Intermediate Financial Accounting II

26/03/2023

Chapter Eight
Statement of Cash Flows
The statement of cash flows reports cash receipts, cash payments, and net change in cash
resulting from a company’s operating, investing, and financing activities during a period. The
primary purpose of the statement of cash flows is to provide information about a company’s
cash receipts and cash payments during a period. A secondary objective is to provide cash-basis
information about the company’s operating, investing, and financing activities.
8.1. Purpose of the Statement of Cash Flows
The primary purpose of a statement of cash flows is to provide relevant information about the
cash receipts and cash payments of an enterprise during a period. To achieve this purpose, the
statement of cash flows reports the following: (1) the cash effects of operations during a period,
(2) investing transactions, (3) financing transactions, and (4) the net increase or decrease in cash
during the period. Reporting the sources, uses, and net increase or decrease in cash helps
investors, creditors, and others know what is happening to a company’s most liquid resource.

Because most individuals maintain a check book and prepare a tax return on a cash basis, they
can comprehend the information reported in the statement of cash flows.
The statement of cash flows provides answers to the following simple but important questions:
1. Where did the cash come from during the period?
2. What was the cash used for during the period?
3. What was the change in the cash balance during the period?
8.2. Classification of Cash Flows
The statement of cash flows classifies cash receipts and cash payments by operating, investing,
and financing activities.
1. Operating activities: involve the cash effects of transactions that enter into the
determination of net income, such as cash receipts from sales of goods and services, and
cash payments to suppliers and employees for acquisitions of inventory and expenses.
2. Investing activities: generally involve long-term assets and include (a) making and
collecting loans, and (b) acquiring and disposing of investments and productive long-
lived assets.

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3. Financing activities: involve liability and stockholders’ equity items and include (a)
obtaining cash from creditors and repaying the amounts borrowed, and (b) obtaining
capital from owners and providing them with a return on, and a return of, their
investment.
The following illustration classifies the typical cash receipts and payments of a company
according to operating, investing, and financing activities.
 Operating
Cash inflows:
From sales of goods or services.
From returns on loans (interest) and on equity securities (dividends).
Cash outflows
To suppliers for inventory.
To employees for services.
To government for taxes.
To lenders for interest.
To others for expenses.
 Investing
Cash inflows
From sale of property, plant, and equipment.
From sale of debt or equity securities of other entities.
From collection of principal on loans to other entities.
Cash outflows
To purchase property, plant, and equipment.
To purchase debt or equity securities of other entities.
To make loans to other entities.
 Financing
Cash inflows
From sale of equity securities.
From issuance of debt (bonds and notes).
Cash outflows
To stockholders as dividends.

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To redeem long-term debt or reacquire capital stock.

The operating activities category is the most important. It shows the cash provided by company
operations. This source of cash is generally considered to be the best measure of a company’s
ability to generate enough cash to continue as a going concern.
Note the following general guidelines about the classification of cash flows:
1. Operating activities involve income statement items.
2. Investing activities involve cash flows resulting from changes in investments and long-
term asset items.
3. Financing activities involve cash flows resulting from changes in long-term liability and
stockholders’ equity items.
Companies classify some cash flows relating to investing or financing activities as operating
activities. For example, companies classify receipts of investment income (interest and
dividends) and payments of interest to lenders as operating activities. Why are these considered
operating activities? Companies report these items in the income statement, where the results of
operations are shown.

Conversely, companies classify some cash flows relating to operating activities as investing or
financing activities. For example, a company classifies the cash received from the sale of
property, plant, and equipment at a gain, although reported in the income statement, as an
investing activity. It excludes the effects of the related gain in net cash flow from operating
activities. Likewise, a gain or loss on the payment (extinguishment) of debt is generally part of
the cash outflow related to the repayment of the amount borrowed. It therefore is a financing
activity.

Format of the Statement of Cash Flows

The three activities we discussed above constitute the general format of the statement of cash
flows. The operating activities section always appears first. It is followed by the investing
activities section and then the financing activities section. The general format of the statement of
cash flows presents the results of the three activities discussed previously–operating, investing,
and financing.

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Company Name
Statement of Cash Flows
Period Covered
Cash flows from operating activities
Net income XXX
Adjustments to reconcile net income to net
cash provided (used) by operating activities:
(List of individual items) XX XX
Net cash provided (used) by operating activities XXX
Cash flows from investing activities
(List of individual inflows and outflows) XX
Net cash provided (used) by investing activities XXX
Cash flows from financing activities
(List of individual inflows and outflows) XX
Net cash provided (used) by financing activities XXX
Net increase (decrease) in cash XXX
Cash at beginning of period XXX
Cash at end of period

8.3. Sources of Information for the statement of Cash flow

Important points to remember in the preparation of the statement of cash flows are these:
1. Comparative balance sheets provide the basic information from which to prepare the
report. Additional information obtained from analyses of specific accounts is also
included.
2. An analysis of the Retained Earnings account is necessary. The net increase or decrease
in Retained Earnings without any explanation is a meaningless amount in the statement.
Without explanation, it might represent the effect of net income, dividends declared, or
prior period adjustments.
3. The statement includes all changes that have passed through cash or have resulted in an
increase or decrease in cash.

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4. Write-downs, amortization charges, and similar “book” entries, such as depreciation of

plant assets, represent neither inflows nor outflows of cash, because they have no effect
on cash. To the extent that they have entered into the determination of net income,
however, the company must add them back to or subtract them from net income, to arrive
at net cash provided (used) by operating activities.
8.4. Steps in Preparation

Preparing the statement of cash flows from the data sources above involves three major steps:
Step 1. Determine the change in cash: This procedure is straightforward. A company can easily
compute the difference between the beginning and the ending cash balance from examining its
comparative balance sheets.
Step 2. Determine the net cash flow from operating activities: This procedure is complex. It
involves analyzing not only the current year’s income statement but also comparative balance
sheets as well as selected transaction data.
To arrive at net cash flow from operating activities, a company must determine revenues and
expenses on a cash basis. It does this by eliminating the effects of income statement transactions
that do not result in an increase or decrease in cash.
Step 3. Determine net cash flows from investing and financing activities: A company must
analyze all other changes in the balance sheet accounts to determine their effects on cash.

Indirect Method
The indirect method (or reconciliation method) starts with net income and converts it to net cash
flow from operating activities. In other words, the indirect method adjusts net income for items
that affected reported net income but did not affect cash.
To compute net cash flow from operating activities, a company adds back noncash charges in the
income statement to net income and deducts noncash credits. We determine net cash flows from
operating activities by adding back to or deducting from net income those items that had no
effect on cash.

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Additions Deductions

Depreciation expense Amortization of bond premium

Amortization of intangibles and deferred charges Decrease in deferred income tax liability
Amortization of bond discount Income on investment in common stock
Increase in deferred income tax liability using equity method
Loss on investment in common stock using equity method Gain on sale of plant assets
Loss on sale of plant assets Increase in receivables
Loss on impairment of assets Increase in inventories
Decrease in receivables Increase in prepaid expense
Decrease in inventories Decrease in accounts payable
Decrease in prepaid expense Decrease in accrued liabilities
Increase in accounts payable
Increase in accrued liabilities

Tax Consultants Inc.

Comparative Balance Sheets
As of December 31, 2022
Change
Assets 2022 2021 Increase/Decrease
Cash $ 54,000 $ 37,000 $ 17,000
Accounts receivable 68,000 26,000 42,000
Inventories 54,000 –0– 54,000
Prepaid expenses 4,000 6,000 (2,000)
Land 45,000 70,000 25,000
Buildings 200,000 200,000 –0–
Accumulated depreciation—buildings (21,000) (11,000) 10,000
Equipment 193,000 68,000 125,000
Accumulated depreciation—equipment (28,000) (10,000) 18,000
Totals $569,000 $386,000

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Liabilities and Stockholders’ Equity

Accounts payable $ 33,000 $ 40,000 ($ 7,000)
Bonds payable 110,000 150,000 (40,000)
Common stock ($1 par) 220,000 60,000 160,000
Retained earnings 206,000 136,000 70,000
Totals $569,000 $386,000

TAX CONSULTANTS INC.

INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 2022
Revenues $890,000
Cost of goods sold $465,000
Operating expenses 221,000
Interest expense 12,000
Loss on sale of equipment 2,000 700,000
Income from operations 190,000
Income tax expense 65,000
Net income $125,000
Additional Information
1. Operating expenses include depreciation expense of $33,000 and expiration of prepaid
expenses of $2,000.
2. Land was sold at its book value for cash.
3. Cash dividends of $55,000 were declared and paid.
4. Interest expense of $12,000 was paid in cash.
5. Equipment with a cost of $166,000 was purchased for cash. Equipment with a cost of
$41,000 and a book value of $36,000 was sold for $34,000 cash.
6. Bonds were redeemed at their book value for cash.
7. Common stock ($1 par) was issued for cash.
Step 1: Determine the Change in Cash

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The first step in the preparation of the statement of cash flows is to determine the change in cash.
As the comparative balance sheets show, cash increased $17,000 in 2022.
Step 2: Determine Net Cash Flow from Operating Activities
The adjustment to net income of $125,000 is explained as follows.
Increase in Accounts Receivable: The increase in accounts receivable of $42,000 represents
recorded accrual-basis revenues in excess of cash collections in 2022. The company deducts this
increase from net income to convert from the accrual basis to the cash basis.
Increase in Inventories: The $54,000 increase in inventories represents an operating use of cash,
not an expense. Tax Consultants therefore deducts this amount from net income, to arrive at net
cash flow from operations. In other words, when inventory purchased exceeds inventory sold
during a period, cost of goods sold on an accrual basis is lower than on a cash basis.

Decrease in Prepaid Expenses: The $2,000 decrease in prepaid expenses represents a charge to
the income statement for which Tax Consultants made no cash payment in the current period.
The company adds back the decrease to net income, to arrive at net cash flow from operating
activities.
Decrease in Accounts Payable: When accounts payable decrease during the year, cost of goods
sold and expenses on a cash basis are higher than they are on an accrual basis. To convert net
income to net cash flow from operating activities, the company must deduct the $7,000 in
accounts payable from net income.
Depreciation Expense (Increase in Accumulated Depreciation): Accumulated Depreciation—
Buildings increased $10,000 ($21,000 _ $11,000). The Buildings account did not change during
the period, which means that Tax Consultants recorded depreciation expense of $10,000 in 2011.
Accumulated Depreciation—Equipment increased by $18,000 ($28,000 _ $10,000) during the
year. But Accumulated Depreciation—Equipment decreased by $5,000 as a result of the sale
during the year. Thus, depreciation for the year was $23,000. The company reconciled
Accumulated Depreciation—Equipment as follows:
Beginning balance $10,000
Add: Depreciation for 2022 23,000
33,000
Deduct: Sale of equipment 5,000

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Ending balance $28,000

The company must add back to net income the total depreciation of $33,000 ($10,000 + $23,000)
charged to the income statement, to determine net cash flow from operating activities.
Loss on Sale of Equipment: Tax Consultants Inc. sold for $34,000 equipment that cost $41,000
and had a book value of $36,000. As a result, the company reported a loss of $2,000 on its sale.
To arrive at net cash flow from operating activities, it must add back to net income the loss on
the sale of the equipment. The reason is that the loss is a noncash charge to the income statement.
The loss did not reduce cash, but it did reduce net income. From the foregoing items, the
company prepares the operating activities section of the statement of cash flows.
Cash flows from operating activities
Net income $125,000
Adjustments to reconcile net income to
net cash provided by operating activities:
Depreciation expense $33,000
Loss on sale of equipment 2,000
Increase in accounts receivable (42,000)
Increase in inventories (54,000)
Decrease in prepaid expenses 2,000
Decrease in accounts payable (7,000) (66,000)
Net cash provided by operating activities 59,000
Step 3: Determine Net Cash Flows from Investing and Financing Activities
By analyzing the remaining changes in the balance sheet accounts, Tax Consultants identifies
cash flows from investing and financing activities.
Land: .Land decreased $25,000 during the period. As indicated from the information presented,
the company sold land for cash at its book value. This transaction is an investing activity,
reported as a $25,000 source of cash.
Equipment: An analysis of the equipment account indicates the following.
Beginning balance $ 68,000
Purchase of equipment 166,000
234,000
Sale of equipment 41,000

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Ending balance $193,000

The company used cash to purchase equipment with a fair value of $166,000—an investing
transaction reported as a cash outflow. The sale of the equipment for $34,000 is also an investing
activity, but one that generates a cash inflow.
Bonds Payable: Bonds payable decreased $40,000 during the year. As indicated from the
additional information, the company redeemed the bonds at their book value. This financing
transaction used $40,000 of cash.
Common Stock: The common stock account increased $160,000 during the year. As indicated
from the additional information, Tax Consultants issued common stock of $160,000 at par. This
financing transaction provided cash of $160,000.
Retained Earnings: Retained earnings changed $70,000 ($206,000 _ $136,000) during the year.
The $70,000 change in retained earnings results from net income of $125,000 from operations
and the financing activity of paying cash dividends of $55,000.
Tax Consultants Inc.
Statement of Cash Flows
For The Year Ended December 31, 2022
Increase (Decrease) In Cash
Cash flows from operating activities
Net income $125,000
Adjustments to reconcile net income to
net cash provided by operating activities:
Depreciation expense $ 33,000
Loss on sale of equipment 2,000
Increase in accounts receivable (42,000)
Increase in inventories (54,000)
Decrease in prepaid expenses 2,000
Decrease in accounts payable (7,000) (66,000)
Net cash provided by operating activities 59,000
Cash flows from investing activities
Sale of land 25,000
Sale of equipment 34,000

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Purchase of equipment (166,000)

Net cash used by investing activities (107,000)
Cash flows from financing activities
Redemption of bonds (40,000)
Sale of common stock 160,000
Payment of dividends (55,000)
Net cash provided by financing activities 65,000
Net increase in cash 17,000
Cash, January 1, 2022 37,000
Cash, December 31, 2022 $ 54,000
8.5. Usefulness of the Statement of Cash Flows
The statement of cash flows provides information to help investors, creditors, and others assess
the following
1. The entity’s ability to generate future cash flows: A primary objective of financial
reporting is to provide information with which to predict the amounts, timing, and
uncertainty of future cash flows. By examining relationships between items such as sales and
net cash flow from operating activities, or net cash flow from operating activities and
increases or decreases in cash, it is possible to better predict the future cash flows than is
possible using accrual-basis data alone.
2. The entity’s ability to pay dividends and meet obligations: Simply put, cash is essential.
Without adequate cash, a company cannot pay employees, settle debts, pay out dividends, or
acquire equipment. A statement of cash flows indicates where the company’s cash comes
from and how the company uses its cash. Employees, creditors, stockholders, and customers
should be particularly interested in this statement, because it alone shows the flows of cash in
a business.
3. The reasons for the difference between net income and net cash flow from operating
activities: The net income number is important: It provides information on the performance
of a company from one period to another. But some people are critical of accrual-basis net
income because companies must make estimates to arrive at it. Such is not the case with
cash. Thus, as the opening story showed, financial statement readers can benefit from

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knowing why a company’s net income and net cash flow from operating activities differ, and
can assess for themselves the reliability of the income number.

The cash and noncash investing and financing transactions during the period. Besides operating
activities, companies undertake investing and financing transactions. Investing activities include
the purchase and sale of assets other than a company’s products or services. Financing activities
include borrowings and repayments of borrowings, investments by owners, and distributions to
owners. By examining a company’s investing and financing activities, a financial statement
reader can better understand why assets and liabilities increased or decreased during the period.

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