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Chapter 17 Statement of Cash Flows
•Slides Authored by
Brian Leventhal
University of Illinois at Chicago
•FINANCIAL REPORTING & ANALYSIS 2e
•REVSINE – COLLINS – JOHNSON
I. General Format
A. The purpose of this statement is to explain
the sources and uses of cash from three
distinct types of activities:

1. Operating cash flows result from events or
transactions that enter into the determination of
net income.

a. In other words, operating cash flows result from
transactions related to the production and delivery of
goods and services to customers.
b. In effect, operating cash flows are the cash basis
revenues and expenses of a company.
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I. General Format
A. The purpose of this statement is to explain
the sources and uses of cash from three
distinct types of activities:

2. Investing cash flows result from the purchase
or sale of productive assets like plant and
equipment, buying and selling marketable
securities (government bonds or stocks and bonds
issued by other companies), and acquisitions and
divestitures of other companies.
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I. General Format
A. The purpose of this statement is to
explain the sources and uses of cash
from three distinct types of activities:

3. Financing cash flows result from a
company selling its own stocks or bonds,
paying dividends or buying back its own
shares (treasury stock), borrowing money
and repaying amounts borrowed.
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I. General Format
B. SFAS No. 95 allows firms the option
of choosing between two alternative
formats for presenting cash flows from
operating activities:
1 the direct approach, and
 2 the indirect approach.

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II. The Direct Approach
A. Exhibit 17.1 in the text presents the 1999
Statement of Cash Flows for ABM Industries.
B. The direct approach requires that firms
report major classes of gross cash receipts
(cash revenues) and gross cash payments
(cash expenses).
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III. The Indirect Approach
A. The indirect approach begins with the
accrual basis net income (before
extraordinary items) and adjusts for:

1. Items included in accrual basis net income that
did not affect cash in the current period, such as:


a. Non-cash revenues or gains (e.g., revenues earned
but not received in cash, and gains on disposal of fixed
assets).
b. Non-cash expenses or losses (e.g., depreciation and
amortization, provision for bad debt expense, and
expenses accrued but not paid in cash).
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III. The Indirect Approach
A. The indirect approach begins with the
accrual basis net income (before
extraordinary items) and adjusts for:

2. Items excluded from accrual basis income that
did affect operating cash flows in the current
period, such as:


a. Cash inflows (revenues) received but not recognized
as earned in the current period (e.g., rent received in
advance and collections on account).
b. Cash outflows (expenses) paid but not recognized for
accrual purposes in the current period (e.g., prepaid
insurance and payments on account).
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III. The Indirect Approach
B. The indirect approach for reporting cash
provided by operating activities is used by
98.8 percent of the 600 companies included
in the AICPA's annual financial reporting
survey.


1. The indirect approach is easier for firms to
implement because it relies exclusively on data
already available in the accrual accounts.
2. The indirect approach is more familiar to many
accountants because this format was widely used
in the changes in working capital statement that
preceded SFAS No. 95.
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III. The Indirect Approach
C. The indirect approach reconciles accrual
accounting net income with cash flows from
operations.

1. Noncash adjustments such as depreciation and
amortization, equity in the net (income) loss of
affiliated companies, (gains) losses on disposals
of fixed assets, and deferred income tax
provisions must be added to (subtracted from) net
income since they do not have a cash flow effect.
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III. The Indirect Approach
C. The indirect approach reconciles accrual
accounting net income with cash flows from
operations.


2. (Increases) decreases in current asset are
(subtracted from) added to net income in
reconciling to cash from operating activities.
3. Increases (decreases) in current liabilities are
added to (subtracted from) net income in
reconciling to cash from operating activities.
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III. The Indirect Approach
D. Both the direct and indirect approaches for
computing net cash provided by operating
activities will report the same amount.

1. Those who prefer the direct approach justify
their preference because this method discloses
operating cash flows by category—inflows from
customers, outflows to suppliers, etc.—facilitating
cash flow predictions.
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III. The Indirect Approach
D. Both the direct and indirect approaches for
computing net cash provided by operating
activities will report the same amount.

2. Analysts who prefer the indirect approach do so
because the size and direction of the items
reconciling income to operating cash flow provide
a rough yardstick for evaluating the quality of
earnings.
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III. The Indirect Approach
D. Both the direct and indirect approaches for
computing net cash provided by operating
activities will report the same amount.


3. For comparability purposes, the FASB requires
firms using the direct approach to reconcile
accrual earnings and operating cash flows as
would occur under the indirect approach.
4. Firms using the indirect approach are required
to separately disclose the amount of interest paid
and income taxes paid.
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III. The Indirect Approach
D. Both the direct and indirect approaches for
computing NCPOA will be the same amount.

5. The entire amount of cash taxes paid is included in the
cash flows from operating activities computation, even
though some of the taxes relate, for example, to gains on
sales of assets whose gross cash flows are included in
the cash flows from investing activities section of the
statement.

a. On the income statement, items not included in the computation
of income from continuing operations such as extraordinary items
and cumulative effects of changes in accounting principles are
reflected net of their associated income tax effects to facilitate
predictions by statement users.
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III. The Indirect Approach
D. Both the direct and indirect approaches for
computing NCPOA will be the same amount.

5. The entire amount of cash taxes paid is included in
the cash flows from operating activities computation,
even though some of the taxes relate, for example, to
gains on sales of assets whose gross cash flows are
included in the cash flows from investing activities
section of the statement.

b. Therefore, tax expense associated with the presumably
recurring income from continuing operations is reported
separately from the tax expense associated with items
appearing below income from continuing operations.
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III. The Indirect Approach
D. Both the direct and indirect approaches for
computing NCPOA will be the same amount.

5. The entire amount of cash taxes paid is
included in the CFOA ……..


c. Regrettably, SFAS No. 95 does not treat cash outflows
for income taxes in the same way.
d. This failure to differentiate tax cash flows by type
(those pertaining to income from continuing operations
versus other items) complicates forecasts of future cash
flows.
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III. The Indirect Approach
E. Other elements of the cash flow
statement:

1. The investing activities and financing
activities sections of the statement show
items that are relatively straightforward and
there should be little difficulty in interpreting
these disclosures.
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III. The Indirect Approach
E. Other elements of the cash flow statement:

2. Investing and financing transactions that do not
directly and immediately affect cash are not
included in the statement of cash flows.


a. Because cash is initially unaffected, SFAS No. 95
does not include either the increase in the investment or
the increase in the financing within the statement of cash
flows.
b. These transactions must be disclosed in a separate
schedule or as a footnote to the statement of cash flows.
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IV. Preparing the Cash
Flow Statement
A. The following three-step process is used to
build the components of the statement:



1. Identify the journal entry or entries that led to
the reported net balance sheet change in each
account.
2. Determine the net cash flow effect of the journal
entry (or entries) identified in Step 1.
3. Compare the financial statement effect of the
entry (Step 1) with its cash flow effect (Step 2) to
determine what cash flow statement treatment is
necessary for each item.
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IV. Preparing the Cash
Flow Statement
B. Comparative balance sheets and an
income statement will provide much of
the information necessary to use the
three-step approach.
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V. Cash Flows from
Operations
A. The purpose of this section is to reconcile
net income to cash from operations.
B. Noncash items are added to (subtracted
from) net income to reconcile to cash from
operations.
C. Noncash components of working capital
are added to (subtracted from) net income to
reconcile to cash from operations.
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VI. Cash Flows from
Investing Activities
A. This section shows component
increases and decreases in long-term
asset accounts.
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VI. Cash Flows from
Investing Activities
B. Sales of equipment are shown at the cash
transaction price.




1. A loss on sale occurs when book value exceeds
the cash proceeds.
2. The loss is added back to cash flows from
operations since it is a nonoperating loss.
3. The loss is then subtracted from the book value
of the item(s) sold so that the cash proceeds are
reported.
4. The converse holds for gains on sales of longterm assets.
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VI. Cash Flows from
Investing Activities
C. Purchases of long-term assets with
debt issuances are not shown in the
statement of cash flows.
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VII. Cash Flows from
Financing Activities
A. This section reports cash flow effects of
transactions affecting long-term liability and
owners’ equity accounts.
B. Net income, which is one component of the
change in retained earnings, is reported in
the operating section.
C. Component increases and decreases in
these accounts are reported separately.
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VIII. Reconciling Between
Statements: Some
Complexities
A. Users of financial statements
frequently encounter situations where
changes in balance sheet accounts over
the year do not reconcile to the
corresponding account change included
in the statement of cash flows.
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VIII. Reconciling Between
Statements: Some
Complexities
B. These differences arise for at least three
reasons:



1. Asset write-offs due to impairment, corporate
restructuring or retirement.
2. Translation adjustments on assets held by
foreign subsidiaries.
3. Acquisitions and divestitures of other
companies.
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VIII. Reconciling Between
Statements: Some
Complexities
C. Footnote disclosures and information
in the income statement and operating
section of the cash flow statement may
be helpful in reconciling some of these
differences.
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IX. Analytical Insights:
Cash Burn Rates of
Internet Stocks
A. The ability to generate positive
operating cash flows is critical to the
survival and success of any company.
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IX. Analytical Insights:
Cash Burn Rates of
Internet Stocks
B. The cash burn rate is a popular metric for
assessing how quickly internet firms are
using up their cash reserves.


1. May be calculated as cash used for operations plus cash
used for capital expenditures and purchases of on-going
businesses divided by the number of months covered by the
cash flow statement.
2. Alternatively, this may be calculated as earnings before
interest, taxes, depreciation and amortization (EBITDA)
adjusted for non-recurring gains and losses divided by
number of months covered by the income statement.
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IX. Analytical Insights:
Cash Burn Rates of
Internet Stocks
C. A related measure is months to burnout.


1. This measure provides an estimate of how
much longer a company can survive without an
infusion of external capital.
2. Calculated as cash, cash equivalents, and
short-term marketable securities divided by the
cash burn rate.
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