Statement of Cash Flows: Financial Accounting Chapter 11 Study Notes

Statement of Cash Flows

Introduction

The Statement of Cash Flows is a key financial statement that reports a company's cash inflows and outflows over a specific period. It provides essential information about the sources and uses of cash, helping users assess the company's liquidity, financial flexibility, and overall financial health.

Purposes of the Statement of Cash Flows

Reporting Cash Flows

• Cash receipts: Inflows of cash from various activities.

• Cash payments: Outflows of cash for expenses, investments, and financing.

• Time span: Covers a period such as a month, quarter, or year.

Four Main Purposes

• Predicts future cash flows: Assists in forecasting the company's ability to generate cash.

• Evaluates management decisions: Shows how management's actions affect cash position.

• Determines ability to pay dividends and interest: Indicates if the company can meet obligations to shareholders and creditors.

• Shows relationship of net income to cash flows: Highlights differences between accrual-based net income and actual cash movements.

Timing of Financial Statements

Exhibit 11-1: Timing Overview

• Balance Sheet: Reports financial position at a point in time.

• Income Statement, Statement of Stockholders' Equity, Statement of Cash Flows: Report activities over a period of time.

Types of Business Activities

Operating, Investing, and Financing Activities

• Operating Activities: Transactions that create revenues, expenses, gains, and losses, resulting in net income.

• Investing Activities: Transactions that increase or decrease long-term assets, such as plant assets and investments.

• Financing Activities: Transactions related to long-term liabilities and owners' equity, such as issuing debt or stock.

Exhibit 11-2: Effects on Balance Sheet

• Operating cash flows affect current assets and current liabilities.

• Investing cash flows affect long-term assets.

• Financing cash flows affect long-term liabilities and stockholders' equity.

Formats for Operating Activities

Indirect vs. Direct Method

• Indirect Method: Reconciles net income to net cash provided by operating activities by adjusting for non-cash items and changes in working capital.

• Direct Method: Reports all cash receipts and cash payments from operating activities directly.

Indirect Method	Direct Method
Net income: $600 Adjustments: Depreciation, etc.: $300 Net cash provided by operating activities: $900	Collections from customers: $2,000 Deductions: Payments to suppliers, etc.: ($1,100) Net cash provided by operating activities: $900

Preparing the Statement of Cash Flows: Indirect Method

Key Steps

• Start with net income from the income statement.

• Add back non-cash expenses (depreciation, depletion, amortization).

• Adjust for gains and losses on sale of long-term assets.

• Adjust for changes in current assets and current liabilities (excluding cash).

Exhibit 11-4 & 11-5: Comparative Balance Sheets and Income Statement

• Use comparative balance sheets to determine changes in assets and liabilities.

• Income statement provides net income and non-cash expenses.

Exhibit 11-6: Example Statement (Indirect Method)

• Net income: $53,000

• Adjustments: Depreciation ($18,000), Gain on sale of assets ($8,000), Changes in receivables, payables, inventory, etc.

Adjustments Explained

• Depreciation, Depletion, Amortization: Added back to net income because these expenses reduce net income but do not affect cash.

• Gains and Losses on Sale of Long-Term Assets: Subtract gains and add losses to reconcile net income to cash flow.

• Changes in Current Assets: Increase in noncash current assets decreases cash; decrease increases cash.

• Changes in Current Liabilities: Increase in current liabilities increases cash; decrease decreases cash.

Cash Flows from Investing Activities

Definition and Examples

• Affect long-term assets such as plant assets and investments.

• Increase (purchase of assets) decreases cash.

• Decrease (sale of assets) increases cash.

Exhibit 11-8: Computing Cash Flows from Investing Activities

Activity	Cash Flow Effect
Purchase of plant assets	Decrease in cash
Sale of plant assets	Increase in cash
Loan to another company	Decrease in cash
Collection of loan	Increase in cash

Cash Flows from Financing Activities

Definition and Examples

• Affect liabilities and stockholders' equity (e.g., notes payable, bonds payable, common stock, retained earnings).

• Most data are obtained from the balance sheet.

• Increase in financing sources (e.g., issuing debt or stock) increases cash.

• Decrease (e.g., repayment of debt, payment of dividends) decreases cash.

Exhibit 11-9: Computing Cash Flows from Financing Activities

Activity	Cash Flow Effect
Issuance of long-term debt	Increase in cash
Repayment of long-term debt	Decrease in cash
Issuance of common stock	Increase in cash
Payment of dividends	Decrease in cash

Noncash Investing and Financing Activities

Definition and Examples

• Some investing and financing activities do not involve cash directly but are significant for financial analysis.

• Examples: Acquisition of assets by issuing stock, conversion of debt to equity.

Noncash Activity	Amount (Thousands)
Acquisition of building by issuing common stock	300
Acquisition of land by issuing note payable	100
Payment of long-term debt by issuing common stock	70
Total noncash investing and financing activities	470

Preparing the Statement of Cash Flows: Direct Method

Overview

• Preferred by FASB and IASB for its clarity in showing sources and uses of cash.

• Rarely used in practice due to complexity and data requirements.

• Investing and financing sections are unaffected by the method chosen.

Key Components

• Cash Receipts: Collections from customers, interest and dividends, other operating receipts.

• Cash Payments: Payments to suppliers, employees, interest, income taxes, other operating expenses.

• Depreciation, depletion, and amortization: Not listed, as they do not affect cash.

Exhibit 11-13: Example Statement (Direct Method)

Receipts	Amount (Thousands)
Collections from customers	288
Interest received	2
Total cash receipts	290

Payments	Amount (Thousands)
To suppliers	(133)
To employees	(59)
For interest	(7)
For income taxes	(15)
Other operating payments	(17)
Total cash payments	(231)

Computing Cash Flows: Direct Method Details

Cash Collections from Customers

• Formula: $\text{Beginning Accounts Receivable} + \text{Sales} - \text{Collections} = \text{Ending Accounts Receivable}$

• Example: $81,000 + 303,000 - X = 96,000$; thus, $X = 288,000$

Cash Receipts of Interest and Dividends

• Interest and dividend receipts are included in operating cash flows.

• Example: $2,000$ interest revenue; no dividend revenue.

Payments to Suppliers and Employees

• Payments to suppliers: Based on purchases and changes in accounts payable.

• Payments to employees: Based on salary and wage expense and changes in salary and wage payable.

Summary of TRRS's 2024 Transactions

Operating Activities

• Sales on credit: $303,000

• Collections from customers: $288,000

• Interest revenue and receipts: $2,000

• Cost of goods sold: $150,000

• Purchases of inventory on credit: $147,000

• Payments to suppliers: $133,000

• Salary and wage expense: $56,000

• Payments of salary and wages: $59,000

• Depreciation expense: $18,000

• Other operating expense: $17,000

• Income tax expense and payments: $15,000

• Interest expense and payments: $7,000

Investing Activities

• Cash payments to acquire plant assets: $196,000

• Loan to another company: $21,000

• Proceeds from sale of plant assets: $62,000 (including $8,000 gain)

Financing Activities

• Proceeds from issuance of long-term debt: $94,000

• Proceeds from issuance of common stock: $4,000

• Payment of long-term debt: $11,000

• Declaration and payment of cash dividends: $17,000

Key Formulas

• Indirect Method: $\text{Net Cash from Operating Activities} = \text{Net Income} + \text{Non-cash Expenses} - \text{Gains} + \text{Losses} + \text{Decrease in Current Assets} - \text{Increase in Current Assets} + \text{Increase in Current Liabilities} - \text{Decrease in Current Liabilities}$

• Direct Method (Collections from Customers): $\text{Beginning Accounts Receivable} + \text{Sales} - \text{Collections} = \text{Ending Accounts Receivable}$

Summary Table: Statement of Cash Flows Sections

Section	Main Activities	Examples
Operating	Cash from core business operations	Receipts from customers, payments to suppliers/employees
Investing	Cash from buying/selling long-term assets	Purchase/sale of equipment, loans to other companies
Financing	Cash from borrowing/repaying debt, issuing stock	Issuance/repayment of debt, payment of dividends

Conclusion

The Statement of Cash Flows is essential for understanding a company's liquidity and financial flexibility. Both the indirect and direct methods provide valuable insights, with the indirect method being more commonly used in practice. Mastery of this statement enables better analysis of a company's ability to generate cash, meet obligations, and make strategic decisions.