STATEMENT OF CASH FLOWS
TUTORIAL
Statement of Cash Flows-Overview
Since 1988, the Financial Accounting Standards Board (FASB) has required companies to include a statement of cash flows in their financial statements. (Before 1988, companies provided funds flow statements explaining changes in working capital.)
Cash flows provide useful information to financial statement users. Accrual accounting involves making many judgments-such as the allowance for uncollectible accounts (to calculate bad debt expense) and useful lives of assets (to calculate depreciation expense). Thus, net income calculations involve many managerial judgments. Cash flows are less subject to manipulation by managers than the net income number reported using accrual accounting.
From the perspective of an investor or financial analyst, cash flows are important because a firm’s value depends on the discounted present value of its cash flows.
From the perspective of a creditor, cash flows are important because amounts owed must be paid with cash. Even if a firm is profitable, if there is insufficient cash flow, the firm could experience problems paying off its obligations as they become due.
Cash flow statements include three sections in the following order of presentation:
1. Operating activities
2. Investing activities
3. Financing activities
Cash Flows… From Operating Activities
OPERATING ACTIVITIES include normal, recurring activities engaged in by the company on a regular basis, that is, activities related to the production and delivery of goods and services to customers.
Changes involving current assets (other than cash) and current liabilities are usually included in the operating activities section.
Cash inflows from operating activities include collections from customers for the sale of goods or services. They also include interest revenue and dividend revenue received by the company from other entities.
Cash outflows from operating activities include payments made to suppliers, employees, operating expenses (such as rent, utilities), interest payments, and taxes.
When a company invests in the stocks and bonds of other companies, it may receive dividend revenue and interest revenue from such investments. Under SFAS No. 95, these types of revenue, although associated with investment activities by the company, must be included in the cash flows from the operating activities section of the Statement of Cash Flows.
Cash Flows From Investing Activities
INVESTING ACTIVITIES involve the purchase and sale of noncurrent assets, including the purchase and sale of financial instruments (such as stocks and bonds issued by other entities).
In general, changes involving noncurrent assets are usually included in the investing activities section. This is only a general rule of thumb and may change, depending on the nature of the business or activity, for example, if a manufacturing firm purchases or sells some machinery that would be included in the investing activities section. However, if a company that is in the business of buying and selling such machinery makes a purchase or sale of machinery, that would be included in the operating activities section.
Cash inflows from investing activities include collections from sale of property, plant, and equipment; sale of a business segment, or sale of stocks or bonds issued by other entities.
Cash outflows from investing activities include payments made for the purchase of property, plant, and equipment and stocks or bonds issued by other entities.
Cash Flows From Financing Activities
FINANCING ACTIVITIES include transactions between the company and its owners and creditors. That is, they include the sale or buyback of stocks or bonds issued by the company and dividend payments by the company to its shareholders.
In general, changes involving noncurrent liabilities and stockholders’ equity are reported in the financing activities section.
Note the difference between investing and financing activities in the context of the purchase and sale of stocks and bonds. When you buy or sell the stock or bond issued by someone else, that is considered an investing activity. When you issue (sell) or buy back stock or bonds that you had issued, that is considered part of a financing activity.
Cash inflows from financing activities arise when the company issues stock or borrows (by issuing a bond or by signing a note, or otherwise).
Cash outflows from financing activities arise when the company buys back its own stock or bonds, repays loans, or pays dividends to shareholders.
Note that dividends paid to shareholders are considered to be part of financing activities-but interest paid to bondholders is included only as an operating activity. Furthermore, as noted earlier, both dividend and interest revenues received by the company are included in cash flows from operating activities section.
NONCASH INVESTING AND FINANCING ACTIVITIES include noncash transactions that affect both noncurrent assets and noncurrent liabilities or owners’ equity.
Review Questions-1
1. Cash collected from customers will normally be reported in the ______activities section of the statement of cash flows.
2. Changes involving ______are usually reflected in the operating activities section of the statement of cash flows.
3. Cash flows related to the purchase of property, plant and equipment are reported in the ______activities section of the statement of cash flows.
4. Changes involving ______are usually reflected in the investing activities section of the statement of cash flows.
5. Cash flows related to the payment of dividends to stockholders are reported in the ______activities section of the statement of cash flows.
6. Changes involving ______are usually reflected in the financing activities section of the statement of cash flows.
ANSWERS: 1. operating 2. current assets and current liabilities 3. investing 4. noncurrent assets 5. financing 6. noncurrent liabilities and stockholders’ equity
Cash Flow Statement Methods
Two methods are used in reporting cash flows. They are (1) the direct method and (2) the indirect method.
The difference between the two methods affects only the operating activities section of the Statement of Cash Flows. The investing activities section and the financing activities section will be the same under these two methods.
The direct method gives information about the cash collections from customers and others, as well as the cash payments made to suppliers, employees, and others.
The indirect method does not directly give information about cash collections and cash payments for operating activities. Instead, it starts with the net income (as reported in the income statement) and adjusts this amount for accruals that do not affect cash flows. There are two types of adjustments, described later.
Cash Flows From Operating Activities-Direct Method
Operating activities of an enterprise include production and delivery of goods and services to customers. One way to examine them is to look at them in the sequence in which they appear in an income statement. Thus, an entity will both
Collect cash from sales of goods and services to customers
Pay cash to (1) outsiders for any purchases of goods and services and (2) employees for services rendered.
We will first examine the direct method and then the indirect method.
Sales and Collections
We need to know the amount of cash collected from customers. To get this information, we have to look at accounts receivable. Specifically, we can calculate cash collections from credit sales as follows:
Cash collected = Beginning accounts receivable + Credit sales Ending accounts receivable
If there are any cash sales during the period, we need to add them to the cash collected from credit sales (calculated as above) to get the total cash collected from sales during the period.
Example
The beginning and ending balances in Accounts Receivable of Smith Company were $3,000 and $2,500, respectively. Credit sales during the period were $24,000. What is the total cash collected from sales to customers during the period?
Answer
Cash collected from sales to customers = $3,000 + $24,000 - $2,500
= $24,500
Purchases and Payments
The logic about payments on accounts payable is the exact reverse of collections from accounts receivable. That is, we can calculate payments to suppliers (for credit purchases) as follows:
Cash payments = Beginning accounts payable + Purchases Ending accounts payable
If any cash purchases occur during the period, we need to add them to the cash payments for credit purchases (calculated as above) to get the total cash payments for purchases during the period.
The same approach can be used to calculate payments made to other outsiders (for other expenses, such as utilities or rent.)
Example
The beginning and ending balances in Accounts Payable of Jackson Company were $6,000 and $8,000, respectively. Purchases during the period were $45,000. What is the total cash paid to suppliers during the period?
Cash payments to suppliers= $6,000 + $45,000 - $8,000
= $43,000
Salaries and Wages Paid
Cash payments to employees are calculated exactly the way the payments to suppliers and other outsiders are determined. Cash payments for employees are calculated as follows:
Cash payments = Beginning salaries payable + Salary expense for the period Ending salaries payable
Example
The beginning and ending balances in Salaries Payable of Logan Company were $12,000 and $9,000, respectively. Salaries expense during the period was $70,000. What is the total cash paid to suppliers during the period?
Cash paid as salaries = $12,000 + $70,000 - $9,000
= $73,000
Cash Flows From Operating Activities-Indirect Method
The first type of adjustment to cash flows from operating expenses involves revenues (or gains) and expenses (or losses) that do not involve operating cash inflows or outflows. For example, depreciation is an expense item, but it does not involve any cash payments. Similarly, to calculate depreciation we subtract from net income any gains on sale of equipment or add back any losses on sale of equipment. (The reason for this is explained in detail later under the cash flows from investing activities section).
The second type of adjustment involves changes in current assets or liabilities. This is best explained using the basic accounting equation, as below.
We know that:
Assets = Liabilities + Owners’ equity, or
Current assets + Noncurrent assets = Current liabilities + Noncurrent liabilities + Owners’ equity
Cash + Other current assets + Noncurrent assets = Current liabilities + Noncurrent liabilities + Owners’ equity
This means that if some current asset (such as inventory) increases and all other accounts stay the same, cash must decrease.
For example, if inventory at the end of the period is higher than that at the beginning of the period (and if accounts payable stays the same), some cash has been spent on inventory purchases. Purchase of inventory is an operating activity, so more cash has been spent on an operating activity as compared to the situation when the inventory has remained the same at the beginning and the end of the period.
Example
The net income of Helen Company for the year ended December 31, 2002, was $25,000. The depreciation expense for the period was $5,000. The beginning and ending balances of Accounts Receivable for the year ended December 31, 2002, were $7,000 and $5,000, respectively. Assuming the company had no other current asset or current liability account, what was the cash flow from operations for the year ended December 31, 2002?
Net income for the period$25,000
Plus: Depreciation expense 5,000
Plus: Decrease in accounts receivable 2,000
Total cash flow from operations$32,000
Cash Flows From Investing Activities
The first thing to note is that there are no differences between the direct and indirect methods when it comes to reporting cash flows from investing activities.
To obtain cash flows from investing activities, we need to look at those accounts affected by investing activities-that is, noncurrent assets (and the related contra asset account, namely accumulated depreciation) and any nonoperating current assets (that is, current assets not used in our operations such as investments in stocks and bonds of other entities).
Sale of Noncurrent Assets
Assume that we sold some equipment. How do we obtain cash inflows from such sale of equipment? We need to look at the equipment account to obtain this information.
Example
The balances in some accounts for Bledsoe Company were as follows:
Equipment, 1/1/2002$40,000
Equipment, 12/31/2002 28,000
Accumulated depreciation, 1/1/2002 6,000
Accumulated depreciation, 12/31/2002 5,000
Depreciation expense, year ended 12/31/2002 3,000
Gain on sale of equipment 2,000
First, the balance in the equipment account has declined from $40,000 at the beginning of the period to $28,000 at the end of the period. This indicates that the historical cost of the equipment sold during the period is $12,000 ($40,000 $28,000).
Next, we examine the accumulated depreciation account. If no equipment had been sold, then the ending balance in this account would be $9,000 ($6,000 beginning balance plus $3,000 depreciation expense during the period). However, the ending balance in this account is only $5,000. This means that the accumulated depreciation of the equipment that was sold must be $9,000 $5,000 = $4,000.
Thus, the net book value of the equipment sold during the period = $8,000 ($12,000 historical cost $4,000 accumulated depreciation). Furthermore, we know that the gain on the sale was $2,000. Hence, the equipment must have been sold for $10,000 ($8,000 net book value plus $2,000 gain on sale). Assuming it was sold for cash, cash inflow from sale of equipment is $10,000.
Note also the following. The net income number includes the gain of $2,000 from the sale of this equipment. Furthermore, we are reporting the entire $10,000 (including the gain of $2,000) in the cash flows from investing activities section. This means that the $2,000 of gain could be double counted if we are using the indirect method to report the cash flows from operating activities-included once in the net income number with which we start the operating activities section if we use the indirect method and again in the investing activities section. This is why it is important that we subtract the gain of $2,000 in the cash flows from operating activities section when using the indirect method. This avoids double counting gains from the sale of equipment.
Why don’t we subtract gains (or add losses) from the sale of equipment in the cash flows from operating activities section if we use the direct method?
Because we do not begin with net income if we use the direct method. So there is no double counting problem, and hence there is no need for any adjustment there.
Purchase of Noncurrent Assets
Assume that we bought some equipment during the period. How do we calculate the amount spent to purchase the equipment?
First, if you are preparing the financial statements, you will have access to the relevant records, which will tell you exactly how much the company spent on the purchase of new equipment. However, even if you do not have access to such records, you can calculate how much was spent to purchase new equipment. An analysis of the equipment account will enable us to do so.
Example
The beginning and ending balances in the equipment account of Glenn Company were $30,000 and $35,000, respectively. Equipment with a book value of $3,000 was sold during the period. How much was spent on purchase of new equipment?
Note that
Beginning balance of equipment (at cost) + Cost of new purchases Cost of equipment sold = Ending balance of equipment (at cost)
So
Cost of new purchases = Ending balance of equipment + Cost of equipment sold Beginning balance of equipment
Thus, in the example above, cost of new purchases = $35,000 + $3,000 $30,000
= $8,000
Cash Flows From Financing Activities
Financing activities involve the following the issue of company stock or bonds (or, other borrowing), buyback of stock or bonds (or other repayment of debt), and payment of dividends.
The amount of cash collected from issuing of stock or bonds or other borrowing can be calculated by examining the common stock (and additional paid-in capital) or bonds payable (or other long-term debt) accounts.
Cash dividend payments can be calculated by examining the retained earnings, net income, and dividends payable accounts.
Example
The beginning and ending balances in the Retained Earnings account of Walter Company were $25,000 and $30,000, respectively. Net income for the period was $12,000, and all dividends declared during the period were paid before the fiscal year-end. What amount of cash was used to pay the dividends during the year?
We know that
Beginning retained earnings + Net income Dividends = Ending retained earnings.
So
Dividends = Beginning retained earnings + Net income Ending retained earnings
= $25,000 + $12,000 - $30,000
= $7,000
Thus, $7,000 was paid as cash dividends during the period.
Review Questions-2
1. The difference between the direct and indirect method is in the ______activities section of the statement of cash flows.
2. The ______method starts with net income and adjusts for accruals that do not affect cash flows.
3. The ______method will not have an adjustment for depreciation in the operating activities section of the statement of cash flows.
4. Gains or losses from sale of equipment are included as an adjustment in the ______of preparing the statement of cash flows.
5. When a company buys back its own stock, the cash flows will be reflected in the ______activities section of the statement of cash flows.
6. Cash flows related to the purchase of long-term bonds issued by another company are reflected in the ______activities section of the statement of cash flows.
ANSWERS: 1. operating 2. indirect 3. direct 4. indirect method 5. financing 6. investing
Glossary
Direct method is one of two methods used to calculate and report the statement of cash flows. The direct method gives information about the cash collections from customers and others, as well as the cash payments made to suppliers, employees, and others.
Financing activities include transactions between the company and its owners and creditors. That is, these activities include the sale or buyback of stocks or bonds issued by the company and dividend payments by the company to its shareholders.
Indirect method is one of two methods used to calculate and report the statement of cash flows. The indirect method starts with the net income (as reported in the income statement) and adjusts this amount for accruals that do not affect cash flows.