Sequence N°: 4

Title: The Statement of Cash Flows

The Statement of Cash Flows

A. 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.

1. 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.
2. 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 in this statement because it alone shows the flows of cash in a
business.
3. The reasons for the difference between net income and net cash provided
(used) by operating activities. Net income provides information on the success
or failure of a business. However, some financial statement users are critical of
accrual-basis net income because it requires many estimates. As a result, users
often challenge the reliability of the number. Such is not the case with cash.
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.
Then, they can assess for themselves the reliability of the income number.
4. 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.

B. Classification of Cash Flows

The statement of cash flows classifies cash receipts and cash payments as
operating, investing, and financing activities. 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.

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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.

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.

Illustration 1-1 lists typical cash receipts and cash payments within each of
the three classifications. Study the list carefully.

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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.

Significant Noncash Activities

Not all of a company’s significant activities involve cash. Examples of
significant noncash activities are as follows.
1. Direct issuance of common stock to purchase assets.
2. Conversion of bonds into common stock.
3. Direct issuance of debt to purchase assets.
4. Exchanges of plant assets.

Companies do not report in the body of the statement of cash flows

significant financing and investing activities that do not affect cash. Instead,
they report these activities in either a separate schedule at the bottom of the
statement of cash flows or in a separate note or supplementary schedule to
the financial statements. The reporting of these noncash activities in a separate
schedule satisfies the full disclosure principle.

C. Format of the Statement of Cash Flows

The general format of the statement of cash flows presents the results of
the three activities discussed previously—operating, investing, and financing—
plus the significant noncash investing and financing activities. Illustration 1-2
shows a widely used form of the statement of cash flows.

Illustration 1-2 Format of statement of cash flows

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 The cash flows from operating activities section always appears first,
followed by the investing activities section and then the financing activities
section. The sum of the operating, investing, and financing sections equals the
net increase or decrease in cash for the period. This amount is added to the
beginning cash balance to arrive at the ending cash balance—the same amount
reported on the balance sheet.

D. Prepare a statement of cash flows

Companies prepare the statement of cash flows differently from the

three other basic financial statements. First, it is not prepared from an adjusted
trial balance. It requires detailed information concerning the changes in account
balances that occurred between two points in time. An adjusted trial balance will
not provide the necessary data. Second, the statement of cash flows deals with
cash receipts and payments. As a result, 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.

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• Additional information. Such information includes transaction data that
are needed to determine how cash was provided or used during the period.

Preparing the statement of cash fl ows from these data sources involves
three major steps, explained in Illustration 1-3.

E. Indirect and Direct Methods of cash flow

In order to perform Step 1, a company must convert net income from an

accrual basis to a cash basis. This conversion may be done by either of two
methods: (1) the indirect method or (2) the direct method. Both methods
arrive at the same amount for “Net cash provided by operating activities.”
They differ in how they arrive at the amount.

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.

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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.
The FASB has expressed a preference for the direct method but allows the use
of either method.

Summary
Direct method A method of preparing a statement of cash flows that shows
operating cash receipts and payments, making it more consistent with the
objective of the statement of cash flows.
Financing activities Cash fl ow activities that include (a) obtaining cash from
issuing debt and repaying the amounts borrowed and (b) obtaining cash from
stockholders, repurchasing shares, and paying dividends.
Indirect method A method of preparing a statement of cash fl ows in which net
income is adjusted for items that do not affect cash, to determine net cash
provided by operating activities.
Investing activities Cash flow activities that include (a) purchasing and
disposing of investments and property, plant, and equipment using cash and (b)
lending money and collecting the loans.
Operating activities Cash flow activities that include the cash effects of
transactions that create revenues and expenses and thus enter into the
determination of net income.
Statement of cash flows A basic financial statement that provides information
about the cash receipts, cash payments, and net change in cash during a period,
resulting from operating, investing, and financing activities.