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
variety of questions such as:
1. Are cash flows sufficient to support ongoing
operations?
iii. The statement of cash flows is based on the
principle that properly analyzing the changes
1
Chapter 12 Statement of Cash Flows
iv. The basic equations for assets, contra-assets,
liabilities, and stockholders’ equity shown on
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
1. Operating activities generate cash inflows
and outflows related to revenue and expense
transactions that affect net income.
2. Investing activities generate cash inflows
8
7
Chapter 12 Statement of Cash Flows
ii. This slide summarizes the most common
B. Key concept #2
i. The net amount of cash inflows and outflows
resulting from operating activities, which is
1. Under the direct method, the income
statement is reconstructed on a cash basis
from top to bottom. For example:
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.
11
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
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
12
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
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)
Chapter 12 Statement of Cash Flows
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
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
E. Summary of four key concepts
i. These slides summarize the four key concepts
related to preparing the statement of cash
flows.
19–20
17
18
16
Chapter 12 Statement of Cash Flows
III. The statement of cash flows—an example
Learning Objective 12-2: Prepare a statement of cash
A. Apparel Inc.: background information
i. Let’s assume that Apparel Inc. reported the
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
22
Chapter 12 Statement of Cash Flows
1. The accounts receivable balance decreased
by $17, 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.
iii. The third step is adjust for gains and losses
included in the income statement.
1. Apparel’s income statement includes a gain
iv. The operating activities section of Apparel’s
statement of cash flows would appear as
shown on this slide.
28
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
D. Financing activities
i. To compute the gross cash flows in the
1. The balance in Bonds Payable decreased
by $41 million. Because the assumptions
state that Apparel did not issue any bonds
Chapter 12 Statement of Cash Flows
3. The basic equation for stockholders’ equity
E. Apparel Inc: statement of cash flows
i. Apparel’s completed statement of cash flows is
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
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
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
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.
Chapter 12 Statement of Cash Flows
iii. Some managers compare the additions to
property, plant, and equipment in the investing
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
34
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.
37