 6, 7
2. Report and interpret cash flows from
operating activities using the indirect
method.
2
6, 7, 8, 9,
10, 11,
14, 16
1, 2, 5
1, 2
1, 2, 4, 5,
6, 7
3. Analyze and interpret the quality of
income ratio.
4
14
3, 7
4. Report and interpret cash flows from
investing activities.
5
15, 16,
17
1, 2, 5
1, 2
1, 2, 4, 7
5. Analyze and interpret the capital
acquisitions ratio.
17, 18
3, 7
6. Report and interpret cash flows from
financing activities.
6
15, 16,
17
1, 2, 5
1, 2
1, 2, 4, 6,
7
7. Understand the format of the cash
flow statement and additional cash
flow disclosures.
7
18
Chapter Supplement A: Reporting cash
flows from operating activities –
indirect method
19, 20,
21
3, 4
3
Chapter Supplement B: Adjustment for
gains and losses on sale of long-term
assets: indirect method
12, 13
5
Chapter Supplement C: T-account
approach (indirect method)
22
6
Synopsis of Chapter Revisions
Focus Company: National Beverage Corporation
▪ Statement of cash flows coverage moved to Chapter 12.
▪ Focus and contrast company data updated.
▪ New GUIDED HELP feature provides free access to step-by-step video instruction on preparing the
operating section of the statement of cash flows using the indirect method.
▪ New Demonstration Case illustrating preparation of the complete statement of cash flows based on the
comparative balance sheet and other related information.
▪ New Chapter Supplement C (and related problem material) illustrates preparation of the statement of
cash flows using the complete T-account approach.
▪ New CONTINUING CASE involving preparation of the complete statement of cash flows for Pool
Corporation, a public company.
Chapter 12 – Statement of Cash Flows
Synopsis of Chapter Revisions, continued
▪ New and updated real companies, as well as modified accounts, names, and amounts for fictional
companies in end-of-chapter exercises, problems, and cases.
PowerPoint Slides
Learning Objectives
PowerPoint® Slides
1. Classify cash flow statement items as part of net cash flows from operating,
investing, and financing activities.
13-1 through 13-6
2. Report and interpret cash flows from operating activities using the indirect
method.
13-7 through 13-23
3. Analyze and interpret the quality of income ratio.
13-24
4. Report and interpret cash flows from investing activities.
13-25 through 13-27
5. Analyze and interpret the capital acquisitions ratio.
13-28
6. Report and interpret cash flows from financing activities.
13-29 through 13-35
7. Understand the format of the cash flow statement and additional cash flow
disclosures.
13-36
Chapter Supplement A: Reporting cash flows from operating activities –
indirect method
13-37 through 13-38
Chapter Supplement B: Adjustment for gains and losses on sale of long-term
assets: indirect method
13-39
Chapter Supplement C: T-account approach (indirect method)
13-40 through 13-42
Related Video Program
Chapter 12 – Statement of Cash Flows
12-3
Chapter Take-Aways
1. Classify cash flow statement items as part of net cash flows from operating, investing, and
financing activities.
The statement has three main sections: Cash Flows from Operating Activities, which are related to
earning income from normal operations; Cash Flows from Investing Activities, which are related to
the acquisition and sale of productive assets; and Cash Flows from Financing Activities, which are
related to external financing of the enterprise. The net cash inflow or outflow for the year is the same
amount as the increase or decrease in cash and cash equivalents for the year on the balance sheet.
Cash equivalents are highly liquid investments with original maturities of three months or less.
2. Report and interpret cash flows from operating activities—Indirect method.
The indirect method for reporting cash flows from operating activities reports a conversion of net
income to net cash flow from operating activities. The conversion involves additions and subtractions
for (1) noncurrent accruals including expenses (such as depreciation expense) and revenues which do
not affect current assets or current liabilities and (2) changes in each of the individual current assets
(other than cash and short-term investments) and current liabilities (other than short-term debt to
financial institutions and current maturities of long-term debt, which relate to financing), which
reflect differences in the timing of accrual basis net income and cash flows.
3. Analyze and interpret the quality of income ratio.
Quality of income ratio (Cash Flow from Operating Activities ÷ Net Income) measures the portion of
income that was generated in cash. A higher quality of income ratio indicates greater ability to
finance operating and other cash needs from operating cash inflows. A higher ratio also indicates that
it is less likely that the company is using aggressive revenue recognition policies to increase net
income.
4. Report and interpret cash flows from investing activities.
Investing activities reported on the cash flow statement include cash payments to acquire fixed assets
and short- and long-term investments and cash proceeds from the sale of fixed assets and short- and
long-term investments.
5. Analyze and interpret the capital acquisitions ratio.
The capital acquisitions ratio (Cash Flow from Operating Activities ÷ Cash Paid for Property,
Plant, and Equipment) reflects the portion of purchases of property, plant, and equipment financed
from operating activities without the need for outside debt or equity financing or the sale of other
investments or fixed assets. A high ratio benefits the company because it provides the company with
opportunities for strategic acquisitions.
6. Report and interpret cash flows from financing activities.
Cash inflows from financing activities include cash proceeds from issuance of short- and long-term
debt and common stock. Cash outflows include cash principal payments on short– and long-term debt,
cash paid for the repurchase of the company’s stock, and cash dividend payments. Cash payments
associated with interest are a cash flow from operating activities.
Chapter 12 – Statement of Cash Flows
12-4
7. Understand the format of the cash flow statement and additional cash flow disclosures.
The statement of cash flows splits transactions that affect cash into three categories: Operating,
Investing, and Financing Activities. The operating section is most often prepared using the indirect
method that begins with Net Income and adjusts the amount to eliminate non-cash transactions.
Noncash investing and financing activities are investing and financing activities that do not involve
cash. They include, for example, purchases of fixed assets with long-term debt or stock, exchanges of
fixed assets, and exchanges of debt for stock. These transactions are disclosed only as supplemental
disclosures to the cash flow statement along with cash paid for taxes and interest under the indirect
method.
Key Ratios
Quality of income ratio indicates what portion of income was generated in cash. It is computed as
follows:
Quality of Income Ratio = Cash Flow from Operating Activities ÷ Net Income
Capital acquisitions ratio measures the ability to finance purchases of plant and equipment from
operations. It is computed as follows:
Cash Acquisitions Ratio =
Cash Flow from Operating Activities ÷ Cash Paid for Property, Plant, and Equipment
Finding Financial Information
Balance Sheet
Changes In Assets, Liabilities, and
Stockholders’ Equity
Income Statement
Net Income and Noncurrent Accruals
Statement of Cash Flows
Cash Flows From Operating Activities
Cash Flows From Investing Activities
Cash Flows From Financing Activities
Separate Schedule (or note)
Non-cash investing and financing activities
Interest and taxes paid
Notes
Under Summary of Significant Accounting
Policies
Definition of cash equivalents
Under a Separate Note
If not listed on cash flow statement:
Non-cash investing and financing activities
Interest and taxes paid
Chapter 12 – Statement of Cash Flows
12-5
Chapter Outline
Teaching Notes
LO 1 – Classify cash flow statement items as part of net cash flows from operating, investing, and
financing activities.
I. Classification of the Statement of Cash Flows
Show Video Program #16
A. Cash and Cash Equivalents
1. Statement of cash flows explains how cash on the balance
sheet at the beginning of the period has become the cash
reported at the end of the period
Illustrated in Exhibit 12.1
2. “Cash” includes cash and cash equivalents – Short-term,
highly liquid investments that are both:
a. Readily convertible to known amounts of cash
b. So near to maturity there is little risk that their value
will change if interest rates change
3. Generally, only investments with original maturities (to
the entity holding the investment) of three months or less
qualify as a cash equivalent
B. Cash Flows from Operating Activities – Indirect and Direct
Methods
1. Cash flows from operating activities (cash flows from
operations) – Cash inflows and outflows directly related
to earnings from normal operations
2. Two alternative approaches for presenting the operating
activities section of the statement:
a. Direct method – reports components of cash flows
from operating activities as gross receipts and gross
payments
i. Although the FASB recommends the direct
method, it is rarely used in the U.S.; it is more
expensive to implement than the indirect method
ii. Both the FASB and the IASB are considering a
proposal to require this method
b. Indirect method – adjusts net income to compute cash
flows from operating activities
c. The two methods are simply alternative ways to arrive
at the same number
d. The total amount of cash flows from operating
activities is always the same, regardless of whether it
is computed using the direct or indirect method
e. Difference between the inflows and outflows is called
net cash inflow (outflow) from operating activities
C. Cash Flows from Investing Activities
1. Cash flows from investing activities – Cash inflows and
outflows related to the acquisition or sale of productive
facilities and investments in the securities of other
companies
2. Difference between these cash inflows and outflows is
called net cash inflow (outflow) from investing activities
Chapter 12 – Statement of Cash Flows
12-6
D. Cash Flows from Financing Activities
1. Cash flows from financing activities – Cash inflows and
outflows related to external sources of financing (owners
and creditors) for the enterprise
2. Difference between these cash inflows and outflows is
called net cash inflow (outflow) from financing activities
E. Net Increase (Decrease) in Cash
1. The combination of the net cash flows from operating
activities, investing activities, and financing activities
must equal the net increase (decrease) in cash for the
reporting period
2. Net cash provided by (used in) operating activities
+ Net cash provided by (used in) investing activities
+ Net cash provided by (used in) financing activities
+ Net increase in cash and cash equivalents
+ Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period
Refer students to Pause for
Feedback – Self-Study Quiz
F. Relationships to the Balance Sheet and Income Statement
1. To prepare the statement of cash flows, we need the
following data:
a. Comparative balance sheets used in calculating the
cash flows from all activities (operating, investing,
and financing)
b. A complete income statement used primarily in
calculating cash flows from operating activities
c. Additional details concerning selected accounts where
the total change amount in an account balance during
the year does not reveal the underlying nature of the
cash flows
2. Approach to preparing and understanding cash flow
statement focuses on changes in balance sheet accounts;
relies on manipulation of balance sheet equation:
Assets = Liabilities + Stockholders’ Equity
Cash + Noncash Assets = Liabilities + Stockholders’
Equity
Cash = Liabilities + Stockholders’ Equity − Noncash
Assets
Δ Cash = Δ Liabilities + Δ Stockholders’ Equity − Δ
Noncash Assets
3. Any transaction that changes cash must be accompanied
by a change in liabilities, stockholders’ equity, or noncash
assets
Illustrated in Exhibit 12.2
4. Next, compute the change in each balance sheet account
(Ending Balance – Beginning Balance) and classify each
change as relating to operating (O), investing (I), or
financing (F) activities by marking it with the
corresponding letter
Use Supplemental
Enrichment Activity #1
Chapter 12 – Statement of Cash Flows
12-7
a. The accounts that should be marked with an O include
the following:
Illustrated in Exhibit 12.3
i. Most current assets (other than short-term
investments, which relate to investing activities,
and cash)
ii. Most current liabilities (other than amounts owed
to investors and financial institutions, all of which
relate to financing activities)
iii. Retained Earnings because it increases by the
amount of net income: Retained Earnings also
decreases by dividends declared and paid, which is
a financing outflow noted by an F
b. The balance sheet accounts related to investing
activities should be marked with an I; these include all
of the remaining assets on the balance sheet:
Illustrated in Exhibit 12.3
i. Short-Term Investments
ii. Property, Plant, and Equipment, net
c. The balance sheet accounts related to financing
activities should be marked with an F; these include
all of the remaining liability and stockholders’ equity
accounts on the balance sheet:
Illustrated in Exhibit 12.3
i. Contributed Capital
ii. Retained Earnings (for decreases resulting from
dividends declared and paid)
LO 2 – Report and interpret cash flows from operating activities using the indirect method.
II. Reporting & Interpreting Cash Flows from Operating Activities
A. Reporting Cash Flows from Operating Activities– Indirect
Method
Use Supplemental
Enrichment Activity #2
1. The indirect method starts with net income and converts it
to cash flows from operating activities
2. This involves adjusting net income for the differences in
the timing of accrual basis net income and cash flows
3. The general structure of the operating activities section is:
Net income
Adjustments to reconcile net income to cash flow from
operating activities:
+ Depreciation and amortization expense
– Gain on sale of long-term asset
+ Loss on sale of long-term asset
+ Decreases in operating assets
+ Increases in operating liabilities
– Increases in operating assets
– Decreases in operating liabilities
Net Cash Flow from Operating Activities
Illustrated in Exhibit 12.4
Chapter 12 – Statement of Cash Flows
12-8
4. Completing the operating section using the indirect
method involves two steps:
a. Step 1: Adjust net income for depreciation and
amortization expense and gains and losses on sale of
investing assets such as property, plant, and equipment
and investments
i. Recording depreciation and amortization expense
does not affect the cash account (or any other
operating asset or liability); it affects a noncurrent
investing asset (property, plant, and equipment,
net)
ii. Since depreciation and amortization expense are
subtracted in computing net income but do not
affect cash, we always add each back to convert net
income to cash flow from operating activities
iii. Gains on sales of property, plant, and equipment
are subtracted and losses on such sales are added to
convert net income to cash flow from operating
activities
b. Step 2: Adjust net income for changes in assets and
liabilities marked as operating (O)
i. Each change in operating assets (other than cash
and short-term investments) and operating
liabilities (other than amounts owed to owners and
financial institutions) causes a difference between
net income and cash flow from operating activities
ii. General rules for converting net income to cash
flow from operating activities:
• Add the change when an operating asset
decreases or an operating liability increases
• Subtract the change when an operating asset
increases or an operating liability decreases
iii. Change in Accounts Receivable
• When sales revenues are recorded, accounts
receivable increases, and when cash is
collected from customers, accounts receivable
decreases
• An increase (reduced collections) is
subtracted; a decrease is added
iv. Change in Inventory
• Purchases of goods increase the balance in
inventory, and recording merchandise sold
decreases the balance in inventory
• An increase (extra purchases) is subtracted
from net income to convert to cash flow from
operating activities; a decrease is added
Chapter 12 – Statement of Cash Flows
12-9
v. Change in Prepaid Expenses
• Cash prepayments increase the balance in
prepaid expenses, and recording of expenses
decreases the balance in prepaid expenses
• A decrease (lower prepayments) is added to
net income; an increase is subtracted
vi. Change in Accounts Payable
• Purchases on account increase accounts
payable and cash paid to suppliers decreases
accounts payable
• A decrease (extra payments) is subtracted; an
increase is added
vii.Change in Accrued Expenses
See International Perspective
feature “Classification of
Interest on the Cash Flow
Statement”
• Recording accrued expenses increases the
balance in the liability accrued expenses and
cash payments for the expenses decrease
accrued expenses
• An increase (lower cash paid) is added; a
decrease is subtracted
Refer students to Pause for
Feedback – Self-Study Quiz
B. Interpreting Cash Flows from Operating Activities
1. The operating activities section of the cash flow statement
focuses attention on the firm’s ability to generate cash
internally through operations and its management of
current assets and current liabilities (also called working
capital)
2. A common rule of thumb followed by financial and credit
analysts is to avoid firms with rising net income but
falling cash flow from operations
3. Rapidly rising inventories or receivables often predict a
slump in profits and the need for external financing
LO 3 – Analyze and interpret the quality of income ratio.
C. Key Ratio Analysis: Quality of Income Ratio
1. Quality of Income Ratio = Cash Flow from Operating
Activities ÷ Net Income
2. Ratio measures how much cash each dollar of net income
generates
3. All other things equal, a higher quality of income ratio
indicates greater ability to finance operating and other
cash needs from operating cash inflows
4. A higher ratio also indicates it is less likely the company
is using aggressive revenue recognition policies to
increase net income
Chapter 12 – Statement of Cash Flows
12–10
5. When this ratio does not equal 1.0, analysts must
establish the sources of the difference to determine the
significance of the findings; four potential causes:
a. Corporate lifecycle (growth or decline in sales)
i. When sales are increasing, receivables and
inventory normally increase faster than accounts
payable..
ii. This often reduces operating cash flows below
income, which, in turn, reduces the ratio
iii. When sales are declining, the opposite occurs, and
the ratio increases.
b. Seasonality – seasonal (from quarter to quarter)
variations in sales and purchases of inventory can
cause the ratio to deviate from 1.0 during particular
quarters
c. Changes in revenue and expense recognition –
aggressive revenue recognition or failure to accrue
appropriate expenses will inflate net income and
reduce the ratio
d. Changes in management of operating assets and
liabilities
i. Inefficient management will increase operating
assets and decrease liabilities, reducing operating
cash flows and the quality of income ratio.
ii. More efficient management, such as shortening of
payment terms, will have the opposite effect
6. The quality of income ratio can be interpreted only based
on an understanding of the company’s business
operations and strategy
a. For example, a low ratio for a quarter can be due
simply to normal seasonal changes
b. However, it also can indicate obsolete inventory,
slowing sales, or failed expansion plans
c. To test for these possibilities, analysts often analyze
this ratio in tandem with the accounts receivable
turnover and inventory turnover ratios
See A Question of Ethics
feature “Fraud and Cash
Flows from Operations”
LO 4 – Report and interpret cash flows from investing activities.
III. Reporting & Interpreting Cash Flows from Investing Activities
Illustrated in Exhibit 12.5
A. Reporting Cash Flows from Investing Activities
1. Preparing this section of the cash flow statement requires
an analysis of the related accounts
a. Property, plant, and equipment;
i. Outflow – Purchase of property, plant, and
equipment for cash
ii. Inflow – Sale of property, plant, and equipment for
cash
Chapter 12 – Statement of Cash Flows
12–11
b. Intangible assets;
i. Outflow – Purchase of intangible assets for cash
ii. Inflow – Sale of intangible assets for cash
c. Investments in the securities of other companies
iii. Outflow – Purchase of investment securities for
cash
iv. Inflow – Sale (maturity) of investment securities
for cash
d. Hints:
i. Only purchases paid for with cash or cash
equivalents are included
ii. The amount of cash that is received from the sale
of assets is included, regardless of whether the
assets are sold at a gain or loss
B. Interpreting Cash Flows from Investing Activities – There
are common ways to assess a company’s ability to internally
finance its expansion:
1. Capital acquisitions ratio
2. Free cash flow
LO 5 – Analyze and interpret the capital acquisitions ratio.
C. Key Ratio Analysis: Capital Acquisitions Ratio
1. Capital Acquisitions Ratio = Cash Flow from Operating
Activities ÷ Cash Paid for Property, Plant, and Equipment
2. Ratio measures degree was the company able to finance
purchases of property, plant, and equipment with cash
provided by operating activities
3. A high ratio indicates less need for outside financing for
current and future expansion
D. Financial Analysis: Free Cash Flow
1. Free Cash Flow = Cash Flows from Operating Activities
− Dividends − Capital Expenditures
2. Managers and analysts often calculate free cash flow as a
measure of firm’s ability to pursue long-term investment
opportunities
3. Any positive free cash flow is available for additional
capital expenditures, investments in other companies, and
mergers and acquisitions
4. Free cash flow also can represent a hidden cost to
shareholders
a. Managers may use free cash flow to pursue
unprofitable investments just for the sake of growth or
to obtain perquisites that do not benefit shareholders
b. Shareholders would be better off if free cash flow
were paid as additional dividends or used to
repurchase the company’s stock on the open market
Chapter 12 – Statement of Cash Flows
12–12
LO 6 – Report and interpret cash flows from financing activities.
IV. Reporting & Interpreting Cash Flows from Financing Activities
A. Reporting Cash Flows from Financing Activities
Illustrated in Exhibit 12.6
1. Preparing this section of the cash flow statement requires
an analysis of the related accounts
a. Short-term debt (notes payable)
i. Inflow – Borrowing cash from banks or other
financial institutions
ii. Outflow – Repayment of loan principal Outflow
b. Long-term debt Issuance of bonds for cash
i. Inflow – Issuance of bonds for cash
ii. Outflow – Repayment of bond principal
c. Common stock and additional paid-in capital
i. Inflow – Issuance of stock for cash
ii. Outflow – Repurchase (retirement) of stock with
cash
d. Retained earnings
i. Outflow – Payment of cash dividends
e. Hints:
i. Cash repayments of principal are cash flows from
financing activities
ii. Interest payments are cash flows from operating
activities
iii. Dividend payments are cash flows from financing
activities
iv. If debt or stock is issued for other than cash, it is
not included in this section
Refer students to Pause for
Feedback – Self-Study Quiz
LO 7 – Understand the format of the cash flow statement and additional cash flow disclosures.
V. Completing the Statement and Additional Disclosures
A. Statement Structure
Net increase or decrease in cash and cash equivalents + cash
and cash equivalents at beginning of period = cash and cash
equivalents at end of period
Illustrated in Exhibit 12.7
B. Noncash Investing and Financing Activities
1. Transactions that do not have direct cash flow effects
2. Reported as a supplement to the statement of cash flows
in narrative or schedule form
C. Supplemental Cash Flow Information
If use the indirect method of reporting cash flows from
operations, must provide: cash paid for interest and cash paid
for income taxes