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chapter
14(13)
Statement of Cash Flows
______________________________________________
OPENING COMMENTS
This chapter demonstrates that the statement of cash flows is necessary for a complete picture of a
company’s financial condition. Both the direct and indirect methods of preparing a statement of cash
flows are presented.
If course timing is restrictive, you may want to cover only one of the two methods of preparing the
statement of cash flows. The indirect method is the most commonly used method for reporting cash
flows. It is very easy to cover only this method since the entire statement of cash flows (including
operating, investing, and financing activities) is presented in Objective 2.
After studying the chapter, your students should be able to:
2. Prepare a statement of cash flows, using the indirect method.
4. Describe and illustrate the use of free cash flow in evaluating a company’s cash flow.
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274 Chapter 14(13) Statement of Cash Flows
KEY TERMS
cash flow per share
cash flows from financing activities
cash flows from investing activities
STUDENT FAQS
Why do most preparers of cash flow statements prefer the indirect method?
I just don’t see a need for the cash flow statement. Who cares about the cash flow statement since it
tells the reader only where the company’s money came from and where the company’s money was
spent?
Why does the cash flow statement have to equal the change in the cash account?
Why does only the Operating section of the cash flow statement change when preparing the
statement under the two different methods?
If the cash flow statement is so important and helpful, why don’t we prepare all the financial
statements on a cash basis?
OBJECTIVE 1
Describe the cash flow activities reported in the statement of cash flows.
SYNOPSIS
The statement of cash flows reports a company’s cash position: it inflows and outflows. It provides
information that answers questions about how the company generates cash from operations, how it
maintains or expands its operations, how it meets its financial obligations, and whether it has the cash to
pay dividends. The cash flow statement is used by both external and internal users. The cash flow
statement is divided into three sections: the operating activities are the cash flows from transactions that
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Chapter 14(13) Statement of Cash Flows 275
affect the net income of the company, the investing activities are the cash flows from transactions that
affect investment in noncurrent assets, and the financing activities are the cash flows from transactions
that affect the debt and equity of the company. The ending cash on the statement of the cash flows equals
the cash reported on the balance sheet at the end of the year.
Cash flows from operating activities report the cash inflow and outflow from a company’s day-to-day
operations. In the direct method, the primary operating inflows of cash are received from customers, and
the primary outflows of cash are for merchandise, operating expenses, interest, and tax payments. The
flows format is shown in Exhibit 3.
Key Terms and Definitions
Cash Flow per Share - Normally computed as cash flow from operations per share.
Cash Flows from Financing Activities - The section of the statement of cash flows that reports
cash flows from transactions affecting the equity and debt of the business.
Cash Flows from Investing Activities - The section of the statement of cash flows that reports
cash flows from transactions affecting investments in noncurrent assets.
Cash Flows from Operating Activities - The section of the statement of cash flows that reports
Relevant Example Exercises and Exhibits
Example Exercise 14(13)-1 Classifying Cash Flows
Exhibit 1 Sources and Uses of Cash
Exhibit 2 Cash Flow from Operations: Direct and Indirect MethodsNetSolutions
Exhibit 3 Format of the Statement of Cash Flows
SUGGESTED APPROACH
Provided below is a Writing Exercise to introduce the statement of cash flows. The exercise asks students
to evaluate financial data from two companies. The goal is to point out that a firm’s profits do not paint a
total picture of its operations; cash flow data is also needed. Follow the Writing Exercise [Transparency
Master (TM) 14(13)-1] by reviewing TM 14(13)-2, which lists the benefits of a statement of cash flows.
A Lecture Aid is also provided here for reviewing the content of each section of the cash flow statement.
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276 Chapter 14(13) Statement of Cash Flows
WRITING EXERCISEImportance of the Statement of Cash Flows
TM 14(13)-1 presents financial information taken from the accounting records of two companies. These
companies have the same net incomes but very different cash flows. Even though both companies have
the same sales, Company B did not collect as much cash from its customers. In addition, Company B did
not invest as much cash in fixed assets; this could inhibit future growth.
Show this data to your students and ask them to comment, in writing, on any strengths or weaknesses they
see in the two companies. After giving them a few minutes to study the information and write their
comments, review their responses.
LECTURE AIDStatement of Cash Flows
TMs 14(13)-3 and 14(13)-4 list the three sections of the statement of cash flows and the transactions
included in each section. TM 14(13)-5 defines the content of the schedule of noncash investing and
financing activities.
After reviewing these TMs, you may want to discuss the treatment of interest on debt and
interest/dividends on investments in the statement of cash flows. These transactions can be called the
“three foolers, because students typically want to identify them as financing and investing activities
OBJECTIVE 2
Prepare a statement of cash flows, using the indirect method.
SYNOPSIS
Using the indirect method of reporting cash flows for operating activities, a comparison is made between
the account balances at the beginning and end of the year. By analyzing changes in noncash balance sheet
accounts, changes in the cash account are determined indirectly. The equation, change in cash = change in
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Chapter 14(13) Statement of Cash Flows 277
Relevant Example Exercises and Exhibits
Example Exercise 14(13)-2 Adjustments to Net IncomeIndirect Method
Example Exercise 14(13)-3 Changes in Current Operating Assets and LiabilitiesIndirect
Method
Example Exercise 14(13)-4 Cash Flows from Operating ActivitiesIndirect Method
SUGGESTED APPROACH
Open your discussion of the indirect method with a basic outline of the reconciliation prepared in the
Operating Activities section. TM 14(13)-7 presents an overview of the reconciliation process. You will
also want to illustrate this process by preparing a statement of cash flows as a demonstration problem.
LECTURE AIDIndirect Method
During your discussion of TM 14(13)-7 (the reconciliation of net income to net cash flows from operating
activities), stress the following points:
1. Noncash expenses must be added to remove these expenses from net income. They must be removed
from net income because they did not cause cash to be paid out.
Ask your students to identify examples of noncash items reported on the income statement and
whether they would be added to or deducted from net income to determine cash flows from operating
activities. Several examples are listed below.
Noncash Item Treatment
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2. Any gains or losses on investing and financing activities affect the amount of cash that was received
from selling investments or the amount of cash paid when settling debts. Because these activities are
reported in the investing and financing sections of the statement of cash flows, the gain or loss
included in the calculation of net income must be removed to isolate operating cash flows.
DEMONSTRATION PROBLEMPreparing a Statement of Cash Flows:
Indirect Method
Because of the amount of data required to prepare a statement of cash flows, it is appropriate to use a
problem from the text to demonstrate the preparation of the statement of cash flows. If you plan to cover
the direct method of reporting cash flows, use Problem 14(13)-1A or 14(13)-1B to demonstrate the
indirect method. Next, use Problems 14(13)-5A or 14(13)-5B to illustrate the Operating Activities section
on a direct method statement of cash flows. Problems 14(13)-5A and 14(13)-5B provide the additional
information needed to do a direct statement for the same company in 14(13)-1A and 14(13)-1B.
Therefore, you can save class time by doing the entire statement under the indirect method but only the
Operating Activities section under the direct method.
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Chapter 14(13) Statement of Cash Flows 279
If you can explain what caused your Noncash Assets, Liabilities, and Stockholders’ Equity account
balances to change, you have explained what caused the Cash account balance to change.
The second preparatory step is to go through the balance sheet accounts and note where the change in
each account balance will be reported (O for operating activities, I for investing activities, and F for
financing activities). A few accounts, namely Retained Earnings and Accumulated Depreciation, must be
considered when preparing two sections of the statement of cash flows.
You will probably want to lead students through this step, instructing them to place an O, I, or A by each
account title in the example problem. The accounts in Problem 14(13)-1A or 14(13)-1B would be coded
as follows:
Now your students are ready to attack the problem, beginning with the Operating Activities section.
Students should be encouraged to use a “check-off” method in completing the statement of cash flows.
The basics of the check-off method are as follows: When the total change in an account has been
explained, check it off. Once an account has been checked off, you don’t need to look at it again.
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280 Chapter 14(13) Statement of Cash Flows
The next step in the Operating Activities section is to add back any depreciation, amortization, or
depletion. What account on the balance sheet would contain the depreciation for the year? (Answer:
Accumulated Depreciation) However, that account is also affected by entries to remove fixed assets when
sold or discarded. In Problem 14(13)-1A, we are told that there were no disposals of equipment.
Therefore, the only entry in the accumulated depreciation account would be the adjusting entry for the
year’s depreciation expense. The $13,800 change in this account is the depreciation expense to be added
to net income. Because the change in the account balance has been fully explained, the accumulated
depreciation account can be checked off. Those are the basic steps in the check-off method.
Now it is time to look at the current assets and current liabilities related to operations. Instruct your
students to go through the accounts coded with O and write down whether each account increased or
decreased and by what amount. Then, ask your students to determine whether the change had a positive or
negative effect on cash. Many students want to cling to text Exhibit 4 to assist with this task, so try to give
them a logical approach to determine how account changes affect cash.
The suggested explanations are overly simplified and, therefore, not “totally” accurate. However, most of
your students will find them useful. For example, accounts receivable in Problems 14(13)-1A and 14(13)-
1B increased. A simplified explanation of how this affects cash flows follows:
If accounts receivable went up, did you sell more or less on credit? More. If you sold more on credit, did
you sell more or less for cash? Less. If you sold less on cash, what was the effect on the Cash account? It
1. Increase in Inventory: The company bought more inventory, so it has to pay for more inventory. Cash
is decreased.
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2. Decrease in Inventory: The company bought less inventory, so it doesn’t have to pay for as much
inventory. Cash is increased.
4. Decrease in Prepaid Expense: The company has prepaid fewer expenses, saving its cash. Cash is
increased.
6. Decrease in Accounts Payable: The company has bought less on credit, so it is buying more with
cash. Cash is decreased.
OBJECTIVE 3
Prepare a statement of cash flows, using the direct method.
SYNOPSIS
Since the two methods are the same for the Investing and Financing sections, only the Operating
Activities section is calculated differently. The direct operating section starts with cash received from
customers. To determine this number, add the decrease in accounts receivable or subtract the increase in
accounts receivable from sales. These steps are shown in Exhibit 9. Next, determine the cash paid for
merchandise by subtracting or adding the differences in inventories and accounts payable from the cost of
merchandise sold reported on the income statement; these steps are found in Exhibit 10. Determine the
cash paid for operating expenses by subtracting or adding the differences in expenses payable from the
operating expenses (other than depreciation) reported on the income statement; these steps are found in
Exhibit 11. The format for the cash flows statement in the direct method is shown in its entirety in Exhibit
14. Also in the exhibit is a comparison of the direct and indirect formats.
Relevant Example Exercises and Exhibits
Example Exercise 14(13)-6 Cash Received from CustomersDirect Method
Example Exercise 14(13)-7 Cash Payments for MerchandiseDirect Method
Exhibit 8 Converting Income Statement to Cash Flows from Operating Activities Using the
Direct Method
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282 Chapter 14(13) Statement of Cash Flows
SUGGESTED APPROACH
The direct method of preparing a statement of cash flows is another topic that can be presented effectively
through a Demonstration Problem. If you have already covered the indirect method, you need only to
illustrate the Operating Activities section.
Prior to beginning the Demonstration Problem, stress that the Operating Activities section is the only
portion of the statement of cash flows that varies between the direct and indirect methods. The direct and
DEMONSTRATION PROBLEMPreparation of a Statement of Cash Flows:
Direct Method
The direct method presents the major classes of cash receipts and payments from operating activities. To
prepare a direct statement of cash flows, an income statement is needed in addition to comparative
balance sheets. Problems 14(13)-5A and 14(13)-5B repeat the information presented in Problems 14(13)-
1A and 14(13)-1B, plus give an income statement.
For example, Problem 14(13)-5A presents the following data:
Sales $5,261,701 Beg. accounts receivable $156,720
End accounts receivable 170,880
Net change $ 14,160
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Chapter 14(13) Statement of Cash Flows 283
The methodology presented under Objective 2 will also work in the direct method. The previous
calculation could be explained as follows:
Accounts receivable increased, so the company is selling more on credit and selling less for cash.
Therefore, the effect on cash receipts is negative.
Or:
Accounts receivable increased, indicating that credit sales on account were $14,160 more than cash
collections. Therefore, the increase must be subtracted from sales to get cash receipts.
Problem 14(13)-5A does not show the detailed calculation of cost of merchandise sold; therefore, the cost
of merchandise purchased cannot be determined just by looking at the income statement. However, it can
be determined as follows:
Beginning Inventory
+ Cost of Merchandise Purchased
Ending Inventory
Cost of Goods Sold
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284 Chapter 14(13) Statement of Cash Flows
The cost of merchandise purchased must be adjusted to determine cash payments for purchase:
Cost of merchandise purchased $3,256,450
Credit purchases not yet paid for (ending balance of
accounts payable) (318,360)
Explain that the increase in inventories can be interpreted as increasing cash payments because more
inventory was purchased. The increase in accounts payable can be interpreted as decreasing cash
payments because the company made more purchases on account.
Continue with the problem, demonstrating the calculations of cash paid for operating expenses and cash
paid for income taxes. When you have completed the Operating Activities section, remind students that
the net cash flow is the same number as computed under the indirect method.
OBJECTIVE 4
Describe and illustrate the use of free cash flow in evaluating a company’s cash flow.
SYNOPSIS
Free cash flow measures the operating cash flow available to a company to use after purchasing the
property, plant, and equipment necessary to maintain current productive capacity. It is also used to
measure the financial strength of a company. Calculate free cash flow as: cash flow from operating
activities investments in PP&E needed to maintain current production = free cash flow. Positive free
cash flow is considered favorable. The company will be able to fund growth, retire debt, pay dividends,
and have financial flexibility.
Key Terms and Definitions
Free Cash Flow - The amount of operating cash flow remaining after replacing current
productive capacity and maintain current dividends.
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Chapter 14(13) Statement of Cash Flows 285
Relevant Example Exercises and Exhibits
Example Exercise 14(13)-8 Free Cash Flow
SUGGESTED APPROACH
DEMONSTRATION PROBLEMFree Cash Flow
Free cash flow is the amount of operating cash flows left after paying dividends and paying for assets
needed to maintain productive capacity. Free cash flow recognizes that operations must generate
sufficient cash to replace assets used in operations. It also recognizes that shareholders want to see
companies maintain steady dividend payments. The formula for free cash flow is:
Cash flow from operations
Cash used to purchase fixed assets needed to maintain productive capacity
Free Cash Flow
If the calculation of free cash flow yields a negative number, a company’s operations cannot support asset
replacement.
1. What is Charles Inc.’s cash flow from operating activities for 2013? (Answer: $148,280)
2. How much cash was used to pay dividends in 2014? (Answer: $72,000)
3. What amount of cash was paid to purchase equipment? (Answer: $114,000)
4. Can we assume all of the equipment purchases were to maintain productive capacity? (Answer: No.)
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286 Chapter 14(13) Statement of Cash Flows
APPENDIX: SPREADSHEET (WORK SHEET)
FOR STATEMENT OF CASH FLOWSTHE
INDIRECT METHOD
SYNOPSIS
The appendix explains how to use a worksheet to create a statement of cash flows using the indirect
method. Using Exhibit 15, follow the seven steps to create the worksheet that will display all the
information needed to make a cash flow statement. The cash flow statement will be identical to the cash
flow statement shown in Exhibit 7.
Relevant Example Exercises and Exhibits
Exhibit 15 End-of-Period Spreadsheet (Work Sheet) for Statement of Cash FlowsIndirect
Method
SUGGESTED APPROACH
A spreadsheet (work sheet) is a tool that can be used to gather data for preparing a statement of cash
flows. It is an alternative to the “check-off” method presented under Objectives 2 and 3.
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Type Item Description LO(s) Difficulty Time Est BUSPROG AICPA ACBSP - APC Bloom's EE Excel GL SMH FAI Service Real World Writing Ethics Internet Group
DQ 1 3 Easy 5 min. Analytic Measurement Statement of Cash Flows Knowledge
DQ 2 2 Easy 5 min. Analytic Measurement Statement of Cash Flows Knowledge
DQ 3 1 Easy 5 min. Analytic Measurement Statement of Cash Flows Knowledge
DQ 4 2 Easy 5 min. Analytic Measurement Statement of Cash Flows Knowledge
DQ 5 2 Easy 5 min. Analytic Measurement Statement of Cash Flows Knowledge
DQ 6 2 Easy 5 min. Analytic Measurement Statement of Cash Flows Knowledge
PE 4B Cash flows from operating activities - indirect method 2 Easy 10 min. Analytic Measurement Statement of Cash Flows Application x
PE 5A Land transactions on the statement of cash flows 2 Easy 5 min. Analytic Measurement Statement of Cash Flows Application x
PE 5B Land transactions on the statement of cash flows 2 Easy 5 min. Analytic Measurement Statement of Cash Flows Application x
PE 6A Cash received from customers - direct method 3 Easy 5 min. Analytic Measurement Statement of Cash Flows Application x
PE 6B Cash received from customers - direct method 3 Easy 5 min. Analytic Measurement Statement of Cash Flows Application x
PE 7A Cash payments for merchandise - direct method 3 Easy 5 min. Analytic Measurement Statement of Cash Flows Application x
PE 7B Cash payments for merchandise - direct method 3 Easy 5 min. Analytic Measurement Statement of Cash Flows Application x
PE 8A Free cash flow 4 Easy 5 min. Analytic Measurement Statement of Cash Flows Application x x
PE 8B Free cash flow 4 Easy 5 min. Analytic Measurement Statement of Cash Flows Application x x
EX 1 Cash flows from operating activities - net loss 1 Easy 5 min. Analytic Measurement Statement of Cash Flows Application x x
EX 2 Effects of transactions on cash flows 1 Easy 10 min. Analytic Measurement Statement of Cash Flows Application
EX 3 Classifying cash flows 1 Easy 10 min. Analytic Measurement Statement of Cash Flows Application
EX 4 Cash flows from operating activities - indirect method 2 Easy 10 min. Analytic Measurement Statement of Cash Flows Application
EX 5 Cash flows from operating activities - indirect method 2 Easy 10 min. Analytic Measurement Statement of Cash Flows Application x x
EX 6 Cash flows from operating activities - indirect method 1,2 Easy 10 min. Analytic Measurement Statement of Cash Flows Application x x
EX 22 Cash flows from operating activities - direct method 3 Moderate 15 min. Analytic Measurement Statement of Cash Flows Application x
EX 23 Cash flows from operating activities - direct method 3 Moderate 15 min. Analytic Measurement Statement of Cash Flows Application
EX 24 Free cash flow 4 Easy 5 min. Analytic Measurement Statement of Cash Flows Application x x x
EX 25 Free cash flow 4 Easy 5 min. Analytic Measurement Statement of Cash Flows Application x x x
EX 26 Free cash flow 4 Easy 5 min. Analytic Measurement Statement of Cash Flows Application x
PR 1A Statement of cash flows - indirect method 2 Moderate 1.5 hours Analytic Measurement Statement of Cash Flows Application x x
PR 2A Statement of cash flows - indirect method 2 Moderate 1.5 hours Analytic Measurement Statement of Cash Flows Application x x
PR 3A Statement of cash flows - indirect method 2 Moderate 1.5 hours Analytic Measurement Statement of Cash Flows Application x
PR 4A Statement of cash flows - direct method 3 Moderate 1.5 hours Analytic Measurement Statement of Cash Flows Application x x x
PR 5A Statement of cash flows - direct method 3 Moderate 1.5 hours Analytic Measurement Statement of Cash Flows Application x
PR 1B Statement of cash flows - indirect method 2 Moderate 1.5 hours Analytic Measurement Statement of Cash Flows Application x x
PR 2B Statement of cash flows - indirect method 2 Moderate 1.5 hours Analytic Measurement Statement of Cash Flows Application x x
PR 3B Statement of cash flows - indirect method 2 Moderate 1.5 hours Analytic Measurement Statement of Cash Flows Application x
PR 4B Statement of cash flows - direct method 3 Moderate 1.5 hours Analytic Measurement Statement of Cash Flows Application x x x
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