12-1
Chapter 12
Statement of Cash Flows
General Comments for Chapter 12
For instructors who prefer the T-account approach to explaining accrual to cash conversions
under the direct method, we have included an alternate detailed lesson plan; it follows the
first outline below.
Students have been exposed to the statement of cash flows throughout the text. They have
prepared statements of cash flows by classifying the transactions recorded in the cash ac-
count as operating, investing, or financing activities. The operating activities section of the
statement has been presented using the direct method only. This chapter introduces the indi-
rect method of presenting operating activities and shows how to derive cash flows from fi-
nancial statement information.
Detailed Outline of a Lesson Plan for Chapter 12
I. Explain accrual to cash conversions. Begin by teaching students to identify the re-
lationships between cash flows and changes in balance sheet accounts. Introduce ex-
amples like those shown below.
A. A land account had a beginning balance of $20,000 and an ending balance of
$30,000. Using this information alone, have students determine the amount and
classification (operating, investing, or financing activity) of cash flow associated
with the change in the land account. This relationship is so simple most students
can picture the $10,000 cash outflow. The outflow for acquiring land is an invest-
ing activity.
This is a good time to explain how to use changes in balance sheet accounts to in-
fer cash flow consequences. Draw a schedule for land. Start with the beginning
balance, leave a question mark, and show the ending balance.
Land
Beginning balance
20,000
?
Ending balance
30,000
Clearly, some event caused land to increase. In the absence of information to the
contrary, we can assume land was purchased for cash. Since the cash purchased a
long-term asset, this analysis results in reporting a $10,000 cash outflow in the in-
vesting activities section of the statement of cash flows.
B. Next, move to an example that requires converting net income to cash flow from
operating activities. Assume a company reported net income of $300. Tell stu-
12-2
dents to assume all sales are made on account. The company had sales of $1,000
during the accounting period and collected $600 from customers. In addition, the
company incurred expenses of $700 on account but only paid $500 on accounts
payable. Have students show the cash flow from operating activities under the di-
rect method:
Direct method
Cash receipts from customers
$ 600
Cash payments for expenses
(500)
Net cash inflow
$ 100
Explain that the indirect method produces the same result by starting with net in-
come and adjusting net income for the changes in accounts receivable ($400 more
revenue was earned than cash collected) and accounts payable ($200 more ex-
penses were incurred than cash paid for them):
Indirect method
Net income
$ 300
Plus increase in accounts payable
200
Less increase in accounts receiva-
ble
(400)
Net cash inflow
$ 100
C. Expand the above principle into the rules for converting net income to cash flow
from operating activities:
Net Income ±
Add decreases and subtract increases in current assets
(other than cash)
Add increases and subtract decreases in current liabilities
Add noncash expenses (e.g., depreciation)
Add losses and subtract gains
Net cash flow from operating activities
Illustrate to students that these rules are based on a pattern and point out that pat-
tern. Use the accounts receivable example to illustrate how to they can start the
pattern as outlined in the rules above. Students can more readily understand the
relationship between net income and cash when sales have been made on account.
This will help the students better understand and retain the rules and avoid memo-
rizing them for test purposes only.
D. Reinforcement. Assign Exercise 12-7A or 12-7B from the textbook as an in-class
exercise. This exercise requires applying the above rules to prepare the operating
activities section of the statement of cash flows using the indirect method.
II. Use financial statements as the source of data for preparing the statement of
cash flows‒indirect method. The next step is to teach students how to use available
balance sheet and income statement information to derive the statement of cash flows.
12-3
Remind your students that the ending balances on last year’s balance sheet represent
the beginning balances for the current year. The current year’s ending balances are
reported on the current balance sheet. The beginning and ending account balances
can therefore be determined by examining two consecutive balance sheets. Revenue,
gain, expense, and loss data are reported on the income statement. Demonstration
Problem 12-1 presents two consecutive balance sheets and the income statement for
the intervening year. The underlying procedure is to explain the changes in every
balance sheet account.
A. Cash flows from operating activities. Have students begin the problem by iden-
tifying the current assets and current liabilities. Then have them compute the
change in each current asset and current liability account, identifying whether the
change is an increase or a decrease. Save time by using the workpapers from the
back of this chapter. Instruct students to use the rules introduced above (the rules
are also presented on the student workpaper for reference), along with the in-
creases and decreases they computed, to determine cash flows from operating ac-
tivities.
B. Cash flows from investing activities. Have students identify the noncurrent as-
sets. Analyzing the changes in equipment requires considering Note 1 of the
“Other information” presented below the income statement. Show students how
to reconstruct equipment changes. After entering the cost of the equipment sold
as a deduction, use algebra to compute the amount of cash paid to purchase
equipment:
Beginning balance in equipment
$27,000
Add: Purchase of equipment (cash outflow)
9,000
Deduct: Sale of equipment (cash inflow)*
(6,000)
Ending balance in equipment
$30,000
*The cash inflow for and cost of equipment sold are given in Note 1. The
$4,000 cash received is reported as an inflow from investing activities on the
statement of cash flows. Verify the cash inflow as follows:
Cash inflow for equipment sale:
Book value of equipment sold + gain = ($6,000 – $5,000) + $3,000 = $4,000
Because it is not affected by cash flows, analysis of accumulated depreciation is
not necessary.
Next analyze the changes in land. Use algebra to compute the cash outflow:
Beginning balance in land
$15,000
Add: Purchases of land (cash outflow)
14,000
Ending balance in land
$29,000
12-4
C. Cash flows from financing activities. The decrease in notes payable suggests
that the company repaid a portion of the debt. Use algebra to determine the cash
outflow.
Beginning balance in notes payable
$20,000
Deduct: debt repayment (cash outflow)
(6,000)
Ending balance in notes payable
$14,000
The increase in common stock suggests the company issued common stock. De-
termine the amount of cash that was received by solving for the amount required
to produce the ending balance.
Beginning balance in common stock
$18,000
Add: common stock issued (cash inflow)
7,000
Ending balance in common stock
$25,000
Retained earnings. Note 2 of the “Other information” indicates the company
paid dividends of $5,000 cash to the stockholders. Combined with the amount of
net income, the changes in retained earnings are explained. Since this is the last
item on the balance sheet, the analysis is complete.
Beginning balance in retained earnings
$ 7,000
Add: Net income
15,000
Deduct: Dividends (cash outflow)
(5,000)
Ending balance in retained earning
$17,000
The $5,000 dividend payment is reported as an outflow from financing activities.
Use the information from the previous analysis to prepare a formal statement of cash
flows.
III. Reconstruct the statement of cash flows using the direct method. Reuse the da-
ta in Demonstration Problem 12-1 to illustrate presenting cash flows from operating
activities using the direct method. With the direct approach, the operating activities
section identifies the specific sources of cash receipts and cash payments. Apply
these rules for converting specific accrual amounts to related cash flows:
Rule 1
Revenue, plus decreases, minus increases in related cur-
rent assets (accrued revenues)
Rule 2
Revenue, plus increases, minus decreases in related cur-
rent liabilities (unearned revenues)
Rule 3
Expense items, plus increases, minus decreases in related
current assets (prepaid expenses)
Rule 4
Expense items, minus increases, plus decreases in related
current liabilities (accrued expenses)
Rule 5
Ignore gains, losses, and noncash revenue and expense
items reported on the income statement
Equals
Net cash flow from operating activities
12-5
. Instruct students to use these rules (the rules are also presented on the student
workpaper for reference), along with the increases and decreases they computed, to
determine specific cash inflows and outflows from operating activities.
A. Cash inflow from revenue. For simplicity, assume all sales are on account. The
relevant items are sales revenue of $98,000 and the $1,000 decrease in accounts
receivable.
Sales revenue
$98,000
Rule 1
Minus increase in accounts receivable
(1,000)
Cash inflow from revenue
$97,000
B. Cash outflow for inventory. Assume all inventory purchases are on account. In
addition to cost of goods sold of $62,000, consider both the $4,000 decrease in
inventory and the $2,000 decrease in accounts payable.
Cost of goods sold
$62,000
Rule 3
Minus decrease in inventory
(4,000)
Rule 4
Minus increase in accounts payable
(2,000)
Cash outflow for inventory
$56,000
C. Cash outflow for salaries. Assume all salaries are accrued before they are paid.
Add the $5,000 decrease in salaries payable to the salary expense of $14,000.
Salaries expense
$14,000
Rule 4
Plus decrease in salaries payable
5,000
Cash outflow for salaries
$19,000
The result is a $22,000 net cash inflow from operating activities. Compare this result
with the cash inflow from operating activities reported using the indirect method.
The identical results reinforce the point that the two approaches are merely different
presentations of the same underlying economic circumstances. The presentation of
investing and financing activities does not differ between the direct and indirect re-
porting approaches.
IV. Time considerations and homework assignments. Spend approximately one hour
of class time introducing accrual to cash conversions and the rules for converting net
income to cash flows from operating activities under the indirect method. It takes an-
other hour to prepare the complete statement of cash flows under the indirect method.
Explaining the direct method of presenting cash flows from operating activities takes
approximately thirty minutes. Use Problem 12-19A or 12-19B as a follow-up to pre-
paring operating activities using the indirect method and Problem 12-21A or 12-21B
as a follow-up to using the direct method. Although these problems in the text specif-
ically require either the direct or indirect method, we suggest you instruct students to
rework the operating activities sections of the problems you’ve assigned for both op-
erating section cash flow presentation methods. This approach seems to drive home
12-6
the differences between the two methods more effectively than assigning problems
that deal with the approaches separately.
12-7
Detailed Outline of an Alternate Lesson Plan for Chapter 12
(T-account Approach, Direct Method)
I. Use T-accounts to explain accrual to cash conversions. Begin by teaching students
to identify the relationships between cash flows and changes in balance sheet ac-
counts. Introduce relationships that are progressively more difficult.
A. Relationship No. 1. A land account had a beginning balance of $20,000 and an
ending balance of $30,000. Using this information alone, have students determine
the amount and classification (operating, investing, or financing activity) of cash
flow associated with the change in the land account. This relationship is so simple
most students can picture the $10,000 cash outflow. The outflow for acquiring
land is an investing activity.
This is a good time to explain how to use T-accounts to infer cash flow conse-
quences. Draw a T-account for land. Enter the beginning and ending balances in
the T-account.
Land
Beginning balance
20,000
?
Ending balance
30,000
Clearly, some event caused land to increase. In the absence of information to the
contrary, we can assume land was purchased for cash. The $10,000 debit that in-
creased the balance from $20,000 to $30,000 coincided with a credit to cash.
Since the cash purchased a long-term asset, this analysis results in reporting a
$10,000 cash outflow in the investing activities section of the statement of cash
flows.
B. Relationship No. 2. Next, move to a more complex example that requires con-
verting accrual data to cash data. Draw a T-account for accounts receivable with
beginning and ending balances of $100 and $500, respectively. Tell students to
assume all sales are made on account and that the company had sales of $1,000
during the accounting period. Again, ask students to determine the cash flow im-
plications.
Accounts Receivable
Beginning balance
100
?
1,000
Ending balance
500
Students must record the increase in accounts receivable from credit sales before
they can determine the amount of the credit to accounts receivable that would
produce the ending balance. The required credit of $600 ($100 + $1,000 ‒ $500)
would coincide with a corresponding debit to the cash account.
12-8
C. Relationship No. 3. Finally, show your students how to determine the amount of
cash paid for inventory given the following beginning and ending balances:
Account Title
Beginning
Ending
Inventory
$600
$500
Accounts Payable (for inventory)
250
230
Tell students to assume all inventory purchases are on account and that cost of
goods sold for the period was $2,200. Challenge them to determine the amount of
cash paid for inventory.
Inventory
Accounts Payable
Bal. 600
2,200(1)
250 Bal.
(2) 2,100
(3) 2,120
2,100 (2)
Bal. 500
230 Bal.
Show students how to determine the cash flow in three steps: (1) Record cost of
goods sold ($2,200) on the credit side of the Inventory account. (2) Determine the
amount of inventory purchased ($2,100) by solving for the debit required to pro-
duce the ending balance ($500) in the Inventory account. Assuming the $2,100 of
inventory was purchased on account, record the corresponding credit to accounts
payable. (3) Determine the amount of cash paid ($2,120) by solving for the debit
required in accounts payable to produce an ending balance of $230.
II. Use financial statements as the source of data for preparing the statement of
cash flows‒direct method. The next step is to teach students how to use available
balance sheet and income statement information to derive the statement of cash flows.
Remind your students that the ending balances on last year’s balance sheet represent
the beginning balances for the current year. The current year’s ending balances are
reported on the current balance sheet. The beginning and ending account balances
can therefore be determined by examining two consecutive balance sheets. Revenue,
gain, expense, and loss data are reported on the income statement. Demonstration
Problem 12-1 presents two consecutive balance sheets and the income statement for
the intervening year.
Have students begin the problem by opening T-accounts for all the balance sheet
items. Save time by using the workpapers from the back of this chapter. Instruct stu-
dents to enter beginning and ending balances in the T-accounts. Have them find the
balances in the financial statements.
Tell students to assume all revenue and expense transactions are on account. Proceed
to reconstruct the cash entries by analyzing the financial statements line by line as
outlined below. Note the entries are cross-referenced in the T-accounts with alpha-
numeric codes. Begin with the items reported on the income statement.
12-9
(a1) This entry records the sales reported on the income statement. All revenue and
expense items are recorded directly into the Retained Earnings account. Em-
phasize that the objective of reconstructing the entries is to prepare the state-
ment of cash flows. The entries in the T-accounts represent summary transac-
tions that occurred throughout the accounting period. They do not represent re-
cording actual individual transactions. It is convenient to record revenue and
expense events directly into retained earnings. Once they have recorded sales,
have students check off the sales amount on the income statement. Tell them
the analysis will be complete when all items on the financial statements have
been checked off.
(a2) Solve for the $97,000 credit to Accounts Receivable. It is the amount that will
produce the ending balance of $9,000. The reduction in receivables coincides
with collecting cash. Enter the corresponding debit to Cash in the operating ac-
tivities section of the Cash account. Changes in accounts receivable have now
been explained. Check off accounts receivable on the balance sheet.
(b1) This entry represents the expense cost of goods sold.
(b2) Given a beginning inventory balance of $20,000, cost of goods sold of $62,000,
and an ending inventory balance of $16,000, $58,000 ($20,000 + x ‒$62,000 =
$16,000) of inventory must have been purchased. Since purchases are assumed
to be made on account, the entry to record them requires debiting Inventory and
crediting Accounts Payable.
(b3) Solve for the $56,000 debit to Accounts Payable ($6,000 + $58,000 ‒ x =
$8,000). It coincides with a corresponding credit in the operating activities sec-
tion of the Cash account. After recording the “b” entries, students can check off
cost of goods sold on the income statement and merchandise inventory and ac-
counts payable on the balance sheet.
(c1) This entry records the salaries expense reported on the income statement.
(c2) Solve for the $19,000 debit to Salaries Payable ($9,000 + $14,000 ‒ x =
$4,000). Enter the corresponding credit in the operating activities section of the
Cash account. After recording the “c” entries, check off salaries expense on the
income statement and salaries payable on the balance sheet.
(d1) This entry records the depreciation expense reported in the income statement.
(d2) This entry records the sale of equipment. The amounts are provided in footnote
1 below the income statement. Record the $4,000 cash inflow from the sale as a
debit in the investing activities section of the Cash account. Credit the Equip-
ment account for $6,000 to remove the asset balance from the account, and debit
the Accumulated Depreciation account to remove the related $5,000 balance
from that account. Enter the $3,000 gain on the sale of the equipment as a cred-
it to the Retained Earnings account.
12–10
(d3) The cost of equipment purchased is determined by solving for the debit required
to produce the ending balance in the Equipment account ($27,000 + x ‒ $6,000
= $30,000; x = $9,000). The entry to record the equipment purchase involves
debiting the Equipment account and crediting the investing activities section of
the Cash account. After recording the “d” entries, check off depreciation ex-
pense and gain on sale of equipment on the income statement, and the equip-
ment and accumulated depreciation accounts on the balance sheet. At this point
all items on the income statement have been checked off. Next analyze the re-
maining unexplained changes on the balance sheet. Start with assets, move on
to liabilities, and then finish with equity.
(e1) The first asset change on the balance sheet that has not been explained is land.
Since a debit entry is required to produce the ending balance, the company must
have purchased land during the period. Determine the amount by solving for
the debit required to produce the ending balance in the Land account ($15,000 +
x = $29,000; x = $14,000). Enter a debit in the Land account and a credit in the
investing activities section of the Cash account. Check off land on the balance
sheet.
(f1) The decrease in notes payable suggests that the company repaid a portion of the
debt. Solve for the debit required to produce the ending balance ($20,000 ‒ x =
$14,000; x = $6,000) to determine the amount the company repaid. Enter a deb-
it in Notes Payable and a corresponding credit in the financing activities section
of the Cash account. Check off notes payable.
(g1) The increase in common stock suggests the company issued common stock.
Determine the amount of cash that was received by solving for the credit re-
quired to produce the ending balance ($18,000 + x = $25,000; x = $7,000). En-
ter a debit in the financing activities section of the Cash account and a credit in
the Common Stock account. Check off common stock.
(h1) Item 2 of Other information indicates the company paid dividends of $5,000
cash to the stockholders. Enter a debit in the Retained Earnings account and a
credit in the financing activities section of the Cash account. Check off retained
earnings. Since this is the last item on the balance sheet, the analysis is com-
plete.
Use the information in the Cash account to prepare a formal statement of cash flows.
III. Reconstruct the statement of cash flows using the indirect method. Reuse the data in
Demonstration Problem 12-1 to illustrate presenting cash flows from operating activities
using the indirect method. With the indirect approach, the operating activities section
starts with reported net income, followed by the appropriate accrual to cash conversions
to determine the amount of cash flow from operating activities. Use an accounts receiva-
ble example to illustrate to students how to they can start the pattern as outlined in the
rules below and then point out the pattern. Students can more readily understand the rela-
tionship between net income and cash when sales have been made on account. This will
12–11
help the students better understand and retain the rules and avoid memorizing them for
test purposes only.
Apply the rules for converting net income to cash flow from operating activities:
Rule 1. Add decreases and subtract increases in current asset account balances
(other than cash). Add the $4,000 decrease in inventory to net income. Deduct
the $1,000 increase in accounts receivable.
Rule 2. Add increases and subtract decreases in current liability account balances.
Add the $2,000 increase in accounts payable to net income. Subtract the $5,000
decrease in salaries payable.
Rule 3. Add noncash expenses to net income. Add the $10,000 of depreciation ex-
pense.
Rule 4. Add losses to net income and subtract gains from net income. Deduct the
$3,000 gain on sale of equipment.
The result is a $22,000 net cash inflow from operating activities. Compare this result
with the cash inflow from operating activities reported using the direct method. The
identical results reinforce the point that the two approaches are merely different
presentations of the same underlying economic circumstances. The presentation of
investing and financing activities does not differ between the direct and indirect re-
porting approaches.
IV. Time considerations and homework assignments. Spend approximately one hour
of class time introducing accrual to cash conversions. It takes another hour and a half
to explain the T-account analysis. Explaining the indirect method of presenting cash
flows from operating activities takes approximately thirty minutes. Problems 12-21A
and 12-21B can be adapted to the T-account approach for the direct method of report-
ing cash flows and problems 12-19A and 12-19B can be adapted for the indirect
method of reporting cash flows. We suggest you instruct students to work the operat-
ing activities sections of the problems you’ve assigned for both the direct and indirect
methods. This approach seems to drive home the differences between the direct and
indirect methods more effectively than assigning problems that deal with the ap-
proaches separately.
12–12
Demonstration Problem 12-1
Statement of Cash Flows—Indirect and Direct Methods
Selected financial information for Hatch Company follows:
Balance Sheets as of December 31
Assets
2016
2015
Cash
$ 1,000
$ 2,000
Accounts receivable
9,000
8,000
Merchandise inventory
16,000
20,000
Equipment
30,000
27,000
Accumulated depreciation
(17,000)
(12,000)
Land
29,000
15,000
Total assets
$68,000
$60,000
Liabilities
Accounts payable (for inventory)
$ 8,000
$ 6,000
Salaries payable
4,000
9,000
Notes payable
14,000
20,000
Total liabilities
26,000
35,000
Stockholders’ equity
Common stock, $10 par value
25,000
18,000
Retained earnings
17,000
7,000
Total stockholders’ equity
42,000
25,000
Total liabilities and stockholders’ equity
$68,000
$60,000
Income Statement
For the Year Ended December 31, 2016
Sales
$98,000
Cost of goods sold
(62,000)
Gross margin
36,000
Salaries expense
(14,000)
Depreciation expense
(10,000)
Operating income
12,000
Gain on sale of equipment
3,000
Net income
$15,000
Other information
1. During 2016, Hatch sold equipment that cost $6,000 for $4,000. Accumulated depreciation at the time of sale
was $5,000.
2. During 2016, Hatch paid cash dividends of $5,000 to the stockholders.
Required
a. Analyze the financial statement data and prepare a formal statement of cash flows for 2016 using the indi-
rect method.
b. Reconstruct the statement of cash flows using the direct method (appendix).
12–13
Demonstration Problem 12-1 Solution, part a.1. Indirect Method,
Cash Flows from Operating Activities
Rules provided for reference:
Rules for Converting Net Income to Cash Flow from Operating Activities
Net Income ±
Rule 1
Add decreases and subtract increases in current assets
(other than cash)
Rule 2
Add increases and subtract decreases in current liabilities
Rule 3
Add noncash expenses (e.g., depreciation)
Rule 4
Add losses and subtract gains
Equals
Net cash flow from operating activities
Noncash Current Asset and Current Liability Account Balances
Account Title
2016
2015
Change
Accounts receivable
$ 9,000
$ 8,000
$ 1,000
Merchandise inventory
16,000
20,000
(4,000)
Accounts payable (for inventory)
8,000
6,000
2,000
Salaries payable
4,000
9,000
(5,000)
Cash flows from Operating Activities
Net income
$15,000
RULE
Add:
Rule 1
Decrease in inventory
4,000
Rule 2
Increase in accounts payable
2,000
Rule 3
Depreciation expense (noncash)
10,000
Subtract:
Rule 1
Increase in accounts receivable
(1,000)
Rule 2
Decrease in salaries payable
(5,000)
Rule 4
Gain on sale of equipment (noncash)
(3,000)
Net cash inflow from operating activities
$ 22,000
12–14
Demonstration Problem 12-1 Solution, part a.2. Indirect Method,
Cash Flows from Investing Activities
Equipment Account Information
Beginning balance in equipment
$27,000
Add: Purchase of equipment (cash outflow)
9,000
Deduct: Sale of equipment (cash inflow)*
(6,000)
Ending balance in equipment
$30,000
*Cash inflow for equipment sale:
Book value of equipment sold + gain
($6,000 – $5,000) + $3,000 = $4,000
Land Account Information
Beginning balance in land
$15,000
Add: Purchases of land (cash outflow)
14,000
Ending balance in land
$29,000
Demonstration Problem 12-1 Solution, part a.3. Indirect Method,
Cash Flows from Financing Activities
Notes Payable Account Information
Beginning balance in notes payable
$20,000
Deduct: debt repayment (cash outflow)
(6,000)
Ending balance in notes payable
$14,000
Common Stock Account Information
Beginning balance in common stock
$18,000
Add: common stock issued (cash inflow)
7,000
Ending balance in common stock
$25,000
Retained Earnings Account Information
Beginning balance in retained earnings
$ 7,000
Add: Net income
15,000
Deduct: Dividends (cash outflow)
(5,000)
Ending balance in retained earnings
$ 17,000
12–15
Demonstration Problem 12-1 Solution, part a.4. Indirect Method,
Statement of Cash Flows
Hatch Company
Statement of Cash Flows
For the Year Ended December 31, 2016
Cash flows from operating activities
Net income
$15,000
Add:
Decrease in inventory
4,000
Increase in accounts payable
2,000
Depreciation expense (noncash)
10,000
Subtract:
Increase in accounts receivable
(1,000)
Decrease in salaries payable
(5,000)
Gain on sale of equipment (noncash)
(3,000)
Net cash inflow from operating activities
$ 22,000
Cash flows from investing activities
Cash inflow from equipment sale
4,000
Cash outflow for equipment purchase
(9,000)
Cash outflow for land purchase
(14,000)
Net cash outflow for investing activities
(19,000)
Cash flows from financing activities
Cash inflow from stock issue
7,000
Cash outflow for debt payment
(6,000)
Cash payments for dividends
(5,000)
Net cash outflow for financing activities
(4,000)
Net decrease in cash
(1,000)
Beginning cash balance
2,000
Ending cash balance
$ 1,000