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Learning Objectives Learning Objectives
1. Understand why using the accrual basis of
accounting to prepare the balance sheet and
income statement creates the need for a
statement of cash flows.
2. Understand the types of transactions that
result in cash flows from operating, investing,
and financing activities.
3. Distinguish between the direct and indirect
methods of reporting and analyzing cash
flows from operations.
Learning Objectives Learning Objectives
4. Develop an ability to analyze the
statement of cash flows, including the
relation among cash flows from
operating , investing, and financing
activities for businesses in various
stages of their growth.
Outline Outline
1. Overview of cash flows.
Classification of cash flows
2. Preparing the statement of cash flows.
Direct and indirect methods.
Columnar and t-account approaches.
3. Effects of a sale of a long-term asset.
4. An international perspective.
Overview of the Overview of the
Statement of Cash Flows Statement of Cash Flows
The statement of cash flows .
(a) explains the reasons for a change
in cash.
(b) classifies the reasons for the
change as an operating, investing or
financing activity.
(c) reconciles net income with cash
flow from operations.
Define the Three Classifications Define the Three Classifications
of Cash Flows of Cash Flows
1. Operations
cash flows related to selling goods and
services; that is, the principle business of
the firm.
2. nvesting
cash flows related to the acquisition or sale
of noncurrent assets.
3. Financing
long term and short term cash flows related
to liabilities and owners' equity; dividends
are a financing cash outflow.
Example of Example of
a Statement a Statement
of Cash of Cash
Flows Flows
Exhibit 4.1 Exhibit 4.1
Components of the Statement of Components of the Statement of
Cash Flows Cash Flows
Cash received Irom
sale oI goods
and services
Cash received Irom
sale oI goods
and services
Cash paid Ior
operating goods
and services
Cash paid Ior
operating goods
and services
cash Ilow
Irom operations
cash Ilow
Irom operations
Operations
=
Cash received Irom
sales oI investments
and PP&E
Cash received Irom
sales oI investments
and PP&E
Cash paid Ior ac-
quisition oI invest-
ments and PP&E
Cash paid Ior ac-
quisition oI invest-
ments and PP&E
cash Ilow
Irom investing
cash Ilow
Irom investing
nvesting
=
Cash received Irom
issue oI debt or
capital stock
Cash received Irom
issue oI debt or
capital stock
Cash paid Ior
dividends and
reacquisition oI
debt or capital stock
Cash paid Ior
dividends and
reacquisition oI
debt or capital stock
cash Ilow
Irom Iinancing
cash Ilow
Irom Iinancing
inancing
=
et change in cash
Ior the period
et change in cash
Ior the period
=
+
+
Figure 4.1
Preparing the Statement of Cash Preparing the Statement of Cash
Flows Flows
Firms could prepare the cash flow statement
directly from the cash account. Most,
however, find it more efficient to prepare the
cash flow statement from the balance sheet
and income statement.
(a) Direct and indirect methods.
(b) Algebraic formulation will present the
underlying concept of the cash flow statement.
(c) Two approaches to producing the cash flow
statement: columnar worksheet and t-account
worksheet.
Define the Direct and ndirect Define the Direct and ndirect
Methods Methods
The Direct Method
of presentation calculates cash flow from
operations by subtracting cash disbursements
to supplies, employees, and others from cash
receipts from customers.
The ndirect Method
calculates cash flow from operations by
adjusting net income for noncash revenues
and expenses.
Most firms present their cash flows using the
indirect method.
Algebraic Formulation Algebraic Formulation
Recall the basic accounting equation:
880t8 = Liabiliti08 + Shar0hold0r8 Equity
or = L + SE
Assets are either cash (C) or not (N$A), so
C + N$ = L + SE
C + N$ = L + SE
here means the change in the balance,
Rearranging gives the basic equation for the
statement of cash flows:
C = L + SE - N$
Algebraic Formulation (Cont.) Algebraic Formulation (Cont.)
C = L + SE - N$
The change in cash, C, is the increase or
decrease in the cash account.
This amount must equal changes in liabilities
plu8 changes in shareholders' equity 2inu8
changes in assets other than cash.
Thus, we can identify the causes in the
change in the cash account by studying the
changes in non-cash accounts.
Two Approaches to Producing Two Approaches to Producing
the Cash Flow Statement the Cash Flow Statement
The basic formula can be implemented
using either of two approaches:
1. Columnar worksheet-- changes in
balance sheet accounts are classified
by definition using a multicolumn
worksheet.
2. T-Account worksheet -- changes are
classified by analysis of the t-
accounts.
Columnar orksheet Columnar orksheet
orks well for relatively simple
situations involving few transactions.
Enhances understanding of the cash
flow statement.
Does not work as well as the T-
account method when the number
and complexity of transactions
increases.
Columnar orksheet (Cont.) Columnar orksheet (Cont.)
0in with a co2parativ0 balanc0 8h00t.
1. Compute the change in each balance sheet
account.
2. Classify each change as operating,
investing or financing activity.
2. Make any needed adjustments (for example,
for a sale of a long-lived asset).
4. Recast the classified changes in the form of
a cash flow statement.
Noncash Expenses Noncash Expenses
Noncash expenses, such as
depreciation expense, are added back.
Not truly sources of cash, even though
they are associated with cash inflows;
rather, a reversal of the accrual process
that required the expenses to be
recognized without regard for the cash
flow.
Changes in Specific Accounts Changes in Specific Accounts
I noncash assets
are increased,
then cash was spent,
so cash is an outIlow,
so negative sign.
I noncash assets
are increased,
then cash was spent,
so cash is an outIlow,
so negative sign.
I noncash assets
are decreased,
then they provided cash
so cash is an inIlow,
so positive sign.
I noncash assets
are decreased,
then they provided cash
so cash is an inIlow,
so positive sign.
I liab. or S.E.
increased, then cash
was obtained,
so cash is an inIlow,
so positive sign.
I liab. or S.E.
increased, then cash
was obtained,
so cash is an inIlow,
so positive sign.
I liab. or S.E.
decreased, then cash
was spent,
so cash is an outIlow,
so negative sign.
I liab. or S.E.
decreased, then cash
was spent,
so cash is an outIlow,
so negative sign.
!65
cash
Assets
Liabilities
a51
Shareh6l1ers'
Equity
i5crease 1ecrease
TT- -account orksheet account orksheet
The columnar works well when the change in
each balance sheet account affects only one
of the three types of activities. t becomes
cumbersome for more complex (and
realistic) situations.
The T-account approach is a direct
extension of T-accounts - facilitates analysis
of a transaction which involves more than
one activity.
For example, the change in #0tain0d
Earnin8 can be due to both net income
(operating activity) and dividends (financing
activity).
TT- -account orksheet account orksheet
1. Obtain beginning and ending balance sheets.
2. Prepare a T-account worksheet with a master
account, cash, divided into operating, investing
and financing sections.
3. Explain the change in the master cash account
by reconstructing the original entries in a
summary form.
4. Make any necessary adjustments.
5. Recast the master account in the format of a
cash flow statement.
TT- -account orksheet (Cont.) account orksheet (Cont.)
ash
-eginning
-,,nce
Operations
nvesting
inancing
ending
-,,nce
Various BaIance Sheet Accounts
-eginning
-,,nce
ending
-,,nce
nnnnnn
nnnnnn
1. adjustments are
made to all balance
sheet accounts to
bring the beginning
balance to the ending
balance.
2. these are
offset by an
opposite entry
in the cash
account.
3. this
part of the
cash
account
becomes
the cash
flow
statement.
Effects of a Sale of a Long Effects of a Sale of a Long- -Term Term
Asset on Cash Flows Asset on Cash Flows
A few transactions complicate the derivation
of a cash flow statement from a comparative
balance sheet, for example, the sale of a
long-term (or fixed) asset.
Recall the journal entry for the sale of an
asset:
Cash 3333
ccumulated Depreciation 3333
sset 3333
Gain (or loss) on sale 3333
Sale of an Asset (Cont.) Sale of an Asset (Cont.)
Each of the four parts of the above journal entry
requires an adjustment in the cash flow statement.
The first line, cash, adds a line to the investing section.
The second line, a debit to accumulated depreciation,
increases the depreciation expense above the change
in the accumulated depreciation account.
The third line, a credit to the asset, increases the
amount of cash invested in long-lived assets above the
change in the fixed asset accounts.
The fourth line, a gain or loss, is reversed out in the
operating sections since this is not a cash flow.
Comparison of Cash Flow to Net Comparison of Cash Flow to Net
ncome ncome
Net income is an accrual based concept and purports
to show the long-term.
Cash flows purport to show the short term.
Consider the outlook for both short-term and long-term
and consider that each is either good or poor.
A strong growing firm would show both good long-term
and good short-term outlooks.
A failing firm would show both poor long-term and poor
short term outlooks.
hat about a firm with good cash flows (short-term)
but poor net income (long-term)?
hat about a firm with poor cash flows (short-term) but
good net income (long-term)?
4. An nternational Perspective 4. An nternational Perspective
The nternational Accounting
Standards Board (AS No. 7)
recommends but does not require a
statement of cash flows.
An approximation to a cash flow
statement can be prepared from a
comparative balance sheet with
some additional information.
Summary Summary
The statement of cash flows is presented. t
reports the effects on cash flows of a firm's
operating, investing and financing activities.
nformation in this statement helps in
understanding:
1. How operations affect liquidity,
2. The level of capital expenditures needed to
support growth, and
3. The major changes in financing.
Two methods are presented to produce a
cash flow statement from a comparative
balance sheet.
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