11th Edition
Chapter 16
McGraw-Hill/Irwin
Copyright © 2006, The McGraw-Hill Companies, Inc.
“How Well Am I Doing?”
Statement of Cash Flows
Chapter Sixteen
McGraw-Hill/Irwin
Copyright © 2006, The McGraw-Hill Companies, Inc.
Purpose of the Statement of Cash Flows
Are cash flows
sufficient to
support ongoing
operations?
Will the company
have to borrow
money to make
needed
investments?
McGraw-Hill/Irwin
Can we meet
our obligations
to creditors?
Why is there a
difference
between net
income and net
cash flow?
Can we pay
dividends?
Copyright © 2006, The McGraw-Hill Companies, Inc.
Cash
The term cash on the statement of cash
flows refers broadly to both currency and
cash equivalents.
Currency and
Bank Accounts
T-bills
Cash
Money Market
Funds
McGraw-Hill/Irwin
Commercial
Paper
Copyright © 2006, The McGraw-Hill Companies, Inc.
Constructing the Statement of Cash Flows Using
Changes in Noncash Balance Sheet Accounts
Changes in
Capital Stock
Dividends
Paid to
Stockholders
Changes in
Liabilities
Net Cash
Flows for a
Period
Changes in
Noncash
Assets
Net Income
McGraw-Hill/Irwin
Copyright © 2006, The McGraw-Hill Companies, Inc.
Constructing the Statement of Cash Flows UsingExh.
16-2
Changes in Noncash Balance Sheet Accounts
Net Income
Net Loss
Changes in noncash assets
Changes in liabilities*
Changes in capital stock
accounts
Dividends paid to stockholders
Sources
Always
Decreases
Increases
Increases
Uses
Always
Increases
Decreases
Decreases
Always
* Contra assets follow the rules for liabilities.
McGraw-Hill/Irwin
Copyright © 2006, The McGraw-Hill Companies, Inc.
Constructing the Statement of Cash Flows Using
Changes in Noncash Balance Sheet Accounts
Increases in noncash asset accounts imply uses
of cash.
Example: Inventory is
purchased on credit from
a supplier.
It is implied that cash
was used to acquire the
inventory.
McGraw-Hill/Irwin
Copyright © 2006, The McGraw-Hill Companies, Inc.
Constructing the Statement of Cash Flows Using
Changes in Noncash Balance Sheet Accounts
Increases in liability accounts imply sources of
cash.
Example: Inventory is
purchased on credit from
a supplier.
It is implied that an increase
in a payable has the effect
of increasing cash available
for other uses.
McGraw-Hill/Irwin
Copyright © 2006, The McGraw-Hill Companies, Inc.
Constructing the Statement of Cash Flows Using
Changes in Noncash Balance Sheet Accounts
Decreases in noncash assets accounts imply
sources of cash.
Example: Accounts receivable
decreases when customers pay
their bill.
When the customer pays his
bill, the company’s cash
increases.
McGraw-Hill/Irwin
Copyright © 2006, The McGraw-Hill Companies, Inc.
Constructing the Statement of Cash Flows Using
Changes in Noncash Balance Sheet Accounts
Decreases in liability accounts imply uses of cash.
Example: The company made a
payment on a note payable held
by a creditor.
I.O.U.
When the company makes
the payment, cash decreases.
McGraw-Hill/Irwin
Copyright © 2006, The McGraw-Hill Companies, Inc.
A Simplified Statement of Cash Flows: An
Example
Ed's Pizza Hut
Comparative Balance Sheet Account Balances
Cash
Accounts Receivable
Inventory
Land
Equipment
Accumulated Depr.
Accounts Payable
Salaries Payable
Note Payable - Joe Doe
Common Stock
Retained Earnings
McGraw-Hill/Irwin
3/31/2005
DR (CR)
$ 71,000
23,000
350,000
68,000
84,000
(45,000)
(38,000)
(9,000)
(500,000)
(4,000)
$
-
3/31/2004
Change
DR (CR) Incr. (Decr.)
$ 90,000 $ (19,000)
40,000
(17,000)
300,000
50,000
100,000
(32,000)
84,000
(39,000)
6,000
(27,000)
11,000
(14,000)
(5,000)
(50,000)
(50,000)
(450,000)
50,000
(34,000)
(30,000)
$
Copyright © 2006, The McGraw-Hill Companies, Inc.
A Simplified Statement of Cash Flows: An
Example
• Additional Information:
 There was a net loss for the year of $27,000.
 Depreciation charges for the year were $6,000.
 During the year, Ed sold land originally costing
$32,000 for $32,000.
 During the year, Ed paid dividends of $3,000 to the
stockholders.
 Ed issued $50,000 of common stock to settle the
note due to Joe Doe.
McGraw-Hill/Irwin
Copyright © 2006, The McGraw-Hill Companies, Inc.
A Simplified Statement of Cash Flows: An
Example
Here is a summary of the sources
of cash for Ed’s Pizza Hut.
Ed's Pizza Hut
Sources of Cash
Decrease in A/R
$
Decrease in Land
Increase in A/P
Depreciation charges
Total sources of cash
$
McGraw-Hill/Irwin
17,000
32,000
11,000
6,000
66,000
Copyright © 2006, The McGraw-Hill Companies, Inc.
A Simplified Statement of Cash Flows: An
Example
Here is a summary of the uses of
cash for Ed’s Pizza Hut.
Ed's Pizza Hut
Uses of Cash
Net loss
Increase in Inventory
Increase in Salaries Payable
Dividends paid
Total uses of cash
$
$
27,000
50,000
5,000
3,000
85,000
The net cash flow for Ed’s Pizza Hut is ($19,000):
$66,000 in sources minus $85,000 in uses.
McGraw-Hill/Irwin
Copyright © 2006, The McGraw-Hill Companies, Inc.
A Simplified Statement of Cash Flows
Ed's Pizza Hut
Sources of Cash
Decrease in A/R
$
Decrease in Land
Increase in A/P
Depreciation charges
Total sources of cash
$
17,000
32,000
11,000
6,000
66,000
Ed's Pizza Hut
Uses of Cash
Net loss
Increase in Inventory
Increase in Salaries Payable
Dividends paid
Total uses of cash
McGraw-Hill/Irwin
$
$
27,000
50,000
5,000
3,000
85,000
This simplified
approach does
not follow the
format required
for external
reporting
purposes. It is
for illustrative
purposes only.
Copyright © 2006, The McGraw-Hill Companies, Inc.
The Full-Fledged Statement of Cash Flows:
Operating Activities
Operating activities are
those activities that enter
into the determination of
net income.
Transactions
affecting current
assets
Transactions
affecting current
liabilities
McGraw-Hill/Irwin
Changes in
noncurrent
balance sheet
accounts that
directly affect net
income
Copyright © 2006, The McGraw-Hill Companies, Inc.
The Full-Fledged Statement of Cash Flows:
Investing Activities
Investing activities relate to
transactions involving the
acquiring or disposing of
noncurrent assets.
Acquiring or
selling property,
plant and
equipment
Acquiring or
selling securities
McGraw-Hill/Irwin
Lending money to
another entity and
subsequently
collecting on the
loan
Copyright © 2006, The McGraw-Hill Companies, Inc.
The Full-Fledged Statement of Cash Flows:
Financing Activities
Financing activities relate to
transactions involving
borrowing from creditors or
repaying creditors and
engaging in transactions with
the company’s owners.
Interest on debt is
classified as an
operating activity
McGraw-Hill/Irwin
Copyright © 2006, The McGraw-Hill Companies, Inc.
The Full-Fledged Statement of Cash Flows:
An Overview
XYZ Company
Cash Flow Statement
For the Period Ending MM/DD/YY
Cash flows
are divided
into three
categories.
McGraw-Hill/Irwin
I.
Operating Activities
$
XXX
II.
Investing Activities
XXX
III.
Financing Activities
XXX
Net Cash Flows for the
Period
Add: Beg. Cash Balance
$
XXX
XXX
Ending Cash Balance
$
XXX
Copyright © 2006, The McGraw-Hill Companies, Inc.
The Full-Fledged Statement of Cash Flows:
An Overview
A reconciliation
of beginning
cash to ending
cash is also
required.
XYZ Company
Cash Flow Statement
For the Period Ending MM/DD/YY
{
McGraw-Hill/Irwin
I.
Operating Activities
$
XXX
II.
Investing Activities
XXX
III.
Financing Activities
XXX
Net Cash Flows for the
Period
Add: Beg. Cash Balance
$
XXX
XXX
Ending Cash Balance
$
XXX
Copyright © 2006, The McGraw-Hill Companies, Inc.
Operating Activities
Net Income (Loss)
$ XXX
Add:
XXX
XXX
XXX
XXX
(XXX)
(XXX)
(XXX)
$ XXX
Decr. in Current Noncash Assets
Incr. in Current Liabilities
Depreciation Charges
Losses
Less:
Incr. in Current Noncash Assets
Decr. in Current Liabilities
Gains
Net Cash Flows from Operating Activities
Includes those activities that enter into the
determination of net income.
McGraw-Hill/Irwin
Copyright © 2006, The McGraw-Hill Companies, Inc.
Operating Activities
Sources of cash are added to net income and
uses of cash are subtracted from net
income.
Impact on Net Income
Sources
Uses
Current
Noncash Assets
Current
Liabilities
McGraw-Hill/Irwin
Decreases
Increases
Increases
Decreases
Copyright © 2006, The McGraw-Hill Companies, Inc.
Operating Activities
Net Income (Loss)
$ XXX
Add:
XXX
XXX
XXX
XXX
(XXX)
(XXX)
(XXX)
$ XXX
Decr. in Current Noncash Assets
Incr. in Current Liabilities
Depreciation Charges
Losses
Less:
Incr. in Current Noncash Assets
Decr. in Current Liabilities
Gains
Net Cash Flows from Operating Activities
Impact on Net Income
Sources
Uses
Current
Noncash Assets
Current
Liabilities
McGraw-Hill/Irwin
Decreases
Increases
Increases
Decreases
Copyright © 2006, The McGraw-Hill Companies, Inc.
Operating Activities
Net Income (Loss)
$ XXX
Add:
XXX
XXX
XXX
XXX
(XXX)
(XXX)
(XXX)
$ XXX
Decr. in Current Noncash Assets
Incr. in Current Liabilities
Depreciation Charges
Losses
Less:
Incr. in Current Noncash Assets
Decr. in Current Liabilities
Gains
Net Cash Flows from Operating Activities
Impact on Net Income
Sources
Uses
Current
Noncash Assets
Current
Liabilities
McGraw-Hill/Irwin
Decreases
Increases
Increases
Decreases
Copyright © 2006, The McGraw-Hill Companies, Inc.
Operating Activities
Net Income (Loss)
$ XXX
Add:
XXX
XXX
XXX
XXX
(XXX)
(XXX)
(XXX)
$ XXX
Decr. in Current Noncash Assets
Incr. in Current Liabilities
Depreciation Charges
Losses
Less:
Incr. in Current Noncash Assets
Decr. in Current Liabilities
Gains
Net Cash Flows from Operating Activities
Depreciation and Amortization charges are added back
to net income because they are decreases in noncash
assets.
McGraw-Hill/Irwin
Copyright © 2006, The McGraw-Hill Companies, Inc.
Operating Activities
Net Income (Loss)
$ XXX
Add:
XXX
XXX
XXX
XXX
(XXX)
(XXX)
(XXX)
$ XXX
Decr. in Current Noncash Assets
Incr. in Current Liabilities
Depreciation Charges
Losses
Less:
Incr. in Current Noncash Assets
Decr. in Current Liabilities
Gains
Net Cash Flows from Operating Activities
Gains are
subtracted from net
income.
McGraw-Hill/Irwin
Losses are added
back to net income.
Copyright © 2006, The McGraw-Hill Companies, Inc.
Investing Activities
Add:
Proceeds from sale of land,
buildings, equipment, or other
noncurrent assets
Receipt of principal from
investments
Less:
Payments to acquire land,
buildings, equipment, or other
noncurrent assets
Payments to acquire
investments
Net Cash Flows from Investing Activities
$ XXX
XXX
(XXX)
(XXX)
$ XXX
Includes transactions that involve the
acquisition or disposal of noncurrent assets.
McGraw-Hill/Irwin
Copyright © 2006, The McGraw-Hill Companies, Inc.
Financing Activities
Add:
Proceeds from borrowings
Proceeds from issuing capital
stock
Proceeds from sale of bonds
Less:
Principal payments on
borrowed funds
Payments related to bond
maturities
Dividend payments
Net Cash Flows from Financing Activities
$ XXX
XXX
XXX
(XXX)
(XXX)
(XXX)
$ XXX
Includes transactions involving receipts
from or payments to creditors and owners.
McGraw-Hill/Irwin
Copyright © 2006, The McGraw-Hill Companies, Inc.
Other Issues: Gross or Net?
For investing and
financing
activities, items on
the statement of
cash flows should
be presented in
gross amounts
rather than in net
amounts.
McGraw-Hill/Irwin
• Example:
 Assume Macy’s
purchases $50
million in property
during the year and
sells other property
for $30 million.
 Instead of showing
the net change of
$20 million, the
company must
report the gross
amounts of both
transactions.
Copyright © 2006, The McGraw-Hill Companies, Inc.
Other Issues: Direct Method or Indirect
Method?
Indirect Method
Net income is adjusted to a cash basis.
No supplemental schedule is required.
Used by 99% of companies.
McGraw-Hill/Irwin
Direct Method
The income statement is reconstructed
on a cash basis.
Requires a supplemental reconciliation
of net income to cash flow from
operating activities.
Used by 1% of companies.
Copyright © 2006, The McGraw-Hill Companies, Inc.
Other Issues: Direct Exchange Transactions
Direct exchange
transactions occur
when noncurrent
balance sheet items
are swapped.
Such exchanges are
not included in the
statement of cash
flows, but must be
disclosed separately.
McGraw-Hill/Irwin
• Example:
 Bobo, Inc. acquires a
building in exchange for
2,000 shares of common
stock.
 No cash has changed
hands so this transaction
would be reported in a
separate supplemental
schedule attached to the
statement of cash flows.
Copyright © 2006, The McGraw-Hill Companies, Inc.
A Full-Fledged Statement of Cash Flows: An
Example
Ed's Pizza Hut
Comparative Balance Sheet Account Balances
Cash
Accounts Receivable
Inventory
Land
Equipment
Accumulated Depr.
Accounts Payable
Salaries Payable
Note Payable - Joe Doe
Common Stock
Retained Earnings
McGraw-Hill/Irwin
3/31/2005
DR (CR)
$ 71,000
23,000
350,000
68,000
84,000
(45,000)
(38,000)
(9,000)
(500,000)
(4,000)
$
-
3/31/2004
Change
DR (CR) Incr. (Decr.)
$ 90,000 $ (19,000)
40,000
(17,000)
300,000
50,000
100,000
(32,000)
84,000
(39,000)
6,000
(27,000)
11,000
(14,000)
(5,000)
(50,000)
(50,000)
(450,000)
50,000
(34,000)
(30,000)
$
-
Let’s revisit the
comparative
balance sheet
account balances
for Ed’s Pizza Hut.
Copyright © 2006, The McGraw-Hill Companies, Inc.
A Full-Fledged Statement of Cash Flows: An
Example
Let’s also refresh our memory regarding the following
additional information.
• Additional Information:
 There was a net loss for the year of $27,000.
 Depreciation charges for the year were $6,000.
 During the year, Ed sold land originally costing
$32,000 for $32,000.
 During the year, Ed paid dividends of $3,000 to the
stockholders.
 Ed issued $50,000 of common stock to settle the
note due to Joe Doe.
McGraw-Hill/Irwin
Copyright © 2006, The McGraw-Hill Companies, Inc.
Preparing the Statement of Cash Flows:
Step 1
Ed's Pizza Hut
Statement of Cash Flows Worksheet
Source Cash Flow
AdjustChange
or Use?
Effect
ments
Assets (except cash and
Current assets
Accounts receivable
Inventory
Noncurrent assets
Land
Equipment
Contra Assets, Liabilities,
Contra assets
Accumulated depreciation
Current liabilities
Accounts payable
Salaries payable
Noncurrent liabilities
Notes payable
Stockholders' equity
Common stock
Retained earnings
Net loss
Dividends
Total (net cash flow)
McGraw-Hill/Irwin
Adjusted
Effect
Classification
List each account
appearing on the
comparative balance
sheets except for cash
and cash equivalents
and retained earnings.
Copyright © 2006, The McGraw-Hill Companies, Inc.
Preparing the Statement of Cash Flows:
Step 2
Ed's Pizza Hut
Statement of Cash Flows Worksheet
Source Cash Flow
AdjustChange
or Use?
Effect
ments
Assets (except cash and
Current assets
Accounts receivable
Inventory
Noncurrent assets
Land
Equipment
Contra Assets, Liabilities,
Contra assets
Accumulated depreciation
Current liabilities
Accounts payable
Salaries payable
Noncurrent liabilities
Notes payable
Stockholders' equity
Common stock
Retained earnings
Net loss
Dividends
Total (net cash flow)
McGraw-Hill/Irwin
$
Adjusted
Effect
Classification
(17,000)
50,000
(32,000)
-
6,000
11,000
(5,000)
(50,000)
Compute the change
from the beginning
balance to the ending
balance for each
account.
50,000
(27,000)
3,000
Copyright © 2006, The McGraw-Hill Companies, Inc.
Preparing the Statement of Cash Flows:
Step 3
Ed's Pizza Hut
Statement of Cash Flows Worksheet
Source Cash Flow
AdjustChange
or Use?
Effect
ments
Assets (except cash and
Current assets
Accounts receivable
Inventory
Noncurrent assets
Land
Equipment
Contra Assets, Liabilities,
Contra assets
Accumulated depreciation
Current liabilities
Accounts payable
Salaries payable
Noncurrent liabilities
Notes payable
Stockholders' equity
Common stock
Retained earnings
Net loss
Dividends
Total (net cash flow)
McGraw-Hill/Irwin
$
(17,000) Source
50,000
Use
Source
11,000 Source
(5,000)
Use
(50,000)
Use
50,000
Source
(27,000)
3,000
Use
Use
Classification
Code each entry on
the worksheet as a
source or use of
cash.
(32,000) Source
-
6,000
Adjusted
Effect
{
Recall that the transaction
involving the Notes Payable and
Common Stock was noncash.
Copyright © 2006, The McGraw-Hill Companies, Inc.
Preparing the Statement of Cash Flows:
Step 4
Ed's Pizza Hut
Statement of Cash Flows Worksheet
Source Cash Flow
AdjustChange
or Use?
Effect
ments
Assets (except cash and
Current assets
Accounts receivable
Inventory
Noncurrent assets
Land
Equipment
Contra Assets, Liabilities,
Contra assets
Accumulated depreciation
Current liabilities
Accounts payable
Salaries payable
Noncurrent liabilities
Notes payable
Stockholders' equity
Common stock
Retained earnings
Net loss
Dividends
Total (net cash flow)
McGraw-Hill/Irwin
$
(17,000) Source
50,000
Use
$
(32,000) Source
-
6,000
Classification
17,000
(50,000)
32,000
-
Source
6,000
11,000 Source
(5,000)
Use
11,000
(5,000)
(50,000)
Use
(50,000)
50,000
Source
50,000
(27,000)
3,000
Use
Use
(27,000)
(3,000)
(19,000)
$
Adjusted
Effect
Code sources
of cash as
positive
numbers and
uses of cash
as negative
numbers.
Copyright © 2006, The McGraw-Hill Companies, Inc.
Preparing the Statement of Cash Flows:
Step 5
Ed's Pizza Hut
Statement of Cash Flows Worksheet
Source Cash Flow
AdjustChange
or Use?
Effect
ments
Assets (except cash and
Current assets
Accounts receivable
Inventory
Noncurrent assets
Land
Equipment
Contra Assets, Liabilities,
Contra assets
Accumulated depreciation
Current liabilities
Accounts payable
Salaries payable
Noncurrent liabilities
Notes payable
Stockholders' equity
Common stock
Retained earnings
Net loss
Dividends
Total (net cash flow)
McGraw-Hill/Irwin
$
(17,000) Source
50,000
Use
$
Adjusted
Effect
17,000
(50,000)
-
32,000
-
-
32,000
-
Source
6,000
-
6,000
11,000 Source
(5,000)
Use
11,000
(5,000)
-
11,000
(5,000)
(50,000)
Use
(50,000)
50,000
50,000
Source
50,000
(50,000)
(27,000)
3,000
Use
Use
(32,000) Source
-
6,000
$
(27,000)
(3,000)
(19,000) $
-
$
17,000
(50,000)
{
Make any
Classifinecessary
cation
adjustments,
including
adjustments
for gains and
losses. The
net effect of
these should
equal zero.
We -need to make an adjustment
for the noncash transaction
relating
to Notes Payable and
Common Stock.
$
(27,000)
(3,000)
(19,000)
Copyright © 2006, The McGraw-Hill Companies, Inc.
Preparing the Statement of Cash Flows:
Step 6
Ed's Pizza Hut
Statement of Cash Flows Worksheet
Source Cash Flow
AdjustChange
or Use?
Effect
ments
Assets (except cash and
Current assets
Accounts receivable
Inventory
Noncurrent assets
Land
Equipment
Contra Assets, Liabilities,
Contra assets
Accumulated depreciation
Current liabilities
Accounts payable
Salaries payable
Noncurrent liabilities
Notes payable
Stockholders' equity
Common stock
Retained earnings
Net loss
Dividends
Total (net cash flow)
McGraw-Hill/Irwin
$
(17,000) Source
50,000
Use
$
17,000
(50,000)
-
32,000
-
Source
Adjusted
Effect
17,000
(50,000)
Operating
Operating
-
32,000
-
Investing
6,000
-
6,000
Operating
11,000 Source
(5,000)
Use
11,000
(5,000)
-
11,000
(5,000)
Operating
Operating
(50,000)
Use
(50,000)
50,000
-
50,000
Source
50,000
(50,000)
-
(27,000)
3,000
Use
Use
-
(27,000)
(3,000)
(19,000)
(32,000) Source
-
6,000
$
(27,000)
(3,000)
(19,000) $
$
Classification
$
Classify
each
entry as
operating,
investing
or
financing
activity.
Operating
Financing
Copyright © 2006, The McGraw-Hill Companies, Inc.
Preparing the Statement of Cash Flows:
Step 7
Ed's Pizza Hut
Statement of Cash Flows
For the Period Ending 3/31/2005
Operating Activities
Net Loss
$
Add: Decrease in A/R
Increase in A/P
Increase in Depr. Charges
Less: Increase in Inventory
Decrease in Salaries Payable
Net Cash Flow from Operations
Investing Activities
Proceeds from sale of Land
Financing Activities
Dividends paid
Net change in cash
McGraw-Hill/Irwin
(27,000)
17,000
11,000
6,000
(50,000)
(5,000)
(48,000)
32,000
Copy the data from
the worksheet into
the Statement of
Cash Flows section
by section.
(3,000)
(19,000)
Copyright © 2006, The McGraw-Hill Companies, Inc.
Preparing the Statement of Cash Flows:
Step 8
Ed's Pizza Hut
Statement of Cash Flows
For the Period Ending 3/31/2005
Operating Activities
Net Loss
$
Add: Decrease in A/R
Increase in A/P
Increase in Depr. Charges
Less: Increase in Inventory
Decrease in Salaries Payable
Net Cash Flow from Operations
Investing Activities
Proceeds from sale of Land
Financing Activities
Dividends paid
Net change in cash
Cash, beginning
Cash, ending
$
McGraw-Hill/Irwin
(27,000)
17,000
11,000
6,000
(50,000)
(5,000)
(48,000)
Prepare a cash
reconciliation at the
bottom of the
statement.
32,000
(3,000)
(19,000)
90,000
71,000
Copyright © 2006, The McGraw-Hill Companies, Inc.
Example – Indirect Method
Ed's Pizza Hut
Statement of Cash Flows
For the Period Ending 3/31/2005
Operating Activities
Net Loss
$
Add: Decrease in A/R
Increase in A/P
Increase in Depr. Charges
Less: Increase in Inventory
Decrease in Salaries Payable
Net Cash Flow from Operations
Investing Activities
Proceeds from sale of Land
Financing Activities
Dividends paid
Net change in cash
Cash, beginning
Cash, ending
$
McGraw-Hill/Irwin
(27,000)
17,000
11,000
6,000
(50,000)
(5,000)
(48,000)
32,000
(3,000)
(19,000)
90,000
71,000
In addition, on the
face of the statement
or in a supplemental
schedule, disclose
the issuance of
$50,000 of stock to a
creditor, a noncash
financing activity.
Copyright © 2006, The McGraw-Hill Companies, Inc.
Interpretation of the Statement of Cash
Flows
Examine the operating activities
section carefully.
 Ed’s Pizza Hut generated a negative
cash flow from operations of $48,000.
This is usually a sign of fundamental
difficulties.
 Ultimately, a positive cash flow is
necessary to avoid liquidating assets or
borrowing money to pay for day-to-day
activities.
McGraw-Hill/Irwin
Copyright © 2006, The McGraw-Hill Companies, Inc.
The Direct Method of
Determining the Net Cash
Provided by Operating Activities
Appendix 16A
McGraw-Hill/Irwin
Copyright © 2006, The McGraw-Hill Companies, Inc.
Computing Net Cash Provided by Operating
Activities
The direct method computes
net cash provided by operating
activities by reconstructing the
income statement on a cash
basis from top to bottom.
Cash provided by operating
activities under the direct
method will always agree with
the amount computed using the
indirect method.
McGraw-Hill/Irwin
Copyright © 2006, The McGraw-Hill Companies, Inc.
Similarities and Differences in Handling Data
Revenue or Expense Item
Sales revenue (as reported)
Adjustments to a cash basis:
1 Increases in accounts receivable
2 Decreases in accounts receivable
Cost of goods sold (as reported)
Adjustments to a cash basis:
3 Increase in merchandise inventory
4 Decrease in merchandise inventory
5 Increase in accounts payable
6 Decrease in accounts payable
Operating expenses (as reported)
Adjustments to a cash basis:
7 Increase in prepaid expenses
8 Decrease in prepaid expenses
9 Increase in accrued liabilities
10 Decrease in accrued liabilities
11 Period's depreciation, depletion and
amortization charges
Income tax expense (as reported)
Adjustments to a cash basis:
12 Increase in accrued taxes payable
13 Decrease in accrued taxes payable
14 Increase in deferred income taxes
15 Decrease in deferred income taxes
McGraw-Hill/Irwin
Add (+) or
Deduct (-) to
Adjust to a
Cash Basis
+
+
+
+
+
-
Adjustments for accounts that
affect revenue are the same in
the direct method and indirect
methods.
Adjustments for accounts that
affect expenses are handled in
opposite ways for the direct and
indirect methods.
+
+
Copyright © 2006, The McGraw-Hill Companies, Inc.
Direct Method: Gains and Losses
Regarding gains and
losses on sale of assets,
no adjustments are
needed at all under the
direct method.
McGraw-Hill/Irwin
Copyright © 2006, The McGraw-Hill Companies, Inc.
The Direct Method: An Example
Ed's Pizza Hut
Comparative Balance Sheet Account Balances
Cash
Accounts Receivable
Inventory
Land
Equipment
Accumulated Depr.
Accounts Payable
Salaries Payable
Note Payable - Joe Doe
Common Stock
Retained Earnings
McGraw-Hill/Irwin
3/31/2005
DR (CR)
$ 71,000
23,000
350,000
68,000
84,000
(45,000)
(38,000)
(9,000)
(500,000)
(4,000)
$
-
3/31/2004
Change
DR (CR) Incr. (Decr.)
$ 90,000 $ (19,000)
40,000
(17,000)
300,000
50,000
100,000
(32,000)
84,000
(39,000)
6,000
(27,000)
11,000
(14,000)
(5,000)
(50,000)
(50,000)
(450,000)
50,000
(34,000)
(30,000)
$
-
Let’s revisit the
comparative
balance sheet
account balances
for Ed’s Pizza Hut.
Copyright © 2006, The McGraw-Hill Companies, Inc.
The Direct Method: An Example
Ed's Pizza Hut
Income Statement
For the Year Ended 3/31/2005
Sales
$
1,000,000
Cost of goods sold
750,000
Gross margin
250,000
Operating expenses
277,000
Net loss
$
(27,000)
McGraw-Hill/Irwin
Let’s assume that
Ed’s Pizza Hut
prepared this
income statement.
Copyright © 2006, The McGraw-Hill Companies, Inc.
The Direct Method: An Example
Step 1: Translate sales revenue into cash
collected from customers.
Sales (as reported)
Add: Decrease in accounts receivable
Cash collected from customers
McGraw-Hill/Irwin
$ 1,000,000
17,000
$ 1,017,000
Copyright © 2006, The McGraw-Hill Companies, Inc.
The Direct Method: An Example
Step 2: Translate cost of goods sold into
cash disbursements for purchases.
Cost of goods sold (as reported)
$
Add: Increase in inventory
Less: Increase in accounts payable
Cash paid for purchases
$
McGraw-Hill/Irwin
750,000
50,000
(11,000)
789,000
Copyright © 2006, The McGraw-Hill Companies, Inc.
The Direct Method: An Example
Step 3: Translate operating expenses
into cash paid for operating expenses.
Operating expenses (as reported)
Add: Decrease in salaries payable
Less: Increase in depreciation
Cash paid for operating expenses
$
$
277,000
5,000
(6,000)
276,000
There is not an adjustment needed for
income taxes because Ed’s Pizza Hut has
a net loss of $27,000.
McGraw-Hill/Irwin
Copyright © 2006, The McGraw-Hill Companies, Inc.
The Direct Method: An Example
Ed's Pizza Hut
Statement of Cash Flows
For the Period Ending 3/31/2005
Operating Activities
Cash received from customers
$ 1,017,000
Cash paid for purchases
(789,000)
Cash paid for operating expenses
(276,000)
Net Cash Flow from Operations
(48,000)
Investing Activities
Proceeds from sale of land
32,000
Financing Activities
Dividends paid
(3,000)
Net change in cash
(19,000)
Cash, beginning
90,000
Cash, ending
$
71,000
McGraw-Hill/Irwin
Notice that the
net cash
provided by
operating
activities agrees
with that
computed using
the indirect
method.
Copyright © 2006, The McGraw-Hill Companies, Inc.
End of Chapter 16
Now, this is
what I call
CA$H
FLOW!
McGraw-Hill/Irwin
Copyright © 2006, The McGraw-Hill Companies, Inc.