Chapter 14 – Lecture Notes
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Chapter 14
Lecture Notes
Chapter theme: This chapter explains how to prepare and
interpret the statement of cash flows.
I. Statement of cash flows
A. Setting the stage
i. The statement of cash flows highlights the
major activities that impact cash flows and
hence, affect the overall cash balance.
ii. The statement of cash flows helps answer a
variety of questions such as:
1. Are cash flows sufficient to support ongoing
operations?
2. Can we pay our debts?
3. Can we pay dividends?
4. Will we have to borrow money to make
needed investments?
5. Why is there a difference between net
income and net cash flow?
iii. The statement of cash flows is based on the
principle that properly analyzing the changes
in all noncash balance sheet accounts will
always quantify the cash inflows and
outflows that explain the change in the
cash balance.
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iv. The basic equations for assets, contra-assets,
liabilities, and stockholders’ equity shown on
this slide will be useful in preparing a
statement of cash flows.
v. The term cash on the statement of cash flows
refers broadly to both currency and cash
equivalents.
II. Statement of cash flows—four key concepts
Learning Objective 1: Classify cash inflows and
outflows as relating to operating, investing, or
financing activities.
A. Key concept #1
i. The statement of cash flows is organized into
three sections that report cash flows resulting
from operating activities, investing
activities, and financing activities.
1. Operating activities generate cash inflows
and outflows related to revenue and expense
transactions that affect net income.
2. Investing activities generate cash inflows
and outflows related to acquiring or
disposing of noncurrent assets such as
property, plant, and equipment, long-term
investments, and loans to another entity.
3. Financing activities generate cash inflows
and outflows related to borrowing from and
repaying principal to creditors and
completing transactions with the company’s
owners.
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ii. This slide summarizes the most common
types of cash inflows and outflows resulting
from operating, investing, and financing
activities.
B. Key concept #2
i. The net amount of cash inflows and outflows
resulting from operating activities, which is
known formally as the net cash provided by
operating activities, can be derived using
either the direct or indirect method.
1. Under the direct method, the income
statement is reconstructed on a cash basis
from top to bottom. For example:
a. Cash collected from customers is listed
instead of revenue, and payments to
suppliers is listed instead of cost of
goods sold.
2. Under the indirect method, net income is
adjusted to a cash basis. That is, rather
than directly computing cash sales, cash
expenses, and so forth, these amounts are
derived indirectly by removing from net
income any items that do not affect cash
flows.
C. Key concept #3
i. The indirect method adjusts net income to net
cash provided by operating activities using
the three-step process summarized on this
slide.
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ii. The first step is to add depreciation charges
to net income. The basic equation for contra-
assets shown on this slide can be used to
determine the amount of this adjustment. For
example:
1. Assume the beginning and ending balances
in the Accumulated Depreciation account
are $300 and $500, respectively. Also,
assume that the accumulated depreciation on
equipment sold during the period was $70.
2. Given these assumptions, the basic equation
for contra-assets can be used to compute
depreciation charges of $270.
iii. The second step is to analyze the net
changes in balance sheet accounts that
affect net income.
1. To complete this step you begin by
computing the change in the balance of
each current asset and current liability
account.
2. If a current asset account balance
increases (decreases), then the amount of
the increase (decrease) is subtracted from
(added to) net income.
3. If a current liability account balance
increases (decreases), then the amount of
the increase (decrease) is added to
(subtracted from) net income.
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iv. The third step is to adjust for gains and
losses included in the income statement.
1. U.S. GAAP and IFRS require gains and
losses to be disclosed in the investing
activities section of the statement of cash
flows.
2. Therefore, we reverse the impact of gains
and losses on net income by subtracting
gains and adding losses.
D. Key concept #4
i. U.S. GAAP and IFRS require that the
investing and financing sections of the
statement of cash flows disclose gross cash
flows.
1. When the balance in a noncurrent asset
account increases (decreases), it signals the
need to record a cash outflow (cash inflow)
in the investing activities section of the
statement of cash flows. However,
computing the correct amount of cash flows
requires further analysis as you’ll see
shortly.
2. When the balances in Bonds Payable and
Common Stock increase (decreases), it
signals the need to record a cash inflow
(cash outflow) in the financing activities
section of the statement of cash flows.
However, computing the correct amount of
cash flows also requires further analysis.
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3. The Retained Earnings account also
requires further analysis to quantify the
amount of dividends as you’ll see shortly.
ii. To illustrate how to compute gross cash
flows, let’s use the Property, Plant, and
Equipment account. Let’s assume the
information as shown in the top half of this
slide.
1. Based on this information, the company
would record a cash inflow of $40 related
to the sale of equipment.
2. The basic equation for assets can be used
to determine that the company would also
need to record a cash outflow of $900.
iii. As another example, let’s look at the
Retained Earnings account and assume the
information as shown in the top half of this
slide.
1. The basic equation for stockholders’ equity
accounts can be used to determine that the
company would need to record dividends (a
cash outflow) of $200 in the financing
activities section of the statement of cash
flows.
E. Summary of four key concepts
i. These slides summarize the four key concepts
related to preparing the statement of cash
flows.
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III. The statement of cash flows—an example
Learning Objective 2: Prepare a statement of cash
flows using the indirect method to determine the net
cash provided by operating activities.
A. Apparel Inc.: background information
i. Let’s assume that Apparel Inc. reported the
income statement shown on this slide.
ii. Let’s assume that the company reported the
balance sheet shown on this slide.
iii. Let’s also assume the additional information
shown on this slide.
B. Computing net cash provided by operating
activities—a three step process
i. The first step in computing the net cash
provided operating activities is to add
depreciation to net income.
1. The basic equation for contra-asset accounts
can be used to determine that Apparel
should add $103 million of depreciation to
net income.
ii. The second step is to analyze net changes in
noncash balance sheet accounts that
impact net income.
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