13-1

FINANCIAL ACCOUNTINGAN INTRODUCTION TO CONCEPTS,

METHODS, AND USES10th Edition

Chapter 13 – Statement of Cash Flows: Another Look

Clyde P. Stickney and Roman L. Weil

13-2 Learning Objectives

1. Review the rationale for the statement of cash flows, particularly regarding why net income differs from cash flows.

2. Review the T-account procedure for preparing the statement of cash flows.

3. Cement an understanding of the effect on the statement of cash flows of various transactions in chapters 6-12.

4. Develop more effective skills in analyzing and interpreting the statement of cash flows.

13-3 Chapter Outline

1. Review of basic concepts.2. Review of T-account procedure for

preparing the statement of cash flows.3. Comprehensive illustration of the statement

of cash flows.4. Interpreting the statement of cash flows.

a. Relation between net income and cash flow from operations.

b. Relations between cash flows from operations, investing, and financing activities.

13-4 1. Review of Basic Concepts

1. The statement of cash flows explains the reasons for a change in cash.

2. Revenues from sales do not necessarily equal cash.

3. Firms typically use the indirect method.4. Cash from investing includes purchases and sales

of marketable securities and p.p.&e.5. Cash from financing includes short- and long-term

borrowing, changes in stock and dividends.Chapter Summary

13-5 1.a. Algebraic Formulation

Recall the basic accounting equation:Assets = Liabilities + Shareholders’ Equity

or A = L + SEAssets are either cash (C) or not (N$A), so

C + N$A = L + SE C + N$A = L + SE

where means the change in the balance.Rearranging gives the basic equation for the

statement of cash flows: C = L + SE - N$A

13-6 1.a. Algebraic Formulation (Cont.)

C = L + SE - N$A The change in cash, C, is the increase or

decrease in the cash account. This amount must equal changes in liabilities

plus changes in shareholders’ equity minus changes in assets other than cash.

Thus, we can identify the causes in the change in the cash account by studying the changes in non-cash accounts.

13-7 1.b. Sections of the Cash Flow Statement

The statement of cash flows is divided into three sections:1. Cash flow from operations.

The core business of the firm Shows the ability of the firm to produce cash

2. Cash flow from investing. Buying or selling long-lived assets Shows the investment in and retirements of

income producing assets3. Cash flow from financing.

Changes in the obligations to owners or creditors

Shows new investments or distributions to owners or creditors

13-8Components of the Cash Flow Statement

Cash received fromsale of goodsand services

Cash received fromsale of goodsand services

Cash paid foroperating goods

and services

Cash paid foroperating goods

and services

cash flowfrom operations

cash flowfrom operationsOperations - =

Cash received fromsales of investments

and PP&E

Cash received fromsales of investments

and PP&E

Cash paid for ac-quisition of invest-ments and PP&E

Cash paid for ac-quisition of invest-ments and PP&E

cash flowfrom investing

cash flowfrom investingInvesting - =

Cash received fromissue of debt or

capital stock

Cash received fromissue of debt or

capital stock

Cash paid for dividends and

reacquisition of debt or capital stock

Cash paid for dividends and

reacquisition of debt or capital stock

cash flowfrom financing

cash flowfrom financingFinancing - =

Net change in cashfor the period

Net change in cashfor the period

=

+ or -

+ or -

cash inflows cash outflows

13-9 2. Review of T-Account Procedure

1. Obtain balance sheet for beginning and ending of period.

2. Prepare T-account work sheet.3. Explain the change in the master cash

account by the changes in the other balance sheet accounts.

4. Prepare a statement of cash flows using the T-account work sheet.

13-10 2. T-account Worksheet

Cash

beginningbalance

Operations

Investing Financing

endingbalance

Various Balance Sheet Accounts

beginningbalance endingbalance

nnnnnn

nnnnnn

1. Adjustments are made to all balance sheet accounts to bring the beginning balance to the ending balance.

2. These are offset by an opposite entry in the Cash account.

3. This part of the Cash account becomes the cash flow statement.

13-11 3. Comprehensive Illustration of the Statement of Cash Flows

This extensive example (text pages 737-54) contains illustrations of the many concepts that have been addressed in the text.

Both journal entries and the effects on the basic accounting equation are shown.

Four items merit special attention because they were not covered earlier:a. Loss on sale of marketable equity securities b. Deferred income taxesc. Amortization of bond premium d. Equity in undistributed earnings of affiliate

13-12 3.a. Loss on Sale of Marketable Equity Securities

The journal entry shows the sale of the securities and the adjustment to market.

(4) Cash 50Realized loss on sale 30 Marketable securities 80

Marketable securities 10 Unrealized holding loss 10

13-13 3.a. Loss on Sale of Marketable Equity Securities (Cont.)

The second line represents a loss which was deducted from income. Losses are added back in the operations section as a step in undoing the accruals to arrive at as estimate of cash flows.

Marketable are a current or short-term asset. However, they are sufficiently peripheral to the core business of most firms that many accountants classify them as investing activities. The net inflow from the sale and the reversal of the unrealized loss is +$70.

13-14 3.b. Deferred Income Taxes

The firm paid income taxes and deferred the difference between tax expense and tax liability.

The journal entry is given below.

(5) Income tax expense 300 Cash 200

Deferred income tax liab. 100

13-15 3.b. Deferred Income Taxes (Cont.)

The cash expenditure portion of this entry has already been covered in net income, so no further adjustment is needed.

However, $100 of the tax expense was a noncash expenditure which needs adjusting.

So $100 is a noncash expense of $100 which is added back in the operations section of the cash flow statement and is hence an inflow.

13-16 3.c. Amortization of Bond Premium

The firm paid interest on a bond issued at a premium. The journal entry is given below.

Each line of this entry requires an adjustment in the statement of cash flows.

(6) Interest expense 450Bonds payable 50

Cash 500

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3.c. Amortization of Bond Premium (Cont.)

The firm spent $500 of cash but recognized only $450 of interest expense because of the amortization of the premium.

This $50 difference is a reduction in expense from what would be recognized on the cash basis.

Whereas noncash expenses are added back, reductions in noncash expenses are subtracted.

The adjustment is to operations for an outflow of $50.

13-18 3.d. Equity in Undistributed Earnings of Affiliate

The firm owns 40% of the common stock of another company which earned $1,200 and paid $400 in dividends.

The journal entries are given below.

(8) Investment in Company B 480 Equity in earnings of affiliate 480

Cash 160 Investment in Company B 160

13-19 3.d. Equity in Undistributed Earnings of Affiliate (Cont.)

The firm recognized $480 of equity income but only receives $160 of it in cash.

The noncash income is the difference ($480 - 160 = $320).

Income is an operations activity and this amount overstates income, so it must be subtracted from net income.

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4. Interpreting the Statement of Cash Flows

In order to understand the cash flow statement, the reader needs to understand:

a. Relation between net income and cash flow from operations, and

b. Relations among cash flows from operations, investing, and financing activities.

13-21 4.a. Relation between Net Income and Cash Flow from Operations

Net income and cash flow from operations differ for two principal reasons:

1. Changes in noncurrent assets and noncurrent liabilities.

2. Changes in operating working capital accounts.

13-22 4.a.1. Changes in Noncurrent Assets and Noncurrent Liabilities

Capital-intensive firms will likely show a substantial add-back to net income for depreciation expense, whereas service firms will show a smaller amount.

Firms engaged in acquisitions may show an add-back for amortization of goodwill.

Rapidly growing firms usually show add-backs for deferred taxes.

Firms that decrease in size will usually show additions or subtractions for losses or gains on the disposal of assets.

13-23 4.a.2. Changes in Operating Working Capital Accounts

Working capital is current assets minus current liabilities and is a measure of the net near-cash assets of the firm.

The adjustments for working capital accounts depend in part on a firm’s rate of growth.

Some firms use suppliers or other creditors to finance these working capital needs,

Other firms may use short- or long-term borrowing or equity financing which would be shown under the financing section.

13-24 4.b. Relations among Cash Flows from Operations, Investing, and Financing Activities

The product life cycle provides insights into the relations amount the sections.

Typical products are assumed to pass through four phases:1. Introduction2. Growth3. Maturing4. Decline

13-254.b.1. Introduction Phase

During the introduction phase, cash outflow exceeds cash inflow from operations because operations not yet earning profits with the firm must invest in inventories and fixed assets.

A large inflow of cash from financing activities is needed during this phase.

Operations and investing are outflows balanced by large financing inflows.

13-264.b.2. Growth Phase

The growth phase reflects increasing sales of the product.

Net income becomes positive. Further investments in fixed assets are needed to

meet the sales growth. Continued large inflows of financing is needed for

the new investment. Sales are growing but may not be profitable yet.

The operating cash flow can be small or still negative.

13-274.b.3. Maturing Phase

With the maturing of a product, net income peaks and investment and financing cash flows are reduced.

Operations should provide a significant inflow.

Financing may show an outflow as debt is repaid and investors take dividends.

13-284.b.4. Decline Phase

Weakening profits indicate the decline phase. Revenues may decline and expenses increase

as machinery wears and is not replaced. Operating cash flow may slow and no new

investments are made. Any cash inflow goes to repay financing or

taken as dividends by shareholders. Some inflows from investing may occur as

assets are retired or sold.

13-29Chapter Summary

This chapter presents a second look at the statement of cash flows.

The t-account method is reviewed. And further details are presented on

transactions that effect the cash flow statement. Relations between net income and operating

cash flows are explained. Relations among the three cash flow sections

are explained.