1.1  How Is Cash Flow to Be Monitored? Beyond just looking at cash on the balance sheet, how is one to assess a company's cash, cash flow, and cash flow prospects? For many years, the accounting profession only required presentation of the balance sheet, income statement, and a statement of retained earnings (or stockholders' equity). In the 1960s, following several prominent and seemingly sudden business failures due to poor cash flow, the profession determined to require a fourth financial statement reporting on funds flow. The specific content and format evolved. In the 1990s, the profession began to require the current format for a statement of cash flows. This statement has become a well-established component of required reporting for corporate entities. The objective of the statement is to provide information that is helpful in assessing the amounts, timing, and uncertainty of an organization's cash inflows and outflows. Accordingly, the statement of cash flows divides cash flow information into key categories related to operating activities, investing activities, and financing activities. The statement also provides information about other investing and financing activities that do not directly entail the generation or consumption of cash. Thus, the statement also provides a key source of insight about a company's overall investing and financing actions. Operating Activities In a sweeping generalization, think of the operating activities of a business as the routine transactions and events that enter into the determination of ongoing income. Thus, the operating activities section of the statement of cash flows is a bit like a cash basis income statement. But, as you will soon see from the following details, this generalization should be used as a frame of reference only. Specifically, cash inflows from operating activities consist of receipts from customers for providing goods and services, the cash amount of interest earnings, and cash dividends received. Cash outflows relate to payments for inventory purchases, salaries, wages, taxes, interest, and other such business expenses. However, another way to view "operating" cash flows is to include anything that is not an "investing" or "financing" cash flow. This means that any cash flows that do not clearly fall into the categories of investing activities or financing activities are regarded as related to operations. Because this view casts the operating activities section as a "default" grouping, it is also necessary to understand the specifics of each of the next two categories. Investing Activities Investing activities relate to acquiring and disposing of longer term investments in stocks and debt issued by others, as well as buying and selling items of property, plant, and equipment. Investing cash inflows result when a company receives the proceeds from selling the stock and debt of others (unless such investment was initially acquired for "trading" rather than longer term investme ...

1. 1.1
How Is Cash Flow to Be Monitored?
Beyond just looking at cash on the balance sheet, how is one to
assess a company's cash, cash flow, and cash flow prospects? Fo
r many years, the accounting profession only required presentati
on of the balance sheet, income statement, and a statement of re
tained earnings (or stockholders' equity). In the 1960s, followin
g several prominent and seemingly sudden business failures due
to poor cash flow, the profession determined to require a fourth
financial statement reporting on funds flow. The specific conte
nt and format evolved. In the 1990s, the profession began to req
uire the current format for a statement of cash flows. This state
ment has become a well-
established component of required reporting for corporate entiti
es. The objective of the statement is to provide information that
is helpful in assessing the amounts, timing, and uncertainty of a
n organization's cash inflows and outflows. Accordingly, the sta
tement of cash flows divides cash flow information into key cat
egories related to operating activities, investing activities, and f
inancing activities. The statement also provides information abo
ut other investing and financing activities that do not directly en
tail the generation or consumption of cash. Thus, the statement
also provides a key source of insight about a company's overall
investing and financing actions.
Operating Activities
In a sweeping generalization, think of the operating activities of
a business as the routine transactions and events that enter into
the determination of ongoing income. Thus, the operating activi
ties section of the statement of cash flows is a bit like a cash ba
sis income statement. But, as you will soon see from the followi
ng details, this generalization should be used as a frame of refer
ence only. Specifically, cash inflows from operating activities c
onsist of receipts from customers for providing goods and servic

2. es, the cash amount of interest earnings, and cash dividends rec
eived. Cash outflows relate to payments for inventory purchases
, salaries, wages, taxes, interest, and other such business expens
es. However, another way to view "operating" cash flows is to i
nclude anything that is not an "investing" or "financing" cash fl
ow. This means that any cash flows that do not clearly fall into t
he categories of investing activities or financing activities are r
egarded as related to operations. Because this view casts the ope
rating activities section as a "default" grouping, it is also necess
ary to understand the specifics of each of the next two categorie
s.
Investing Activities
Investing activities relate to acquiring and disposing of longer t
erm investments in stocks and debt issued by others, as well as
buying and selling items of property, plant, and equipment. Inve
sting cash inflows result when a company receives the proceeds
from selling the stock and debt of others (unless such investmen
t was initially acquired for "trading" rather than longer term inv
estment purposes) and when proceeds from the sale of plant asse
ts are received. Similarly, if longer term loans have been made t
o others, an investing cash inflow occurs when the principal am
ount of debt is repaid. As noted in the discussion of operating a
ctivities, it is important to note that interest earned on loans is r
egarded as an operating cash inflow. Only the principal collecti
ons are reported as investing inflows. Conversely, cash outflows
from investing activities result on payment to acquire land, buil
dings, and equipment, as well as the acquisition of long-
term investments
in other firms, loans to others, and similar items.
Financing Activities
Financing activities relate to obtaining and repaying capital fun
ding needs. Cash inflows result by interactions with investors a
nd lenders via the issuance of stock and bonds as well as borrow
ing from specific lenders. Conversely, repaying the principal am
ounts borrowed is a financing activity that results in a cash outf
low. One must be very careful to differentiate between repayme

3. nts of principal on debt versus the interest cost. Interest is treat
ed as an expense in income and is also treated as an operating c
ash flow in the cash flow statement. One generally thinks of obt
aining capital from shareholders as a cash inflow; however, a co
mpany may occasionally buy back treasury shares, and these tra
nsactions are reported as a cash outflow in the financing activiti
es section. Likewise, dividends paid to shareholders are similarl
y classified as a cash outflow.
The classification of dividends and interest is potentially confus
ing and bears clarification. Accounting rules require that divide
nds paid be reported as a financing cash outflow. Dividends rec
eived, interest received, and interest paid are all reported as ope
rating cash flows. Because the classification of these amounts is
subject to conceptual debate, the accounting rules have explicit
ly adopted this specific classification model.
The preceding discussion was intended to build your general un
derstanding of the classification scheme for various cash flow it
ems. At times, accounting can become somewhat detailed, and T
able 1.1 dives deeper into this subject by providing a more detai
led listing of appropriate schemes to use for classifying most ca
sh flow items.
Table 1.1: Summary table of investing/financing/operating activ
ities
Inflows
Outflows
Investing activities
Receipts from collections or sales of loans made by the enterpri
se and of other entities' debt instruments
Disbursements for loans made by the enterprise and payments to
acquire debt instruments of other entities
Receipts from sales of equity instruments of other enterprises an
d from returns on investment in those instruments
Payments to acquire equity instruments of other enterprises
Receipts from sales of property, plant, and equipment and other
productive assets
Payments at the time of purchase or soon before or after purchas

4. e to acquire property, plant, and equipment and other productive
assets
Financing activities
Proceeds from issuing equity instruments
Payments of dividends or other distributions to owners, includin
g outlays to reacquire the enterprise's equity instruments
Proceeds from issuing bonds, mortgages, and notes and from oth
er short- or long-term borrowing
Repayments of amounts borrowed
Receipts from contributions and investment income that by dono
r stipulation are restricted for the purposes of acquiring, constru
cting, or improving property, plant, equipment, or other long-
lived assets
Other principal payments to creditors who have extended long-
term credit
Proceeds received from derivative instruments that include fina
ncing elements at inception
Distributions to counterparties of derivative instruments that inc
lude financing elements at inception
Cash retained as a result of the tax deductibility of increases in
the value of certain equity instruments issued under share-
based payment arrangements
Operating activities
Cash receipts from sales of goods or services, including receipts
from collection or sale of accounts and both short- and long-
term notes receivable from customers arising from those sales
Cash payments to acquire materials for manufacture or goods fo
r resale, including principal payments on accounts and both shor
t- and long-
term notes payable to suppliers for those materials or goods
Cash receipts from returns on loans, other debt instruments of ot
her entities, and equity securities—interest and dividends
Cash payments to other suppliers and employees for other goods
or services
All other cash receipts that do not stem from transactions define

5. d as investing or financing activities, such as amounts received
to settle lawsuits; proceeds of insurance settlements except for t
hose that are directly related to investing or financing activities,
such as from destruction of a building; and refunds from suppli
ers
Cash payments to governments for taxes, duties, fines, and othe
r fees or penalties and the cash that would have been paid for in
come taxes if increases in the value of certain equity instrument
s issued under share-based payment arrangements
Cash payments to lenders and other creditors for interest
All other cash payments that do not stem from transactions defi
ned as investing or financing activities, such as payments to sett
le lawsuits, cash contributions to charities, and cash refunds to
customers
Table 1.1 was adapted from the scheme set forth by the Financia
l Accounting Standards Board (Statement of Financial Accounti
ng Standard No. 95, Statement of Cash Flows, FASB, 1997) and
provides a useful decision table for most transactions that are a
pt to arise in the ordinary course of business. As you can see, th
e classification scheme can become rather detailed; at this point
in your studies, you should not be overly concerned about unde
rstanding the nuances of unfamiliar-sounding transactions.
Noncash Investing and Financing Activities
The statement of cash flows represents a compilation of all oper
ating, investing, and financing activities that cause a change in
cash. The net change represents the increase or decrease to cash
during a period and should serve to reconcile the change from t
he beginning- of-period to end-of-
period cash balances. This reconciliation within the statement of
cash flows could be viewed as complete fulfillment of the objec
tives for a cash flow statement. However, the statement has an e
nhanced purpose. It is expanded to reveal other noncash investi
ng and financingactivities. For example, a company may exchan

6. ge common stock for land. Such transactions do not trigger a dir
ect inflow or outflow of cash, but they are nonetheless highly si
gnificant investing/financing events. Other examples include ac
quiring a building for a note payable, retiring debt with stock, a
nd so forth. The statement of cash flows includes a separate sect
ion reporting noncash investing and financing activities.
Example Statement
The following example presents a statement of cash flows. For n
ow, do not be too concerned with details. Instead, just take note
of the overall structure. Notice that this is an operating stateme
nt covering a defined period of time, much like the income state
ment and statement of retained earnings. Thus, the date calls att
ention to the period of time covered by the report. The statemen
t contains a major section for each category of cash flow activiti
es and culminates with a reconciliation of the change in cash bal
ance over the span of the period. Finally, it concludes with detai
ls on the noncash investing/financing actions.
Exhibit 1.1
Exhibit 1.1 prepared the operating activities section under a dire
ct approach. That is, each cash flow component was directly pre
sented (e.g., cash received from customers). An alternative indir
ect approach is also permitted. Later sections of this chapter ma
ke this distinction much clearer, and you will be exposed to bot
h techniques by chapter's end.
1.2
A Deeper Focus on Operating Cash Flows
It is now time to focus on the details within the operating activit
ies section of the statement of cash flows for Example Corporati
on. Therein, it is revealed that $167,000 of cash was generated f
rom operations. This is noted by the total for the operating activ
ities section. The first line within the operating activities sectio
n shows that customers paid the company $1,500,000. But much

7. of that cash flow was spent on inventory, salaries, rent, interest
, other operating expenses, and taxes. These data are relatively e
asy to identify by looking at the operating activities section of t
he cash flow statement. Also, they tend to be self-
explanatory as to their meaning. But, how are the data derived?
Some companies have very strong information systems that allo
w accountants to mine their databases for specific cash payment
s. At other times, a company must use analytical procedures and
assumptions to estimate the specific cash flow amounts. Let's t
hink about how this would occur, beginning with the calculation
of cash received from customers.
Cash Received From Customers
The operating activities section revealed cash collections from c
ustomers of $1,500,000. If all sales were for cash, then this amo
unt would correspond to total sales in the income statement. Ho
wever, companies typically make some sales on account. Thus,
cash collected is not exactly the same as total sales. The differe
nce between cash collections and total sales is reflected as an in
crease or decrease in accounts receivable. In other words, increa
sing accounts receivable balances signal that more sales occurre
d on account than were collections on account. The opposite is
of course true. Thus, one can adjust total sales found on an accr
ual basis income statement by the change in accounts receivable
to estimate cash collections from customers. This assumes unco
llectible accounts are not material; if they were, additional adju
stments would be necessary.
Students generally understand this concept, but an additional ex
ample may prove helpful. Suppose you started a new business.
During your first year of operations, total sales were $100,000.
If you ended the year with $20,000 in accounts receivable, how
much of the sales did you collect? Hopefully, it is apparent that
the answer to this question is $80,000. In other words, cash coll
ected from customers was $80,000. If you discontinued the busi
ness and made no additional sales in the second year, but did co
llect the $20,000 owed to you from the prior year sales, then yo
ur cash collections would be $20,000. In the first year, accounts

8. receivable increased (and you subtracted that from sales to find
cash collections); in the second year, accounts receivable decre
ased (and you added that to sales to find cash collections). This
gives rise to the general model that you can use to calculate cas
h collected from customers:
Total Sales Minus the Increase in Receivables (or, plus a decrea
se in receivables)
Next, let's apply this model to Example Corporation. Assume tot
al sales were $1,750,000, and accounts receivable increased fro
m $300,000 to $550,000. The $250,000 increase in receivables (
i.e., uncollected sales) would be subtracted from total sales to a
rrive at cash collections of $1,500,000. Applying the standard f
ormula produces the correct calculation, as shown:
$1,750,000 − ($550,000 − $300,000) = $1,500,000
Cash Paid for Inventory
The operating activities section revealed that $800,000 in cash
was paid for the purchase of inventory. This calculation is a bit
trickier because it must take into consideration both changes in
inventory and changes in accounts payable related to the purcha
se of inventory. The starting point to calculate cash paid for inv
entory is to determine total purchases of inventory. If inventory
levels were unchanged during the period, then cost of goods sol
d would equal total purchases. However, if inventory on the bal
ance sheet increased, then total purchases would exceed cost of
goods sold (and vice versa). The following formula shows the g
eneral frame of reference for converting cost of goods sold to to
tal purchases:
Cost of Goods Sold Plus the Increase in Inventory (or, minus a
decrease in inventory)
Once total purchases are determined, it is next necessary to asse
ss how much of the purchases were for cash. In other words, tot
al inventory purchased must be adjusted for the portion that was
purchased on credit. This is similar logic to that which was use
d for calculating cash collected on sales. The following formula
shows the general frame of reference for converting purchases o
f inventory to cash paid for inventory:

9. Inventory Purchased Minus the Increase in Payables (or, plus a
decrease in payables)
To be clear, the preceding formula only takes into consideration
payables related to the purchase of inventory. Payables related
to utilities, rent, and other operating expenses should not be co
mmingled with this particular calculation.
Assume that Example Corporation had $750,000 in cost of good
s sold during the period. Furthermore, inventory on the balance
sheet increased by $100,000, and accounts payable related to in
ventory increased by $50,000. Logically, total purchases were $
850,000, but the increase in payables means that only $800,000
of total purchases were funded.
Cash Paid for Operating Expenses
Example Corporation incurred operating expenses for salaries, r
ent, interest, other costs, and taxes. Any or all of these could ha
ve been paid in cash, in which case the reported amount of expe
nse and cash flow effects would be identical. However, to the ex
tent there were/remain unpaid obligations, an adjustment would
be needed. Assume that the company reported salaries expense o
f $250,000. The beginning balance sheet included $35,000 of sal
aries payable and the ending balance sheet included $10,000 of
salaries payable. The $275,000 cash paid for salaries would refl
ect the total expense plus the additional $25,000 paid to bring a
bout a reduction in the payable balance. Similar considerations
would be needed for each expense category, as reflected by the
following formulation:
Expense Plus the Decrease in Related Payable (or, minus an incr
ease in related payable)
For Example Corporation, assume that all other expenses were e
qual to their respective cash payment amounts.
Noncash Expenses and Gains/Losses
Some expenses do not impact operating cash flows. One of the
most prominent examples is depreciation. Consider the journal e
ntry that is used to record depreciation:
12-31-X3
Depreciation Expense

10. 80,000
Accumulated Depreciation
80,000
To record annual depreciation expense
Notice that this expense is not accompanied by a credit to cash.
There is no impact on cash from this entry, even though an expe
nse is recorded. Thus, it is not reported as an operating cash flo
w item, despite its negative impact on income. You can extend t
he logic applicable to depreciation to other noncash expenses. T
hey should not be reported within cash flows from operating act
ivities. Of course, it may occur to you that cash was expended t
o buy the depreciable asset. Thus, there is a cash flow effect at t
he time the asset is purchased for cash. As will be demonstrated
subsequently, the cash paid to purchase a depreciable item is sh
own as an investing activity at the time the asset is acquired.
Another element that you might find in an income statement is a
gain or loss on the sale of an item of property, plant, and equip
ment. Here, it is important to note that the full proceeds from th
e asset sale are reported as a cash inflow within the investing ac
tivities section of the cash flow statement. This is true, whether
the asset sale is at a gain or loss. Thus, nothing additional needs
to be reported in the operating activities section. In other words
, the gain or loss you will observe in the income statement does
not have a corollary impact on the operating activities section o
f the cash flow statement.
1.3
Alternative View of Operating Activities
Previously, it was mentioned that the operating activities sectio
n of the cash flow statement was akin to a cash basis income sta
tement. The illustrated approach was the direct approach to pres

11. enting the operating activities of the business. In other words, e
ach line item shows the direct amount of cash flow attributable t
o the described object. However, current accounting rules permi
t an alternative format called the indirect approach. The indirect
approach starts with a company's reported income number and r
econciles that number to the amount of cash provided by operati
ng activities. Thus, the method is a roundabout, or "indirect," te
chnique to come up with operating cash flows. Importantly, the
amount of cash provided by operating activities is the same und
er both approaches. They are simply alternative ways to demons
trate how cash from operations is reported: (a) by measuring eac
h direct contribution to a company's cash or (b) by starting with
reported income and reconciling for differences between income
and operating cash flow.
It is interesting that most companies opt for the indirect approac
h, although accounting standard setters have long suggested that
the direct approach is preferable. One reason is that compiling
direct cash flow data can be more problematic than the simpler i
ndirect approach. Companies often do not have a sufficiently ro
bust information system to sort all cash receipts and payments i
n a way that enables a precise assessment of each category of di
rect cash flows. Actual business environments are more comple
x than the illustration provided within. With that having been sa
id, let's look closer at the indirect approach. In the next few par
agraphs, the logic of each amount included within the indirect a
pproach will be explained. First, however, is a comparative vie
w of the presentation of operating activities under each of the t
wo methods (Exhibit 1.2). In particular, (a) take note that the in
direct approach begins with net income and reconciles to operati
ng cash flows, and (b) operating cash flows are the same under
both approaches. This is just a road map to what you are about t
o learn. Don't allow yourself to be overwhelmed by this initial v
iew.
Exhibit 1.2
To begin to understand the indirect approach better, start by exa

12. mining the income statement
for Example Corporation in Exhibit 1.3.
Exhibit 1.3
The net income of $457,000 is not equivalent to the operating c
ash flows or change in cash. It is the accrual basis measure of th
e results of operations. Some of the data points within the inco
me statement may look familiar from the preceding narrative. F
or example, take notice that total sales are $1,750,000, which eq
uals the amount noted previously in the discussion about cash c
ollected from sales.
The indirect approach begins with the company's income and pr
ovides a listing of various adjustments that are needed to conver
t the results to a measure of operating cash flows. Exhibit 1.4 is
the cash flow statement for Example Corporation, this time pre
pared under the indirect approach. This statement is identical to
the one presented previously, except that the operating activities
section has been significantly revised to reflect the indirect app
roach.
Exhibit 1.4
Perhaps additional explanation will help you follow the constru
ction of the indirect presentation of operating cash flows. Table
1.2 provides an added explanation for each adjustment for each
of Example Corporation components within the operating activit
ies section.
Table 1.2: Explanation for each adjustment for each of Example
Corporation components within the operating activities section
Depreciation expense
Added back to net income because it is a noncash expense
Increase in accounts receivable
Subtracted because it represents uncollected sales
Increase in inventory
Subtracted because it corresponds to purchases of inventory in e
xcess of cost of goods sold
Increase in accounts payable

13. Added because it represents costs not yet funded
Decrease in salaries payable
Subtracted because it represents payments in excess of the amou
nt expensed
Gain on sale of equipment
Subtracted because (a) it is not related to operating activities, a
nd (b) the full proceeds from the land sale are shown in the inve
sting activities section
In a full business setting, the logic evident in the preceding tabl
e would potentially be extended to a countless variety of other r
evenue and expense items. Table 1.3 is at times helpful in classi
fying the needed adjustments within the operating activities sect
ion.
Table 1.3: Needed adjustments within operating activities
Current assets
Current liabilities
Those that increased are subtracted
Examples include increases in accounts receivable, inventory, p
repaid expenses
Those that decreased are subtracted
Examples include decreases in accounts payable, salaries payabl
e, interest payable
Those that decreased are added
Examples include decreases in accounts receivable, inventory, p
repaid expenses
Those that increased are added
Examples include increases in accounts payable, salaries payabl
e, interest payable
Indeed, a following section in this chapter will show how a wor
ksheet can be used to pinpoint the change in each balance sheet.
Eventually, the change in all accounts on the balance sheet mus
t be considered in preparing a statement of cash flows. Logical
analysis and reasoning is necessary to tackle this challenge, and
in some respects the ability to translate accrual basis income to
operating cash flows can be viewed as a litmus test of your und
erstanding of accounting. For Example Corporation, the convers

14. ion process distills itself to an amount equal to the $167,000 net
cash provided by operating activities. This is an identical result
to the direct approach. Either approach is an accepted manner o
f presentation. However, for companies opting to report under t
he direct approach, a supplemental table is required to reconcile
net income to operating cash flows. Thus, as a practical matter,
companies opting for the direct approach also present the indire
ct information. Conversely, companies opting for the indirect ap
proach must also report supplement data about the amount of ca
sh paid for interest and taxes.
As you have already noted, following the operating activities se
ction you will find the investing and financing activities. These
are presented in the same manner, regardless of the method used
to report operating activities.
Investing Activities
The next section of the cash flow statement relates to investing
activities and is much simpler. Both inflows and outflows relate
d to investment-
related transactions are reported within this category. During th
e year, Example Corporation had the following unique investing
transactions:
1.
Sold land costing $130,000 for a total of $175,000 (producing a
$45,000 gain)
2. Purchased equipment for $96,000
3. Acquired $70,000 of land in exchange for a note payable
Reviewing the statement, you should notice that Example Corpo
ration reported a cash inflow from the sale of land and a cash ou
tflow for the purchase of equipment. The $70,000 note-for-
land transaction is a noncash transaction and is reported in the s
eparate section reserved for such activities.
Recall that the sale of land produced a gain of $45,000, as refle
cted in the income statement (and operating activities section of
the cash flow statement using the indirect approach). Regardles
s of whether a gain or loss resulted on the sale of land, what is r
eported in the investing activities section is the gross sales proc

15. eeds of $175,000. Because the gain was either (a) not reported u
nder the direct approach or (b) subtracted from income under th
e indirect approach, the result is that the operating activities sec
tion is void of any effect from this transaction. Thus, the investi
ng activity section need only report an addition for the sales pri
ce. Conversely, the cash paid to purchase equipment is subtracte
d. Noncash acquisitions are not reported in this section but are i
nstead reserved for the noncash investing/financing activities se
ction.
Financing Activities
The next major section of the cash flow statement relates to fina
ncing activities. This section reveals the inflows and outflows r
elated to securing and repayment of corporate funding. You will
notice that Example Corporation issued stock for a total consid
eration of $200,000. Assume that the par value of the newly issu
ed shares was $100,000, thus the balance sheet will include an i
ncrease to Common Stock for $100,000 and an increase to Paid-
in-
Capital in Excess of Par for $100,000. Nevertheless, the only lin
e item in the cash flow statement pertains to the gross cash recei
ved upon issuance of the shares. Dividends paid on common sto
ck are shown as a cash outflow within this section. As long as t
he amounts declared and paid were identical, the dividends from
the statement of retained earnings would equal the amount on t
he cash flow statement.
Had the company borrowed cash or repaid amounts borrowed, th
e financing activities section would also show these amounts. R
ecall, however, that interest paid on debt is instead shown in the
operating activities section.
Net Change in Cash
The net amount of cash generated or consumed by the operating,
investing, and financing sections should equal the change in ca
sh for the period. Usually, a company will show the change in c
ash and reconcile it to the beginning and end cash positions on t
he balance sheet, as was done for Example Corporation. Exampl
e Corporation had a $421,000 increase in cash; when added to th

16. e beginning cash amount of $251,000, the ending balance of $67
2,000 results.
Noncash Investing/Financing Activities
As previously noted, the noncash investing and financing sectio
n reports on investing and financing actions that do not directly
entail the use of cash. It is quite common for a company to purc
hase property, plant, and equipment in exchange for a promissor
y note. Likewise, a company may exchange stock for assets or e
ven issue stock to retire debt. There are many such transactions
and events where assets/debt/equity increase/decrease without tr
iggering cash flow. Example Corporation's event related to the a
cquisition of land in exchange for a note payable. It is assumed
that this is the only debt incurred by the company; the interest d
uring the period of $3,000 was paid in cash and is reported in th
e operating activities section.
1.4
Using a Worksheet to Prepare the Statement
You may be wondering how to go about preparing a statement o
f cash flows. One approach is to set up the shell structure for th
e statement and gradually fill in known information about specif
ic cash flow events. This is like solving a puzzle. You know the
change in cash by reference to the balance sheet. Once you have
assembled all the known information so that it fully explains th
e change in cash, you probably will have successfully completed
the task. But, this approach can prove very frustrating, as there
may be elusive components that escape your attention. A far bet
ter approach is to employ a systematic worksheet.
The worksheet forces one to compare the change in every balanc
e sheet account during the period and squeeze out the correspon
ding cash flow consequences. Following is the beginning-
and end-of-
period balance sheets for Example Corporation. To the right of t
he balance sheet is an additional table showing the change in ea
ch balance sheet account. This will prove helpful in visually con

17. necting the worksheet in Exhibit 1.5.
Exhibit 1.5
This balance sheet information is incorporated into the leftmost
and rightmost numerical data columns of Exhibit 1.6.
Exhibit 1.6
The middle two columns of the top half of the worksheet captur
e the change for each row (i.e., balance sheet accounts). For inst
ance, Example Corporation's beginning accounts receivable was
$300,000, and the ending balance was $550,000. This is a net de
bit to accounts receivable, as shown in the middle column. Impo
rtantly, one is not actually debiting or crediting these accounts a
t this time. The worksheet is merely used to demonstrate the net
change for each account. The change for every row of the balan
ce sheet must be explained. On occasion (such as with the Land
account in the example), there can be both increases and decreas
es that must be taken into consideration as part of the full expla
nation of all balance changes.
For each element of change to a balance sheet account, the lowe
r half of the worksheet shows the corresponding (offsetting debi
t or credit) effect of the change on a company's cash flow. For e
xample, the increase in accounts receivable (debit) is subtracted
from net income as part of the calculation of operating cash flo
w. In other words, cash was not generated for uncollected sales,
and this is shown in the credit column in the lower portion of t
he worksheet. Similar effects are noted for each item, and the s
mall letters key the changes in the top half of the worksheet to t
he bottom half of the worksheet. Table 1.4 provides a fuller exp
lanation of each keyed item for Example Corporation.
Table 1.4: Example Corporation
Upper portion
Lower portion
Comment
(a)

18. Increase to Cash via Debit
Remaining Net Positive Cash Flow as Credit
This is the net change in cash
(b)
Increase to Accounts Receivable via Debit
Negative Cash Flow Effect via Credit
Reflects uncollected sales
(c)
Increase to Inventory via Debit
Negative Cash Flow Effect via Credit
Reflects buying inventory in excess of what was sold
(d)
Increase to Land via Debit and Increase to Note Payable via Cre
dit
Debit and Credit as NoncashInvesting/Financing
Reflects increase in land from purchase (via note)
(e)
Decrease to Land via Credit
Positive Cash Flow Effect via Debit for Sales Proceeds, and Off
setting Credit for Gain Portion to be Excluded From Operating
Activities
Reflects decrease to land from sale and inflows from investing a
ctivity
(f)
Increase to Buildings and Equipment viaDebit
Negative Cash Flow Effect via Credit
This is the purchase price of new equipment bought for cash
(g)
Increase to Accumulated Depreciation viaCredit
Offsetting Debit for Expense Portion to be Excluded From Oper
ating Activities
Reflects the amount of depreciationexpense
(h)
Increase to Accounts Payable via Credit
Positive Cash Flow Effect via Debit
Reflects unpaid inventory purchases

19. (i)
Decrease to Salaries Payable via Debit
Negative Cash Flow Effect via Credit
Reflects payments for salaries previouslyexpensed
(j)
Increase to Common Stock and Paid-
in Capital in Excess of Par via Credit
Positive Cash Flow Effect via Debit
Reflects issuance of stock for cash
(k)
Decrease to Retained Earnings for Dividends via Debit
Negative Cash Flow Effect via Credit
Reflects cash paid for dividends
(l)
Increase to Retained Earnings for Net Income via Credit
Positive Cash Flow Effect (before considering all other operatin
g adjustments as per above) via Debit
The amount of net income during the period (starting point for c
alculating cash flows from operations under the indirect approac
h)
Finally, you should take time to compare the lower portion of th
e worksheet to the indirect statement of cash flows presented pr
eviously. It is important for you to note how the information fro
m the worksheet is transferred to a cash flow statement. Althoug
h the worksheet can at first appear daunting, it is actually a sim
plifying procedural tool that will ease the frustration that can ac
company the process of preparing a cash flow statement. Withou
t this thoughtful approach of taking into consideration all the ac
counts on the balance sheet, one can easily overlook a few data
points that are needed to complete a correct statement of cash fl
ows.
1.5
Comprehensive Example
Many accounting educators agree that the statement of cash flo

20. ws is the most challenging topic for new accounting students. It
is often seen as a capstone topic for financial accounting and a l
itmus test for your depth of accounting knowledge. To assist yo
u in gaining comprehension, this chapter closes with an addition
al comprehensive example of a statement of cash flows prepared
under the indirect approach. The following example does not in
troduce new knowledge. Instead, it is designed to reinforce the
concepts of this chapter and provide a framework for garnering
a deeper appreciation of the approach you can use to master you
r ability to prepare a statement of cash flows. Take sufficient ti
me to review the facts and exhibits carefully, and try to reconcil
e each number reported in the statement of cash flows.
Corporation presented the comparative balance sheet shown in E
xhibit 1.7.
Exhibit 1.7
Additional information about transactions and events occurring
in 20X9 follows:
·
Net income was $160,000, and dividends of $10,000 were declar
ed and paid.
·
Accounts payable and accounts receivable relate only to purchas
es and sales of inventory.
·
The decrease in land resulted from the sale of a parcel of land th
at cost $100,000 but was sold for $125,000, producing a $25,00
0 gain.
·
A building valued at $50,000 was acquired in exchange for 10,0
00 shares of $1 par value stock.
·
A new piece of equipment was acquired in exchange for cash of
$25,000.
·
$75,000 cash was borrowed via issuing an additional note payab

21. le.
·
Total interest expense was $100,000, of which $75,000 was paid
in cash.
· Total taxes were $46,000, all paid in cash.
Exhibit 1.8 shows the worksheet for Graham Corporation. Be su
re to observe how the beginning and ending balances for each b
alance sheet account are compared and the differences noted. Ea
ch difference identifies a cash flow statement impact, as further
explained in Table 1.5.
Exhibit 1.8
Table 1.5: Cash flow statement impact
Upper portion
Lower portion
Comment
(a)
Increase to Cash via Debit
Remaining Net Positive Cash Flow asCredit
This is the net change in cash
(b)
Increase to Accounts Receivable viaDebit
Negative Cash Flow Effect via Credit
Reflects uncollected sales
(c)
Increase to Inventory via Debit
Negative Cash Flow Effect via Credit
Reflects buying inventory in excess of what was sold
(d)
Increase to Prepaid Rent via Debit
Negative Cash Flow Effect via Credit
Reflects paying rent in advance
(e)
Decrease to Land via Credit
Positive Cash Flow Effect via Debit for Sales Proceeds, and Off

22. setting Credit for Gain Portion to be Excluded From Operating
Activities
Reflects decrease to land from sale and inflow from investing ac
tivity
(f)
Increase to Building via Debit and Increase to Common Stock a
nd Paid-in Capital via Credit
Debit and Credit as NoncashInvesting/Financing
Reflects increase in building from purchase (via stock)
(g)
Increase to Equipment via Debit
Negative Cash Flow Effect via Credit
This is the purchase price of new equipment bought for cash
(h)
Increase to Accumulated Depreciation viaCredit
Offsetting Debit for Expense Portion to be Excluded From Oper
ating Activities
Reflects the amount of depreciationexpense
(i)
Increase to Accounts Payable via Credit
Positive Cash Flow Effect via Debit
Reflects unpaid inventory purchases
(j)
Increase to Interest Payable via Credit
Positive Cash Flow Effect via Debit
Reflects unpaid interest
(k)
Decrease to Retained Earnings for Dividends via Debit
Negative Cash Flow Effect via Credit
Reflects cash paid for dividends
(l)
Increase to Retained Earnings for Net Income via Credit
Positive Cash Flow Effect (before considering all other operatin
g adjustments as per above) via Debit
The amount of net income during the period (starting point for c
alculating cash flows from operations under the indirectapproac

23. h)
The lower portion of the worksheet is readily assembled into the
following proper format for presentation of the statement of cas
h flows in Exhibit 1.9.
Exhibit 1.9
In summary review of the statement, it appears that the bulk of
Graham's $175,000 increase in cash was due to the sale of asset
s and loans. Although the company is profitable, the operating c
ash flow was slight. The simple explanation, as revealed by the
operating activities section, is that most of the profits were need
ed to support growth in receivables and inventory. This is a com
mon problem for successful growing businesses, and it undersco
res the need to look beyond the income statement to determine t
he ability of a business to grow and prosper. The cash flow state
ment is an often overlooked but highly important financial state
ment!