Chapter 12
The Statement of
Cash Flows
After studying this chapter, students should be able to:
◼ Explain the concept of cash flows and accrual accounting and the purpose of a statement of cash
flows (Module –LO1).
◼ Explain what cash equivalents are and how they are treated on the statement of cash flows
(Module 1–LO2).
INSTRUCTOR’S MANUAL
12-2
Chapter Outline
MODULE 1 PURPOSE AND FORMAT FOR THE STATEMENT OF
CASH FLOWS
Module 1
LO 1
Purpose and Format for the Statement of Cash Flows
A statement of cash flows complements an accrual-based income statement by providing information on a
company’s cash flows from operating, investing, and financing activities.
◼ All external parties have an interest in a company’s cash flows.
• Stockholders need assurance there is enough cash generated from operations to pay dividends
and invest in company’s future.
◼ Net income is computed on an accrual basis, not a cash basis.
• Income statement primarily reflects events related to the operating activities of a business.
◼ One of four combinations is possible:
• A company can report an increase in cash and a net profit.
Purpose of the Statement of Cash Flows
Statement of cash flows is an important complement to the other major financial statements.
CHAPTER 12 THE STATEMENT OF CASH FLOWS
12-3
◼ Statement of cash flows reports the changes in cash over a period of time and explains those
changes.
Reporting Requirements for a Statement of Cash Flows
Accounting standards specify both the basis for preparing the statement of cash flows and the classification
of items on the statement.
◼ Must be prepared on a cash basis.
Module 1
LO 2
The Definition of Cash: Cash and Cash Equivalents
Certain items are recognized as being cash equivalents and are combined with cash on the balance sheet
and statement of cash flows.
◼ Cash equivalents are items readily convertible to a determinable amount of cash, with a maturity
to the investor of three months or less.
Module 1
LO 3
Classification of Cash Flows
Companies are required to classify activities into three categories – operating, investing, and financing,
which represent the major functions of an entity (Exhibit 12-1). This allows users to look at important
relationships. Each of the three categories can result in both cash inflows and cash outflows to the
company.
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◼ Operating activities involve acquiring and selling products and services. The specific activities of
a business depend on its type.
• Purchase of raw materials is an operating activity to a manufacturing company.
• The acquisition of the stocks or bonds (cash outflow) and the sale of stocks or bonds (cash
inflow) of other companies are also investing activities.
◼ Financing activities are activities concerned with the raising and repaying of funds in the form of
debt and equity.
• Cash inflows include the issuance of the company’s stock and borrowing of various types of
long-term debt.
• Cash outflows include the repurchase of the company’s own stock, repayment of various
forms of debt, and the payment of cash dividends to stockholders.
Noncash Investing and Financing Activities
Companies can engage in important investing and financing activities that do not affect cash.
(Example 12–3)
CHAPTER 12 THE STATEMENT OF CASH FLOWS
Transaction does not involve cash and therefore is not reported on the statement of cash
flows.
Module 1
LO 4
Two Methods of Reporting Cash Flow from Operating Activities
Companies use one of two methods to report the amount of cash flows from operating activities – the direct
method or the indirect method.
◼ Direct method reports major sources of gross cash receipts and cash payments.
• Cash collected from customers, cash collected from interest and dividends.
• Cash paid for inventory, cash paid for salaries and wages, etc.
• Examine each item on the income statement and decide how much cash it either generated or
used.
A net increase in accounts receivable must be deducted from sales to calculate the cash
collected from sales.
The cash outflow for expenses is computed by deducting any increase in related liability
accounts from the expense.
◼ To report cash flow from operating activities under the indirect method: (Example 12-5) (Exhibits
12-3, 12-4, and 12-6)
• The first line of the Operating Activities section is always the net income of the period.
• Then certain adjustments need to be made to reconcile net income to the amount of cash
provided by operating activities, including:
INSTRUCTOR’S MANUAL
12-6
MODULE 2 PREPARING THE STATEMENT OF CASH FLOWS
USING THE DIRECT METHOD
Module 2
LO 5
Preparing the Statement of Cash Flows Using the Direct Method
◼ Emphasis is on why cash changed, not on the fact that it did change.
• Change can be found by comparing two balance sheets.
The Accounting Equation and the Statement of Cash Flows
◼ Assets = Liabilities + Stockholders’ Equity is the format for the basic accounting equation.
• Then refining the equation: Cash + Noncash current assets + Long-term assets = Current
liabilities + Long-term liabilities + Capital stock + Retained earnings
A Master T-Account Approach to Preparing the Statement of Cash Flows: Direct
Method
The following steps can be used to prepare a statement of cash flows:
◼ Step 1. Set up three master T accounts with the following headings:
• Cash Flows from Operating Activities (Exhibit 12-9).
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12-7
• Analyze each item on the income statement and in the Current Asset and Current Liability
accounts.
◼ Step 3. Determine the cash flows from investing activities.
• Generally, the Long-Term Asset accounts must be analyzed, along with any additional
information provided.
◼ Step 4. Determine the cash flows from financing activities.
• In general, the Long-Term Liabilities and Stockholders’ Equity accounts will be analyzed,
along with any additional information provided.
Cash Flows from Operating Activities
◼ To determine the cash flows from operating activities, consider each of the items on the income
statement (Exhibit 12-7) and any related current assets or liabilities from the balance sheet.
(Exhibit 12-8)
◼ Examples illustrated (Exhibit 12-9 and 12-10)
• Sales revenue and accounts receivable: an increase in accounts receivable indicates that more
sales than cash collections were made.
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• Cost of goods sold, inventory, and accounts payable.
Cost of goods results in a credit to inventory, but this is inventory sold, not purchased;
inventory is analyzed to determine purchases, resulting in the conclusion that a decrease
in inventory indicates that cost of goods sold exceeded purchases.
Thus, cost of goods sold less decrease in inventory equals purchases.
• Salaries and wages expense, and salaries and wages payable: any decrease in the liability
indicates that cash paid exceeded expense accrued; or, expense less decrease in liability
equals cash paid.
To summarize: Salaries and wages expense plus a decrease in salaries and wages payable
or minus an increase in salaries and wages payable equals cash paid to suppliers.
The journal entry to record wages paid is a debit to Salaries and Wages Payable and a
credit to Cash.
• The credit to Cash should be entered in the master T account Cash Flows from
Operating Activities.
• Depreciation expense: since it has no effect on cash, is not considered when preparing the
operating section under the direct method.
CHAPTER 12 THE STATEMENT OF CASH FLOWS
• Income tax expense and income tax payable: as with other liabilities, the expense is reduced
by the increase in the liability to determine the cash actually paid.
Cash Flows from Investing Activities
◼ To determine the cash flows from investing activities, look at the Long-Term Asset accounts and
any additional information available about these accounts.
◼ Examples illustrated (Exhibit 12–11):
• Purchase of long-term investments for cash, found in supplemental information.
Journal entry is a debit to Long-Term Investments and a credit to Cash.
• The credit to Cash should be posted to the master T account Cash Flows from
Investing Activities.
Cash Flows from Financing Activities
◼ Cash flows from financing activities generally involve long–term liabilities and stockholders’
equity.
◼ Examples illustrated (Exhibit 12–12):
• Notes Payable account was included in a footnote discussing the acquisition of land.
INSTRUCTOR’S MANUAL
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• The credit to Cash is posted to the master T account Cash Flows from Financing
Activities.
• Sale of stock for cash.
Using the Master T Accounts to Prepare a Statement of Cash Flows
◼ All of the information needed to prepare a statement of cash flows is now available in the three
master T accounts, along with the supplemental schedule prepared earlier.
◼ Exhibits 12-9, 12-11, and 12-12 are used to prepare the completed statement of cash flows
(Exhibit 12–13).
MODULE 3 PREPARING THE STATEMENT OF CASH FLOWS
USING THE INDIRECT METHOD
Module 3
LO 6
Preparing the Statement of Cash Flows Using the Indirect Method
Instead of reporting cash receipts and disbursements, the indirect method reconciles net income (accrual
basis) to net cash flow from operating activities (cash basis). (Exhibit 12-14)
◼ Investing Activities and Financing Activities sections remain unchanged.
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12–11
Sales are reported as part of net income on the accrual basis.
The increase in receivables did not result in cash, so an increase in accounts receivable is
deducted from net income to adjust to cash received.
• Increase in accounts payable indicates that purchases for the period exceeded cash payments
for purchases.
The increase is added back to net income because cost of goods sold includes items for
which company has not yet paid cash.
• Decrease in salaries and wages payable: deducted from income to reflect the fact that
payments were made in excess of the period’s expense.
• Depreciation expense was deducted to arrive at net income, but required no cash, so it is
added back.
Comparison of the Indirect and Direct Methods
◼ The amount of cash provided by operating activities is the same under the direct and indirect
methods.
◼ The FASB has a strong preference for the direct method, but allows indirect approach.
INSTRUCTOR’S MANUAL
MODULE 4 CASH FLOW ANALYSIS
Module 4
LO 7
Cash Flow Analysis
The statement of cash flows is a critical disclosure to a company’s investors and creditors.
◼ Concern that accrual accounting can mask cash flow problems.
Creditors and Cash Flow Adequacy
◼ Bankers and other creditors are concerned with a company’s ability to meet its principal and
interest obligations. Cash flow adequacy is a measure intended to help in this regard.
• Ratio Analysis Model:
1. Formulate the Question. Did Nordstrom generate enough cash this year from its operations to
pay for its capital expenditures and meet its maturing debt obligations?
2. Gather the Information From the Financial Statements. Net cash from operating activities, and
capital expenditures are found on the statement of cash flows, average debt maturing over the
next five years is found in the notes to the financial statements.
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4. Compare the Ratio With Other Ratios. Compare to prior years and to competitors.
5. Interpret the Ratios. Nordstrom’s ratios are significantly lower than Dillard’s. Still generating
1. Formulate the Question. If you were a banker, would you lend money to Nordstrom?
2. Gather Information from the Financial Statements and Other Sources. This information will
come from a variety of sources, not limited to, but including:
The balance sheet (liquidity), income statement (profitability), and statement of cash
flows.
3. Analyze the Information Gathered.
Compare cash flow adequacy ratio with competitors, and industry averages.
Look at trends over time in cash flow adequacy ratio.
Look at trends in cash provided by operations over time as an indication of the ability to
generate enough cash to make necessary capital expenditures and meet debt obligations.
Review projections for the economy and industry.
Stockholders and Cash Flow per Share
◼ Cash flow per share: a ratio of the stock market price per share to the company’s cash flow per
share.
• Cash flow from operating activities is used for this ratio.
INSTRUCTOR’S MANUAL
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MODULE 5 APPENDIX A WORK SHEET APPROACH TO
PREPARING THE STATEMENT OF CASH FLOWS
Module 5
Appendix
LO 8
A Work-Sheet Approach to the Statement of Cash Flows
Steps in completing a work sheet to prepare a statement of cash flows, using the indirect method to
arrive at cash flow from operating activities (the direct method can also be used):
◼ Note that this is an alternative method to the T account method.
◼ Example work sheet in text (Exhibit 12-15)
• Step 1: Enter the balances of each account at the end (column 1) and the beginning (column 2)
of the period in the first two columns of the work sheet.
Work sheet lists all balance sheet accounts.
Total debits must equal the total credits.
CHAPTER 12 THE STATEMENT OF CASH FLOWS
Lecture Suggestions
Module 1
LO 1
Emphasize that the purpose of the statement of cash flows is not to calculate the change in cash,
which can easily be done from comparative balance sheets. The purpose is to explain why cash
changed this period. Many business owners don’t understand how they can have a net profit and a
decrease in cash. Have students come up with instances where this can happen.
Have students give examples of operating, investing, and financing activities from their personal
lives or from the business they work for. For example, the purchase of a vehicle is an investing
activity. Taking out the loan to purchase the vehicle is a financing activity. The purchase of a
pizza oven is also an investing activity, while paying the employees is an operating activity.
Module 2
LO 5
Problem 12-3 and Problem 12-4 are similar to the chapter example, which students should have
reviewed before class. These problems can be used for an in-class illustration, with students
working together to calculate the necessary figures.
involved in the transaction and it is not an operating activity. The gain increased net income, so in
A loss reduces net income but did not affect cash so it would have to be added to net income.
Module 4
LO 7
Reinforce to students that a positive cash flow does not mean a company is financially healthy.
The statement of cash flows explains where the cash is coming from. If there is a positive cash
flow from operations, this is a good sign. But if a company had a positive inflow from investing
and financing activities and a negative flow from operations, this is not good. Companies are not
in business to sell assets or obtain debt. Investors and analysts want to see a positive flow from
operations.
INSTRUCTOR’S MANUAL
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Projects and Activities
Module 1
LO 1
Purpose of the Statement of Cash Flows
In-class discussion: Differences between income and cash flows—Julian Corporation
Refer to the income statement (Exhibit 12-7) and the statement of cash flows (Exhibit 12-13 & 14) for
Julian Corporation in the text.
◼ Did Julian have positive or negative cash flow from operations? Did Julian have operating income
or an operating loss? Should these be the same? Why or why not?
◼ Which nonoperating items were the primary users of cash? Are these nonoperating items likely to
be repeated in future periods? Why or why not?
◼ Which item was the principal contributor to the difference between net income and net cash
provided by operating activities? Is this item likely to be repeated in future periods? Why or why
not?
◼ What was the chief source of cash from financing activities? From investing activities?
◼ How was capital investments paid for?
Solution
◼ Julian had positive cash flow from operating activities of $174,000. The income statement showed
operating income of $120,000. These are not required to be the same because the income
CHAPTER 12 THE STATEMENT OF CASH FLOWS
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Module 1
LO 4
Two Methods of Reporting Cash Flow from Operating Activities
Reporting of noncash investing and financing activities
When a significant liability is incurred to purchase an asset, the company must report this transaction in a
footnote to the statement of cash flows, even though it involved no cash.
◼ Why do you think this is true?
◼ What impact does this transaction have on the company’s present or future cash position?
Suppose that the company believes the disclosure is important but prefers not to use a footnote to make this
disclosure. They decide that even though the purchase of the asset in exchange for a liability was a single
transaction, they will report it on the statement of cash flows as two transactions. In the Investing Activities
section of the statement they will report the purchase of an asset as cash outflow. In the Financing
Activities section they will report a cash inflow resulting from the issue of debt.
◼ Will this result in an incorrect total for the net increase or decrease in cash for the period? Explain
why or why not.
◼ Will this treatment on the statement of cash flow distort, for the reader, the company’s present or
future cash position or commitments?
◼ Would it be dishonest, or unethical, to report the transaction in this way?
Solution
◼ Significant noncash transactions are important because the debt involved may commit the
company to material cash outflow in the future. Since the statement is intended not only to report
INSTRUCTOR’S MANUAL
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In-class discussion: Depreciation and cash flows
Your roommate, who has a basic knowledge of accounting, has been watching you solve a number of
problems involving the indirect method at arriving at cash flow from operating activities. She suddenly has
a flash of inspiration. “Why don’t more companies use accelerated depreciation? It could increase their
cash flow from operations significantly during the first couple of years of every new asset’s life.”
◼ Is your roommate right or wrong? Explain this to your roommate, using a simple set of financial
statements to prove your argument.
Solution
◼ This simple problem often appears in one form or other, probably because so many people confuse
depreciation with cash flow. It is not uncommon to see depreciation referred to as though it were a
CHAPTER 12 THE STATEMENT OF CASH FLOWS
Module 3
LO 6
A Master T-Account Approach to Preparing the Statement of Cash Flows: Indirect
Method
Outside assignment: Which method do users prefer, direct or indirect?
Although the FASB prefers that companies use the direct method of arriving at cash flow from operating
activities, the overwhelming majority of companies use the indirect method, for a variety of reasons.
◼ Do you yourself, after preparing and studying both, have a preference? Explain why.
◼ Which method do you think ordinary users of financial statements, if they had a choice in this
matter, would prefer?
Since your question centers on the Operating Activities section, you may elect to show only that portion of
the statement, to simplify what the respondents see. On the other hand, you may think that it is important
that they see the entire statement in order to put the Operating Activities section in perspective.
Many readers of corporate annual reports are not trained in accounting. You may therefore want to specify
that subjects used for the survey should have no accounting background (work or courses). Students can be
reminded that their survey subjects need not be other students, either. Anyone willing to take the time to
participate is a legitimate participant, as long as they have the ability to understand the basic concept.
Afterward, compile and compare results for the entire class. What conclusions did you reach?
Solution
Students are sometimes surprised to see how far they have come, and how much they understand about
INSTRUCTOR’S MANUAL
Decision
Models
The Business Decision Model and the Statement of Cash Flows
You are a loan officer and have just received the loan application and financial statements for The Butterfly
Company. While reviewing the information, you note the following:
• Net income of $30,000, which includes a gain on the sale of equipment of $40,000.
•
Based on the above information, use the Business Decision Model to determine if the bank should loan the
money to The Butterfly Company.
1. Formulate the Question. After considering all relevant information, should the bank loan
money to The Butterfly Company?
2. Gather Information from the Financial Statements and Other Sources.
• The balance sheet will provide information about liquidity.
• The income statement will provide information about profitability.
3. Analyze the Information Gathered. The information that is of concern to the loan officer is
the information that appears on the income statement and statement of cash flows. Although
the income statement shows a net profit of $30,000, included in that figure is a gain on the
sale of equipment of $40,000. So without the gain, the company would have shown a net loss
of $10,000. Since the company is not in business to sell their equipment, this net loss figure is
the more relevant number.