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5-1 Notes
CHAPTER 5
STATEMENT OF CASH FLOWS: REPORTING THE EFFECTS OF
OPERATING, INVESTING, AND FINANCING ACTIVITIES ON CASH
FLOWS
I. Learning Objectives
1. Understand why using the accrual basis of accounting to prepare the
balance sheet and income statement creates the need for a statement of
cash flows.
2. Understand the types of transactions that result in cash flows from
operating, investing, and financing activities.
3. Develop an ability to prepare a statement of cash flows from comparative
balance sheet and income statement.
4. Develop an ability to analyze the statement of cash flows, including the
relations among cash flows from operating, investing, and financing
activities for various growth stages.
II. Organization of Class Sessions
We place the material on the statement of cash flows at this early stage
in the book to provide more effective integration with the material in preceding
chapters covering the balance sheet and income statement. An understanding of
how the beginning-of-the-period balance sheet transforms into the end-of-the-
period balance sheet requires information from both the income statement and
statement of cash flows. We find that placing the material on the statement of
cash flows at the end of the text tends to de-emphasize its significance. Also, such
placement tends to make the integration of this statement with the balance sheet
and income statement more difficult.
Students often gasp for breath after the first four chapters. You may
prefer to delay coverage of this chapter to allow students time to cement their
understanding of the accounting framework. The procedure suggested for
preparing the statement of cash flows requires the working "backwards" from
balance sheet changes to the transactions recorded during the period.
Understanding the material in Chapter 4 is, therefore, essential. The chapter
presents the rationale for the statement and the procedures for preparing it at an
elementary level so as not to burden the student with unnecessary complexity.
Later chapters discuss more complex problems in preparing the statement of cash
flows.
Notes 5-2
If you prefer to delay coverage of this chapter until after Chapter15, you
can do so without loss of continuity. You will want to suggest to students that
they skip the appendices in Chapters 8 through 15 dealing with the statement of
cash flows.
We begin coverage of this chapter by emphasizing that a full
understanding of how the beginning-of-the-period balance sheet transforms into
the end-of-the-period balance sheet requires information from the statement of
cash flows. This discussion permits consideration of the purpose of the
statement, the various sources and uses of cash, and the algebraic derivation of
cash flow from balance sheet changes. We then work several problems using the
T-account work sheet and leading to the preparation of formal statements of cash
flows. We conclude with analysis of the statement of cash flows for various
businesses.
If so, we point out that they have already prepared the essence of a
statement of cash flows, and all that remains is to master various formatting
issues.
On reflection, you may agree with us that almost all the complication in
this material results from the indirect method of presenting cash flow from
operations. Problem 5.44 shows how counter-intuitive is the indirect method.
We assure the students that almost no one, and surely no one we have ever met,
understands the indirect method on first exposure, while the direct method seems
so trivial as hardly to be worth taking time to discuss.
III. Lecture Outline
1. Understand why using the accrual basis of accounting to prepare the
balance sheet and income statement creates the need for a statement of
cash flows.
A. Begin with the comparative balance sheets of Solinger Corporation in
Exhibit 5.4 in the text. What can you deduce about causes of the changes in
each balance sheet account? One can conclude little from looking at balance
recognized during the period?
B. Next, look at the income statement for Solinger Corporation in Exhibit 5.5.
What additional information does the income statement add to our
understanding of balance sheet changes? Because retained earnings
increased $13,000 during the period and net income was $20,000, the firm
5-3 Notes
must have declared dividends of $7,000. We still do not have sufficient
information to fully explain the changes in the balance sheet accounts other
than retained earnings.
C. Finally, look at the statement of cash flows of Solinger Electric Corporation
in Exhibits 5.7 and 5.8. What additional insights does it provide about the
changes in balance sheet accounts? We can see that the Bonds Payable
account increased because the firm issued long-term debt. The Buildings
and Equipment (Cost) account increased because of the acquisition of some
fixed assets. This statement, therefore, provides information about the
major financing and investing activities of the firm during the period. The
statement also indicates how the operating, or earnings, process affected
cash. The statement, therefore, provides useful information for assessing
the firm's liquidity and the structure of its assets, liabilities, and
shareholders' equity. (Questions 5.4, 5.5, 5.6, 5.11 and 5.7)
2. Understand the types of transactions that result in cash flows from
operating, investing, and financing activities.
By this point in the course, students should be familiar with the nature of
operating, investing, and financing activities. To cement understanding of
these three categories of activities, we place the following on the board or an
overhead transparency.
We then ask: Which of the four categories of the balance sheet above is
most often involved in recording operating activities? investing activities?
financing activities? The following presentation assumes the instructor wants
to focus first on the more common indirect method for presenting cash flows
from operations. Later, we show our thoughts on focusing first on the direct
method.
Notes 5-4
A. Operating Activities: Operating activities usually involve current asset
and current liability accounts as well as retained earnings. Purchases
and sales of marketable securities and increases and decreases in short-
term bank borrowing involve current asset or current liability accounts
B. Investing Activities: Most investing activities involve noncurrent assets
(acquisitions and sales of property, plant, equipment, investments in
securities and intangible assets). We ask then why depreciation and
amortization appear in the operating section. The concept is difficult for
many students to grasp at this point in the course because their
appearance there is to undo the subtraction in net income to derive cash
flows without accruals. We ask: when does a cash flow occur with
respect to an item of equipment? Most students respond by saying:
C. Financing Activities: Most financing activities involve noncurrent
liabilities and shareholders’ equity accounts (issues and redemptions of
debt, issues and repurchases of capital stock, payment of dividends).
The most difficult concept for students to grasp is why interest expense
on debt appears as an operating activity while dividends on capital stock
appear as a financing activity. At this stage we admit to a seeming
inconsistency and suggest this classification is at least consistent with
the treatment of interest as an expense, but not dividends, when
computing net income. (Questions 5.6 and 5.8)
5-5 Notes
3. Develop an ability to prepare a statement of cash flows from
comparative balance sheet and income statement.
A. Algebraic Derivation of Statement of Cash Flows
i. Start with the following form of the balance sheet equation:
ii. If we subtract the amounts on the balance sheet at the beginning of
the period from the amounts at the end of the period, we obtain the
changes (∆) in each balance sheet component.
iii. We can now expand this equation for balance sheet changes as
follows:
Rearranging:
This form of the equation shows that changes in cash must
equal changes in all other balance sheet accounts. In the statement
of cash flows, we not only show the change in cash (left-hand side of
equation) but the causes of the change in cash that affect noncash
accounts (right-hand side of equation).
iv. At this point, we work Exercise 5.26 or 5.27 or Problem 5.33 or 5.34
to demonstrate the effect of various transactions on the cash change
equation. As an alternative, you may wish to use Exercise5.32 which
ties various transactions into the statement of cash flows. The key at
this point is to get students to see the relation between transactions
data covered in Chapter 4and the statement of cash flows.
B. Preparation of Columnar Work Sheet
i. We find it most effective to move next to preparation of the Columnar
work sheet. The work sheet is a natural extension of the cash change
equation considered above. We tend to work full-length problems at
the outset to emphasize the entire procedure. (Problems 5.41 and
5.42) We may then assign shorter exercises to reinforce particular
elements of the procedure. (Exercises 5.18, 5.29, 5.30, and 5.31)
Notes 5-6
ii. The difficult transaction for students at this point in their study of
accounting is the sale of fixed assets. We defer to Chapter 9, the
treatment of sales at an amount different from book value. If your
students understand Problem 5.5 for Self-Study in the text, you can
introduce the notions of disposition at gain or loss. We find it helpful to
have students derive the journal entry the firm made in its accounts to
record the sale. We then ask: how much total cash did the firm receive?
Most students respond by saying, “The amount debited to the cash
account.” As a result of our discussion about Learning Objective 2. above,
students understand why accountants classify this cash inflow as an
investing activity. We then ask: does the income statement include any
amount related to the sale of fixed assets? After some time, students
realize that net income includes the gain or loss on the sale. We then
ask: do we misstate cash flows if we both include the gain or loss in the
calculation of cash flow from operations and include the cash received as
an investing activity? In responding affirmatively to this question,
students realize the need either to eliminate an amount equal to the gain
or loss from net income when computing cash flow from operations or
eliminate a similar amount from the cash proceeds when computing cash
flow from investing activities. GAAP requires the former procedure so
that the investing section shows the full cash proceeds. (Exercise 5.31)
4. Develop an ability to analyze the statement of cash flows, including
the relation among cash flows from operating, investing, and
financing activities for various growth stages.
Accomplishing this learning objective is important at this point in the
course because it brings together information from all three principal financial
statements. Students tend to have a good handle on the dual-entry recording
framework as it applies to the three financial statements but often need to be
led into interpretation of the statement. We use Problem 5.35 or 5.36 to
develop the skills to infer cash flow amounts from balance sheet and income
statement information. We use Problem 5.36 or 5.46 for time series analyses.
These latter problems use financial statement data for real companies.
5-7 Notes
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