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With these adjustments to the income statement, we can now present the operating
activities section of the statement of cash flows using either the direct or indirect methods. The indirect method would involve beginning with net income and adding or subtracting the adjustments (in the third column of the matrix) to arrive at cash flow from
operations of $57,000. The direct method would simply detail the figures presented in
the fourth column of the matrix. The formal cash flow statement, using the indirect
method, is shown later in this section.
T-Account Approach to Preparing a
Statement of Cash Flows—Indirect Method
With a comprehensive T-account approach, special “cash flow” T-accounts are established. These accounts are used to summarize cash flows from operations and from
investing and financing activities during the period. They provide the basis for preparing
the formal cash flow statement. Individual T-accounts are also established for Cash and all
other balance sheet accounts.
During the process of analysis, the change in each account is explained as providing
or using cash. In the three T-accounts summarizing cash flows from operating, investing,
and financing activities, a debit represents an increase in cash, while a credit reflects a
decrease. Once the changes in all balance sheet accounts have been reconciled and the
cash flow T-accounts balanced, the formal cash flow statement can be prepared.
In preparing a cash flow statement for Western Resources, Inc., we begin by determining the change in the cash balance, in this case an $8,700 decrease. All noncash
accounts may now be analyzed using the T-accounts illustrated on pages 268 and 269.As
noted, the cash flow statement is prepared directly from the cash flow T-accounts and is
illustrated following those T-accounts.
Generally, the most efficient approach to developing T-accounts for a statement of
cash flows is to begin with an analysis of the change in Retained Earnings. After the
change in Retained Earnings has been accounted for, the remaining noncash accounts
should be reviewed in conjunction with the income statement and supplementary information to determine what additional adjustments are required. Operating income should
be adjusted to determine the actual amount of cash provided or used by operations
[items (e), (i), (j), and (l) – (p)]. Analysis must also be made to determine all other cash
flows from investing and financing activities [items (b), (c), (d), (e), (f), (h), (k), and (q)]
and to reflect significant investing and financing activities that have no effect on cash
[item (g)].
Explanations for individual adjustments for Western Resources, Inc., follow. The letter preceding each explanation corresponds with that used in the T-accounts, which are
presented on pages 268 and 269. Entries are presented to help explain the preparation of
a statement of cash flows. They are not journal entries that would be recorded in the
accounting records.
(a) Net income is recorded in the T-accounts as follows:
Cash Flows—Operating .......................................................................................
Retained Earnings ...........................................................................................
36,300
36,300
(b) The cash dividends declared and deducted from retained earnings are adjusted for
the change in the dividends payable balance in arriving at the amount of dividends
actually paid during the year. The entry would be:
Retained Earnings .................................................................................................
Dividends Payable ..........................................................................................
Cash Flows—Financing ..................................................................................
25,100
4,400
20,700
(c) The destruction of the building and the subsequent insurance reimbursement have
the effect of providing cash of $10,000, the proceeds from the insurance company.
The entry would be:
The Statement of Cash Flows
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Accumulated Depreciation—Buildings ................................................................
Cash Flows—Investing ..........................................................................................
Buildings ..........................................................................................................
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267
30,000
10,000
40,000
(d) The buildings account was increased by the cost of constructing a new building,
$105,000. The cost of the new building is reported separately as an investment of
cash by the following entry:
Buildings ................................................................................................................
Cash Flows—Investing ....................................................................................
105,000
105,000
(e) The sale of long-term investments was recorded by a credit to the asset account at
cost, $96,000, and a credit to a gain on sale of investment account. At the end of the
period, the gain account was closed to Retained Earnings as part of income from
continuing operations. Because the effect of the sale was to provide cash of
$102,500, this amount is reported as cash provided by investing activities. The
investments account balance is reduced, and cash provided by operations is
decreased by the amount of the gain. The following adjustment is made:
Cash Flows—Investing ..........................................................................................
Investments.......................................................................................................
Cash Flows—Operating .................................................................................
102,500
96,000
6,500
(f) and (g) Land was acquired at a price of $108,500; payment was made in common
stock valued at $40,000 and cash of $68,500. Two separate entries are made to segregate the cash and noncash components of this transaction:
(f) Land .................................................................................................................
Cash Flows—Investing ...............................................................................
(g) Land .................................................................................................................
Common Stock ............................................................................................
68,500
68,500
40,000
40,000
The issuance of common stock for land has no effect on cash, but it is a significant
transaction that should be disclosed separately. Recall that the body of the cash flow
statement reports only transactions affecting cash, in accordance with FASB Statement
No. 95.
(h) Machinery costing $12,000 was acquired during the year. Payment was made in cash
and is reported as cash used for investing purposes. The adjustment for the acquisition of machinery is:
Machinery and Equipment ...................................................................................
Cash Flows—Investing ....................................................................................
12,000
12,000
(i) and (j) The changes in the accumulated depreciation accounts and in the patents
account result from the recognition of depreciation and amortization expenses for
the period. These noncash expenses are added in computing cash flows from operations by the following adjustments:
(i) Cash Flows—Operating .................................................................................
Accumulated Depreciation—Buildings ......................................................
Accumulated Depreciation—Machinery and Equipment .........................
(j) Cash Flows—Operating .................................................................................
Patents .........................................................................................................
20,900
5,600
15,300
5,000
5,000
(k) During the year, bonds were issued at their face value of $30,000. The entry is:
Cash Flows—Financing ........................................................................................
Bonds Payable .................................................................................................
30,000
30,000
(l)–(p) In preparing a cash flow statement, operating income must be adjusted from an
accrual basis to a cash basis, as explained earlier in the chapter. The entries (l)
through (p) reflect that analysis for Western Resources, Inc.:
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(l) Cash Flows—Operating .................................................................................
Accounts Receivable ...................................................................................
(m) Cash Flows—Operating .................................................................................
Inventories ...................................................................................................
(n) Prepaid Operating Expenses ..........................................................................
Cash Flows—Operating .............................................................................
(o) Accounts Payable ............................................................................................
Cash Flows—Operating .............................................................................
(p) Cash Flows—Operating .................................................................................
Income Taxes Payable ................................................................................
10,500
10,500
1,500
1,500
4,500
4,500
6,700
6,700
500
500
(q) As noted earlier in the chapter, available-for-sale securities are treated differently
from other current assets in preparing a cash flow statement. The adjustment to
reflect the purchase of $2,000 of available-for-sale securities would be:
Available-for-Sale Securities ................................................................................
Cash Flows—Investing ....................................................................................
2,000
2,000
(r) After all changes in account balances have been reconciled and the effects of the
changes on cash flow have been recorded in the cash flows T-accounts, the balances
of those T-accounts are determined and transferred to a Cash Flows Summary
T-account as shown below. The excess of credits (decreases in cash) over debits
(increases in cash) is equal to the net change in the cash balance for the period of
$8,700. The following entry is made to reflect the net decrease in cash:
Net Decrease in Cash ...........................................................................................
Cash .................................................................................................................
8,700
8,700
Cash Flows—Operating
(a)
(i)
(j)
(l)
(m)
(p)
Net cash provided by operating activities
36,300
20,900
5,000
10,500
1,500
500
(e)
(n)
(o)
6,500
4,500
6,700
57,000
Cash Flows—Investing
(c)
(e)
10,000
102,500
(d)
(f)
(h)
(q)
105,000
68,500
12,000
2,000
75,000
Net cash used in investing activities
Cash Flows—Financing
(k)
Net cash provided by financing activities
30,000
(b)
20,700
9,300
Cash Flows Summary
Net
Net
Net
Net
cash provided—operating
cash used—investing
cash provided—financing
decrease in cash
57,000
75,000
(r)
9,300
8,700
75,000
75,000
The Statement of Cash Flows
❘
Cash and Cash Equivalents
Beg. bal.
55,000
End. bal.
46,300
(r)
70,500
End. bal.
60,000
(l)
8,700
12,000
4,500
End. bal.
16,500
10,000
2,000
End. bal.
12,000
75,000
68,500
40,000
End. bal.
183,500
10,500
Beg. bal.
76,500
End. bal.
75,000
30,000
Beg. bal.
106,000
End. bal.
10,000
Beg. bal.
(d)
225,000
105,000
End. bal.
290,000
1,500
(e)
96,000
(c)
40,000
Machinery and Equipment
Beg. bal.
(i)
155,000
5,600
Beg. bal.
(h)
120,000
12,000
End. bal.
130,600
End. bal.
132,000
Patents
Beg. bal.
(i)
43,500
15,300
End. bal.
58,800
Beg. bal.
40,000
End. bal.
35,000
Accounts Payable
6,700
(m)
Buildings
Accumulated Depreciation—
Machinery and Equipment
(o)
269
Investments
Accumulated Depreciation—Buildings
(c)
❘
Inventories
Land
Beg. bal.
(f)
(g)
Chapter 5
Beg. bal.
(q)
Prepaid Operating Expenses
Beg. bal.
(n)
❘
Available-for-Sale Securities
Accounts Receivable
Beg. bal.
EM
(j)
5,000
Income Taxes Payable
Beg. bal.
97,700
End. bal.
91,000
Beg. bal.
(p)
9,500
500
End. bal.
10,000
Bonds Payable
Dividends Payable
Beg. bal.
(b)
0
4,400
Beg. bal.
(k)
0
30,000
End. bal.
4,400
End. bal.
30,000
Retained Earnings
Common Stock
Beg. bal.
(g)
250,000
40,000
End. bal.
290,000
(b)
25,100
Beg. bal.
(a)
234,300
36,300
End. bal.
245,500
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All T-accounts are now complete, and a statement of cash flows for Western
Resources, Inc., can be prepared in an appropriate format, such as the one below.
Western Resources, Inc.
Statement of Cash Flows
For the Year Ended December 31, 2002
Cash flows from operating activities:
Net income .....................................................................................................
Adjustments:
Depreciation expense ..............................................................................
Amortization of patents ...........................................................................
Gain on sale of investments ....................................................................
Decrease in accounts receivable .............................................................
Decrease in inventories ...........................................................................
Increase in prepaid operating expenses ................................................
Decrease in accounts payable ................................................................
Increase in income taxes payable ...........................................................
Net cash provided by operating activities ....................................................
Cash flows from investing activities:
Involuntary conversion of building ...............................................................
Construction of building ................................................................................
Sale of long-term investments .......................................................................
Purchase of land ............................................................................................
Purchase of machinery and equipment ........................................................
Purchase of available-for-sale securities ......................................................
Net cash used in investing activities .............................................................
Cash flows from financing activities:
Issuance of bonds ..........................................................................................
Payment of cash dividends ............................................................................
Net cash provided by financing activities ....................................................
Net decrease in cash and cash equivalents .......................................................
Cash and cash equivalents at beginning of year...............................................
Cash and cash equivalents at end of year .........................................................
Supplemental Disclosure:
Cash payments for:
Interest ......................................................................................................
Income taxes ............................................................................................
Noncash transaction:
Land acquired by issuing common stock ................................................
$ 36,300
20,900
5,000
(6,500)
10,500
1,500
(4,500)
(6,700)
500
$57,000
$ 10,000
(105,000)
102,500
(68,500)
(12,000)
(2,000)
(75,000)
$ 30,000
(20,700)
9,300
$ (8,700)
55,000
$46,300
$
3,600
23,500
40,000
A reader analyzing the cash flow statement for Western Resources, Inc., can readily
see that $57,000 cash was provided internally from operating activities. This amount was
not sufficient to satisfy the investment needs of the company, and so additional cash was
generated from external financing activities involving the issuance of bonds. The cash
generated from operations clearly met the need for payment of cash dividends, but when
other cash needs are considered, the total cash outflow exceeded the total inflow of cash
for the period, causing the cash balance to decrease by $8,700, or 15.8%.
In addition to the formal statement of cash flows, supplemental disclosure is
required for significant noncash investing and financing transactions. Thus, Western
Resources would report the acquisition of land valued at $40,000 in exchange for common stock. When the indirect method is used to report operating activities, the amount
of cash paid for interest and income taxes also must be disclosed. For Western Resources,
the amount paid for interest, $3,600, is taken directly from the income statement because
there is no interest payable at the beginning or end of the year. The amount paid for taxes
is determined as follows:
The Statement of Cash Flows
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271
Income tax expense (reported in the income statement) ..........................................................
Deduct increase in income taxes payable ..............................................................................
$24,000
(500)
Amount of cash paid for income taxes ..................................................................................
$23,500
In the Western Resources illustration, the supplemental disclosures are presented in
a schedule accompanying the statement of cash flows. Alternatively, the information
could be presented in the notes to the financial statements.
Work Sheet Approach to Preparing a
Statement of Cash Flows—Indirect Method
This section illustrates a work sheet approach to preparing a statement of cash flows
using the indirect method. As shown, this approach produces the same results as the Taccount approach; only the format is different. To highlight the similarities in the two
approaches, the information and account analysis used in the T-account illustration for
Western Resources, Inc., will also be used for the work sheet illustration.
Using a work sheet, such as the one on page 272, facilitates the analysis of account
changes when using the indirect method. The format of the work sheet is straightforward. The first amount column contains the beginning balances, then there are two
columns for analysis of transactions to arrive at the ending balances in the fourth column.
In preparing a work sheet, accumulated depreciation balances, instead of being
reported as credit balances in the debit (asset) section, may be more conveniently listed
with liability and owners’ equity balances in the credit section. Similarly, contra liability
accounts and contra owners’ equity balances may be separately recognized and more
conveniently listed with assets in the debit section.
The lower portion of the work sheet shows the major categories of cash flows: operating, investing, and financing. A debit in the lower section means an increase in cash,
while a credit is a decrease in cash. It is from the lower section of the work sheet that the
formal statement of cash flows is prepared. In following the illustration, it may be helpful to refer to the detailed explanations for individual adjustments described on 266–268.
Once the changes in all accounts have been reconciled and the work sheet is complete,
the formal cash flow statement can be prepared, as illustrated on page 270.
CONCLUSION
This chapter has been an overview of the statement of cash flows. Along with the balance sheet and the income statement, the statement of cash flows is one of the three primary financial statements. However, because it is relatively new (required only since
1988), it sometimes does not receive the emphasis that it deserves. Cash flow variables
and ratios are only now starting to make it into the mainstream of financial statement
analysis. You are now a cash flow statement expert; be patient with those who learned
their accounting back in the pre-1988 days of the statement of changes in financial position.
All the basic aspects of cash flow reporting and disclosure have been covered in this
chapter. Additional complexities are introduced in later chapters as appropriate. An
expanded illustration, incorporating these complexities, is provided in the last chapter of
the text. You might start thinking now about how the cash flow statement will be
affected by revenue recognition assumptions, FIFO and LIFO, capitalize or expense decisions, operating leases, bonds issued at a discount, stock splits and dividends. . . .
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Western Resources, Inc.
Work Sheet for Statement of Cash Flows—Indirect Method
For the Year Ended December 31, 2002
Balance
Dec. 31,
2001
Accounts
Adjustments
Debit
Credit
Balance
Dec. 31,
2002
Debits
Cash and Cash Equivalents .........................................................
Available-for-Sale Securities .......................................................
Accounts Receivable ....................................................................
Inventories ....................................................................................
Prepaid Operating Expenses ......................................................
Investments ..................................................................................
Land ..............................................................................................
55,000
10,000
70,500
76,500
12,000
106,000
Buildings .......................................................................................
Machinery and Equipment ..........................................................
Patents ..........................................................................................
225,000
120,000
40,000
(q)
(r)
8,700
(l)
(m)
10,500
1,500
(e)
(f)
96,000
68,500
(c)
40,000
(j)
5,000
2,000
(n)
4,500
(g)
(d)
(h)
75,000
40,000
105,000
12,000
790,000
46,300
12,000
60,000
75,000
16,500
10,000
183,500
290,000
132,000
35,000
860,300
Credits
Accumulated Depreciation—Buildings .......................................
Accumulated Depreciation—Machinery and Equipment ..........
Accounts Payable.........................................................................
Income Taxes Payable..................................................................
Dividends Payable .......................................................................
Bonds Payable .............................................................................
Common Stock .............................................................................
Retained Earnings ........................................................................
155,000
43,500
97,700
9,500
–0–
–0–
250,000
234,300
(c)
30,000
(o)
6,700
(b)
790,000
Cash flows from operating activities:
Net income .............................................................................
Adjustments:
Depreciation expense ......................................................
Amortization of patents ...................................................
Gain on sale of investments .............................................
Decrease in accounts receivable .....................................
Decrease in inventories ....................................................
Increase in prepaid operating expenses .........................
Decrease in accounts payable.........................................
Increase in income taxes payable ...................................
Cash flows from investing activities:
Involuntary conversion of building ........................................
Construction of building ........................................................
Sale of long-term investments ................................................
Purchase of land ....................................................................
Purchase of machinery and equipment ................................
Purchase of available-for-sale securities...............................
Cash flows from financing activities:
Issuance of bonds...................................................................
Payment of cash dividends ....................................................
Net decrease in cash...................................................................
25,100
(i)
(i)
5,600
15,300
(p)
(b)
(k)
(g)
(a)
500
4,400
30,000
40,000
36,300
130,600
58,800
91,000
10,000
4,400
30,000
290,000
245,500
293,800
860,300
293,800
(a)
36,300
(i)
(j)
20,900
5,000
(l)
(m)
10,500
1,500
(p)
500
(c)
10,000
(e)
102,500
(e)
6,500
(n)
(o)
4,500
6,700
(d)
105,000
(f)
(h)
(q)
68,500
12,000
2,000
(k)
30,000
225,900
(r)
217,200
8,700
225,900
225,900
(b)
20,700