1 Tools of the Trade, Part III The Statement of Cash Flows: Bringing the Focus Back to Cash CHAPTER...

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Tools of the Trade, Part Tools of the Trade, Part IIIIII

The Statement of Cash The Statement of Cash Flows: Bringing the Flows: Bringing the Focus Back to CashFocus Back to Cash

CHAPTER F11

© 2007 Pearson Custom © 2007 Pearson Custom PublishingPublishing

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Explain the purpose of Explain the purpose of the statement of cash the statement of cash

flows.flows.

Learning Objective 1:


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The Statement of Cash The Statement of Cash FlowsFlows

When the balance sheet and income When the balance sheet and income statement are prepared on the accrual statement are prepared on the accrual basis, the focus is shifted away from the basis, the focus is shifted away from the cash flows of the company. cash flows of the company.

The The Statement of Cash Flows (SCF)Statement of Cash Flows (SCF) is an is an additional financial statement that is additional financial statement that is provided for the express purpose of provided for the express purpose of putting the focus back on cash.putting the focus back on cash.

© 2007 Pearson Custom Publishing© 2007 Pearson Custom Publishing

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Discussion Discussion QuestionsQuestions

How do revenue recognition andHow do revenue recognition andexpense recognition criteria underexpense recognition criteria underaccrual accounting take the focusaccrual accounting take the focusoff cash?off cash?

If cash is so important, why do we If cash is so important, why do we not use the cash basis when not use the cash basis when preparing income statements and preparing income statements and balance sheets?balance sheets?


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CFS: A New CFS: A New Financial StatementFinancial Statement

In the grand scheme of financial In the grand scheme of financial reporting, the SCF is a new financial reporting, the SCF is a new financial statement. It has only been required statement. It has only been required since 1988. since 1988.

Financial statement users were exerting Financial statement users were exerting more and more pressure on the more and more pressure on the accounting profession to provide this accounting profession to provide this type of cash flow data.type of cash flow data.


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Cash Flow Cash Flow InformationInformation

One of the main uses of financial One of the main uses of financial statements is to aid in the prediction of statements is to aid in the prediction of future cash flows. future cash flows.

Should it not seem reasonable to base Should it not seem reasonable to base your predictions of future cash flows on your predictions of future cash flows on the historical cash flows of a business, the historical cash flows of a business, at least as a starting point?at least as a starting point?


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Basic Features of the Basic Features of the SCFSCF

The SCF provides information The SCF provides information about the cash receipts and cash about the cash receipts and cash disbursements during a specific disbursements during a specific time period time period

The time period covered by the SCF The time period covered by the SCF should be the same as the income should be the same as the income statement.statement.


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Uses of the SCFUses of the SCF The SCF also helps to:The SCF also helps to:

assess a company’s ability to generate assess a company’s ability to generate positive future cash flows,positive future cash flows,

assess a company’s need for external assess a company’s need for external financing and its ability to pay its debts financing and its ability to pay its debts and dividends,and dividends,

reconcile differences between net reconcile differences between net income and the change in the cash income and the change in the cash balance.balance.© 2007 Pearson Custom Publishing© 2007 Pearson Custom Publishing

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Describe the three Describe the three types of activities that types of activities that can either generate or can either generate or

use cash in any use cash in any business.business.



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Basic Layout of SCFBasic Layout of SCFStatement of Cash Flows

For the Year Ending December 31, 2007

Cash flows from Operating Activities:Use either the Direct or Indirect Method

Net cash provided by Operating Activities $XX,XXX

Cash Flows from Investing Activities:Inflows $XX,XXXOutflows -XX,XXX

Net cash provided by Investing Activities $XX,XXX

Cash Flows from Financing Activities:Inflows $XX,XXXOutflows -XX,XXX

Net cash provided by Financing Activities $XX,XXX

Net Increase in Cash During 2007 $XX,XXX


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If you owned a small bookstore, what If you owned a small bookstore, what do you think would be yourdo you think would be your a. operating activities?a. operating activities? b. investing activities?b. investing activities? c. financing activities?c. financing activities? Explain your reasons for the Explain your reasons for the

classifications you made.classifications you made.


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Operating Operating ActivitiesActivities

Operating activities are those centered Operating activities are those centered around the company’s primary business around the company’s primary business activities. activities.

These activities generate the company’s These activities generate the company’s operating revenues and expenses.operating revenues and expenses.

Operating activities for an online Operating activities for an online bookseller would be different than those bookseller would be different than those for a heavy equipment manufacturer.for a heavy equipment manufacturer.


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Operating cash inflows come from the Operating cash inflows come from the firm’s:firm’s: CustomersCustomers Interest or dividendsInterest or dividends Sale of trading securitiesSale of trading securities

Trading SecuritiesTrading Securities are debt and equities, are debt and equities, traded on organized exchanges, that traded on organized exchanges, that management intends to sell within a very management intends to sell within a very short time.short time.© 2007 Pearson Custom Publishing© 2007 Pearson Custom Publishing

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Where would you look for the Where would you look for the information to determine net cash information to determine net cash flow from operations if your flow from operations if your business used the cash basis of business used the cash basis of accounting?accounting?

If your company used the cash basis If your company used the cash basis of accounting, would you still want of accounting, would you still want to prepare a statement of cash to prepare a statement of cash flows?flows?


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Keep in mind that there are some Keep in mind that there are some similarities between the income similarities between the income statement and the SCF.statement and the SCF.

Revenues and expenses related to Revenues and expenses related to operations are reported on the income operations are reported on the income statement.statement.

The SCF will report the cash inflows and The SCF will report the cash inflows and outflows for these same activities.outflows for these same activities.


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Examples of Operating Examples of Operating InflowsInflows

Operating cash inflows from:Operating cash inflows from: customers for sale of products and customers for sale of products and

service revenue.service revenue. interest earned on loans to others.interest earned on loans to others. dividends received on investments dividends received on investments

in other corporations.in other corporations. sale of trading securities.sale of trading securities.


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Examples of Examples of Operating OutflowsOperating Outflows

Cash outflows to:Cash outflows to: suppliers for purchases of inventory.suppliers for purchases of inventory. employees for wages and salaries.employees for wages and salaries. other operating expenses.other operating expenses. governments for taxes.governments for taxes. creditors for creditors for interestinterest on loans (but not on loans (but not

for repayment of principal). for repayment of principal).


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Think back to the situation in which you Think back to the situation in which you owned a small bookstore. If one of your owned a small bookstore. If one of your customers purchased a large book order customers purchased a large book order on account and had 30 days after she on account and had 30 days after she received the books to pay for them, how received the books to pay for them, how would this credit sale be reported for your would this credit sale be reported for your company:company: a. on a cash basis?a. on a cash basis? b. on an accrual basis?b. on an accrual basis?


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Investing ActivitiesInvesting Activities

Investing activities come in two basic Investing activities come in two basic forms:forms: (1) investments within the company for (1) investments within the company for

plant, property, equipment, intangible plant, property, equipment, intangible assets assets

(2) long-term investments in other (2) long-term investments in other entities.entities.


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Investing ActivitiesInvesting Activities Examples of investments in other entities Examples of investments in other entities

include:include: Available-for-sale securities – equity and Available-for-sale securities – equity and

debt securities traded on organized debt securities traded on organized exchanges that management may keep for exchanges that management may keep for an indefinite time.an indefinite time.

Held-to-maturity securities – debt securities Held-to-maturity securities – debt securities that managements intends to hold until that managements intends to hold until maturity. maturity.


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Examples of Examples of Investing ActivitiesInvesting Activities

Cash inflows from sale of:Cash inflows from sale of: property, plant, and equipment.property, plant, and equipment. investments in stocks and bonds of investments in stocks and bonds of

other companies.other companies. Cash outflows to purchase:Cash outflows to purchase:

property, plant, and equipment.property, plant, and equipment. investments in stocks and bonds of investments in stocks and bonds of

other companies.other companies.


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Financing ActivitiesFinancing Activities

This section of the SCF focuses on the This section of the SCF focuses on the external financing activities of the external financing activities of the company. External financing comes in company. External financing comes in two basic forms:two basic forms: (1) equity financing, and (1) equity financing, and (2) debt financing.(2) debt financing.


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Financing ActivitiesFinancing Activities Equity financing includes the use of both Equity financing includes the use of both

common and preferred stocks. Selling common and preferred stocks. Selling additional shares of stock is one way to additional shares of stock is one way to raise a large amount of cash.raise a large amount of cash.

Debt financing (long term) includes Debt financing (long term) includes borrowing money with notes (loans) and borrowing money with notes (loans) and bonds. Selling bonds is another way to bonds. Selling bonds is another way to raise a large amount of cash from the raise a large amount of cash from the general public.general public.


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Examples ofExamples ofFinancing ActivitiesFinancing Activities

Cash inflows from:Cash inflows from: selling shares of common or preferred stock selling shares of common or preferred stock

or reselling treasury stock.or reselling treasury stock. borrowings through bank loans or sale of borrowings through bank loans or sale of

bonds.bonds. Cash outflows to:Cash outflows to:

pay dividends to stockholders.pay dividends to stockholders. reacquire shares of our own stock (treasury reacquire shares of our own stock (treasury

stock).stock). repay principal on loans or bonds.repay principal on loans or bonds.


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Assume that you are a sole proprietor. Assume that you are a sole proprietor. Your business has been doing well, and Your business has been doing well, and you find that you have about $10,000 cash you find that you have about $10,000 cash just “laying around,” collecting dust.just “laying around,” collecting dust.

You identify three options:You identify three options: 1. Spend it on a new big advertising campaign.1. Spend it on a new big advertising campaign. 2. Buy a new computer system for the firm.2. Buy a new computer system for the firm. 3. Take the cash and treat yourself to a 3. Take the cash and treat yourself to a

vacation.vacation.


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For each of the three options listed, which For each of the three options listed, which section of the SCF would it be reported section of the SCF would it be reported in? In other words, which option is an in? In other words, which option is an investing activity, which is a financing investing activity, which is a financing activity, and which is an operating activity, and which is an operating activity?activity?

HINT: option #3 is actually a withdrawal by HINT: option #3 is actually a withdrawal by the owner since the money is being spent the owner since the money is being spent on personal uses rather than business.on personal uses rather than business.


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Reconcile accrual net Reconcile accrual net income to the change income to the change

in operating cash.in operating cash.



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Direct or Indirect?Direct or Indirect?

The top section of the SCF is for The top section of the SCF is for reporting the results of cash flows related reporting the results of cash flows related to operating activities.to operating activities.

The FASB has identified two methods for The FASB has identified two methods for presenting this information, the presenting this information, the direct direct method and the method and the indirectindirect method. method.


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Direct Method Direct Method DescriptionDescription

For the direct method, each major For the direct method, each major category of operating cash inflow will category of operating cash inflow will be listed along with each major be listed along with each major category of operating cash outflow.category of operating cash outflow.

It is very similar to an income It is very similar to an income statement prepared on a cash basis.statement prepared on a cash basis.


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Direct Method Direct Method IllustrationIllustration

When using the direct method of preparing When using the direct method of preparing the SCF, you prepare a list of the various the SCF, you prepare a list of the various activities that result in operating cash inflows activities that result in operating cash inflows and outflows for the company.and outflows for the company.

Direct Method

Cash flows from Operating Activities:Cash collected from customers 150,000$ Dividends received on investments 8,000 Payments to suppliers (52,000) Payments to employees for salaries (34,000) Payments for taxes (12,000)

Net cash provided by Operating Activities 60,000$


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Indirect Method Indirect Method DescriptionDescription

For the indirect method, net income from For the indirect method, net income from the income statement serves as the the income statement serves as the starting point. starting point.

Since net income is based on the Since net income is based on the concept of accrual accounting, we need concept of accrual accounting, we need to adjust it for any revenues and to adjust it for any revenues and expenses that were not matched by an expenses that were not matched by an equal amount of cash flow.equal amount of cash flow.


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Net Income Net Income AdjustmentsAdjustments

For the indirect method, the following are For the indirect method, the following are the most common adjustments needed:the most common adjustments needed: Add back non-cash expenses such as Add back non-cash expenses such as

depreciation and amortization.depreciation and amortization. Add back losses from non-operating activities.Add back losses from non-operating activities. Subtract out gains from non-operating Subtract out gains from non-operating

activities.activities. Add or subtract changes in current assets and Add or subtract changes in current assets and

current liabilities.current liabilities.


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Adjustment for Adjustment for DepreciationDepreciation

Since depreciation expense is a “non-Since depreciation expense is a “non-cash” expense, it lowers net income cash” expense, it lowers net income without reducing cash.without reducing cash.

If we are to properly adjust the accrual If we are to properly adjust the accrual net income figure to the net cash flow, we net income figure to the net cash flow, we need to add back the amount of need to add back the amount of depreciation expense taken during the depreciation expense taken during the period.period.


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Adjusting a Current Adjusting a Current AssetAsset

Assume that a company had sales of Assume that a company had sales of $155,000 during the year. Furthermore, $155,000 during the year. Furthermore, the accounts receivable balance the accounts receivable balance increased from $15,000 at the beginning increased from $15,000 at the beginning of the year to $20,000 at the end.of the year to $20,000 at the end.

That increase of $5,000 represents the That increase of $5,000 represents the excess of sales over cash inflows from excess of sales over cash inflows from sales. We need to subtract $5,000 from sales. We need to subtract $5,000 from net income in the reconciliation.net income in the reconciliation.


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Adjusting a Current Adjusting a Current LiabilityLiability

Assume that a company had COGS of Assume that a company had COGS of $62,000 during the year. Furthermore, the $62,000 during the year. Furthermore, the accounts payable balance increased by accounts payable balance increased by $10,000 during the year. $10,000 during the year.

That increase of $10,000 represents the That increase of $10,000 represents the excess of inventory purchases over cash excess of inventory purchases over cash outflows for purchases. We need to add outflows for purchases. We need to add $10,000 to net income in the $10,000 to net income in the reconciliation.reconciliation.

© © 20072007 Pearson Custom Publishing Pearson Custom Publishing

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Indirect MethodIndirect Method The following example of the indirect method The following example of the indirect method

shows just three of the common adjustments shows just three of the common adjustments needed to reconcile net income to the needed to reconcile net income to the net cash net cash provided by operating activities.provided by operating activities.

Indirect Method

Cash flows from Operating Activities:Net income 40,000$ Adjustments to reconcile:

Depreciation expense 15,000$ Increase in accounts receivable (5,000) Increase in accounts payable 10,000 20,000



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Comparing Direct and Comparing Direct and Indirect Method of CFSIndirect Method of CFS

The direct or indirect method applies The direct or indirect method applies only to the operating section of the CFS. only to the operating section of the CFS.

If a company presents the direct If a company presents the direct method, it must also prepare and report method, it must also prepare and report the indirect method.the indirect method.

If a company presents the indirect If a company presents the indirect method, it does not have to prepare the method, it does not have to prepare the direct method.direct method.


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Comparing Direct and Comparing Direct and Indirect Method of the Indirect Method of the

Operating SectionOperating Section The direct method statement is widely The direct method statement is widely

believed to be easier to read and believed to be easier to read and understand.understand.

The indirect method statement is widely The indirect method statement is widely believed to be easier to prepare.believed to be easier to prepare.

About 97% of companies prepare the About 97% of companies prepare the indirect method statement.indirect method statement.


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Completing the Investing Completing the Investing Activities SectionActivities Section

To gather data for the investing section, you To gather data for the investing section, you need to analyze transactions in the following need to analyze transactions in the following categories:categories: Property, plant, equipmentProperty, plant, equipment IntangiblesIntangibles Investments in securities (long term)Investments in securities (long term)

Available-for-saleAvailable-for-sale Held-to-maturityHeld-to-maturity Long-term investmentsLong-term investments


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Investing Activities Investing Activities ExamplesExamples

Assume the following transactions:Assume the following transactions: We replaced some old factory equipment:We replaced some old factory equipment:

Sold old equipment: Sold old equipment: ($10,000)($10,000) Bought new equipment: Bought new equipment: 40,000 40,000 Net cash flow for equipment: Net cash flow for equipment: ($30,000) ($30,000)

We sold some of our investments in other We sold some of our investments in other companies: companies: Sale of stocks and bonds: Sale of stocks and bonds: $15,000 $15,000


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Completing the Completing the Financing Activities Financing Activities

SectionSection To gather data for the financing To gather data for the financing

section, you need to analyze section, you need to analyze transactions in the following transactions in the following categories:categories: Long-term liabilitiesLong-term liabilities Common stock and related accountsCommon stock and related accounts Retained earnings and related Retained earnings and related

accountsaccounts (such as dividends)(such as dividends)


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Financing Activities Financing Activities ExamplesExamples

Assume the following transactions:Assume the following transactions: Executives executed stock options, buying Executives executed stock options, buying

additional shares of company stock:additional shares of company stock: Sale of common stock: Sale of common stock: $50,000$50,000

Board of directors declared cash dividends:Board of directors declared cash dividends: Common dividends declared: Common dividends declared: ($10,000)($10,000)


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Adjustments to reconcile:

Depreciation expense 15,000$

Increase in accounts receivable (5,000)

Increase in accounts payable 10,000 20,000


Cash Flows from Investing Activities:

Replacement of equipment (30,000)$

Sale of investments in stocks and bonds 15,000

Net cash provided by Investing Activities (15,000)$

Cash Flows from Financing Activities:

Proceeds from sale of common stock 50,000$

Payment of cash dividends (10,000)

Net cash provided by Financing Activities 40,000$

Net Increase in Cash During 2007 85,000$


Statement of Cash Flows

For the Year Ending December 31, 2007

Cash flows from Operating Activities:

Net income $ 40,000

Adjustments to reconcile:

Depreciation expense $ 15,000

Increase in accounts receivable (5,000)

Increase in accounts payable 10,000 20,000

Net cash provided by Operating Activities $ 60,000

Cash Flows from Investing Activities:

Replacement of equipment $ (30,000)

Sale of investments in stocks and bonds 15,000

Net cash provided by Investing Activities $ (15,000)

Cash Flows from Financing Activities:

Proceeds from sale of common stock $ 50,000

Payment of cash dividends (10,000)

Net cash provided by Financing Activities $ 40,000

Net Increase in Cash During 2007 $ 85,000

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Supplemental Supplemental DisclosureDisclosure

In addition to the SCF, a firm is required In addition to the SCF, a firm is required to include an additional schedule that to include an additional schedule that details all significant non-cash investing details all significant non-cash investing and financing activities.and financing activities.

For example, if a company traded a For example, if a company traded a building for a piece of land, the building for a piece of land, the transaction would not appear on the SCF, transaction would not appear on the SCF, but should appear in the supplemental but should appear in the supplemental disclosure.disclosure.


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Determine where a Determine where a company obtains its company obtains its

financing by financing by examining its examining its

statement of cash statement of cash flows.flows.



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Using the SCFUsing the SCF Some of the more important things that you Some of the more important things that you

can “glean” from the SCF include:can “glean” from the SCF include: (1) A general idea as to whether the (1) A general idea as to whether the

company is relying on company is relying on internal financinginternal financing (operating activities) or (operating activities) or external financingexternal financing (financing activities).(financing activities).

Keep in mind that over the long run, Keep in mind that over the long run, the only the only renewable source of cash is from operations.renewable source of cash is from operations.


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(2) Is the company (2) Is the company investing investing internallyinternally (PPE), (PPE), externallyexternally (stocks/bonds of others), or (stocks/bonds of others), or both?both?

(3) Whether operating cash flows are (3) Whether operating cash flows are greater than or less than the accrual greater than or less than the accrual net income. It is possible to show a net income. It is possible to show a large net income but have a negative large net income but have a negative cash flow. Analysts refer to this as cash flow. Analysts refer to this as the the quality of earnings.quality of earnings.

Using the SCFUsing the SCF


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(4) Whether recent additions to (4) Whether recent additions to external financing are primarily in the external financing are primarily in the form of form of equityequity (sell stocks) or (sell stocks) or debtdebt (sell (sell bonds). Remember that debt has to be bonds). Remember that debt has to be paid back, and equity does not.paid back, and equity does not.

Using the SCFUsing the SCF


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The End of Chapter 11


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