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Financial Accounting:
A Business Process Approach
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
9 -1
Preparing and Analyzing
the Statement of Cash Flows
Chapter 9
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
9- 2
Learning Objectives
When you are finished studying Chapter 9, you
will be able to:
1. Explain the importance of the statement of cash flows
and the three classifications of cash included on it.
2. Explain the difference between the direct method and
the indirect method of preparing the statement of cash
flows.
3. Convert accrual amounts to cash amounts.
4. Prepare the cash flows from operating activities section
of the statement of cash flows using the direct method.
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9- 3
Learning Objectives
5. Prepare the cash flows from operating
activities section of the statement of cash flows
using the indirect method.
6. Prepare the cash flows from investing
activities section and the cash flows from
financing activities section of the statement of
cash flows.
7. Perform general analysis of the statement of
cash flows and calculate free cash flow.
8. Use the statement of cash flows and the
related controls to evaluate the risk of investing
in a firm.
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9- 4
Ethics Matters
the
settlement
of these
GE did
InIn
May
2008,
a Wall Street
Journalcharges,
(WSJ) article
emphasized
of cash flows in
evaluating
not admitthe
or importance
deny the allegations.
Did
the gap
stocks.
Because
earnings
can to
be
affected
by
accounting
In August
2009,
GE agreed
pay
a
$50
million
fine
between
GE’s
cash
flows
and
net
income,
as
choices,
cash
flows
mayExchange
be
a better
gauge than
net
In
theSecurities
WSJ
article,
General
Electric
Co.
was
to the
and
Commission
(SEC)
to
observed
by
Sloan,
provide
some
hint
about
income
a firm’s
health.
settleof
civil
fraud financial
and other
charges that GE’s 2002
cited
as an example
of a at
company
the
accounting
problems
GE thatwith
wereayet
and 2003 financial
statements
misled
investors.
growing
gap
between
net
income
and cash
to
be
uncovered?
Never
underestimate
the
Headline
earnings
numbers—typically
net
income—can
According to the SEC’s Division of Enforcement,
“GE be
flow
which
“suggested
the
company
had
massaged
by
legal
tricks,
such
asthe
changing
a
insights
toperfectly
be
gained
by
following
cash.
bent the
accounting
rules
beyond
the breaking
point.
depreciation
schedule
ormeet
the way
revenue
been
stretching
to
its
numbers.”
Overly
aggressive
accounting
can
distortisarecognized.
company’s
Start
by
understanding
the
statement
of cash
Cash
flows—how
much actual
money
company spits
true
financial
condition
and
misleadainvestors.”
flows,
the
topic
of
this
chapter.
out—are by no means immune from shenanigans, but
many analysts consider them a cleaner way to assess a
company’s health.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
9- 5
Learning
Objective 1
Statement of Cash Flows
The Statement of Cash Flows:
provides
crucial information to
decision makers to help predict
future cash flows of the business.
shows
how the business acquired
its cash during the current year.
shows
how the business spent its
cash during the current year.
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9- 6
The Statement Of Cash Flows
The Statement of Cash Flows is divided
into three categories:
1. Operating
Cash related to the day-to-day activities
2. Investing
Cash related to buying and selling firm
assets to be used longer than one year
3. Financing
Cash receipts and disbursements related
to loans (principal), cash contributions from
and distributions to owners
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9- 7
Categories of Cash Flows:
Operating Activities
Operating Activities:
Cash inflows and outflows that are directly
related to income from normal operations.
FASB defines operating activities as those
that are not investing or financing activities.
Activities related to operating cash flows:
c. (inflow) cash collections from customers
b. (outflow) cash paid to vendors
c. (related balance sheet accounts)
current assets and current liabilities
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9- 8
Categories of Cash Flows:
Investing Activities
Investing Activities:
Cash inflows and outflows that are
related to the purchase and sale of
productive assets.
Activities related to investing cash flows:
a. (inflow) cash proceeds from sale of
long-term assets (building, land, etc.)
b. (outflow) cash paid to purchase
long- term assets
c. (related balance sheet accounts)
long-term assets
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9- 9
Categories of Cash Flows:
Financing Activities
Financing Activities:
Cash inflows and outflows that are related to
how cash was obtained to finance the
business.
Activities related to financing cash flows:
a. (inflow) cash proceeds from a new stock
issue or sale of bonds or other borrowing
b. (outflow) cash dividends paid to
shareholders’ principal payments, retire
bonds or loans
c. (related balance sheet accounts)
liabilities and shareholders’ equity
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9 - 10
Cash Flows from Noncash Activities
Investing and financing activities
that do not involve cash, e.g.,
Retirement
of bonds by issuing
stock.
Settlement of debt by transferring
assets.
Noncash activities must be
disclosed separately in the
financial statements.
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9 - 11
Cash Budget
Preparing a cash budget is a crucial activity
for all companies. The sources and uses of
cash must be estimated in detail—
both the amounts of cash and when it is
needed.
Each month, projected cash inflows and
outflows must be budgeted by source and
use.
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9 - 12
Cash Budget
With this level of detail, a company can plan
ahead for any cash shortage by:
(1) securing a line of credit from a
local bank,
(2) borrowing the money, or
(3) altering the timing of its receipts
(tightening up credit policies) or
disbursements (postponing purchases).
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9 - 13
Learning
Objective 2
Two Alternative Approaches
Indirect Method
Shows
net cash inflow (outflow) from
operations as an adjustment of net income.
Used
by 97% of companies.
Direct Method
Reports
the components of cash from
operations as gross receipts and payments.
Recommended
used.
by the FASB, but rarely
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9 - 14
Direct and Indirect Method
Two ways to compute net cash flow from
Operating Activities:
Direct method
 Shows every cash inflow and outflow
 Converts every number on the income
statement to its cash amount.
Indirect method
 Starts with net income and makes
adjustments for items that are not cash
Both methods result in the same net cash
from operating activities.
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9 - 15
Preparing the Statement of Cash Flows
The face of the statement includes:
Net Cash Flows from Operating Activities
+Net Cash Flows from Investing Activities
+Net Cash Flows from Financing Activities
Net Cash Flows for the period
+ Beginning Cash Balance
End of period Cash Balance
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9 - 16
Preparing the Statement of Cash Flows
Direct Method
Cash from operating activities:
Cash collected from customers . . . . . . . . $500
Cash paid for supplies . . . . .. . . . . . . . . . . (30)
Cash paid to vendors for inventory . . . . (200)
Net cash from operating activities . . . . . $270
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9 - 17
Preparing the Statement of Cash Flows
Indirect Method
Cash from operating activities:
Net Income . . . . . . . . . . . . . . . . . . . . . . .$330
- Increase in accounts receivable. . . . . . . 500
- Increase in supplies . . . . . . . . . . . . . . . . (10)
+ Increase in accounts payable . . . . . . . . 50
Net cash from operating activities . . . . . $270
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9 - 18
Your Turn 9-1
What is the major difference between the
direct and indirect methods of presenting the
statement of cash flows? What are the
similarities?
The difference is in the section that examines cash
flows from operating activities. The direct method
identifies each cash flow, whereas the indirect
method starts with net income and adjusts it to a
cash amount. The net cash flow from operating
activities is the same no matter which method is
used. The other two sections—1) cash from
investing activities and 2) cash from financing
activities—are identical with both methods.
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9 - 19
Learning
Objective 3
Converting Accrual Data to
Cash Data
Accounting records are kept on the
accrual basis (GAAP).
Cash data must be developed before
the Statement of Cash Flows can be
prepared (especially for operating
activities).
The examples that follow demonstrate
the direct method for converting
accrual data to cash data.
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9 - 20
Sales  Cash collected from
customers
Beginning AR
+ Sales
- Cash collected
= Ending AR
$ 500
3,000
x
600
In this example, a firm had sales of $3,000 during
the period. If accounts receivable (AR) went up by
$100, then the firm must have collected only $2,900.
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9 - 21
Salary expense  Cash paid
to employees
Beginning Salaries payable
+ Salary expense
$ 690
75,000
- Cash paid to employees
x
= Ending Salaries payable
500
In this example, the firm started the period with $690 in
salaries payable. During the period, salary expense of $75,000
was incurred (income statement amount). If salaries payable
ended the period with a balance of $500, the firm must have
paid all of the $75,000 PLUS an additional $190 to reduce
salaries payable. That total is $75,190.
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9 - 22
Your Turn 9-2
Robo Company began the year with $25,000 in
accounts receivable. During the year, Robo’s
sales totaled $50,000. At year end, Robo had an
accounts receivable balance of $15,000. How
much cash did Robo collect from customers
during the year? How is that amount of cash
classified on the statement of cash flows?
$50,000 + ($25,000 - $15,000) = $60,000.
This is a cash flow from operating activities.
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9 - 23
Learning
Objective 4
Direct Method of Preparing
the Statement of Cash Flows
Each amount on the income statement
must be converted to its cash
equivalent.
At the same time, you must account for
the change in every current asset and
current liability.
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9 - 24
Direct Method
To use the direct method of preparing a
statement of cash flows, we’ll examine
each item on the income statement and
make it “cash.” The indirect method is
applied just to the operating section of
the statement of cash flows.
We’ll need the income statement and
beginning and ending balance sheets
for the period.
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9 - 25
Revenue
Accrual basis revenue includes cash sales and
sales that did not result in cash inflows accounts receivables.
Cash collected for sales from previous periods
must be counted as cash collected even though
it is not included in revenue.
Can be computed as:
Revenue,
Accrual basis
+ or =
change in
Accounts
Receivable
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Revenue,
Cash basis
9 - 26
Sales  Cash collected from
customers
Beginning AR
+ Sales
- Cash collected
= Ending AR
$ 150
2,000
x
150
In this example, Team Shirts had sales of $2,000
during the period. If accounts receivable (AR) did
not change during the period, then the firm must
have collected $2,000.
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9 - 27
Cost of Goods Sold
Converting Cost of Goods Sold to Cash Basis
Requires analysis of two accounts:
inventory and accounts payable.
Can be computed as:
Cost of
+or - changes in inventory
Goods Sold
and
+ or - changes in accounts
payable
Cash payments
to suppliers
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9 - 28
Cost of Goods Sold
Why is COST OF GOODS SOLD (from the income
statement) not equal to cash?
We might have sold some goods that we
already had in the inventory or we may have
had to buy all of the goods we sold PLUS some
more that we put into building up the
inventory.
So, we must look at the change in inventory to
see if cost of goods sold is more or less than
the inventory we bought during the period.
Inventory went up from $100 to $300.
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9 - 29
Cost of Goods Sold (COGS)
Given the balances in the following accounts,
how much cash was paid to suppliers?
COGS:
$ 800
Beginning Inventory: $100
Purchases:
X
Ending Inventory:
$300
Accounts Payable beginning balance: $800
Accounts Payable ending balance:
$0
First, look at cost of goods sold and inventory. What
happened to inventory during the period? It went up.
That means that of the $800 of COGS, $100 came from
the beginning inventory, but purchases must have been
$200 more than COGS because ending inventory is
$200 greater than beginning inventory.
Purchases must have been $1,000 ($800 – 100 + 300).
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Cost of Goods Sold
Did we actually have to pay for all
$1,000 worth of those goods? (Or did
we pay for those plus some we
purchased the period before?)
To figure that out, we have to look at
Accounts Payable (A/P).
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9 - 31
Cost of Goods Sold
Since A/P went down, that means we
must have paid the $1,000 for this
month’s purchases and the $800 owed
for February, the decrease in A/P.
So, rather than just paying $1,000 for
the purchases, we paid a total of $1,800
to vendors.
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9 - 32
Depreciation Expense
The cash we spend to buy equipment is
considered an investing cash flow, and the
related depreciation expense is a non-cash
expense, so we can simply ignore it when
we prepare the statement of cash flows
using the direct method.
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9 - 33
Other Expenses
Insurance expense is $50. But the balance sheet shows
that Prepaid insurance decreased by $50 during the
month. That means that Team Shirts did not pay any
cash for insurance during the month.
Interest expense is $30. Interest payable went from -0to $30 during the month. This means that Team Shirts
did not pay any cash for interest during the month.
Finally, Other payables (balance sheet) went from $50
to -0- during the month. This means that there was a
cash payment made to satisfy this liability, even though
the expense was recorded in a prior period.
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9 - 34
Direct Method Example
Adding up all the disbursements:
To vendors
Insurance
Inventory
Other
Total outflow
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$1,800
$
0
$
0
50
$1,850
9 - 35
Direct Method
In summary, what kinds of
All accounts
income statement
accounts
and examined
all current assetto
and
need
to be
current liability accounts.
see if there is a difference
between our accrual accounting
records and actual cash?
versus
General Ledger
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9 - 36
Statement of Cash Flows
Team Shirts
Partial Statement of Cash Flows
For the month ended March 31, 2010
Cash from operating activities:
Cash from customers
Cash paid to vendors
Cash paid for other expenses
Net cash (outflow) from operations
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$
150
(1,800)
(50)
$(1,700)
9 - 37
Your Turn 9-3
Flex Company began the year 2010 with
$350
prepaid
insurance.
For 2010, the
$400 -of($350
- $250)
= $300.
company’s
income
statement
showed
This is a cash
flow from
operating
insurance
activities. expense of $400. If Flex
Company ended the year with $250 of
prepaid insurance, how much cash was
paid for insurance during 2010? On the
statement of cash flows, how would that
cash be classified?
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9 - 38
Learning
Objective 5
Indirect Method
All current assets and current
liabilities need to be examined in
conjunction with revenue and
expense accounts.
These accounts include:
Accounts Receivable
Prepaids
Inventory
Accounts Payable
Other Payables
The indirect method puts more focus on the
balance sheet for the adjustments.
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9 - 39
Income Statement
Team Shirts
Income Statement
For the month ended March 31, 2010
Sales revenue
Expenses
Cost of goods sold
Depreciation expense
Insurance expense
Interest expense
Net Income
$2,000
800
100
50
30
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(980)
$ 1,020
9 - 40
Comparative Balance Sheets
Cash
A/R
Inventory
Prepaid Ins.
Equipment
March 31 March 1
$3,995 $6,695
2,000
150
300
75
100
125
3,900
0
(net of $100
accumulated
depreciation)
Total Assets
$10,270
$7,070
A/P
Other
payables
Interest Pay.
March 31 March 1
$-0$800
-030
50
-0-
Notes Pay.
Total
liabilities
Common
Stock
3,000
3,030
-0850
5,000
5,000
Retained
Earnings
2,240
1,220
$10,270
$7,070
Total Liab +
Shareholders'
Equity
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9 - 41
Indirect Method
Net cash flows from operating activities are
determined by the indirect method:
Start with net income, then . . .
Add and subtract items that reconcile net
income to operating cash flows.
Requires an analysis of changes in all
current asset and current liability accounts,
except cash.
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Indirect Method
Noncash additions to net income:
Depreciation, depletion, and
amortization.
All losses.
Noncash deductions from net income:
All gains.
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9 - 43
Indirect Method
Then, adjust for the change in every
current asset and every current
liability:
Current asset increases  subtract
Current asset decreases  add
Current liability increases  add
Current liability decreases  subtract
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9 - 44
Indirect Method
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9 - 45
Indirect Method
Cash from Operations—Indirect Method
Team Shirts
For the month ended March 31, 2010
$1,020
Net Income
100
+depreciation expense
(1 , 8 5 0 )
- increase in AR
( 200)
- increase in inventory
50
+decrease in prepaid insurance
( 820)
- decrease in payables
$ (1,700)
Net cash from operations
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9 - 46
Summary of Direct and
Indirect Methods
The direct method provides more detail
about cash from operating activities.
Shows individual operating cash flows.
Shows reconciliation of operating cash
flows to net income in a supplemental
schedule.
The investing and financing sections for the
two methods are identical.
Net cash flow is the same for both methods.
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9 - 47
Your Turn 9-4
Suppose
a company
had
net
income
$50,000 for
Begin
with
net income
and
add
back of
depreciation
the year. $50,000
Depreciation
expense,
the onlyThen,
noncash
expense:
+ $7,000
= $57,000.
item on the
$7,000.
The only
subtract
theincome
$2,000 statement,
increase in was
accounts
receivable.
current
thatwere
changed
during
the income
year was
Sales
onasset
account
included
in net
but
accounts
began
should
bereceivable,
deducted ifwhich
the cash
hasthe
notyear
beenat $6,500
and endedNext,
the year
$8,500.
The onlyincurrent
collected.
add at
the
$500 increase
salaries
liability that
changed
was salaries
payable,
which
payable.
Some
of the salaries
expense,
which
was
began theon
year
$2,500statement,
and endedwas
the not
yearpaid
at at
deducted
theat
income
$3,000.
Assume
is all the relevant information.
the
balance
sheetthis
date.
Calculate+net
cash -from
operating
using
$50,000
$7,000
$2,000
+ $500activities
= $55,500
net
the indirect
method. activities.
cash
from operating
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9 - 48
Learning
Objective 6
Investing and Financing Activities
No matter which method you use to prepare
the statement of cash flows, direct or indirect,
the investing and financing activities sections
are prepared the same way – by reviewing
noncurrent balance sheet accounts.
Bonds
payable
Property
Plant
Equipment
Retained
Earnings
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Notes
payable
Common
Stock
9 - 49
Investing Activities
Team Shirts’ March 31 balance sheet shows equipment
with a cost of $4,000, and accumulated depreciation of
$100 with a carrying value of $3,900. The equipment
was not on the March 1 balance sheet. The company
must have bought it during March.
The equipment purchase is an investing activity. We
must now determine how the company paid for the
asset. Team Shirts paid $1,000 cash and signed a note
payable for the $3,000 difference. The note is disclosed
on the Statement of Cash Flows as non-cash activity
because it is implicit in the transaction. There were no
other notes, principal payments, or capital transactions
such as dividends paid or stock issues during March.
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9 - 50
Statement of Cash Flows
Cash from Operations—Indirect Method
Team Shirts
For the month ended March 31, 2010
Net Income
+depreciation expense
- increase in AR
- increase in inventory
+decrease in prepaid insurance
- decrease in payables
Net cash from operations
Cash from investing activities
Purchase of equipment
Net Cash from investing activities
Cash from financing activities
Net Increase (decrease) in cash
Beginning cash balance
Ending cash balance
aMachine
$1,020
100
(1,850)
( 200)
50
( 820)
$(1,700)
$1,000
a
(1,000)
0
($2,700)
6,695
3,995
was purchased for $4,000. A note was signed for $3,000 and cash paid was $1,000.
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9 - 51
How Important is the Statement of
Cash Flows?
It is crucial to the presentation of a complete
picture of the financial status of a business.
Many businesses with great ideas and
potential have failed due to their failure to
manage their cash flows.
Remember, the statement is REQUIRED by
GAAP.
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9 - 52
Learning
Objective 7
Ratio Analysis
Free cash flow is cash flows from operating activities
minus dividends and capital expenditures.
AutoZone had $921.1 million in cash flows from
operating activities, 0 dividends paid, and $243.6
million in capital expenditures as of 08/30/2008.
$921.1 M – 243.6 M = $677.5 Million
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9 - 53
Your Turn 9-5
DRP Company reported net cash from
operating activities of $45,600. Suppose the
firm
$25,000
worth
new long-Free purchased
cash flow =
Net cash
fromof
operations
term
assets
cash and
did not
pay any =
Purchase
of for
long-term
assets
- Dividends
dividends
the
year.
The firm’s average
$45,600 - during
$25,000
- $0
= $20,600.
current liabilities for the year were $40,000.
What was the firm’s free cash flow during the
year?
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9 - 54
Learning
Objective 8
Business Risk, Control, and Ethics
Investors’ risks associated with the Statement of Cash Flows:
The statement of cash flows is considered to be one
statement that cannot be manipulated. Beware!
Although managers can rarely falsify cash inflows and
outflows, they can manipulate the classification of the
cash flows to prepare misleading financial statements.
Because analysts are looking for positive cash flow
from operating activities, investors want to see low
numbers for costs of doing business, and investing
cash outflows are interpreted as a positive signal of
future growth. The statement of cash flows and related
controls should be used to evaluate the risk of
investing in a firm.
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9 - 55
All rights reserved. No part of this publication may
be reproduced, stored in a retrieval system, or
transmitted, in any form or by any means,
electronic, mechanical, photocopying, recording,
or otherwise, without the prior written permission
of the publisher. Printed in the United States of
America.
Copyright © 2011 Pearson Education, Inc.
publishing as Prentice Hall
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