Chapters 4 B: Statement of Cash Flows

Chapters 4 B
Statement of Cash Flows

Objectives of this Chapter
I. Identify business activities which can

generate or use cash and differentiate
between income flows (i.e., accrual
basis) and cash flows from operating
activities.
II. The Importance and the usefulness of

the statement of cash flows.
Statement of Cash Flows 2
Objectives of this Chapter (contd.)
III. Learn how to prepare the statement of
cash flows.
VI. The “cash burn rate” and the use of this
rate in evaluating the financial viability of
start-up companies.
V. Learn the two alternatives (direct and
indirect methods) in preparing net cash
flows from operating activities.

I. Activities which can either generate
cash or use cash for a business entity
A. Operating activities.
B. Investing activities.
C. Financing activities.

A. Operating Activities (i.e., sales
revenue, expenses)
n All these activities are reported in the I/S
(income statement). However, I/S only
provides the accrual-basis net income
(revenue –expense + gains – losses )
which very often is not the change in
cash.
n Therefore, we need to adjust from net
income flows to cash flows in order to
report the net cash provided by (or used
in) operating activities .
A. Operating Activities (contd.)
n There are two approaches to reconcile
net income to net cash provided by (or
used in) operating activities:
1. Indirect Method
==> Lump-Sum Adjustment
2. Direct Method
==> Individual Account Adjustment

1. Indirect Method
n Adjust net income (the lump sum

amount of all revenues and expenses)
for all differences between income
flows and cash flows.

2. Direct Method
n Adjust each revenue account to cash
collection and adjust each expense
account to cash payment. Subtract total
cash payments from total cash collections
to derive net cash flows of the operation
activities.
n SFAS No. 95 allows a choice between the
direct and indirect approach for the cash
flow statement
Cash flows from operating activities
n Cash Inflows:
1. Collections from customers including
cash received from sales (or services)
and collections of A/R.
2. Cash receipts of interests or dividends.
3. Collections of other operating receipts
(i.e., unearned revenue, rent revenue).

Cash Flows from
Operating Activities (contd.)
n Cash Outflows:
1. Payments to suppliers.
2. Payments to employees.
3. Payments for interest expense.
4. Payments for income taxes.
5. Payments for other expenses(i.e.,
Prepaid expenses; rent expenses).

Activities which can either generate

B. Investing Activities
n In addition to generate cash from or use cash
in the operating activities, companies can also
generate cash from (or use cash in) investing
activities.

Cash Flows from
Investing Activities
n Transactions involving acquiring
(Investing (Cash outflows)) and selling
(Disinvesting (Cash inflows)) :
a. Property, Plant and Equipment.
b. Investments (current and non-
current).
c. Notes Receivable (current and non-
current).
Notes Receivable
n Notes Receivable (current and non-
current), including:
u Lending money (N/R , cash outflow);
u Collecting of loan (N/R , cash
inflow);
u Selling of N/R (N/R, discounting N/R,
cash inflow)
Activities which can either generate

C. Financing Activities
n Companies can also generate cash or

use cash through financing activities:

Cash Flows from
Financing Activities
n Obtaining resources from owners and
creditors (cash inflows) and repaying
the amount borrowed (cash outflows).
n Cash inflows:
u Cash received from issuance of
common stock.
u Cash received from issuance of bonds.
u Cash received from issuance of N/P
(short-term or long term).
Cash Flows from
Financing Activities (contd.)
n Cash Outflows:
u Retirement of bonds.
u Retirement of stock.
u Payments of N/P.
u Payments of dividends.

II. The Importance and Usefulness of
the Statement of Cash Flows
 Possible earnings managements may result
in unreliable accrual earnings.
 Accrual accounting relies on many
subjective judgments that may introduce
measurement error and uncertainty into
reported earnings.
 One-time write-offs and restructuring
charges can reduce the quality of reported
earnings.
 For these reasons, analysts scrutinize a
firm’s cash flows—not just its accrual
earnings—to evaluate performance and
creditworthiness.
The Importance and Usefulness of the
Statement of Cash Flows (cont.)
n In order to show cash flows of a
company, cash flows of all three
activities should be reported.
n In doing so, investors can also obtain
all the information of operating,
investing, and financing activities of a
company. Moreover, the following
questions can also be answered:
The Importance and the Usefulness of
the Statement of Cash Flows (contd.)
1. What is the relationship between net
income and cash provided by
operations?
2. Why did cash decreased when net
income increased?
3. What expansion (investment) activities
took place and how were they
financed?
The Importance and the Usefulness of
the Statement of Cash Flows (contd.)
4. How much is the cash provided by
operating activities?
5. What happened to the proceeds
received from issuance of bonds or
common stock?
All of these cannot be answered from
either the income statement or the
balance sheet statement.
SFAS No. 95
n To improve the comparability, SFAS

No. 95, “Statement of Cash Flows,”
requires companies present the
statement of cash flows using a specific
format.

SFAS No. 95 (contd.)
n Following SFAS No. 95, the statement

of cash flows should have three
sections:
1. Cash flows from operating activities
(using a direct or an indirect method).
2. Cash flows from investing activities.
3. Cash flows from financing activities.
Cash flow statement:
Wal-Mart example
Adjustments to accrual earnings
4-25
Cash flow statement:
Wal-Mart example
4-26
III. Procedures for Preparation of
the Statement of Cash Flows
1. Operating Cash Flows (indirect
method).
2. Investing Cash Flows.
3. Financing Cash Flows.

1. Operating Cash Flows
(Indirect Method; Reconciliation Method)
Net Income
 Adjustments
+ Any increase in current Liabilities (except
for N/P)
+ Any decrease in current assets (except for
cash and N/R)
- Any decrease in current liabilities (except
for N/P)
- Any increase in current assets (except for
cash and N/R)
2. Investing Cash Flows
Inflows: decrease in noncurrent assets
(i.e., long-term investments,
P.P.E.) and certain current
assets (i.e., trading securities,
N/R).
Outflows: increases in noncurrent assets

and certain current assets

3. Financing Cash Flows
Inflows: increases in noncurrent liabilities
(i.e., B/P, N/P), stockholders’
equity and certain current liability
(i.e., N/P).
Outflows: decreases in noncurrent

liabilities, stockholders’ equity,
certain current liability and
dividend payment.
Adjustments to Convert Net Income to
Net Cash Flow from Operating Activities
Net Income
+ Depreciation, depletion and amortization

expense, B/D expense
+ Amortization of discount on B/P
+ Amortization of premium on investment
Adjustments
in bonds
+ Increase in deferred income tax liability
+ Loss on disposal of assets or liabilities
+ Investment loss under the equity method
Adjustments to Convert Net Income to Net
Cash Flow from Operating Activities (contd.)
+ Increases in current liabilities other than N/P
(i.e., A/P, salaries payable, interest payable, I/T
payable, deferred I/T, and any other current
liabilities related to operations)
+ Decreases in current assets other than cash
and N/R (i.e., A/R, interest receivable,
inventory, prepaids, and any other current
assets related to operations)

Adjustments to Convert Net Income to Net
Cash Flow from Operating Activities (contd.)
- Amortization of premium on B/P
- Amortization of discount on investment
Adjustments
in bonds
- Gain on disposal of assets or liabilities
- Investment income under the equity
method
- Decrease in deferred income tax liability
- Decreases in current liabilities
- Increases in current assets
||
Net Cash Flows from Operating Activities
Adjustments:
+ Amortization of Discount on B/P
n Example: Issue a 2-year bond, market int.
rate = 12%, bond int. rate = 10%
P.V. of Bond = $10,000 x 0.797 + 1,000 x
1.690 = 9,600
1. 1/1/x1
Cash 9,660
Discount on B/P 340
B/P 10,000
Adjustments:
+ Amortization of Dis. on B/P (contd.)
2. Payment of Interest on 12/31/x1
Interest Expense
(12% x 9660) 1159.2
Cash 1,000.0
Dis. On B/Pa 159.2
a. Amortization of bond discount increase
interest expense but does not use cash.
Adjustments:
+ Amortization of Dis. on B/P (contd.)
3. Payable of Interest on 12/31/x2
Interest Expense
(9660 +159.2)  0.12 1,174.4
Cash 1,000.0
Discount On B/P 174.4
Dis
340 159.2
174.4
Adjustments:
+ Amortization of Premium on Investment in Bonds
n Example: GEO Corp. purchased

$100,000, 10% 5-year bonds on 1/1/x2,
with interest payable on 7/1 and 1/1.
The bonds sell for $108,111 which
results in bond premium of $8,111 and
an effective interest rate of 8%.

+ Amortization of Premium on
Investment in Bonds (contd.)
Example (contd.)
Record the purchase on 1/1/x2:
Investments 108,111
Cash 108,111
Record the interest revenue on 7/1/x2:
Cash 5,000
Interest Revenue 4,324a
Investments 676
a. Interest revenue = $108,111 x 4% = $4,324
Adjustments:
+ Loss on Disposal of PPE or Investments
n Example: Sale a piece of land with a
cost of $7,000 for $5,000
Cash 5,000
Loss on Sale of Landa 2,000
Land 7,000
a. This transaction results in a cash increase of
$5,000 reported in the investing activity section,
not the operating activity section.
Adjustments:
+ Investment Loss under equity method
n Equity method must be used to account
for return on investment in stock when
gaining ownership of 20% ~ 50% with
significant influence.
n Example:
Obtain 30% of ownership with
significant influence on investment in
stock of Green Corp. for $40,000
+ Investment Loss under equity method
(contd.)
2/4/x2
Investment in Stock 40,000
Cash 40,000
12/31/x2
Green’s Loss of Year x2
= 100,000
Loss in Investment 30,000
Investment in Stock 30,000
Data needed to prepare statement
of cash flows
1. Comparative balance sheet statements.
2. The income statement.
3. The retained earnings statement.
4. Other supplemental information
concerning the reasons for the changes
in the B/S accounts (other than cash).

Example 1
Layton Company Balance Sheet (12/31/x2)
Balance Balance Change
Accounts 1/1/x2 12/31/x2
Cash 4,000 6,600
A/R 6,300 9,000 2,700
Land 9,000 6,000 3000a
Buildings & Equipment 48,000 60,000 12,000b
Accummulated Depreciation (12,500) (14,800)
Total Assets $54,800 $ 66,800
a. Land was sold at cost for cash during the year.
b. A building was purchased for cash during the year
and no building or equipment was sold during the
year. Statement of Cash Flows 43
Example 1 (contd.)
Layton Company Balance Sheet (12/31/x2)
Balance Balance Change

Accounts 1/1/x2 12/31/x2
A/P 7,500 9,000 1,500
a
B/P 14,000 21,000 7000
Common Stock, $10 22,000 22,000 0
Retained Earnings 11,300 14,800
Total Liabilities &
Stockholdrs' Equity $54,800 $66,800
a. Bonds were issued at the end of year.

Example 1 (contd.)
Income Statement (for the year ended 12/31x2)
Sales Revenue $31,800

Opeating Expenses
Depreciation Expense 2,300
Interest Expense 1,400
Other Expenses 18,100 (21,800)
Income before Income Tax 10,000
Income Tax Expense (3,000)
Net Income $7,000

Example 1 (contd.)
Layton Company Retained Earnings (20x2)
Beginning Retained Earnings $11,300

Add: Net Income 7,000
$18,300
Less: Dividends (3,500)
Ending Retained Earnings $14,800

Layton Company
For the Year Ended December 31, 20x2
Net cash flow from operating activities:
Net Income $7,000
Adjustments to reconcile net
income to net cash provided by
operating activities:
Add: Depreciation expense 2,300
Increase in A/P 1,500
Less: Increase in A/R (2,700)
Net cash provided by
operating activities $8,100
Layton Company
Statement of Cash Flows (contd.)
Cash flows from investing activities:
Proceeds from sale of land $3,000
Payments for
purchase of building (12,000)
Net cash used
by investing activities (9,000)
Cash flows from financing activities:
Proceeds from issuance of bonds 7,000
Payments of dividends (3,500)
Net cash provided by
financing activities 3,500
Layton Company
Net increase in cash $2,600

Cash, Jan 1, 20x2 $4,000
Cash, Dec 31, 20x2 $6,600

Example 2:
Green Company Balance Sheet
Accounts 1/1/x2 12/31/x2 Difference
Cash $3,500 $5,500
A/R 4,400 3,600 800 
Inventory 5,000 6,600 1,600 
Land 8,200 12,200 4,000c 
Building & Equip 35,700 48,700 13,000a,d 
Acc. Depr. (6,000) (8,700)
Total Assets $50,800 $67,900
Green Company Balance Sheet (contd.)
A/P $5,100 $3,200 1,900

Salary Payable 1,400 1,800 400
B/P, 10% 7,000 15,000 8,000b
Common Stock, $10 par 8,000 9,000 1,000
Paid-in Capital 16,000 19,000 3,000
R/E 13,300 19,900
Total Liabilities
& Equity $50,800 $67,900

Income Statement
For the Year Ended 12/31/20x2
Sales Revenue $80,000
CGS (48,600)
Gross Profit $31,400
Operating Expenses:
Deprecation Expense $3,400
Other Expenses 15,900 (19,300)
$12,100
Other Revenues & Expenses
Gains on Sale of Equipment $600
Interest Expense (700) (100)
Income Before Income Tax $12,000
Income Tax Expense (3,600)
Net Income $8,400 .

52
Retained Earnings (20x2)
Beginning balance
of retained earnings $13,300
Add: Net Income 8,400
21,700
Less: Dividends (1,800)
Ending balance
of retained earning $19,900
Supplemental Information for 20x2
(a) Equipment was purchased for cash at a
cost of $15,200.
(b) Ten-year bonds payable with a face value
of $8,000 were issued for $8,000 at the end
of the year.
(c) Land was acquired through the issuance of
100 shares of $10 par common stock when
the stock was selling at a market price of
$40 per share.
(d) Equipment with a cost of $2,200 and a book
value of $1,500 was sold for $2,100 cash.
GREEN Company
For the Year Ended December 31, 20x2
Net cash flows from operating activities:
Net Income $8,400
Adj. To reconcile net income to net
cash provided by operating activities:
Add: Depreciation Expense 3,400
Decrease in A/R 800
Increase in S/P 400
Less: Increase in Inventory (1,600)
Decrease in A/P (1,900)
Gain on sale of Equipment (600)
Net cash provided by operating activities $8,900
GREEN Company
Cash flows from investing activities:
Payments for purchase of equip. (15,200)
Proceeds from sale of equipment 2,100
Net cash used by investing activities (13,100)
Cash flows from financing activities:
Proceeds from issuance of bonds 8,000
Payments of dividends (1,800)
Net cash provided by financing activities 6,200
Net increase in cash (see Schedule 1) $2,000
Cash, Jan 1, 20x2 $3,500
Cash, Dec 31, 20x2 $5,500
56
GREEN Company
Schedule 1: Investing & financing

activities not affecting cash flows:
Investing activities:
Acquisition of land by Issuance of
common stock ($4,000)
Financing Activities:
Issuance of common stock for land $4,000

Special Topics
1. Direct exchange.
2. Partial cash investing and
financing activities.
3. Cash dividends declared.

1. Direct Exchange
n Direct exchange: An example of a
direct exchange is issuing bonds to
acquire a building. This transaction
should appear in the supplementary
schedule of the cash flow statement as
an investing activity (i.e., acquisition of
building) and as a financing activity
(i.e., issue bonds for building).

2. Partial Cash Investing and
Financing Activities
n Example: acquiring land costing
$10,000 by paying $1,000 down and
signing a $9,000 notes payable.

2. Partial Cash Investing and
Financing Activities (contd.)
n Presentation on Cash Flow Statement for
Partial Investing & Financing Activities:
Cash Flows from Investing Activities:
Purchase of land by issuance
of note and cash ($10,000)
Less: issuance of note 9,000
Cash payment
for purchase of land ($1,000)
Other examples of Direct Exchange
Other examples of significant noncash investing
and financing activities include (required
disclosure in the supplementary schedule of the
cash flow statement):
conversion of bonds to stock.
purchase of assets with issue of stock.
purchase of assets with debt.
declaration (but not payment) of cash
dividend.
stock dividends and stock splits.
3. Cash Dividends Declared
(Stock dividends not reported on
statement of cash flows.)
a. Cash dividends declared and paid in
the same year:
F Reported as a cash outflow of
financing activities

3. Cash Dividends Declared (contd.)
b. Cash dividends declared in the current
year but paid in the next year:
(1)No impact on cash of the current
year; only increase dividends
payable (D/P).
(2)When D/P decrease next year,
reported as a cash outflow of
financing activity.
IV. Cash Burn Rate (Source: RCJ
textbook)
The ability to generate positive operating cash flow is critical to the
survival and success of any company.
This is particularly true for start-up companies:

Cash is essential for establishing the business and for growth.
Investment outlays are often large.
Operating cash flows are negative.
Cash burn rate is a popular metric for assessing how quickly a start-
up firm will consume its cash reserves:
Cash used for Cash used for capital
operations + expenditures or acquisitions
Cash burn rate =
# of months covered by cash flow statement
Cash burn rate: Amazon.com illustration
Cash burn rate:

= - ($119,782 + $50,321 +$6,198)/12 months = -$14,692 per month
Months to burnout:
= $996,585/14,692 = 67.8 months

Cash burn rate:
Selected companies
V. Cash Flows from
the Operating Activities ( the
Direct Method)
Activities can be presented using:
a. Indirect Method (as used in examples
1,2,and 3):
N/I  Adjustments to reconcile net income
to cash flows.
b. Direct Method: The operating cash
outflows are deducted from the operating
cash inflows to determine the net cash
provided by (or used in) operating activities.
Cash Flows from
the Operating Activities (contd.)
n SFAS No. 95 allows the use of both
methods, but encourages the use of
the direct method. However, if the
direct method is used, a reconcile of
net income and cash using the indirect
method must also be provided in the
supplementary statement.

Using The Direct Method in Preparing
The Operating Cash Flows
Cash inflows from operating activities:
1. Collections from customers.
2. Interest & dividends collected.
3. Other operating receipts.

Using The Direct Method in Preparing
The Operating Cash Flows (contd.)
Cash outflows from operating activities:
1. Payments to suppliers.
2. Payments to employees.
3. Payments of interest.
4. Other operating payments.
5. Payments of income taxes.

Adjustments to Convert I/S Amount to
Operating Cash Flows -- A Direct Approach
I/S Cash Flows from
Amounts Adjustments Operating Activities Net
Collections
Sales +Dec. in A/R; or = from
Revenue -Inc. in A/R Customers
Cash
+Dec. in Int. Rec.; or Inflows
-Inc. in Int. Rec. from
Operating
Interest+Amort. Of Interest Activities
Premium on = Collected
Revenue Invest in Bonds;
or
-Amort. Of
Discount on
Invest in Bonds
Operating Cash Flows (contd.)
I/S Cash Flows from
Dividend +Dec. in Dividend Rec. = Dividend
Revenue -Inc. in Dividend Rec. Collected
Cash
+Inc. in Unearned Rev.; Inflows
or from
Other -Dec. in Unearned Rev. Operating
-Gain on Disposal of Other Activities
Revenue Assets & Liabilities = Operating
Receipts
-Investment Income*
(Equity Method)
+Dec. (-Inc.) in Other
Receivable Accounts
* Unless listed as separate Statement
itemsofon
CashIncome
Flows Statement (I/S).
73
I/S Cash Flows from
+Inc. in Inventory;
Cost of or Payments
Goods -Dec. in Inventory = to
Sold +Dec. in A/P; or Suppliers Cash
-Inc. in A/P Outflows
from
Salary +Dec. in Sal. Payable; Payments Operating
or = to Activities
Expense -Inc. in Sal. Payable Employees
74
Adjustments to Convert I/S Amount to Operating
Cash Flows (contd.)
I/S Cash Flows from
+Dec. in Int. Payable
Interest -Inc. in Int. Payable = Payments
Expense +Amort. of Prem. on B/P of Interest
or Cash
-Amort. of Dis. on B/P Outflows
from
+Inc. in Prepaids Operating
-Dec. in Prepaids Activities
-Depre., Depletion exp.
Other Amort. Exp.*, B/D exp. Other
-Losses on disposal of = Operating
Expense Assets and Liabilities Payments
-Investment loss a
(Equity method) a. Unless listed as
+Dec. (-Inc.) in Other separate items on the
Payable Accounts Income Statement
I/S Cash Flows from
+Dec. in I/T Payable;
or
Income -Inc. in I/T Payable Payments Cash
Tax +Dec. in Deferred I/T = of Income Outflows
Expense Liability; or Tax from
-Inc. in Deferred I/T Operating
Liability Activities
76

Green Company
(Using the direct method in preparing the operating
activities section of a cash flow
statement.Information as provided in Example 2.)
Cash flows from Operating Activities:
Cash inflows:
Collections from customers $80,8001
Cash inflows from
operating activities
$80,800
1. 80,000 + 800 = 80,800.

Green Company
Cash outflows:
Payments to suppliers $(52,100) 1
Payments of interest (700)
Other operating payments (15,500) 2
Payments of income tax (3,600)
Cash outflows
from operating activities (71,900)
1. 48,600 + 1600 + 1900 = 52,100.

2. 15,900 - 400 = 15,500.
Green Company
Net cash inflow
from operating activities $8,900
Cash flows from investing activities
:
:
Cash flows from Financing Activities
:
:
* A reconciliation of net income and cash flows using

indirect method must also be presented.
Information as provided in Example 3 (direct method)
Cash flows from Operating Activities:
Cash inflows:
Collections from customers $86,0201
Cash inflows
Cash outflows:
Payments to suppliers (53,200)2
1. 88,020 - 2,000 = 86,020.

2. 52,200 - 300 + 1300 = 53,200.
Payments of other expenses (16,000)1
Payments of interest expense (500)2
Payments if Income Tax (2,820)3
Cash outflows
from operating activities (72,520)
Net cash inflows
1. 15,800 + 200 = 16,000.
2. 1100 - 500 - 100 = 500.
3 3,630 - 630 -180 = 2,820.

Chapters 4 B: Statement of Cash Flows

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Chapters 4 B: Statement of Cash Flows

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Chapters 4 B

Statement of Cash Flows

I. Identify business activities which can

II. The Importance and the usefulness of

Statement of Cash Flows 3

Statement of Cash Flows 4

Statement of Cash Flows 6

n Adjust net income (the lump sum

Statement of Cash Flows 7

Statement of Cash Flows 9

Statement of Cash Flows 10

Statement of Cash Flows 11

Statement of Cash Flows 12

Statement of Cash Flows 15

n Companies can also generate cash or

Statement of Cash Flows 16

Statement of Cash Flows 18

n To improve the comparability, SFAS

Statement of Cash Flows 23

n Following SFAS No. 95, the statement

Adjustments to accrual earnings

Statement of Cash Flows 27

Outflows: increases in noncurrent assets

Statement of Cash Flows 29

Outflows: decreases in noncurrent

+ Depreciation, depletion and amortization

Statement of Cash Flows 32

n Example: GEO Corp. purchased

Statement of Cash Flows 37

Statement of Cash Flows 42

Balance Balance Change

Statement of Cash Flows 44

Sales Revenue $31,800

Statement of Cash Flows 45

Beginning Retained Earnings $11,300

Statement of Cash Flows 46

Net increase in cash $2,600

Statement of Cash Flows 49

A/P $5,100 $3,200 1,900

Statement of Cash Flows 51

Statement of Cash Flows 52

Schedule 1: Investing & financing

Statement of Cash Flows 5757

Statement of Cash Flows 58

Statement of Cash Flows 59

Statement of Cash Flows 60

Statement of Cash Flows 63

This is particularly true for start-up companies:

Cash burn rate:

= $996,585/14,692 = 67.8 months

Statement of Cash Flows 69

Statement of Cash Flows 70

Statement of Cash Flows 71

Statement of Cash Flows 76

1. 80,000 + 800 = 80,800.

1. 48,600 + 1600 + 1900 = 52,100.

* A reconciliation of net income and cash flows using

1. 88,020 - 2,000 = 86,020.