978-0136115274 Chapter 9 Lecture Notes

CHAPTER 9

PREPARING AND ANALYZING THE STATEMENT OF

CASH FLOWS

CHAPTER OVERVIEW

The chapter begins with a presentation of the importance of the statement of cash flows, focusing

on the necessity of management and external users to monitor the cash flows of a business. Next

there is a general discussion of the two methods of preparing the statement of cash flows: direct

method and indirect method.

The next part of the chapter reviews the three sections of the statement of cash flows: operating

activities, investing activities, and financing activities. Examples of cash flows from each of the

three activities are given.

Accrual basis accounting versus cash basis accounting is then covered. Examples are provided to

explain the difference between cash flow and the recognition of revenues and expenses. It is

pointed out that changes in current asset and current liability accounts reflect the differences in

accrual-based income statement amounts and cash amounts.

At the end of the chapter there is a presentation of how to use the statement of cash flows for

analysis. A discussion of free cash flow is also included.

LEARNING OBJECTIVES

After completing Chapter 9, your students should be able to answer these questions:

1. Explain the importance of the statement of cash flows and the three classifications

of cash on the statement of cash flows.

2. Explain the difference between the direct method and the indirect method of

preparing the statement of cash flows.

3. Convert accrual amounts to cash amounts.

4. Prepare the cash flows from operating activities section of the statement of cash

flows using the direct method.

5. Prepare the cash flows from operating activities section of the statement of cash

flows using the indirect method.

6. Prepare the cash flows from investing activities section and the cash flows from financing

activities section of the statement of cash flows.

7. Perform general analysis of the statement of cash flows and calculate free cash flow.

8. Use the statement of cash flows and the related controls to evaluate the risk of investing

in a firm.

CHAPTER OUTLINE

The Importance of the Statement of Cash Flows (LO 1)

I. One of the four basic financial statements required by GAAP

II. Shows all of the cash that the company has received during the period and all of the cash

the company has disbursed during the period

III. Net income is important (as reported on the income statement), but cash pays the bills.

IV. Companies must manage cash effectively.

a. Amounts of cash flow

b. Timing of cash flow

V. Steps in preparing the statement of cash flows:

a. Identify each cash transaction from the asset column on the accounting equation

worksheet.

b. Classify each cash amount as one of three types: operating, investing, or financing.

Teaching Tip

While a business must have profitable operations in order to operate over a long period of time, it

must also have cash to operate. More information can be obtained for evaluation of the company

by studying the income statement together with the cash-flow statement.

Teaching Tip

Operating cash flows relate to →Current assets and liabilities

Investing cash flows relate to →Long-term assets

Financing cash flows relate to →Long-term liabilities and shareholders’ equity

Two Methods of Preparing and Presenting the Statement of Cash Flows (LO 2)

I. GAAP allows two methods of preparing the statement of cash flows: direct and indirect.

a. Named for the way in which the operating activities section is prepared

b. Cash flow from operations includes all cash receipts and disbursements for routine

sales and purchases made in the course of doing business.

II. Direct method shows every cash inflow and outflow to prepare the statement of cash

flows.

a. Converts every number on the income statement to its cash amount

III. Indirect method starts with net income and makes adjustments for items that are not

cash to prepare the statement of cash flows.

IV. The other two sections of the statement of cash flows (investing and financing) are

unaffected by the method used to prepare the operating activities section.

Teaching Tip

Remind students that the total net cash flow from operating activities will be the same whether

the direct or indirect method is used; just the presentation of data differs.

Teaching Tip

Use the example that begins on page 417 to illustrate the two methods of preparing the operating

activities section.

Accrual Accounting versus Cash Basis Accounting (LO 3)

I. Companies that follow GAAP maintain their accounting records using the accrual basis.

II. Preparing the statement of cash flows is actually converting the records of the business to

a cash basis.

III. Differences in accrual basis and cash basis

a. Cash inflows can occur before, at the same time as, or after revenue is recognized

under the accrual basis.

b. Cash outflows can occur before, at the same time as, or after expense is recognized

under the accrual basis.

c. When cash flow and revenue or expense recognition do not occur at the same time,

current asset and current liability accounts are affected.

i. Accounts receivable

ii. Supplies

iii. Accounts payable

iv. Salaries payable

d. Changes in current asset and current liability accounts will reflect the difference

between the accrual-based income statement amount and the cash amount.

Teaching Tip

Ask students to suggest some reasons why accrual-basis net income is not the same as cash-basis

net income. Possible ideas: depreciation, depletion, and amortization are noncash expenses that

are deducted for accrual-basis net income; at year end, accrued expenses have not yet been paid

in cash; likewise, at year end, accrued revenues have not yet been received in cash. There may

also be cash payments for expenses that were recorded in previous periods or cash receipts for

revenues recorded in previous periods. Students may have additional suggestions.

Preparing the Statement of Cash Flows: Direct Method (LO 4)

I. Start with the income statement.

II. Analyze every item on the income statement to determine how much cash was actually

disbursed or collected.

III. Cash inflows:

a. Cash collected from customers

b. Cash collected for interest

Cash outflows:

c. Cash paid to employees

d. Cash paid to suppliers of inventory

e. Cash paid for operating expenses

f. Cash paid for interest

g. Cash paid for taxes

Teaching Tip

Explain why an increase or decrease in a current asset is adjusted differently than an increase or

decrease in a current liability. Transactions affecting current assets and current liabilities have

the opposite effect on cash and net income, and also assets and liabilities are on opposite sides of

the accounting equation.

Teaching Tip

Remind students that the reason these items are added (or subtracted) is to negate the effect the

item had on net income. For example, depreciation lowered income but did not affect cash.

Therefore, depreciation must be added back.

Teaching Tip

Help students understand why cash collections from customers are not the same as sales revenue.

There may have been credit sales from last year that were not collected until early this year.

Also, at the end of this year, any credit sales made will not be collected in cash until next year.

What we need to know for the cash-flow statement is just the actual cash collected. (Try to help

students understand a similar type of analysis for each type of operating cash flow that is

calculated, for the direct method approach.)

Teaching Tip

Use the examples on pages 421 and 422 to illustrate how income statement information is

converted to cash flow from operations.

Preparing the Statement of Cash Flows: Indirect Method (LO 5)

I. Start with net income.

II. Any amounts of net income that are noncash must be removed.

a. Depreciation expense

b. Amortization expense

III. Next, adjustments are made to convert the accrual-basis measurement to a cash flow

measurement.

a. Changes in current asset and current liability accounts reflect the differences in

accrual-basis net income and cash flow.

b. Increases in current asset accounts are subtracted.

c. Decreases in current asset accounts are added.

d. Increases in current liability accounts are added.

e. Decreases in current liability accounts are subtracted.

Teaching Tip

Use the example on pages 423 and 424 to illustrate how the indirect method is used to compute

cash flow from operations.

Cash from Investing and Financing Activities (LO 6)

I. Cash from investing activities

a. Consists of cash flows related to investing

b. GAAP defines investing as activities that involve buying and selling assets that the

company plans to keep for more than one year.

c. Includes all cash inflows and outflows for long-term business assets and other

investments

i. Cash inflows

1. Cash proceeds from the sale of property, plant, and equipment

2. Cash proceeds from the sale of marketable securities

ii. Cash outflows

1. Cash paid to buy property, plant, and equipment

2. Cash paid for investments

3. Cash loaned to others

II. Cash from financing activities

a. Consists of cash flows related to financing

b. Includes all cash inflows and outflows related to noncurrent liabilities and equity

i. Cash inflows

1. Cash proceeds from sale of stock

2. Cash proceeds from loans

ii. Cash outflows

1. Cash paid for treasury stock

2. Cash paid to retire debt principal

3. Cash payment of dividends

III. Regardless of the method used to compute cash flow from operations, the cash flows

from investing and financing activities are prepared the same way.

a. Review noncurrent asset and noncurrent liability accounts.

i. Property, plant, and equipment

ii. Investments

iii. Notes payable

iv. Bonds payable

b. Review equity accounts.

i. Common stock

ii. Treasury stock

iii. Retained earnings

Teaching Tip

Use this information to calculate the amounts to report on the cash-flow statement for investing

activities:

Beginning plant assets $76,000

Beginning accumulated depreciation 5,200

Depreciation for the year 1,300

Purchases of new assets 4,200

Ending net plant assets 72,850

Loss on sale of plant assets 150

In the investing activities section on the statement of cash flows:

Purchase of assets $(4,200)

Sale of plant assets 700

[$76,000 – $5,200 = $70,800 beginning net plant assets; $70,800 + $4,200 – $1,300 – x =

$72,850;

x = $850, the book value of plant assets sold. If the assets were sold at a loss, then cash received

from the sale = $700 ($850 – $150)]

Teaching Tip

Use the example on pages 425 and 426 to illustrate how the investing and financing activities

sections are prepared.

Summary of Direct and Indirect Methods (LO 6)

I. There are two ways to prepare and present the statement of cash flows – direct and

indirect.

II. The direct method:

a. Provides more detail about cash from operating activities

b. Must also include a reconciliation of net income to cash from operating activities,

which, in effect, requires the company to compute operating cash flows under the

indirect method anyway

III. The indirect method:

a. Is easier to prepare but the presentation is not easily understood

b. Must also include separate disclosures for cash paid for interest and taxes

Applying Your Knowledge: Financial Statement Analysis (LO 7)

I. Examine each section of the statement of cash flows.

a. Cash flows from operating activities

b. Cash flows from investing activities

c. Cash flows from financing activities

d. Reconciliation of beginning cash balance to ending cash balance

II. Free cash flow is equal to cash from operating activities minus dividends and minus

capital expenditures.

a. Measures a firm’s ability to engage in long-term investment opportunities

b. Sometimes seen as a measure of a company’s financial flexibility

Business Risk, Control, and Ethics (LO 8)

I. Managers can rarely falsify the amounts of cash inflow and outflow.

II. However, managers can manipulate the classifications of the cash flows.

Teaching Tip

Ask students what some warning signs are that individuals are experiencing cash flow

difficulties. Examples include difficulty making payroll (operating cash flow), meeting current

obligations, borrowing money, and taking money from savings (selling investments). Explain

that the warning signs that companies are experiencing cash-flow difficulties are very similar.

Some potential problems to watch for are:

1. A company that does not replace the fixed assets that are sold

2. A company that does not reinvest some of its earnings in the company but pays out most

or all of its income as dividends

3. A company that continually uses borrowed funds to fund operations

CHAPTER 9 NAME ___________________________________

TEN-MINUTE QUIZ Section _____________ Date____________

_____________________________________________________________________________

_

_____ 1. Two methods of preparing the statement of cash flows are the:

a. Direct and operating methods

b. Indirect and investing methods

c. Direct and indirect methods

d. Operating and investing methods

_____ 2. The difference between the direct method and the indirect method applies only to:

a. Operating section

b. Investing section

c. Financing section

d. Indirect section

_____ 3. Cash flows from operations include:

a. Cash received from customers

b. Cash paid for dividends

c. Cash paid for interest

d. All of the above

_____ 4. Cash flows from investing include:

a. Cash proceeds from the sale of property, plant, and equipment

b. Cash borrowed to buy property, plant, and equipment

c. Cash dividends paid

d. All of the above

_____ 5. Cash inflows from financing include:

a. Cash proceeds from loans

b. Cash loaned to others

c. Cash paid for interest

d. All of the above

_____ 6. According to generally accepted accounting principles, the preferred method of

computing operating cash flows is the:

a. Direct method

b. Sales method

c. Allowance method

d. Indirect method

_____ 7. Cash from investing activities includes all cash receipts and disbursements for:

a. Long-term business assets

b. Long-term loans

c. Contributions from and distributions to owners

d. All of the above

_____ 8. Cash from financing activities includes all cash receipts and disbursements for:

a. Long-term business assets

b. Long-term loans

c. Interest

d. All of the above

_____9. Print Fast, Inc. disclosed the following items:

Issuance of mortgage $70,000

Purchase of land 50,000

Payment of cash dividends 25,000

Sale of equipment 10,000

How much is cash flow from financing activities?

$95,000 inflow

$85,000 outflow

$45,000 inflow

None of the above

_____ 10. Free cash flow equals:

Net increase in cash during the period

Cash flows from operating activities divided by cash flows for capital

expenditures – cash proceeds from the sale of capital assets

Cash flows from operating activities – cash dividends – capital expenditures

The balance of cash

ANSWER KEY – CHAPTER 9 – TEN-MINUTE QUIZ

C

A

B

C

A