CHAPTER FIVE: STATEMENT OF CASH FLOWS

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. The statement of
cash flows therefore reports cash receipts, cash payments, and net change in cash resulting from
a company’s operating, investing, and financing activities during a period. Its format reconciles
the beginning and ending cash balances for the period.

Usefulness of the Statement of Cash Flows

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.

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.

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 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

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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.

5.1 Classifications of Cash Flows

The statement of cash flows classifies cash receipts and cash payments by operating, investing,
and financing activities. Transactions and other events characteristic of each kind of activity is as
follows.
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.
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.
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.

Along with an income statements and balance sheet, a statement of cash flows is included in
annual reports to stockholders of publicly owned companies and is covered by the auditors’
opinion. The objectives of this statement are:
1. To summarize the financing, operating, and investing activities of a business enterprise
during an accounting period, including the amount of cash equivalent obtained from
operations, and
2. To complete the disclosure for changes in financial position during an accounting period
that is not readily apparent in comparative balance sheets.
The statement of cash flows discloses transactions that affect cash directly, as well as significant
investing and financing transactions that do not affect cash.
The statement of cash flows is prepared in three sections.

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 1. Operating cash flows: includes cash transaction that enters into the determination of net
income. Reported under this classification are both the cash inflows and the cash
outflows that are related to net income. The usual cash flows identified are:
Inflows – cash received from Outflows-cash paid for
- Cash sales to Customers – Purchase of goods for sale
- Interest on receivables – interest on liabilities
- Dividends from investment – income taxes, duties, & fines
- Refunds from suppliers – salaries and wages
2. Investing cash flows:
This classification includes cash inflows and cash outflows related to the disposing of or acquiring
operating facilities (plant, property, equipment), the sale or purchase of investments, and other non-
operating (investment) assets. Inflows under this classification occur only when cash is received from the
sale or disposal of prior investments.
The following are typical cash flows under investing activities:
Inflows – cash received from Outflows – cash paid for
- Disposal / sale of property – Acquisition / purchase of property
- Disposal / sale of investment securities – Long-term investment in debt
- Collection of a loan (excluding and equity securities.
- Interest which is an operating activity) – Loans to other parties
- Principal repayment of loan by borrowers - Acquisition of intangible assets
3. Financing cash flows
This classification includes both cash inflows and outflows related to the financing activities (borrowing
or issuing stock) used to obtain cash for the business. Outflows occur when principle amounts are
returned to the owners and creditors for their earlier investments. The usual cash flows under these
classifications are:
Inflows – cash received from Outflows – cash paid to
- Owners from issuing equity securities – Owners for dividends &
- Creditors from issuing debt securities other cash distributions
-Issuing notes - repurchase of equity securities
Or treasury stock purchased
Repayment of amount borrowed
(Excluding interest, which
Included in operating activities)

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A complete discussion of the statement of cash flows is found in other accounting books. In this
chapter we illustrate the statement without further explanation.

5.1 Comprehensive illustration of statement of cash flows

Steps in Preparation
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.
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.

A company may convert net income to net cash flow from operating activities through either a
direct method or an indirect method.

Direct Method
The direct method (also called the income statement method) reports cash receipts and cash
disbursements from operating activities. The difference between these two amounts is the net
cash flow from operating activities. In other words, the direct method deducts operating cash
disbursements from operating cash receipts. The direct method results in the presentation of a
condensed cash receipts and cash disbursements statement.

As indicated from the accrual-based income statement, Tax Consultants reported revenues of
$125,000. However, because the company’s accounts receivable increased during 2011 by
$36,000, the company collected only $89,000 ($125,000 - $36,000) in cash from these revenues.
Similarly, Tax Consultants reported operating expenses of $85,000. However, accounts payable
increased during the period by $5,000. Assuming that these payables relate to operating
expenses, cash operating expenses were $80,000 ($85,000 - $5,000). Because no taxes payable

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exist at the end of the year, the company must have paid $6,000 income tax expense for 2011 in
cash during the year. Computation of net cash flow from operating activities:
Cash collected from revenues $89,000
Cash payments for expenses 80,000
Income before income taxes 9,000
Cash payments for income taxes 6,000
Net cash provided by operating activities $ 3,000
“Net cash provided by operating activities” is the equivalent of cash basis net income.

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. The two adjustments to net income for Tax Consultants are
as follows.

Example:The following cash flow related information is provided by Matyo Corporation and
relevant for the preparation of statement of cash flow for the year ended dec 31, 2015

Cash, January 1, 2007 $ 10,900

Net income 14,000
Depreciation Expense 8000
Adjustments for differences between incomes flows And cash flows from operating activities:
Decrease in accounts receivable $ 2,600
Less: Increase in inventory 2,000
Decrease in accounts payable 7,000
Payment for purchase of building 28,000
Payment for purchase of equipment 4,000
Proceeds from sale of land, at cost 10,000
Proceeds from issuance of common stock 18,000
Proceeds from issuance of bonds 12,000
Payment of dividends 9,000

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Payment of note payable 13,000
Cash, December 31, 2007 $13,300
Based on the above information prepare statement of cash flow for the year ended 2015
Matyo Corporation
Statement of Cash Flows
For Year Ended December 31, 2015
Net Cash Flow from Operating Activities
Net income $ 14,000
Adjustments for differences between income flows
And cash flows from operating activities:
Add: Depreciation expense 8,000
Decrease in accounts receivable 2,600
Increase in salaries payable 800
Less: Increase in inventory (2,000)
Decrease in accounts payable (7,000)
Net cash provided by operating activities $16,400
Cash Flows from Investing Activities
Payment for purchase of building $(28,000)
Payment for purchase of equipment (4,000)
Proceeds from sale of land, at cost 10,000
Net cash used for investing activities (22,000)
Cash Flows from Financing Activities
Proceeds from issuance of common stock $ 18,000
Proceeds from issuance of bonds 12,000
Payment of dividends (9,000)
Payment of note payable (13,000)
Net cash provided by financing activities 8,000
Net Increase in Cash $ 2,400
Cash, January 1, 2007 10,900
Cash, December 31, 2007 $13,300