Principles of Accounting Volume 1: Financial Accounting chapter 16

1. PowerPoint Image Slideshow
Chapter 16 STATEMENT OF CASH FLOWS
Principles of Accounting, Volume 1: Financial Accounting

2. Chapter Outline
• 16.1 Explain the Purpose of the Statement of Cash Flows
• 16.2 Differentiate between Operating, Investing, and Financing
Activities
• 16.3 Prepare the Statement of Cash Flows Using the Indirect Method
• 16.4 Prepare the Completed Statement of Cash Flows Using the
Indirect Method
• 16.5 Use Information from the Statement of Cash Flows to Prepare
Ratios to Assess Liquidity and Solvency
• 16.6 Appendix: Prepare a Completed Statement of Cash Flows Using
the Direct Method

3. Module 16.1 Explain the Purpose of the Statement of Cash Flows
• One purpose of the statement of cash flows to answer the following two
questions:
• What are the sources of cash (where does the cash come from)?
• What are the uses of cash (where does the cash go)?
• The statement of cash flows shows the amount of cash inflows and
outflows during a year.
• The statement of cash flows provides information about the quality of a
company’s net income.
• A company that shows significantly less cash inflow on the statement of cash flows
than the reported net income on the income statement could very well be reporting
revenue for which cash will never be received from the customer or underreporting
expenses.
• A third use of the statement of cash flows is that it provides information
about a company’s sources and uses of cash not related to the income
statement.

4. Methods of Generating the Statement of Cash Flows
• Two methods:
• The indirect method approach reconciles net income to cash flows by
subtracting noncash expenses and adjusting for changes in current assets and
liabilities, which reflects timing differences between accrual-based net
income and cash flows. A noncash expense is an expense that reduces net
income but is not associated with a cash flow; the most common example is
depreciation expense.
• The direct method lists net cash flows from revenue and expenses; in other
words, accrual basis revenue and expenses are converted to cash basis
collections and payments.

5. Module 16.2 Differentiate between Operating, Investing, and
Financing Activities
The statement of cash flows presents sources and uses of cash in three distinct
categories:
• Cash flows from operating activities: primarily arise from the activities a business uses to
produce net income; basically the cash generated from doing what the company is in
business to do such as cash from selling inventory, cash used to buy inventory, cash used to
pay wages, etc.
• Cash flows from investing activities: arise from the business buying and selling of long-term
assets such as buying and selling of equipment or investments
• Cash flows from financing activities: arise from the changes related to long-term debt and
equity financing such as issuing bonds or stock, borrowing money, and paying back long-term
loans
• The same net cash flow will be derived from both the indirect and the direct
method. The investing and financing activities will be identical under the two
methods. Only the presentation of the operating activities will differ.
• These categories help users assess a company’s strategy and ability to generate a
profit and stay in business by assessing how much a company relies on operating,
investing, and financing activities to produce its cash flows.

6. Module 16.3 Prepare the Statement of Cash Flows Using the Indirect
Method
The five steps are:
• Step 1: Determine Net Cash Flows from Operating Activities
• Begin with net income from the income statement.
• Add back noncash expenses, such as depreciation, amortization, and depletion.
• Remove the effect of gains and/or losses from disposal of long-term assets, as cash from
the disposal of long-term assets is shown under investing cash flows.
• Adjust for changes in current assets and liabilities to remove accruals from operating
activities.
• Step 2: Determine Net Cash Flows from Investing Activities
• Step 3: Present Net Cash Flows from Financing Activities
• Step 4: Reconcile Total Net Cash Flows to Change in Cash Balance during the
Period
• Step 5: Present Noncash Investing and Financing Transactions

7. • To prepare a statement of cash flows, we need both the balance
sheet and income statement.
• The balance sheet and income statement for Prosperity, Company,
are presented on the next two slides and will provide the sources of
information needed to generate the statement of cash flows.

8. Figure 16.2
Comparative Balance Sheet. Modified for PPT. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
The change in the
account balances
from the
beginning of the
year to the end of
the year is needed
for the statement
of cash flows.
This will be the
net change in cash
on the statement
of cash flows.

9. Figure 16.3
Income Statement. Modified for PPT. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
Net Income the is starting
point for the statement of
cash flows under the
Indirect Method.

10. Additional information needed to help construct a statement of cash flows:
• Propensity Company sold land with an original cost of $10,000, for $14,800
cash.
• A new parcel of land was purchased for $20,000, in exchange for a note
payable.
• Plant assets were purchased for $40,000 cash.
• Propensity declared and paid a $440 cash dividend to shareholders.
• Propensity issued common stock in exchange for $45,000 cash.

11. Figure 16.4
Statement of Cash Flows. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
The final
product: but
what are the
individual five
steps that
resulted in this
statement?

12. • Step 1: Determine Net Cash Flows from Operating Activities
• Begin with net income from the income statement.
• Add back noncash expenses, such as depreciation, amortization, and
depletion.
• Remove the effect of gains and/or losses from disposal of long-term assets, as
cash from the disposal of long-term assets is shown under investing cash
flows.
Prepare the Operating Section of the Statement of Cash Flows:
Indirect Method
Modified for PPT.

13. Step 1: Determine Net Cash Flows from Operating Activities
(continued)
• Adjust for changes in current assets and liabilities to remove accruals
from operating activities.
• Increases in current assets indicate a decrease in cash, because either
(1) cash was paid to generate another current asset, such as
inventory, or (2) revenue was accrued, but not yet collected, such as
accounts receivable.

14. • Decreases in current assets indicate lower net income compared to
cash flows from (1) prepaid assets and (2) accrued revenues.
Step 1: Determine Net Cash Flows from Operating Activities
(continued)

15. • Increases in current liabilities indicate an increase in cash, since these
liabilities generally represent (1) expenses that have been accrued,
but not yet paid, or (2) deferred revenues that have been collected,
but not yet recorded as revenue.
Step 1: Determine Net Cash Flows from Operating Activities
(continued)

16. • Decreases in current liabilities indicate a decrease in cash relating to
(1) accrued expenses, or (2) deferred revenues.
Step 1: Determine Net Cash Flows from Operating Activities
(continued)

17. Figure 16.5: Net Cash Flow from Operating Activities
(Indirect Method)
Putting it all together:
Cash from Operating. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

18. Your Turn: Cash Flow from Operating Activities
Assume you own a specialty bakery that makes gourmet cupcakes.
Excerpts from your company’s financial statements are shown.
How much cash flow from operating activities did your company
generate?

19. Sample Exercise
EA6. Use the following information from Birch Company’s balance
sheets to determine net cash flows from operating activities (indirect
method), assuming net income for 2018 of $122,000.

20. Think It Through: Explaining Changes in Cash Balance
Assume that you are the chief financial officer of a company that
provides accounting services to small businesses. You are called upon
by the board of directors to explain why your cash balance did not
increase much from the beginning of 2018 until the end of 2018, since
the company produced a reasonably strong profit for the year, with a
net income of $88,000. Further assume that there were no investing or
financing transactions, and no depreciation expense for 2018. What is
your response? Provide the calculations to back up your answer.

21. Prepare the Investing Section of the Statement of Cash Flows
• Preparation of the investing section of the statement of cash flows is
an identical process for both the direct and indirect methods, since
only the technique used to arrive at net cash flow from operating
activities is affected by the choice of the direct or indirect approach.
• The long-term asset section of the balance sheet will be examined for
changes that occurred from the beginning of the year to the end of
the year. Any additional information will be considered to help assess
if the changes that occurred were cash changes or the result of
noncash activities.

22. Focus on this section of the long-term assets from the balance sheet:
Also recall the following
additional information:
• Propensity Company sold land
with an original cost of
$10,000, for $14,800 cash.
• A new parcel of land was
purchased for $20,000, in
exchange for a note payable.
• Plant assets were purchased
for $40,000 cash.
Modified for PPT.

23. Analysis of investing activities would yield the following results:
Cash received
from sale of
land
Cash paid to
buy equipment
Land purchased
through a loan
(noncash activity)
Modified for PPT.

24. Putting it all together:
Net Cash Flow from Investing Activities
Modified for PPT.

25. Your Turn: Cash Flow from Investing Activities
Assume your specialty bakery makes gourmet cupcakes and has been
operating out of rented facilities in the past. You owned a piece of land
that you had planned to someday use to build a sales storefront. This
year your company decided to sell the land and instead buy a building,
resulting in the following transactions.
What are the cash flows from investing activities relating to these
transactions?

26. Prepare the Financing Section of the Statement of Cash Flows
• Preparation of the financing section of the statement of cash flows is
an identical process for both the direct and indirect methods, since
only the technique used to arrive at net cash flow from operating
activities is affected by the choice of the direct or indirect approach.
• The liability and stockholders’ equity section of the balance sheet will
be examined for changes that occurred from the beginning of the
year to the end of the year. Any additional information will be
considered to help assess if the changes that occurred were cash
changes or the result of noncash activities.

27. Focus on these parts of the long-term liabilities and the stockholders’ equity
sections of the balance sheet:
Also recall the following
additional information:
• A new parcel of land was
purchased for $20,000, in
exchange for a note
payable.
• Propensity declared and
paid a $440 cash dividend
to shareholders.
• Propensity issued common
stock in exchange for
$45,000 cash.
Modified for PPT.

28. Analysis of financing activities would yield the following results:
Cash received
from issuance
of stock
Cash used to
pay notes
payable and to
pay dividends
Land purchased
through a loan
(noncash activity)
Modified for PPT.

29. Putting it all together:
Net Cash Flow from Financing Activities

30. Figure 16.4: Complete Statement of Cash Flows: Indirect Method
Statement of Cash Flows. Modified for PPT. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
This equals the cash
balance on the balance
sheet at December 31,
2018.
This equals the change
in cash from beginning
of the year to end of
the year on the balance
sheet.

31. Sample Exercise
EA1. Provide journal entries to record each of the following
transactions. For each, identify whether the transaction represents a
source of cash (S), a use of cash (U), or neither (N).
A. Declared and paid to shareholders, a dividend of $24,000.
B. Issued common stock at par value for $12,000 cash.
C. Sold a tract of land that had cost $10,000, for $16,000.
D. Purchased a company truck, with a note payable of $38,000.
E. Collected $8,000 from customer accounts receivable.

32. Module 16.4 Prepare the Completed Statement of Cash Flows Using
the Indirect Method
Review problem: preparing the Virtual Co. statement of cash flows
• The balance sheet and income state for Virtual Co. follow in the next
two slides. Prepare a statement of cash flows using the indirect
method.

33. Figure 16.6
Comparative Balance Sheet. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

34. Figure 16.7
Income Statement. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

35. Additional information needed to help construct a statement of cash
flows:
• Investments that originally cost $30,000 were sold for $47,500 cash.
• Investments were purchased for $50,000 cash.
• Plant assets were purchased for $66,000 cash.
• Cash dividends were declared and paid to shareholders in the amount
of $8,000.

36. Figure 16.8
Statement of Cash Flows. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

37. Sample Exercise
EA13. Provide the missing piece of information for the following
statement of cash flows puzzle.

38. Module 16.5 Use Information from the Statement of Cash Flows to
Prepare Ratios to Assess Liquidity and Solvency
• Cash flow ratio analysis allows financial statement users to see the
company’s liquidity position from a clearer perspective.
• The following ratios will be evaluated for Propensity Company:
• Free cash flow
• Cash flows to sales
• Cash flows to assets

39. Free cash flow: measure of cash remaining after the company pays for
capital expenditures, operating expenses, and dividends
• The absence of free cash flow is an indicator of severe liquidity concern for
Propensity Company and could be an early indicator that the company may
not be able to continue operations.
• This could also be a one-time occurrence, in a year where a large capital
investment was planned, to be financed with resources from the
company’s capital reserves from previous years’ profits. In such a case, the
negative free cash flow would not be an issue of concern.

40. • Cash flows to sales: how much sales are contributing to free cash
flow
Free Cash Flow ÷ Sales Revenue
• Since free cash flow for Prosperity Company was negative, this ratio
cannot be calculated.
• Cash flows to assets: how well assets are being utilized to generate
free cash flow
Free Cash Flow ÷ Total Assets
• Since free cash flow for Prosperity Company was negative, this ratio
cannot be calculated.

41. Sample Exercise
EA16. The following are excerpts from Hamburg Company’s statement of cash flows and
other financial records.
Compute the following for the company:
A. free cash flow
B. cash flows to sales ratio
C. cash flows to assets ratio

42. Think It Through: Classification of Cash Flows Makes a Difference
Assume you are the chief financial officer of T-Shirt Pros, a small business that makes custom-
printed T-shirts. While reviewing the financial statements that were prepared by company
accountants, you discover an error. During this period, the company had purchased a warehouse
building, in exchange for a $200,000 note payable. The company’s policy is to report noncash
investing and financing activities in a separate statement, after the presentation of the statement of
cash flows. This noncash investing and financing transaction was inadvertently included in both the
financing section as a source of cash, and the investing section as a use of cash.
T-Shirt Pros’ statement of cash flows, as it was prepared by the company accountants, reported the
following for the period, and had no other capital expenditures.
Because of the misplacement of the transaction, the calculation of free cash flow by outside
analysts could be affected significantly. Free cash flow is calculated as cash flow from operating
activities, reduced by capital expenditures, the value for which is normally obtained from the
investing section of the statement of cash flows. As their manager, would you treat the accountants’
error as a harmless misclassification, or as a major blunder on their part? Explain.

43. Module 16.6 Appendix: Prepare a Completed Statement of Cash
Flows Using the Direct Method
• Recall the net cash flows for all sections of the statement of cash flows are
identical when using the direct method or the indirect method.
• The difference is just in the way that net cash flows from operating
activities are calculated and presented.
• The direct method requires that each item of income and expense be
converted from the accrual basis value to the cash basis value for that item.
• This is accomplished by adjusting the accrual amount for the revenue or expense by
any related current operating asset or liability.
• Revenue and expense items that are not related to those current asset and
liability accounts would not need an adjustment.

44. Figure 16.9: Complete Statement of Cash Flows: Direct Method
Statement of Cash Flows. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

45. Module 16.6: Cash Collected from Customers

46. Cash Paid to Suppliers for Inventory
Changes in the inventory
account only indicate that
inventory was purchased or
sold; the payment for
inventory is associated with
the accounts payable
account.

47. Cash Paid for Salaries

48. Cash Paid for Insurance

49. Figure 16.9: Complete Statement of Cash Flows: Direct Method
Statement of Cash Flows. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

50. SAME
SAME
Side-by-Side Comparison: Indirect and Direct Method
Modified for PPT.

51. Sample Problem
PA1. Provide journal entries to record each of the following
transactions. For each, also identify *the appropriate section of the
statement of cash flows, and **whether the transaction represents a
source of cash (S), a use of cash (U), or neither (N).
A. paid $12,000 for inventory that was purchased on account
B. collected $6,000 from a customer note receivable
C. issued common stock at par for $24,000 cash
D. paid $6,000 cash dividend to shareholders
E. sold products to customers on credit, $15,000
F. paid current month’s utility bill, $1,500

52. Summary
• The statement of cash flows presents the sources and uses of cash.
• There are two approaches utilized to prepare the statement of cash flow: the indirect method and
the direct method.
• Transactions must be segregated into the three types of activities presented on the statement of
cash flows: operating, investing, and financing.
• Operating cash flows arise from the normal operations of producing income, such as cash receipts
from revenue and cash disbursements to pay for expenses.
• Investing cash flows arise from a company investing in or disposing of long-term assets.
• Financing cash flows arise from a company raising funds through debt or equity and repaying
debt.
• Company activities that reflect changes in long-term assets, long-term liabilities, or equity, but
have no cash impact, require special reporting treatment, as noncash investing and financing
transactions.
• Three cash flow rations to helps assess liquidity are free cash flow, cash flow to assets ratio, and
cash flow to sales ratio.
• The direct method of preparing the statement of cash flows is identical to the indirect method
except for the cash flows from the operating and financing sections.
• To complete the cash flows from operating activities, the direct method directly shows the cash
collected from customers from revenue activities and the cash spent on operations, rather than
reconciling net income to cash flows from operating activities as done using the indirect method.

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