CHAPTER 17
STATEMENT OF CASH FLOWS
Learning Objectives
1. DISCUSS THE USEFULNESS AND FORMAT OF THE
STATEMENT OF CASH FLOWS.
2. PREPARE A STATEMENT OF CASH FLOWS USING
THE INDIRECT METHOD.
3. ANALYZE THE STATEMENT OF CASH FLOWS.
CHAPTER REVIEW
Usefulness of the Statement of Cash Flows
1. (L.O. 1) The fourth basic financial statement is the statement of cash flows. The primary purpose
of the statement is to provide information about an entity’s cash receipts and cash payments
during a period.
2. The information in the statement of cash flows should help investors to assess the
a. entity’s ability to generate future cash flows.
Classification of Cash Flows
3. The statement of cash flows classifies cash receipts and cash payments by:
a. Operating activities which include cash effects of transactions that create revenues and
expenses and thus enter into the determination of net income.
b. Investing activities which include (1) acquiring and disposing of investments and (2) lending
money and collecting the loans.
4. Significant noncash transactions will include the conversion of bonds into common stock and
the acquisition of assets through the issuance of bonds or capital stock. These transactions are
Format of the Statement of Cash Flows
5. The three classes of activities constitute the general format of the statement with the operating
activities section appearing first, followed by the investing activities and financing activities sections.
a. The net cash provided or used by each activity is totaled to show the net increase (decrease)
in cash for the period.
b. The net change in cash for the period is then added to or subtracted from the beginning–of–
the-period cash balance.
The Major Steps
7. The major steps in preparing the statement are:
Step 1: Determine net cash provided/used by operating activities. This step involves analyzing
not only the current year’s income statement, but also comparative balance sheets and
selected additional data.
Step 2: Analyze changes in noncurrent asset and liability accounts and record as investing and
financing activities, or disclose as noncash transactions. This step involves analyzing not
only the current year’s income statement, but also comparative balance sheets and
selected additional data.
Step 3: Compare the net change in cash on the statement of cash flows with the change in the
Cash account reported on the balance sheet to make sure the amounts agree.
The Indirect Method
9. (L.O. 2) The following points 10 through 15 explain and illustrate the indirect method.
The First Step—Indirect
10. The first step is to determine net cash provided/used by operating activities.
a. Under generally accepted accounting principles the accrual basis of accounting is used
which results in recording revenues when recognized and expenses when incurred.
b. In order to determine net cash provided from operating activities it is necessary to report
revenues and expenses on a cash basis. This is determined by adjusting net income for
items that did not affect cash.
11. The operating section of the statement of cash flows should (a) begin with net income, (b) add
(or deduct) items not affecting cash, and (c) show net cash provided by operating activities.
The Second Step—Indirect
13. The second step, analyze changes in noncurrent asset/liability accounts and record as investing
and financing activities is generally determined from changes in noncurrent accounts reported in
comparative balance sheets and selected additional data.
a. If the account, Land, increases $50,000 and the transaction data indicates that land was
purchased for cash, a cash outflow from an investment activity has occurred.
–
The Third Step—Indirect
15. The third step is to determine the net change in Cash on the statement of cash flows with the
change in the Cash account reported on the balance sheet to make sure the amounts agree.
Analysis of the Statement of Cash Flows
16. (L.O. 3) Free cash flow describes the net cash provided by operating activities after adjustment
for capital expenditures and dividends. The formula for free cash flow is:
Preparing the Statement of Cash Flows—
The Direct Method
*17. (L.O. 4) The following points 18 through 23 explain and illustrate the direct method.
The First Step—Direct
*18. The first step is to determine net cash provided/used by operating activities by adjusting each item
in the income statement from the accrual basis to the cash basis.
a. If the income statement shows sales revenue of $120,000 and accounts receivable (net)
increased $20,000 during the year, cash receipts are $100,000 ($120,000 – $20,000).
*19. In the operating activities section, only major classes of cash receipts and cash payments are reported
as follows:
a. Cash receipts from (1) sales of goods and services to customers and (2) interest and
*20. The formula for computing cash receipts from customers is:
Sales
Revenue
+
–
Decrease in Accounts Receivable
or
Increase in Accounts Receivable
*21. The formula for computing cash payments to suppliers is:
Cost of Goods
+
Increase in Inventory
+
*22. The formula for computing cash payments for operating expenses is:
Operating
+
Increase in Prepaid Expenses
+
Decrease in Accrued Expenses Payable
*23. The formula for computing cash payments for income taxes is:
Income Tax
+
Decrease in Income Taxes Payable
The Second Step—Direct
*24. The second step, analyze changes in noncurrent asset/liability accounts and record as investing
and financing activities is generally determined from changes in noncurrent accounts reported in
comparative balance sheets and selected additional data. This is the same as under the indirect
method.
The Third Step—Direct
*25. The third step is to determine the net increase or decrease in cash by determining the difference
Use of a Worksheet
*26. (L.O. 5) A worksheet may be used to assemble and classify the data that will appear on the
statement of cash flows. The worksheet is divided into two parts:
a. Balance sheet accounts with columns for (1) end of last year balances, (2) reconciling items
(debit and credit), and end of current year balances.
*27. The following guidelines are important in using a worksheet.
a. In the balance sheet section, accounts with debit balances are listed separately from those
with credit balances.
b. In the cash flow effects section, inflows of cash are entered as debits in the reconciling
columns and outflows of cash are entered as credits in the reconciling columns.
c. The reconciling items shown in the worksheet are not entered in any journal or posted to any
account.
*28. The steps in preparing a worksheet are:
a. Enter the balance sheet accounts and their beginning and ending balances in the balance
sheet accounts section.
b. Enter the data that explains the changes in the balance sheet accounts (other than cash) and
*29. The statement of cash flows is prepared entirely from the data that appears in the worksheet
under Statement of Cash Flows Effects.
LECTURE OUTLINE
A. Usefulness of the Statement of Cash Flows.
1. The statement of cash flows reports the cash receipts, cash payments, and
net change in cash resulting from operating, investing, and financing
activities during a period.
2. The information in a statement of cash flows should help investors,
creditors, and others assess:
a. The entity’s ability to generate future cash flows.
B. Classification of Cash Flows.
1. The statement of cash flows classifies cash receipts and cash payments
as operating, investing, and financing activities.
a. Operating activities include the cash effects of transactions that create
revenues and expenses. They enter into the determination of net
income.
2. Note that (1) operating activities involve income statement items, (2) invest–
ing activities involve cash flows resulting from changes in investments
C. Significant Noncash Activities.
1. Companies do not report in the body of the statement of cash flows
significant financing and investing activities that do not affect cash.
2. They report these activities in either a separate schedule at the bottom
of the statement of cash flows or in a separate note or supplementary
schedule to the financial statements.
3. Examples of significant noncash activities are:
a. Direct issuance of common stock to purchase assets.
ACCOUNTING ACROSS THE ORGANIZATION
Net income is not the same as net cash provided by operating activities. Net cash
provided by operating activities is usually significantly larger than net income.
In general, why do differences exist between net income and net cash provided
by operating activities?
Answer: The differences are explained by differences in the timing of the reporting
of revenues and expenses under accrual accounting versus cash.
D. Format of the Statement of Cash Flows.
1. The cash flows from operating activities section always appears first,
followed by the investing activities and then the financing activities
sections.
2. Companies report the individual inflows and outflows from investing and
financing activities separately.
E. Preparing the Statement of Cash Flows.
1. Companies prepare the statement of cash flows differently from the three
other basic financial statements. It is not prepared from an adjusted trial
balance because the trial balance will not provide the necessary data.
The information to prepare the statement of cash flows usually comes
from three sources:
b. Current income statement.
c. Additional information.
2. Preparing the statement of cash flows from these data sources involves
three major steps:
a. Determine net cash provided/used by operating activities by con–
verting net income from an accrual basis to a cash basis. Determining
net cash provided/used by operating activities involves analyzing
not only the current year’s income statement but also comparative
balance sheets and selected additional data.
3. A company must convert net income from an accrual basis to a cash
basis to determine net cash provided/used by operating activities by
using either (1) the indirect method or (2) the direct method.
F. Preparing the Statement of Cash Flows—Indirect Method.
1. Step 1: Determine net cash provided/used by operating activities by
converting net income from an accrual basis to a cash basis.
a. Under the accrual basis of accounting, net income is not the same
as net cash provided by operating activities.
c. Noncash charges (depreciation expense, amortization, depletion)
and losses in the income statement are added back to net income and
gains are deducted which results in net cash provided by operating
activities.
d. A final adjustment in reconciling net income to net cash provided by
operating activities involves examining all changes in current asset
and current liability accounts.
e. Deduct from net income increases in current asset accounts, and
add to net income decreases in current asset accounts, to arrive at
net cash provided by operating activities.
f. Increases in current liability accounts are added to net income, and
decreases in current liability accounts are deducted from net income,
to arrive at net cash provided by operating activities.
(1) When the Accounts Payable balance increases, operating ex-
penses on an accrual basis are higher than they are on a cash
basis because expenses are incurred for which payment has
2. Step 2: Analyze changes in noncurrent asset and liability accounts and
record as investing and financing activities, or as noncash investing and
financing activities.
b. Increases in long-term debt (Bonds Payable) or paid-in capital
(Common Stock) accounts represent cash inflows from financing
activities. Decreases in long-term debt or paid-in capital accounts
represent cash outflows from financing activities as does the payment
of dividends.
G. Using Cash Flows to Evaluate a Company.
1. In the statement of cash flows, net cash provided by operating activities
is intended to indicate the cash-generating capability of the company.
2. Net cash provided by operating activities fails to take into account that a
company must invest in new fixed assets just to maintain its current level
of operations.
*H. Statement of Cash Flows—Direct Method.
1. Step 1: Determine the net cash provided/used by operating activities by
converting net income from an accrual basis to a cash basis.
a. Companies compute net cash provided by operating activities by
adjusting each item in the income statement from the accrual basis
to the cash basis.
(2) Increase in accounts payable: when accounts payable
increase during the year, purchases on an accrual basis are
higher than they are on a cash basis.
2. Step 2: Analyze changes in noncurrent asset and liability accounts and
record as investing and financing activities, or as significant noncash
activities.
a. Increases in any noncurrent assets (Land, Buildings, Equipment
and Long-Term Investments) represent outflows of cash from
investing activities. Decreases represent inflows of cash from investing
activities.
3. Step 3: Compare the net change in cash on the statement of cash flows
with the change in the Cash account reported on the balance sheet to
make sure the amounts agree.
*I. Preparing the Worksheet—Indirect Method.
The steps in preparing a worksheet are:
a. Enter in the balance sheet accounts section the balance sheet
accounts and their beginning and ending balances.
b. Enter in the reconciling columns of the worksheet the data that
A Look at IFRS
As in GAAP, the statement of cash flows is a required statement for IFRS. In
addition, the content and presentation of an IFRS statement of cash flows is
similar to the one used for GAAP. However, the disclosure requirements related
to the statement of cash flows are more extensive under GAAP. IAS 7 (“Cash
Flow Statements”) provides the overall IFRS requirements for cash flow
information.
KEY POINTS
• Companies preparing financial statements under IFRS must prepare a
statement of cash flows as an integral part of the financial statements.
• Both IFRS and GAAP require that the statement of cash flows should have
three major sections—operating, investing, and financing activities—along with
changes in cash and cash equivalents.
• The definition of cash equivalents used in IFRS is similar to that used in GAAP.
A major difference is that in certain situations, bank overdrafts are considered
part of cash and cash equivalents under IFRS (which is not the case in GAAP).
Under GAAP, bank overdrafts are classified as financing activities in the
statement of cash flows and are reported as liabilities on the balance sheet.
• One area where there can be substantial differences between IFRS and GAAP
relates to the classification of interest, dividends, and taxes.
• Under IFRS, some companies present the operating section in a single line
item, with a full reconciliation provided in the notes to the financial statements.
This presentation is not seen under GAAP.
• Similar to GAAP, under IFRS companies must disclose the amount of taxes and
interest paid. Under GAAP, companies disclose this in the notes to the financial
LOOKING TO THE FUTURE
Presently, the FASB and the IASB are involved in a joint project on the
presentation and organization of information in the financial statements. One
interesting approach, revealed in a published proposal from that project, is that in
the future the income statement and balance sheet would adopt headings similar
to those of the statement of cash flows. That is, the income statement and
balance sheet would be broken into operating, investing, and financing sections.
With respect to the statement of cash flows specifically, the notion of cash
20 MINUTE QUIZ
Circle the correct answer.
True/False
1. Inflows and outflows from investing and financing activities should be reported separately
on the statement of cash flows.
True False
2. In addition to the adjusted trial balance, information for the statement of cash flows is taken
from comparative balance sheets, the current income statement and other transactional
information.
True False
3. The purchase of inventory and investments in property, plant, and equipment are considered
cash outflows from operations.
True False
4. An increase in equipment will increase net cash provided by operating activities.
True False
5. When accounts receivable increases during the year, revenues on a cash basis are
higher than revenues on an accrual basis.
True False
6. Cash outflows to purchase property, plant, and equipment would be reported in the investing
section of the statement of cash flows.
True False
7. A statement of cash flows starts with net income and adds (or deducts) items that did not
affect cash to arrive at net cash provided by operating activities if the indirect method is
used.
True False
8. The only use of a statement of cash flows is to help investors, creditors, and others assess
the reasons for the difference between net income and net cash provided by operating
activities.
True False
9. The amortization of a patent is added back to net income to arrive at net cash provided
by operating activities.
True False
10. The issuance of shares of stock for plant assets is a significant noncash transaction.
True False
Multiple Choice
1. A company has credit sales of $900,000 and cash sales of $540,000 during the same
year that the Accounts Receivable account decreased by $120,000. What was the total
of cash receipts from sales?
a. $1,320,000.
b. $1,560,000.
c. $1,020,000.
d. $780,000.
2. Cash inflows from investing activities include
a. sale of common stock.
b. purchase of equipment.
c. sale of land.
d. issuance of long-term debt.
3. Operating activities do not include cash
a. inflows from revenue.
b. inflows from sale of equipment.
c. outflows for income taxes.
d. outflows for wages.
4. Which of the following would decrease net cash provided by operating activities?
a. Decrease in short-term notes payable.
b. Depreciation expense.
c. Decrease in inventory.
d. Loss on disposal of equipment.
5. Noncash investing and financing activities
a. may represent significant investing and financing activities.
b. do not involve cash receipts or cash payments.
c. are disclosed on a separate schedule.
d. All of the answer choices are correct.
ANSWERS TO QUIZ
True/False
1. True 6. True
2. False 7. True
Multiple Choice
1. b.