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Chapter 12 Statement of Cash Flows
Chapter 12
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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Chapter 12 Statement of Cash Flows
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 12-1: 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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Chapter 12 Statement of Cash Flows
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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Chapter 12 Statement of Cash Flows
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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Chapter 12 Statement of Cash Flows
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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Chapter 12 Statement of Cash Flows
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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Chapter 12 Statement of Cash Flows
III. The statement of cash flows—an example
Learning Objective 12-2: 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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Chapter 12 Statement of Cash Flows
1. The accounts receivable balance decreased
by $17, so this amount needs to be added to
net income.
2. The inventory balance increased by $49, so
this amount needs to be subtracted from
net income.
3. The accounts payable balance increased
by $44, so this amount needs to be added to
net income.
4. The accrued liabilities balance increased
by $3, so this amount needs to be added to
net income.
5. The income taxes payable balance
increased by $4, so this amount needs to be
added to net income.
iii. The third step is adjust for gains and losses
included in the income statement.
1. Apparel’s income statement includes a gain
of $3 million, so this amount must be
subtracted from net income.
2. Subtracting the gain on sale removes it from
the operating activities section of the
statement of cash flows. The entire amount
of the proceeds related to this sale will be
recorded in the investing activities section of
the statement.
iv. The operating activities section of Apparel’s
statement of cash flows would appear as
shown on this slide.
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Chapter 12 Statement of Cash Flows
C. Investing activities
i. To compute the gross cash flows in the
investing activities section of the statement,
we need to focus on the Property, Plant, and
Equipment account.
1. Apparel would record an $8 million cash
inflow related to the sale of the store.
2. The basic equation for asset accounts can
be used to determine that Apparel needs to
record a $138 million cash outflow related
to the purchase of property, plant, and
equipment.
D. Financing activities
i. To compute the gross cash flows in the
financing activities section of the statement,
we need to focus on the Bonds Payable,
Common Stock, and Retained Earnings
accounts.
1. The balance in Bonds Payable decreased
by $41 million. Because the assumptions
state that Apparel did not issue any bonds
during the year, the $41 million decrease
relates to retiring bonds and represents a
cash outflow.
2. The balance in Common Stock increased
by $2 million. Because the assumptions
state that Apparel did not repurchase any of
its own stock, the $2 million increase
relates to issuing common stock and
represents a cash inflow.
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Chapter 12 Statement of Cash Flows
3. The basic equation for stockholders’ equity
accounts can be used to determine that
Apparel paid dividends of $28 million
that need to be recorded as a cash
outflow.
E. Apparel Inc: statement of cash flows
i. Apparel’s completed statement of cash flows is
shown on this slide. Notice, the net increase in
cash and cash equivalents ($62) explains the
change in the cash balance.
F. Apparel Inc: seeing the big picture
i. T-accounts can be used to summarize how
changes in Apparel Inc.’s noncash balance sheet
accounts quantify the cash inflows and outflows
that explain the change in its cash balance.
1. The first entry records Apparel’s net
income ($140 million) in the credit side of
the Retained Earnings account and the debit
side of the Cash account.
2. The second entry adds depreciation of
$103 million to net income.
3. Entries 3-7 adjust net income for the
changes in the current asset and current
liability accounts.
4. Entries 8-11 summarize the cash outflows
and inflows related to property, plant, and
equipment, the retirement of bonds
payable, the payment of the cash
dividend, and the issuance of common
stock.
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Chapter 12 Statement of Cash Flows
5. The final entry records the sale of the store.
Notice, the gain on the sale ($5 million) is
recorded in the credit side of the cash
account so that the entire amount of the cash
proceeds from the sale ($8 million) can be
recorded as an investing activity.
IV. Interpreting the statement of cash flows
A. Consider a company’s specific circumstances
i. Start-up companies often have negative net cash
provided by operating activities, large spikes in
net cash used for investing activities and net cash
provided by financing activities.
ii. As start-up companies mature, the net cash
provided operating activities should swing from a
negative to a positive number. The net cash used
for investing activities should decline somewhat
and stabilize and the net cash provided by
financing activities should decrease.
B. Consider the relationships among the numbers
i. Some managers study their company’s trends in
cash flow margins by comparing net cash
provided by operating activities to sales.
ii. Managers also compare the net cash provided
by operating activities to the ending balance of
current liabilities to see if they generated enough
cash flow to pay their bills at the end of the
period.
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Chapter 12 Statement of Cash Flows
iii. Some managers compare the additions to
property, plant, and equipment in the investing
activities section of the statement to depreciation
included in the operating activities section.
1. If the additions to property, plant, and
equipment are less than depreciation, it
suggests the company is not investing
enough money to maintain its noncurrent
assets.
Learning Objective 12-3: Compute free cash flow.
iv. Free cash flow looks at the relationship among
three numbers from the statement of cash flows—
net cash provided by operating activities,
additions to property, plant, and equipment,
and dividends.
1. Free cash flow measures a company’s
ability to fund its capital expenditures
and dividends from its net cash provided
by operating activities.
2. The equation for computing free cash flow
is net cash provided by operating
activities minus capital expenditures and
dividends.
3. Apparel’s free cash flow of $93 million is
computed as shown.
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Chapter 12 Statement of Cash Flows
v. Managers and investors look at the relationship
between net income and net cash provided by
operating activities to assess earnings quality.
Managers perceive that earnings are of higher
quality when the earnings:
1. Are not unduly influenced by inflation.
2. Are computed using conservative
accounting principles and estimates.
3. Are correlated with net cash provided by
operating activities.
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