Statement of Cash Flows

Indirect Method. Free Cash Flow

Learning Objectives

• Discuss the usefulness and format of the statement of cash flows.

• Prepare a statement of cash flows using the indirect method.

• Analyze the statement of cash flows.

Usefulness of the Statement of Cash Flows
The statement of cash flows reports the cash receipts, cash payments, and net change in cash resulting from
operating, investing, and financing activities during a period. The information in a statement of cash flows
helps investors, creditors, and others assess the following.
• The entity’s ability to generate future cash flows. By examining relationships between items in the
statement of cash flows, investors can better predict the amounts, timing, and uncertainty of future cash
flows than they can from accrual-basis data.

• The entity’s ability to pay dividends and meet obligations. If a company does not have adequate cash, it
cannot pay employees, settle debts, or pay dividends. Employees, creditors, and stockholders should be
particularly interested

• The reasons for the difference between net income and net cash provided (used) by operating activities.
Some financial statement users are critical of accrual-basis net income because it requires many
estimates. Many readers of the statement of cash flows want to know the reasons for the difference
between net income and net cash provided by operating activities.

• The cash investing and financing transactions during the period. By examining a company’s investing and
financing transactions, a financial statement reader can better understand why assets and liabilities
changed during the period.
Classification of Cash Flows Transactions and other events characteristic of each kind of activity are as follows.

1. Operating activities include the cash effects of transactions that create revenues
and expenses. They thus enter into the determination of net income.

2. Investing activities include (a) acquiring and disposing of investments and property,
plant, and equipment, and (b) lending money and collecting the loans.

3. Financing activities include (a) obtaining cash from issuing debt and repaying the
amounts borrowed, and (b) obtaining cash from stockholders, repurchasing shares, and
paying dividends.

Note : 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 sufficient cash to continue as
a going concern.
TYPES OF CASH INFLOWS AND OUTFLOWS
TYPES OF CASH INFLOWS AND OUTFLOWS
TYPES OF CASH INFLOWS AND OUTFLOWS

Note the following general guidelines:

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 as operating activities some cash flows related to investing or financing activities. For
example, receipts of investment revenue (interest and dividends) are classified as operating activities. So
are payments of interest to lenders. Why are these considered operating activities?

“Because companies report these items in the income statement, where results of operations are
shown.”
Format of the Statement of Cash Flows
Check Point 1 - Classification of Cash Flows

During its first week, Duffy & Stevenson Company had these transactions.

1. Issued 100,000 shares of $5 par value common stock for $800,000 cash.
2. Borrowed $200,000 from Castle Bank, signing a 5-year note bearing 8% interest.
3. Purchased two semi-trailer trucks for $170,000 cash.
4. Paid employees $12,000 for salaries and wages.
5. Collected $20,000 cash for services performed.

Classify each of these transactions by type of cash flow activity.

Prepare a statement of cash flows using the indirect method.
Companies prepare the statement of cash flows differently from the three other basic financial statements.
- it is not prepared from an adjusted trial balance.
- the statement of cash flows deals with cash receipts and payments. The company adjusts the effects of the use of
accrual accounting to determine cash flows.

The information to prepare this statement usually comes from three sources:

• Comparative balance sheets. Information in the comparative balance sheets indicates the amount of the changes
in assets, liabilities, and stockholders’ equities from the beginning to the end of the period.

• Current income statement. Information in this statement helps determine the amount of net cash provided or
used by operating activities during the period.

• Additional information. Such information includes transaction data that are needed to determine how cash was
provided or used during the period.
Indirect and Direct Methods
The indirect method adjusts net income for items that do not affect cash. A great majority of companies
use this method. Companies favor the indirect method for two reasons: (1) it is easier and less costly to
prepare, and (2) it focuses on the differences between net income and net cash flow from operating
activities.

The direct method shows operating cash receipts and payments. It is prepared by adjusting each item in
the income statement from the accrual basis to the cash basis.

Indirect Method—Computer Services Company

To explain how to prepare a statement of cash flows using the indirect method, we use financial information from
Computer Services Company.
We now apply the three steps for
preparing a statement of cash
flows to the information provided
for Computer Services Company.
Step 1: Operating Activities
DETERMINE NET CASH PROVIDED/USED BY OPERATING ACTIVITIES BY CONVERTING NET INCOME FROM AN ACCRUAL
BASIS TO A CASH BASIS

Why net income must be converted to net cash provided by operating activities?
Because under the accrual basis, net income is not the same as net cash provided by operating activities.

Three types of adjustments

to convert net income to
net cash provided by
operating activities
DEPRECIATION EXPENSE

Depreciation is similar to any other expense in that it reduces net income. It differs in that it does not involve a
current cash outflow. That is why it must be added back to net income to arrive at net cash provided by operating
activities.

As the first adjustment to net income in the statement of cash flows, companies frequently list
depreciation and similar noncash charges such as amortization of intangible assets, depletion
expense, and bad debt expense.
LOSS ON DISPOSAL OF EQUIPMENT
Cash received from the sale (disposal) of plant assets is reported in the investing activities section. Because of this,
companies eliminate from net income all gains and losses related to the disposal of plant assets, to arrive at net
cash provided by operating activities.

Computer Services’ income statement reports a $3,000 loss on the disposal of equipment (book value $7,000, less
$4,000 cash received from disposal of equipment). The company’s loss of $3,000 should not be included in the
operating activities section of the statement of cash flows.

If a gain on disposal occurs, the company deducts the gain from net income in order to determine net cash provided
by operating activities.
CHANGES TO NONCASH CURRENT ASSET AND CURRENT LIABILITY ACCOUNTS

A final adjustment in reconciling net income to net cash provided by operating activities
involves examining all changes in current asset and current liability accounts.

Companies need to adjust net income for these accruals and prepayments to determine
net cash provided by operating activities. Thus, they must analyze the change in each
current asset and current liability account to determine its impact on net income and
cash.
CHANGES TO NONCASH CURRENT ASSET AND CURRENT LIABILITY ACCOUNTS

DECREASE IN ACCOUNTS RECEIVABLE Computer Services’ accounts receivable decreased by $10,000 (from $30,000 to
$20,000) during the period. For Computer Services, this means that cash receipts were $10,000 higher than sales
revenue.

To adjust net income to net cash provided by operating activities, the company adds to net income the decrease
of $10,000 in accounts receivable.

INCREASE IN INVENTORY Computer Services’ inventory increased $5,000 (from $10,000 to $15,000) during the
period. The change in the Inventory account reflects the difference between the amount of inventory purchased and the
amount sold.

The company deducts from net income this inventory increase of $5,000 during the period, to arrive at net cash
provided by operating activities. If inventory decreases, the company adds to net income the amount of the change, to
arrive at net cash provided by operating activities.
CHANGES TO NONCASH CURRENT ASSET AND CURRENT LIABILITY ACCOUNTS

INCREASE IN PREPAID EXPENSES Computer Services’ prepaid expenses increased during the period by $4,000. To adjust
net income to net cash provided by operating activities, the company deducts from net income the $4,000 increase in
prepaid expenses.

If prepaid expenses decrease, reported expenses are higher than the expenses paid. Therefore, the company adds to net
income the decrease in prepaid expenses, to arrive at net cash provided by operating activities.
CHANGES IN CURRENT LIABILITIES.
Add to net income increases in current liability accounts and deduct from net income decreases in current liability
accounts, to arrive at net cash provided by operating activities.
INCREASE IN ACCOUNTS PAYABLE For Computer Services, Accounts Payable increased by $16,000 (from $12,000
to $28,000) during the period. That means the company received $16,000 more in goods than it actually paid
for. To adjust net income to determine net cash provided by operating activities, the company adds to net income the
$16,000 increase in Accounts Payable.
DECREASE IN INCOME TAXES PAYABLE When a company incurs income tax expense but has not yet paid its
taxes, it records income taxes payable. To adjust net income to a cash basis, the company must reduce net income
by $2,000.
Summary of Conversion to Net Cash Provided by Operating Activities—Indirect Method
As shown in the previous illustrations, the statement of cash flows prepared by the indirect method starts with net
income. It then adds or deducts items to arrive at net cash provided by operating activities. The required adjustments are
of three types:
1. Noncash charges such as depreciation and amortization.
2. Gains and losses on the disposal of plant assets.
3. Changes in noncash current asset and current liability accounts.
Check Point. Cash from Operating Activities
Step 2: Investing and Financing Activities
ANALYZE CHANGES IN NONCURRENT ASSET AND LIABILITY ACCOUNTS AND RECORD AS INVESTING AND FINANCING
ACTIVITIES, OR AS NONCASH INVESTING AND FINANCING ACTIVITIES
INCREASE IN LAND As indicated from the change in the Land account and the additional information,
Computer Services purchased land of $110,000 by directly exchanging bonds for land.

Note: The issuance of bonds payable for land has no effect on cash. But, it is a significant noncash investing and
financing activity that merits disclosure in a separate schedule

INCREASE IN BUILDINGS As the additional data indicate, Computer Services acquired an office building for
$120,000 cash. This is a cash outflow reported in the investing activities section.
Step 2: Investing and Financing Activities
ANALYZE CHANGES IN NONCURRENT ASSET AND LIABILITY ACCOUNTS AND RECORD AS INVESTING AND FINANCING
ACTIVITIES, OR AS NONCASH INVESTING AND FINANCING ACTIVITIES

INCREASE IN EQUIPMENT The Equipment account increased $17,000. The additional information explains that
this net increase resulted from two transactions: (1) a purchase of equipment of $25,000, and (2) the sale
for $4,000 of equipment costing $8,000.
Step 2: Investing and Financing Activities
ANALYZE CHANGES IN NONCURRENT ASSET AND LIABILITY ACCOUNTS AND RECORD AS INVESTING AND FINANCING
ACTIVITIES, OR AS NONCASH INVESTING AND FINANCING ACTIVITIES

INCREASE IN BONDS PAYABLE The Bonds Payable account increased $110,000. As indicated in the additional
information, the company acquired land from the issuance of these bonds. It reports this noncash transaction
in a separate schedule at the bottom of the statement.
INCREASE IN COMMON STOCK The balance sheet reports an increase in Common Stock of $20,000. The
additional information section notes that this increase resulted from the issuance of new shares of stock. This
is a cash inflow reported in the financing activities section.
INCREASE IN RETAINED EARNINGS Retained earnings increased $116,000 during the year. This increase can be
explained by two factors: (1) net income of $145,000 increased retained earnings, and (2) dividends of $29,000
decreased retained earnings.

Payment of the dividends (not the declaration) is a cash outflow that the company reports as a fi nuancing activity.
Step 3: Net Change in Cash
COMPARE THE NET CHANGE IN CASH ON THE STATEMENT OF CASH FLOWS WITH THE CHANGE IN THE CASH ACCOUNT
REPORTED ON THE BALANCE SHEET TO MAKE SURE THE AMOUNTS AGREE

Indicates that the net change in cash during the period was an increase of $22,000. This
agrees with the change in Cash account reported on the balance sheet
Check Point! Indirect Method Cash Flow
Free Cash Flow
In the statement of cash flows, net cash provided by operating activities is intended to indicate the cash-
generating capability of a company. Analysts have noted, however, that net cash provided by operating
activities fails to take into account that a company must invest in new fi xed assets just to maintain its
current level of operations.

Companies also must at least maintain dividends at current levels to satisfy investors. The measurement
of free cash flow provides additional insight regarding a company’s cash-generating ability. Free cash flow
describes the net cash provided by operating activities after adjustment for capital expenditures and
dividends.
Illustration below provides basic information (in millions) excerpted from the 2013 statement of cash flows of Microsoft
Corporation.
Check Point: Free Cash Flow
Use the T-account approach to prepare a statement of cash flows.
T- accounts of non-cash balance sheet accounts.
Prepare smaller T-accounts for all of the other noncash balance sheet accounts.
T- accounts of Cash Accounts
Prepare a large Cash T-account with sections for operating, investing, and financing activities.
1. Post net income as a debit to the operating section of the Cash T-account and a credit to Retained
Earnings. Make sure to label all adjustments to the Cash T-account.
2. Post depreciation expense as a debit to the operating section of Cash and a credit to each of the
appropriate accumulated depreciation accounts.
3. Post any gains or losses on the sale of property, plant, and equipment. To do this, it is best to first
prepare the journal entry that was recorded at the time of the sale and then post each element of the
journal entry.
4 -8. Next, post each of the changes to the noncash current asset and current
liability accounts.
9. Analyze the changes in the noncurrent accounts. Land was purchased by issuing bonds payable. Note
that this is a significant noncash event that requires disclosure at the bottom of the statement of cash
flows.
10. Buildings is debited for $120,000, and the investing section of the Cash T-account is credited for
$120,000 as a use of cash from investing.
11. Equipment is debited for $25,000 and the investing section of the Cash T-account is credited for
$25,000 as a use of cash from investing.
12. Common Stock is credited for $20,000 for the issuance of shares of stock, and the financing section of
the Cash T-account is debited for $20,000.
13. Retained Earnings is debited to reflect the payment of the $29,000 dividend, and the fi nancing section
of the Cash T-account is credited to reflect the use of Cash.