Chapter 12:
Statement of Cash Flows
General Information on SCF
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Required for financial statements by SFAS 95 (1987).
Primary purpose is to provide relevant information about cash
receipts and cash disbursements of the company during the
year.
Serves to complement the other financial statements.
Focus is on cash flows, not income.
Reconciles the balance sheet and the income statement.
Content of Statement of Cash Flows
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Explains change in cash and cash equivalents.
Cash equivalents are defined as short-term, highly liquid
investments near to maturity.
Examples of cash equivalents are Treasury bills commercial
paper (short-term notes issued by corporations) and money
market funds.
Format of SCF includes the following three sections:
A. Cash flow from operating activities.
B. Cash flow from investing activities.
C. Cash flow from financing activities.
A. Cash Flows from Operating Activities
 CF
from operating activities is based on the income
statement, and converts income activity to a cash basis in
its presentation.
 There are two formats for the presentation of CF from
operating activity:
– direct method: this technique shows cash received
from customers and cash paid to various entities for
operating activities.
– indirect method: this technique starts with net income
and makes adjustments to net income to convert it to a
cash basis.
Cash Flows from Operating Activities
 If
the direct method is used, the indirect method must be
presented in a supplementary schedule.
 The direct method is more informative, but the vast
majority of companies present only the indirect method.
 FASB is considering a change to require the direct
method.
 Our coverage of Chapter 12 will focus only on the indirect
method.
B. Cash Flows from Investing Activities
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CF from investing activities explain the changes in cash from the
purchase or sale of the company’s (primarily) long-term assets.
Examples of investing activity includes:
– cash paid for purchase of equipment, land, buildings,
investments, intangible assets, and most other long term assets.
– cash received from sale of equipment, land, buildings,
investments, intangible assets, and most other long term assets.
C. Cash Flows from Financing Activities
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CF from financing activities explain the changes in cash from the
issue or retirement of the company’s (primarily) long-term
liabilities and equity.
Examples of financing activity includes:
– cash received from issue of bonds, mortgages and other longterm debt.
– cash received from issue of common stock and preferred
stock.
– cash paid for the retirement of long-term debt.
– cash paid for the repurchase of treasury stock.
– cash paid for dividends.
Cash Flows from Financing Activities
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Note that cash paid for dividends is classified as a financing
activity, but cash paid for interest is classified as an operating
activity.
Note that cash received for dividends and cash received for interest
are both classified as operating activities.
How is the cash paid for dividends different from the other
activities? Why did the FASB choose to classify it as a financing
activity?
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FASB chose to leave income related items (int. revenue, int.
expense, div. income) in the operating section, rather than
reclassify.
However, dividends declared has nothing to do with net income,
and must be classified with financing.
A. CF from Operations (indirect method):
Specific Calculations
To understand the adjustments to get from net income to CF
from operations, we will classify the adjustments into 3
categories:
(1) Noncash items.
(2) Double counted gains and losses.
(3) Change in related (accrual basis) assets and liabilities
Remember: net income includes many activities that are
noncash, or only partly cash.
(1) Indirect Method - Noncash Items
Noncash activities include
-Depreciation expense. For example:
Depreciation Expense
xx
Accumulated Depreciation
xx
-Amortization expense on intangible assets such as patents and
goodwill.
Amortization Expense
xx
Goodwill
xx
-Bad debt expense on the estimation of uncollectibles:
Bad Debt Expense
xx
Allowance for Doubtful Accts.
xx
Since these expenses originally reduced net income, the amount of these
expenses would need to be added back to net income to get to cash from
operations.
(2)Indirect Method - Double Counted Items
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The double counted items come from gains and losses on
investing and financing activity.
For example, assume that land is sold for $10,000 cash, and the
original cost was $9,000:
Cash
10,000
Land
9,000
Gain on Sale of Land
1,000
In this case, the $10,000 cash received would be shown in
Investing. However, if the gain is not adjusted out of net income,
we would be “double counting” that effect.
(2)Indirect Method - Double Counted Items
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Therefore, any gains or losses from sale of investing
(nonoperating) assets (equipment, land, buildings, AFS and equity
investments, intangibles). The adjustment to reverse out the
effects would be:
– add the amount of loss to net income.
– subtract the amount of the gain from net income.
The same holds true for gains and losses from the early
extinguishment of debt (like the gains/losses from the retirement of
bonds).
– add the amount of loss to net income.
– subtract the amount of the gain from net income.
(3) Indirect Method Change in Related Assets and Liabilities
 The
third category examines the change in the assets and
liabilities that relate to the remaining income statement
items, after the items in (1) and (2) have been removed.
 The adjustment for the effect of these changes is to
effectively “squeeze” the income statement item from the
accrual basis of accounting to the cash basis of
accounting.
(3) Indirect Method Change in Related Assets and Liabilities
Example: Sales = 100,000, and change in A/R from 2,000 to 3,000
or 1,000 increase .
A/RB + Sales - A/RE = Cash Collections
2,000 + 100,000 - 3,000 = Cash Collections
99,000 = Cash Collections
Note that, to convert from accrual basis sales revenues to cash basis
sales revenues, an increase in A/R should be subtracted from net
income to convert net income to a cash basis.
Correspondingly, a decrease in A/R should be added to net income
to convert net income to a cash basis.
(3) Indirect Method Change in Related Assets and Liabilities
This pair of rules can be expanded to a general set of rules to convert
NI from accrual to cash basis:
Subtract increases in related assets.
Add decreases in related assets.
Add increases in related liabilities.
Subtract decreases in related liabilities.
Mnemonic to help you remember:
AOLS
Assets Opposite, Liabilities Same
(3) Indirect Method Change in Related Assets and Liabilities
The types of assets that relate to the income statement are primarily
current assets, but not always. To decide, you must look at each
asset and its related income statement component. Also,
remember that we are looking at the remaining assets and
liabilities (after the eliminations in part 1). Since we have already
eliminated depreciation expense and amortization expense, etc.,
we would not include the changes in these related assets (Accum.
Depr., Patents, etc.).
(3) Indirect Method Change in Related Assets and Liabilities
(primarily current assets and liabilities)
Examples of related assets are:
Accounts Receivable.
Interest Receivable.
Inventories.
Prepaid Expenses.
Examples of related liabilities include:
Accounts Payable.
Interest Payable.
Wages Payable.
Income Tax Payable.
Other Current Liabilities.
Unearned Revenues.
Additional Issues - SCF
 The
FASB requires that significant noncash investing and
financing activities be disclosed in a note or supplementary
schedule to the SCF.
 Examples of significant noncash investing and financing
activities include:
– conversion of bonds or preferred stock to common
stock.
– purchase of assets with issue of stock.
– purchase of assets with debt.
– declaration (but not payment) of cash dividend.