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Chapter 14
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
i. The statement of cash flows highlights the
ii. The statement of cash flows helps answer a
variety of questions such as:
1. Are cash flows sufficient to support ongoing
operations?
2. Can we pay our debts?
3. Can we pay dividends?
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iv. The basic equations for assets, contra-assets,
liabilities, and stockholders’ equity shown on
this slide will be useful in preparing a
statement of cash flows.
II. Statement of cash flows—four key concepts
Learning Objective 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
three sections that report cash flows resulting
from operating activities, investing
activities, and financing activities.
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ii. This slide summarizes the most common
types of cash inflows and outflows resulting
from operating, investing, and financing
activities.
B. Key concept #2
statement is reconstructed on a cash basis
from top to bottom. For example:
a. Cash collected from customers is listed
instead of revenue, and payments to
suppliers is listed instead of cost of
goods sold.
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1. Assume the beginning and ending balances
in the Accumulated Depreciation account
2. Given these assumptions, the basic equation
for contra-assets can be used to compute
depreciation charges of $270.
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
each current asset and current liability
iv. The third step is to adjust for gains and
losses included in the income statement.
gains and adding losses.
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.
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3. The Retained Earnings account also
requires further analysis to quantify the
amount of dividends as you’ll see shortly.
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.
Retained Earnings account and assume the
information as shown in the top half of this
slide.
E. Summary of four key concepts
i. These slides summarize the four key concepts
related to preparing the statement of cash
flows.
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III. The statement of cash flows—an example
Learning Objective 2: Prepare a statement of cash
flows using the indirect method to determine the net
cash provided by operating activities.
A. Apparel Inc.: background information
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.
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1. The accounts receivable balance decreased
by $17, 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
of $3 million, so this amount must be
iv. The operating activities section of Apparel’s
statement of cash flows would appear as
shown on this slide.
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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.
D. Financing activities
i. To compute the gross cash flows in the
financing activities section of the statement,
we need to focus on the Bonds Payable,
Common Stock, and Retained Earnings
accounts.
3. The basic equation for stockholders’ equity
accounts can be used to determine that
Apparel paid dividends of $28 million
that need to be recorded as a cash
outflow.
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
side of the Cash account.
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5. The final entry records the sale of the store.
Notice, the gain on the sale ($5 million) is
recorded in the credit side of the cash
account so that the entire amount of the cash
proceeds from the sale ($8 million) can be
recorded as an investing activity.
IV. Interpreting the statement of cash flows
A. Consider a company’s specific circumstances
i. Start-up companies often have negative net cash
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.
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iii. Some managers compare the additions to
property, plant, and equipment in the investing
activities section of the statement to depreciation
included in the operating activities section.
Learning Objective 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.
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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:
V. Appendix 14A: The direct method of determining the
net cash provided by operating activities (Slide #38 is a
title slide for the appendix)
Learning Objective 4: Use the direct method to
determine the net cash provided by operating activities.
A. Computing net cash provided by operating activities
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B. Similarities and differences in the handling of data
i. The adjustments for accounts that affect
revenue are the same in the direct and
indirect methods.
expenses are handled in opposite ways for
the direct and indirect methods. Under the
indirect method, the adjustments are made to
net income, whereas under the direct
method the adjustments are made to the
expense accounts themselves. For example:
iii. Regarding gains and losses on sale of assets,
no adjustments are needed at all under the
direct method.
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