INTERMEDIATE
ACCOUNTING
Chapter 21
The Statement of Cash Flows
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What Financial Statement Users Want to Know
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What is the relationship between net income and
cash provided by operations?
Were the company’s operations a source or a use
of cash?
What investments and growth activities took place?
How were they financed?
What were the proceeds received from issuing
capital stock or debt and how were the funds used?
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FASB Requirements
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The FASB recognized the importance of providing
answers to user’s questions by stating that financial
reporting should provide information about a
company’s:
Methods for obtaining and spending cash
 Data on borrowing and repayment of debt
 Capital transactions, including cash dividends and other
distributions of resources to owners
 Other factors that may affect its liquidity or solvency.
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To satisfy these objectives, GAAP requires a company
to present a statement of cash flows for the accounting
period along with its income statement and balance
sheet.
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What Information Does the Statement of
Cash Flows Provide and How is it Reported?
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The primary purpose of a company’s statement of cash
flows is to provide relevant information about its cash
receipts and cash payments during an accounting period.
The FASB states that the information in a statement of cash
flows, if used with information in the other financial
statements, helps external users assess:
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a company’s ability to generate positive future net cash flows
a company’s ability to meet its obligations and pay dividends
company’s need for external financing
the reasons for differences between a company’s net income and
related cash receipts and payments
both the cash and noncash aspects of a company’s financing and
investing transactions during the accounting period
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How Does the Statement of Cash Flows
Present Information?
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According to GAAP, a company’s statement of cash
flows for the accounting period must clearly show:
 cash
provided by or used in its operating activities
 cash provided by or used in its investing activities
 cash provided by or used in its financing activities
 net increase or decrease in its cash, reconciling the
change from the beginning cash balance to the ending
cash balance reported on the year-end balance sheet
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Operating Activities
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A company’s operating activities are part of the day-to-day
business activities of a company—acquiring (purchasing or
manufacturing), selling, and delivering goods and services to
customers.
Cash inflows from operating activities include cash receipts from:
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sale of goods or services to customers
collection of accounts receivable
collection of interest on loans
receipts of dividends on investments in equity securities
Cash outflows for operating activities include cash payments to:
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suppliers for inventory and other goods and services used in operations
employees
government for taxes
lenders for interest (unless capitalized)
other suppliers for various expenses
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Investing Activities
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A company’s investing activities are those transactions that involve
acquiring and selling productive assets and investments needed to
achieve the operating objectives of the business.
Investing activities include transactions involving cash receipts from:
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sale of property, plant, and equipment
sale of investments classified as available for sale and held-to-maturity
repayment of principal from loans made to other companies
Cash outflows for investing activities include cash payments to:
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acquire property, plant, and equipment
acquire investments classified as available for sale and held-to-maturity
make loans to other companies
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Financing Activities
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A company’s financing activities include its transactions involving
obtaining resources from owners and providing them with a return on
their investment as well as borrowing money from creditors and
repaying those obligations.
Cash inflows from financing activities include cash receipts from
issuing:
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equity securities (i.e., common stock and preferred stock)
financing instruments (i.e., bonds, short-term or long-term notes,
mortgages, capital leases, and other short- or long-term borrowings)
Cash outflows for financing activities include cash payments for:
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dividends
repurchase of the company’s equity securities
repayments of amounts borrowed through financing instruments
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Noncash Investing and Financing Activities
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Most financing and investing activities of a company affect
its cash; however, some transactions are ‘‘simultaneous’’
investing and financing activities that do not affect its cash.
Examples of these transactions include:
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acquisitions of assets by issuing equity securities (noncash investing
and financing activities)
acquisitions of assets by assuming liabilities such as capital lease
obligations (noncash investing and financing activities)
exchanges of debt securities or preferred stock for equity
securities such as the conversion of bonds or preferred stock for
common stock (noncash financing activities)
exchanges of assets for assets (noncash investing activities)
exchanges of liabilities for liabilities (noncash financing activities)
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Cash and Cash Equivalents
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Part of a company’s cash management procedures
include investing its cash in short-term, highly liquid
investments, such as treasury bills, commercial paper,
and money market funds.
These investments are called cash equivalents and,
instead of reporting ‘‘Cash’’ as a current asset on its
balance sheet, the company reports ‘‘Cash and Cash
Equivalents.’’
In this case, the company’s statement of cash flows
explains the change during the accounting period in its
cash and cash equivalents.
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What Company Information Does the Statement of Cash
Flows Help Financial Statement Users Understand? (Slide 1 of 2)
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Information from the statement of cash flows
enables financial statement users to assess a
company’s liquidity and risk.
The operating cash flow ratio provides a measure
of resources generated over a period of time, which
a company may be able to use to meet current
liabilities and is computed as:
Cash Flow from Operating Activities
Average Current Liabilities
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What Company Information Does the Statement of Cash
Flows Help Financial Statement Users Understand? (Slide 2 of 2)
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Another cash flow ratio examined by analysts to
assess risk is the operating cash flow to total
liabilities ratio, which provides recognition of a
company’s ability to generate cash flows from
operations to pay its debt.
This ratio is computed as:
Cash Flow from Operating Activities
Average Total Liabilities
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Cash Inflows and Outflows
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Inflows of Cash
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Decreases in Assets. The sale or other disposal of assets (other than
cash) typically causes a direct increase in cash when cash is received
or collected in exchange for the assets (such as selling an investment
security for cash or collecting a receivable in cash). In some cases,
however, a decrease in assets implies an increase (savings) in cash
because the asset being consumed was purchased for cash in a prior
period.
Increases in Liabilities. The issuance or incurrence of liabilities
typically causes a direct increase in cash when cash is borrowed
(such as issuing a note payable for cash). In some cases, the
incurrence of a liability implies an increase in cash even though the
cash flow may not have literally occurred during the period.
Increases in Shareholders’ Equity. Shareholders’ equity increases
mainly because of net income and additional investments by owners.
Additional investments cause an increase in cash because cash is
received in exchange for the common stock issued.
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Outflows of Cash
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Increases in Assets. The acquisition of assets (other than cash)
typically causes a decrease in cash because cash is paid in
exchange for the assets. Again, in some cases, however, an increase
in assets implies a decrease (use) of cash, even though cash may not
have literally been used to acquire the asset during the current
period.
Decreases in Liabilities. The payment of liabilities typically causes
a decrease in cash when cash is paid to satisfy the liabilities. Again,
in some cases, the reduction of a liability implies a use in cash even
though the cash flow may not have literally occurred during the
period.
Decreases in Shareholders’ Equity. Shareholders’ equity may
decrease as a result of several transactions. Two common
transactions are the payment of dividends and the acquisition of
treasury stock. In each case, a decrease in shareholders’ equity is
accompanied by a decrease in cash.
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Relationship Between Accruals and Cash Flows
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Direct Method of Reporting
Operating Activities
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GAAP allows a company to choose one of two ways to report its net cash
flow from operating activities on its statement of cash flows: the direct
method or the indirect method.
Under the direct method, a company computes operating cash inflows and
deducts its operating cash outflows to determine its net cash flow from
operating activities.
A company’s operating cash inflows are:
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collections from customers
collections of interest and dividends
other operating receipts
A company’s operating cash outflows are:
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payments to suppliers
payments to employees
other operating payments
payments for interest
payments for income taxes
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Indirect Method of Reporting
Operating Activities
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Under the indirect method, a company’s net income is adjusted (reconciled)
to its net cash flow from operating activities.
To do so, net income is listed first and then adjustments (additions or
subtractions) are made to net income:
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Add back noncash expenses, such as depreciation and amortization expense,
deferred income taxes, and share based compensation expense.
Add back noncash charges, such as restructuring and impairment charges.
Subtract noncash revenues, such as equity method income and excess tax
benefits from share based compensations awards.
Add back losses or subtract gains recognized in income from the sale of assets,
so that the full amount of the proceeds from the sale can be reported in the
investing activities section.
Subtract increases and add back decreases in current operating assets (other
than cash) and add back increases and subtract decreases in current operating
liabilities to adjust for accruals and deferrals effects on cash flows.
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Adjustments to Convert Net Income to
Net Cash Flow from Operating Activities (Slide 1 of 2)
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Net income
Plus
 Decreases
in Current Assets
 Increases in Current Liabilities
 Other Adjustments
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Minus
 Increases
in Current Assets
 Decreases in Current Liabilities
 Other Adjustments
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Equals Net Cash Flow from Operating Activities
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Adjustments to Convert Net Income to
Net Cash Flow from Operating Activities (Slide 2 of 2)
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Visual Inspection Method of Preparing
the Statement of Cash Flows (Slide 1 of 3)
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There are two methods that you may use to prepare
a company’s statement of cash flows: the visual
inspection method or the spreadsheet method.
Under the visual inspection method, you review
the company’s financial statements and prepare its
statement of cash flows without using a spreadsheet.
This method may be used when a company’s
financial statements are simple and when the
relationships between changes in account balances
can be easily analyzed.
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Visual Inspection Method of Preparing
the Statement of Cash Flows (Slide 2 of 3)
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There are four steps in the visual inspection method.
Step 1. Prepare the heading for the statement of cash flows
and list the three sections:
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Operating Activities, Investing Activities, and Financing Activities.
List the company’s net income as the first item in the operating activities
section.
Step 2. Calculate the increase or decrease that occurred
during the accounting period in each balance sheet account
(except cash) and determine whether it caused an inflow or
outflow of cash. If so, report it in the appropriate category:
Operating Activities, Investing Activities, or Financing Activities.
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Visual Inspection Method of Preparing
the Statement of Cash Flows (Slide 3 of 3)
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Step 3. If no cash flow occurred in Step 2 determine whether
the increase or decrease was (a) the result of a noncash
income statement item or (b) a simultaneous investing and/or
financing transaction.
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If (a), then determine the adjustment (addition or subtraction) to convert
net income to the net cash flow from operating activities.
If (b), then identify the components of the simultaneous investing and/or
financing activity and report them in a separate note or schedule.
Step 4. Complete the various sections of the statement of cash
flows (based on the analysis in Steps 2 and 3. Check that the
sum of the three subtotals of the sections equals the net change
in cash. Also check that the sum of the net change in cash and
the beginning cash balance is equal to the ending cash
balance reported on the balance sheet.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Spreadsheet Method of Preparing the
Statement of Cash Flows (Slide 1 of 3)
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Companies usually use the spreadsheet method to
prepare their statements of cash flows.
Under this method, a company uses a spreadsheet
to:
 record
its cash receipts and payments according to the
operating, investing, and financing sections of the
statement of cash flows
 record the investing and financing activities not
affecting cash
 account for the change in each asset, liability, and
shareholders’ equity account
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Spreadsheet Method of Preparing
the Statement of Cash Flows (Slide 2 of 3)
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After gathering information from the financial
statements and supplemental information from the
accounting records, a company completes a series
of four steps to prepare the spreadsheet and its
statement of cash flows:
 Step
1. Preparing the spreadsheet
 Step 2. Completing the spreadsheet
 Step 3. Preparing the final spreadsheet entry
 Step 4. Preparing the statement of cash flows
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Spreadsheet Method of Preparing
the Statement of Cash Flows (Slide 3 of 3)
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There are three issues related to the spreadsheet method:
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After starting with net income, there is no required order in which
the spreadsheet entries are constructed, but most companies
proceed line-by-line through each account on the balance sheet.
You should develop a method to account for all the changes in the
noncash accounts in an orderly way.
You may have to make more than one spreadsheet entry to
reconcile the change in an account. For instance, the change in the
Land account may be the result of both a sale and a purchase of
land. In these cases, both the cash receipt and cash payment are
accounted for and reported separately.
Remember that these spreadsheet entries are not posted to any
accounts. They are recorded on the spreadsheet only to help
prepare the statement of cash flows.
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How Are Special Items Accounting for in the
Statement of Cash Flows?
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Sale of a depreciable asset
Retirement of bonds
Interest Paid and Income Taxes Paid
Short-Term and Long-Term Investments
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Sale of Depreciable Assets
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company computes the gain or loss on the sale of a
depreciable asset by subtracting the current book value
of the asset from the selling price.
 When the company records the transaction, it increases
cash, eliminates the book value (cost and accumulated
depreciation), and recognizes a gain or loss that it
reports on its income statement.
 On the statement of cash flows, the gain (loss) must be
subtracted from (added back to) net income, and the
total proceeds from the sale must be reported as a
cash inflow in the investing section.
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Retirement of Bonds
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A company computes the gain or loss on the retirement of
bonds by comparing the current book value of the bonds
payable to the retirement price.
When the company records the transaction, it decreases
cash, eliminates the book value (face value and any related
premium or discount), and recognizes a gain or loss that it
reports on its income statement.
At the end of the year, this journal entry must be properly
reconstructed on the spreadsheet to account for the changes
in the various accounts.
On the statement of cash flows, the gain (loss) must be
subtracted from (added back to) net income, and the total
proceeds to retire the bonds be reported as a cash outflow
in the financing section.
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Interest Paid and Income Taxes Paid
(Slide 1 of 2)
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GAAP requires a company using the indirect method of
reporting its operating cash flows to also disclose its interest
paid and income taxes paid.
This disclosure may be made in a separate schedule,
narrative description, or the notes to the financial
statements.
Interest expense is affected by the cash paid, accruals, any
premium or discount amortizations on bonds (or notes)
payable, and any amounts capitalized.
Income tax expense is affected by the cash paid, accruals,
and changes in deferred income taxes.
The next slide illustrates the necessary adjustments to convert
interest expense to interest paid and to convert income tax
expense to income taxes paid.
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Interest Paid and Income Taxes Paid
(Slide 2 of 2)
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Short-Term and Long-Term Investments
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As discussed previously, a company recognizes
investment securities as either
 trading,
 available-for-sale,
 or
held-to-maturity securities.
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Trading Securities
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GAAP requires that a company report the cash flows from
purchases, sales, and maturities of trading securities as
either operating or investing cash flow activities, based on
the nature and purpose for which the securities were
acquired.
GAAP also requires a company to report investments in
trading securities at their fair value and report any resulting
unrealized holding gain or loss in net income.
Consequently, for reporting its operating cash flows under
the indirect method, a company adds (deducts) an
unrealized holding loss (gain) on trading securities to (from)
net income to help adjust net income from an accrual basis
to a cash basis.
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Available-for-Sale Securities
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If a company uses an allowance account and an unrealized increase or
decrease account to value the investment in available-for-sale securities, it
must carefully analyze any changes in these accounts to determine the
impact (if any) on its statement of cash flows.
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The company reports an increase in the investment account due to the purchase
of the securities on its statement of cash flows as a cash payment for an investing
activity.
The entry on the spreadsheet to prepare the statement is also made in the usual
manner.
The company does not report any changes in the allowance and the unrealized
increase or decrease accounts resulting from a revaluation to fair value at yearend on its statement of cash flows. However, it must account for the changes on
the spreadsheet.
The company reports a decrease in the investment account because of the sale
of the securities on its statement of cash flows as a cash receipt from an investing
activity in the usual manner. However, the spreadsheet entry must reconcile the
changes in the investment, allowance, unrealized increase/decrease, and
realized gain (or loss) accounts.
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Held-to-Maturity Securities
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If a company makes a long-term investment in debt
securities (e.g., bonds) that it expects to hold to maturity:
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It must amortize any premium or discount each year as an
adjustment to interest revenue, and report the investment at its
amortized cost on the year-end balance sheet. For cash flow
reporting purposes, it reports the purchase as a cash payment for
investing activities.
The company must also add any premium amortization on this
type of investment to net income in the operating activities section
of the statement of cash flows because the amortization reduced
interest revenue to an amount lower than the cash received.
The company subtracts any discount amortization from net income
because the amortization increased interest revenue to an amount
higher than the cash received.
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Equity Method Investments
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The equity method of accounting for investments
also creates a need for a noncash adjustment.
The equity method results in recognition of revenue
and an increase in the investment account equal to
the investor’s share of the investee’s net income or
net loss.
In addition, the equity investment account is
decreased (and the cash account is increased) for
any share of the investee’s dividends received.
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Other Investment Related Events
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Cash dividends declared
Cash flows for compensatory share option plans
Effects of foreign currency exchange rates
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.