Show Me the Money!

Investors usually look to net income as a key indicator of a company's financial health and future prospects. The following graph shows the net income of one company over a seven-year period.

The company showed a pattern of consistent profitability and even some periods of income growth. Between years 1 and 4, net income for this company grew by 32 percent, from $31 million to $41 million. Would you expect its profitability to continue? The company had consistently paid dividends and interest. Would you expect it to continue to do so? Investors answered these questions by buying the company's shares. Eighteen months later, this company—W. T. Grant (USA)—filed for bankruptcy, in what was then the largest bankruptcy filing in the United States.

How could this happen? As indicated by the bottom line in the graph, the company had experienced several years of negative cash flows from its operations even though it reported profits. How can a company have negative cash flows while reporting profits? The answer lays partly in the fact that W. T. Grant was having trouble collecting the receivables from its credit sales, causing cash flow to be less than net income. Investors who analyzed the cash flows would have been likely to find an early warning signal of W. T. Grant's operating problems.

Investors can also look to cash flow information to sniff out companies that can be good buys. As one analyst stated when it comes to valuing shares: “Show me the money!” Here's the thinking behind that statement. Start with the “cash flows from operations” reported in the statement of cash flows, which (as you will learn in this chapter) consists of net income with non-cash charges (like depreciation and deferred taxes) added back and cash-draining events (like an inventory pile-up) taken out. Now subtract capital expenditures and dividends. What you're left with is free cash flow (as discussed in Chapter 5).

Many analysts like companies trading at low multiples of their free cash flow—low, that is, in relation to rivals today or the same company in past years. Why? They know that reported earnings can be misleading. Case in point: Computer-game firm Activision Blizzard (USA) reported net income of $113 million in a recent year. But it did better than that. It took in an additional $300 million, mostly for subscriptions to online multiplayer games. It gets the cash now but records the revenue only over time, as the subscriptions run out. A couple of investment houses put these shares on their buy list on the strength of its cash flows. So watch cash flow—to get an indicator of companies headed for trouble, as well as companies that may be undervalued.

Sources: Adapted from James A. Largay III and Clyde P. Stickney, “Cash Flows, Ratio Analysis, and the W. T. Grant Company Bankruptcy,” Financial Analysts Journal (July–August 1980), p. 51; and D. Fisher, “Cash Doesn't Lie,” Forbes (April 12, 2010), pp. 52–55.

PREPARATION OF THE STATEMENT OF CASH FLOWS

The primary purpose of the statement of cash flows is to provide information about a company's cash receipts and cash payments during a period. A secondary objective is to provide cash-basis information about the company's operating, investing, and financing activities. [1] The statement of cash flows therefore reports cash receipts, cash payments, and net change in cash resulting from a company's operating, investing, and financing activities during a period. Its format reconciles the beginning and ending cash balances for the period.

See the Authoritative Literature section (page 1223).

Usefulness of the Statement of Cash Flows

The statement of cash flows provides information to help investors, creditors, and others assess the following:

1. 1. The entity's ability to generate future cash flows. A primary objective of financial reporting is to provide information with which to predict the amounts, timing, and uncertainty of future cash flows. By examining relationships between items such as sales and net cash flow from operating activities, or net cash flow from operating activities and increases or decreases in cash, it is possible to better predict the future cash flows than is possible using accrual-basis data alone.
2. 2. The entity's ability to pay dividends and meet obligations. Simply put, cash is essential. Without adequate cash, a company cannot pay employees, settle debts, pay out dividends, or acquire equipment. A statement of cash flows indicates where the company's cash comes from and how the company uses its cash. Employees, creditors, shareholders, and customers should be particularly interested in this statement because it alone shows the flows of cash in a business.
3. 3. The reasons for the difference between net income and net cash flow from operating activities. The net income number is important: It provides information on the performance of a company from one period to another. But some people are critical of accrual-basis net income because companies must make estimates to arrive at it. Such is not the case with cash. Thus, as the opening story showed, financial statement readers can benefit from knowing why a company's net income and net cash flow from operating activities differ and can assess for themselves the reliability of the income number.
4. 4. The cash and non-cash investing and financing transactions during the period. Besides operating activities, companies undertake investing and financing transactions. Investing activities include the purchase and sale of assets other than a company's products or services. Financing activities include borrowings and repayments of borrowings, investments by owners, and distributions to owners. By examining a company's investing and financing activities, a financial statement reader can better understand why assets and liabilities increased or decreased during the period. For example, by reading the statement of cash flows, the reader might find answers to following questions:
   • Why did cash decrease for Aixtron Aktiengesellschaft (DEU) when it reported net income for the year?
   • How much did Telefónica, S.A. (ESP) spend on property, plant, and equipment, and intangible assets last year?
   • Did dividends paid by BP plc (GBR) increase last year?
   • How much money did Coca-Cola (USA) borrow last year?
   • How much cash did Delhaize Group (BEL) use to repurchase ordinary shares?

Classification of Cash Flows

The statement of cash flows classifies cash receipts and cash payments by operating, investing, and financing activities. Transactions and other events characteristic of each kind of activity are as follows. [2]

1. 1. Operating activities involve the cash effects of transactions that enter into the determination of net income, such as cash receipts from sales of goods and services, and cash payments to suppliers and employees for acquisitions of inventory and expenses. The amount of cash flows arising from operating activities is a key indicator of the extent to which the operations of the entity have generated sufficient cash flows to repay loans, maintain the operating capability of the entity, pay dividends, and make new investments without recourse to external sources of financing.
2. 2. Investing activities generally involve non-current assets and include (a) making and collecting loans, and (b) acquiring and disposing of investments and productive long-lived assets. The separate disclosure of cash flows arising from investing activities is important because the cash flows represent the extent to which expenditures have been made for resources intended to generate future income and cash flows.
3. 3. Financing activities involve liability and equity items and include (a) obtaining cash from creditors and repaying the amounts borrowed, and (b) obtaining capital from owners and providing them with a return on, and a return of, their investment. The separate disclosure of cash flows arising from financing activities is important because it is useful in predicting claims on future cash flows by providers of capital to a company.

Illustration 23-1 (page 1184) classifies the typical cash receipts and payments of a company according to operating, investing, and financing activities. The operating activities category is the most important. It shows the cash provided by company operations. This source of cash is generally considered to be the best measure of a company's ability to generate enough cash to continue as a going concern.

Note the following general guidelines about the classification of cash flows.

1. 1. Operating activities involve income statement items.
2. 2. Investing activities involve cash flows resulting from changes in investments and other non-current asset items.
3. 3. Financing activities involve cash flows resulting from changes in equity and non-current liability items.

IFRS allows some flexibility regarding the classification of certain items. Interest and dividends paid can be classified as either operating or financing, depending on what treatment the company thinks is most appropriate. Similarly, interest and dividends received can be classified as either operating or investing. Taxes paid are classified as operating except in circumstances where they can be identified with specific investing or financing activities. In order to limit the complexity of our presentation and to avoid ambiguity in assignment material, in Illustration 23-1 we have identified specific treatment for each of these items rather than allowing choices. All assignment material is based on this treatment.¹

ILLUSTRATION 23-1
Classification of Typical Cash Inflows and Outflows

Also, companies classify some cash flows relating to operating activities as investing or financing activities. For example, a company classifies the total cash received from the sale of property, plant, and equipment as an investing activity. Therefore, sales of those assets are not considered operating activities. Because of this (as is discussed more fully later in the chapter), companies must eliminate any gains or losses arising from the disposal of these assets to arrive at net cash flow from operating activities. Likewise, the payment to extinguish debt is a financing cash flow and should be classified as such. Any gain or loss related to the extinguishment is eliminated from net cash provided by operating activities.

Cash and Cash Equivalents

The basis recommended by the IASB for the statement of cash flows is actually “cash and cash equivalents.” Cash equivalents are short-term, highly liquid investments that are both:

• Readily convertible to known amounts of cash, and
• So near their maturity that they present insignificant risk of changes in value (e.g., due to changes in interest rates).

Generally, only investments with original maturities of three months or less qualify under this definition. Examples of cash equivalents are Treasury bills, commercial paper, and money market funds purchased with cash that is in excess of immediate needs. Equity investments are excluded from cash equivalents unless they are, in substance, cash equivalents. Although we use the term “cash” throughout our discussion and illustrations, we mean cash and cash equivalents when reporting the cash flows and the net increase or decrease in cash. [3]

Format of the Statement of Cash Flows

The three activities we discussed above constitute the general format of the statement of cash flows. The operating activities section always appears first. It is followed by the investing activities section and then the financing activities section.

A company reports the individual inflows and outflows from investing and financing activities separately. That is, a company reports them gross, not netted against one another. Thus, a cash outflow from the purchase of property is reported separately from the cash inflow from the sale of property. Similarly, a cash inflow from the issuance of debt is reported separately from the cash outflow from its retirement.

The net increase or decrease in cash reported during the period should reconcile the beginning and ending cash balances as reported in the comparative statements of financial position. The general format of the statement of cash flows presents the results of the three activities discussed previously—operating, investing, and financing. Illustration 23-2 shows a widely used form of the statement of cash flows.

ILLUSTRATION 23-2
Format of the Statement of Cash Flows

Steps in Preparation

Companies prepare the statement of cash flows differently from the three other basic financial statements. For one thing, it is not prepared from an adjusted trial balance. The cash flow statement requires detailed information concerning the changes in account balances that occurred between two points in time. An adjusted trial balance will not provide the necessary data. Second, the statement of cash flows deals with cash receipts and payments. As a result, the company must adjust the effects of the use of accrual accounting to determine cash flows. The information to prepare this statement usually comes from three sources:

1. 1. Comparative statements of financial position provide the amount of the changes in assets, liabilities, and equities from the beginning to the end of the period.
2. 2. Current income statement data help determine the amount of net cash provided by or used by operations during the period.
3. 3. Selected transaction data from the general ledger provide additional detailed information needed to determine how the company provided or used cash during the period.

Preparing the statement of cash flows from the data sources above involves three major steps:

Step 1. Determine the change in cash. This procedure is straightforward. A company can easily compute the difference between the beginning and the ending cash balance from examining its comparative statements of financial position.

Step 2. Determine the net cash flow from operating activities. This procedure is complex. It involves analyzing not only the current year's income statement but also comparative statements of financial position as well as selected transaction data.

Step 3. Determine net cash flows from investing and financing activities. A company must analyze all other changes in the statement of financial position accounts to determine their effects on cash.

On the following pages, we work through these three steps in the process of preparing the statement of cash flows for Tax Consultants Inc. over several years.

ILLUSTRATIONS—TAX CONSULTANTS INC.

We show the steps in preparing the statement of cash flows using data for Tax Consultants Inc. To begin, we use the first year of operations for Tax Consultants Inc. The company started on January 1, 2015, when it issued 60,000 ordinary shares of $1 par value for $60,000 cash. The company rented its office space, furniture, and equipment, and performed tax consulting services throughout the first year. The comparative statements of financial position at the beginning and end of the year 2015 appear in Illustration 23-3.

ILLUSTRATION 23-3
Comparative Statements of Financial Position, Tax Consultants Inc., Year 1

Illustration 23-4 shows the income statement and additional information for Tax Consultants.

ILLUSTRATION 23-4
Income Statement, Tax Consultants Inc., Year 1

Step 1: Determine the Change in Cash

To prepare a statement of cash flows, the first step is to determine the change in cash. This is a simple computation. Tax Consultants had no cash on hand at the beginning of the year 2015. It had $49,000 on hand at the end of 2015. Thus, cash changed (increased) in 2015 by $49,000.

Step 2: Determine Net Cash Flow from Operating Activities

To determine net cash flow from operating activities,² companies adjust net income in numerous ways. A useful starting point is to understand why net income must be converted to net cash provided by operating activities.

Under IFRS, most companies use the accrual basis of accounting. As you have learned, this basis requires that companies record revenue when they satisfy performance obligations and record expenses when incurred. Revenues may include credit sales for which the company has not yet collected cash. Expenses incurred may include some items that the company has not yet paid in cash. Thus, under the accrual basis of accounting, net income is not the same as net cash flow from operating activities.

To arrive at net cash flow from operating activities, a company must determine revenues and expenses on a cash basis. It does this by eliminating the effects of income statement transactions that do not result in an increase or decrease in cash. Illustration 23-5 shows the relationship between net income and net cash flow from operating activities.

ILLUSTRATION 23-5
Net Income versus Net Cash Flow from Operating Activities

In this chapter, we use the term net income to refer to accrual-based net income. A company may convert net income to net cash flow from operating activities through either a direct method or an indirect method. Due to its widespread use in practice, in the following sections we illustrate use of the indirect method. Later in the chapter, we describe the direct method and discuss the advantages and disadvantages of the two methods.

The indirect method (or reconciliation method) starts with net income and converts it to net cash flow from operating activities. In other words, the indirect method adjusts net income for items that affected reported net income but did not affect cash. To compute net cash flow from operating activities, a company adds back non-cash charges in the income statement to net income and deducts non-cash credits. We explain the two adjustments to net income for Tax Consultants, namely, the increases in accounts receivable and accounts payable, as follows.

Increase in Accounts Receivable–Indirect Method

Tax Consultants' accounts receivable increased by $36,000 (from $0 to $36,000) during the year. For Tax Consultants, this means that cash receipts were $36,000 lower than revenues. The Accounts Receivable account in Illustration 23-6 shows that Tax Consultants had $125,000 in revenues (as reported on the income statement), but it collected only $89,000 in cash.

ILLUSTRATION 23-6
Analysis of Accounts Receivable

As shown in Illustration 23-7, to adjust net income to net cash provided by operating activities, Tax Consultants must deduct the increase of $36,000 in accounts receivable from net income. When the Accounts Receivable balance decreases, cash receipts are higher than revenue recognized under the accrual basis. Therefore, the company adds to net income the amount of the decrease in accounts receivable to arrive at net cash provided by operating activities.

Increase in Accounts Payable–Indirect Method

When accounts payable increase during the year, expenses on an accrual basis exceed those on a cash basis. Why? Because Tax Consultants incurred expenses, but some of the expenses are not yet paid. To convert net income to net cash flow from operating activities, Tax Consultants must add back the increase of $5,000 in accounts payable to net income.

As a result of the accounts receivable and accounts payable adjustments, Tax Consultants determines net cash provided by operating activities is $3,000 for the year 2015. Illustration 23-7 shows this computation.

ILLUSTRATION 23-7
Computation of Net Cash Flow from Operating Activities, Year 1—Indirect Method

Step 3: Determine Net Cash Flows from Investing and Financing Activities

After Tax Consultants has computed the net cash provided by operating activities, the next step is to determine whether any other changes in the statement of financial position accounts caused an increase or decrease in cash.

For example, an examination of the remaining statement of financial position accounts for Tax Consultants shows increases in both ordinary shares and retained earnings. The Share Capital—Ordinary increase of $60,000 resulted from the issuance of ordinary shares for cash. The issuance of ordinary shares is reported in the statement of cash flows as a receipt of cash from a financing activity.

Two items caused the retained earnings increase of $20,000:

1. 1. Net income of $34,000 increased retained earnings.
2. 2. Declaration of $14,000 of dividends decreased retained earnings.

Tax Consultants has converted net income into net cash flow from operating activities, as explained earlier. The additional data indicate that it paid the dividend. Thus, the company reports the dividend payment as a cash outflow, classified as a financing activity.

Statement of Cash Flows–2015

We are now ready to prepare the statement of cash flows. The statement starts with the operating activities section. Tax Consultants may use either the direct or indirect method to report net cash flow from operating activities.

The IASB encourages the use of the direct method over the indirect method. [4] If a company uses the indirect method, it can either report the reconciliation within the statement of cash flows or can provide it in a separate schedule, with the statement of cash flows reporting only the net cash flow from operating activities. Throughout this chapter, we use the indirect method, which is also used more extensively in practice.³

Illustration 23-8 shows the statement of cash flows for Tax Consultants Inc., for year 1 (2015).

ILLUSTRATION 23-8
Statement of Cash Flows, Tax Consultants Inc., Year 1

As indicated, the $60,000 increase in ordinary shares results in a financing-activity cash inflow. The payment of $14,000 in cash dividends is a financing-activity outflow of cash. The $49,000 increase in cash reported in the statement of cash flows agrees with the increase of $49,000 shown in the comparative statements of financial position (in Illustration 23-3 on page 1187) as the change in the Cash account.

Illustration–2016

Tax Consultants Inc. continued to grow and prosper in its second year of operations. The company purchased land, building, and equipment, and revenues and net income increased substantially over the first year. Illustrations 23-9 and 23-10 (on page 1191) present information related to the second year of operations for Tax Consultants Inc.

ILLUSTRATION 23-9
Comparative Statements of Financial Position, Tax Consultants Inc., Year 2

ILLUSTRATION 23-10
Income Statement, Tax Consultants Inc., Year 2

Step 1: Determine the Change in Cash

To prepare a statement of cash flows from the available information, the first step is to determine the change in cash. As indicated from the information presented, cash decreased $12,000 ($49,000−$37,000).

Step 2: Determine Net Cash Flow from Operating Activities–Indirect Method

Using the indirect method, we adjust net income of $134,000 on an accrual basis to arrive at net cash flow from operating activities. Explanations for the adjustments to net income follow.

Decrease in Accounts Receivable. Accounts receivable decreased during the period because cash receipts (cash-basis revenues) are higher than revenues reported on an accrual basis. To convert net income to net cash flow from operating activities, the decrease of $10,000 in accounts receivable must be added to net income.

Increase in Prepaid Expenses. When prepaid expenses (assets) increase during a period, expenses on an accrual-basis income statement are lower than they are on a cash-basis income statement. The reason: Tax Consultants has made cash payments in the current period, but expenses (as charges to the income statement) have been deferred to future periods. To convert net income to net cash flow from operating activities, the company must deduct from net income the increase of $6,000 in prepaid expenses. An increase in prepaid expenses results in a decrease in cash during the period.

Increase in Accounts Payable. Like the increase in 2015, Tax Consultants must add the 2016 increase of $35,000 in accounts payable to net income, to convert to net cash flow from operating activities. The company incurred a greater amount of expense than the amount of cash it disbursed.

Depreciation Expense (Increase in Accumulated Depreciation). The purchase of depreciable assets is a use of cash, shown in the investing section in the year of acquisition. Tax Consultants' depreciation expense of $21,000 (also represented by the increase in accumulated depreciation) is a non-cash charge; the company adds it back to net income, to arrive at net cash flow from operating activities. The $21,000 is the sum of the $11,000 depreciation on the building plus the $10,000 depreciation on the equipment.

Certain other periodic charges to expense do not require the use of cash. Examples are the amortization of intangible assets and depletion expense. Such charges are treated in the same manner as depreciation. Companies frequently list depreciation and similar non-cash charges as the first adjustments to net income in the statement of cash flows.

As a result of the foregoing items, net cash provided by operating activities is $194,000, as shown in Illustration 23-11.

ILLUSTRATION 23-11
Computation of Net Cash Flow from Operating Activities, Year 2—Indirect Method

Step 3: Determine Net Cash Flows from Investing and Financing Activities

After you have determined the items affecting net cash provided by operating activities, the next step involves analyzing the remaining changes in the statement of financial position accounts. Tax Consultants Inc. analyzed the following accounts.

Increase in Land. As indicated from the change in the Land account, the company purchased land of $70,000 during the period. This transaction is an investing activity, reported as a use of cash.

Increase in Buildings and Related Accumulated Depreciation. As indicated in the additional data, and from the change in the Buildings account, Tax Consultants acquired an office building using $200,000 cash. This transaction is a cash outflow, reported in the investing section. The $11,000 increase in accumulated depreciation results from recording depreciation expense on the building. As indicated earlier, the reported depreciation expense has no effect on the amount of cash.

Increase in Equipment and Related Accumulated Depreciation. An increase in equipment of $68,000 resulted because the company used cash to purchase equipment. This transaction is an outflow of cash from an investing activity. The depreciation expense entry for the period explains the increase in Accumulated Depreciation—Equipment.

Increase in Bonds Payable. The Bonds Payable account increased $150,000. Cash received from the issuance of these bonds represents an inflow of cash from a financing activity.

Increase in Retained Earnings. Retained earnings increased $116,000 during the year. Two factors explain this increase: (1) net income of $134,000 increased retained earnings, and (2) dividends of $18,000 decreased retained earnings. As indicated earlier, the company adjusts net income to net cash provided by operating activities in the operating activities section. Payment of the dividends is a financing activity that involves a cash outflow.

Statement of Cash Flows–2016

Combining the foregoing items, we get a statement of cash flows for 2016 for Tax Consultants Inc., using the indirect method to compute net cash flow from operating activities.

ILLUSTRATION 23-12
Statement of Cash Flows, Tax Consultants Inc., Year 2

Illustration–2017

Our third example, covering the 2017 operations of Tax Consultants Inc., is more complex. It again uses the indirect method to compute and present net cash flow from operating activities.

Tax Consultants Inc. experienced continued success in 2017 and expanded its operations to include the sale of computer software used in tax-return preparation and tax planning. Thus, inventory is a new asset appearing in the company's December 31, 2017, statement of financial position. Illustrations 23-13 and 23-14 (on page 1194) show the comparative statements of financial position, income statements, and selected data for 2017.

Step 1: Determine the Change in Cash

The first step in the preparation of the statement of cash flows is to determine the change in cash. As the comparative statements of financial position show, cash increased $17,000 in 2017.

ILLUSTRATION 23-13
Comparative Statements of Financial Position, Tax Consultants Inc., Year 3

ILLUSTRATION 23-14
Income Statement, Tax Consultants Inc., Year 3

Step 2: Determine Net Cash Flow from Operating Activities–Indirect Method

We explain the adjustments to net income of $125,000 as follows.

Increase in Accounts Receivable. The increase in accounts receivable of $42,000 represents recorded accrual-basis revenues in excess of cash collections in 2017. The company deducts this increase from net income to convert from the accrual basis to the cash basis.

Increase in Inventories. The $54,000 increase in inventories represents an operating use of cash, not an expense. Tax Consultants therefore deducts this amount from net income, to arrive at net cash flow from operations. In other words, when inventory purchased exceeds inventory sold during a period, cost of goods sold on an accrual basis is lower than on a cash basis.

Decrease in Prepaid Expenses. The $2,000 decrease in prepaid expenses represents a charge to the income statement for which Tax Consultants made no cash payment in the current period. The company adds back the decrease to net income, to arrive at net cash flow from operating activities.

Decrease in Accounts Payable. When accounts payable decrease during the year, cost of goods sold and expenses on a cash basis are higher than they are on an accrual basis. To convert net income to net cash flow from operating activities, the company must deduct the $7,000 in accounts payable from net income.

Depreciation Expense (Increase in Accumulated Depreciation). Accumulated Depreciation—Buildings increased $10,000 ($21,000 − $11,000). The Buildings account did not change during the period, which means that Tax Consultants recorded depreciation expense of $10,000 in 2017.

Accumulated Depreciation—Equipment increased by $18,000 ($28,000 − $10,000) during the year. But Accumulated Depreciation—Equipment decreased by $5,000 as a result of the sale during the year. Thus, depreciation for the year was $23,000. The company reconciled Accumulated Depreciation—Equipment as follows.

The company must add back to net income the total depreciation of $33,000 ($10,000 + $23,000) charged to the income statement, to determine net cash flow from operating activities.

Loss on Sale of Equipment. Tax Consultants sold for $34,000 equipment that cost $41,000 and had a book value of $36,000. As a result, the company reported a loss of $2,000 on its sale. To arrive at net cash flow from operating activities, it must add back to net income the loss on the sale of the equipment. The reason is that the loss is a non-cash charge to the income statement. The loss did not reduce cash, but it did reduce net income.

From the foregoing items, the company prepares the operating activities section of the statement of cash flows, as shown in Illustration 23-15.

ILLUSTRATION 23-15
Operating Activities Section of Cash Flow Statement

Step 3: Determine Net Cash Flows from Investing and Financing Activities

By analyzing the remaining changes in the statement of financial position accounts, Tax Consultants identifies cash flows from investing and financing activities.

Land. Land decreased $25,000 during the period. As indicated from the information presented, the company sold land for cash at its book value. This transaction is an investing activity, reported as a $25,000 source of cash.

Equipment. An analysis of the Equipment account indicates the following.

The company used cash to purchase equipment with a fair value of $166,000—an investing transaction reported as a cash outflow. The sale of the equipment for $34,000 is also an investing activity, but one that generates a cash inflow.

Bonds Payable. Bonds payable decreased $40,000 during the year. As indicated from the additional information, the company redeemed the bonds at their book value. This financing transaction used $40,000 of cash.

Share Capital—Ordinary. The Share Capital—Ordinary account increased $160,000 during the year. As indicated from the additional information, Tax Consultants issued ordinary shares of $160,000 at par. This financing transaction provided cash of $160,000.

Retained Earnings. Retained earnings changed $70,000 ($206,000 − $136,000) during the year. The $70,000 change in retained earnings results from net income of $125,000 from operations and the financing activity of paying cash dividends of $55,000.

Statement of Cash Flows–2017

Tax Consultants Inc. combines the foregoing items to prepare the statement of cash flows shown in Illustration 23-16.

ILLUSTRATION 23-16
Statement of Cash Flows, Tax Consultants Inc., Year 3

Sources of Information for the Statement of Cash Flows

Important points to remember in the preparation of the statement of cash flows are these:

1. 1. Comparative statements of financial position provide the basic information from which to prepare the report. Additional information obtained from analyses of specific accounts is also included.
2. 2. An analysis of the Retained Earnings account is necessary. The net increase or decrease in Retained Earnings without any explanation is a meaningless amount in the statement. Without explanation, it might represent the effect of net income, dividends declared, or prior period adjustments.
3. 3. The statement includes all changes that have passed through cash or have resulted in an increase or decrease in cash.
4. 4. Write-downs, amortization charges, and similar “book” entries, such as depreciation of plant assets, represent neither inflows nor outflows of cash because they have no effect on cash. To the extent that they have entered into the determination of net income, however, the company must add them back to or subtract them from net income, to arrive at net cash provided (used) by operating activities.

Indirect Method–Additional Adjustments

For consistency and comparability and because it is the most widely used method in practice, we used the indirect method in the Tax Consultants' illustrations. We determined net cash flow from operating activities by adding back to or deducting from net income those items that had no effect on cash. Illustration 23-17 presents a more complete set of common types of adjustments that companies make to net income to arrive at net cash flow from operating activities.

ILLUSTRATION 23-17
Adjustments Needed to Determine Net Cash Flow from Operating Activities—Indirect Method

The additions and deductions in Illustration 23-17 reconcile net income to net cash flow from operating activities, illustrating why the indirect method is also called the reconciliation method.

Net Cash Flow from Operating Activities–Direct Method

Two different methods are available to adjust income from operations on an accrual basis to net cash flow from operating activities. We showed the indirect method in the Tax Consultants' illustrations in the prior sections.

The direct method reports cash receipts and cash disbursements from operating activities. The difference between these two amounts is the net cash flow from operating activities. In other words, the direct method deducts operating cash disbursements from operating cash receipts. The direct method results in the presentation of a condensed cash receipts and cash disbursements statement.

As indicated from the accrual-based income statement (see Illustration 23-4 on page 1187), Tax Consultants reported revenues of $125,000. However, because the company's accounts receivable increased during 2015 by $36,000, the company collected only $89,000 ($125,000 − $36,000) in cash from these revenues. Similarly, Tax Consultants reported operating expenses of $85,000. However, accounts payable increased during the period by $5,000. Assuming that these payables relate to operating expenses, cash operating expenses were $80,000 ($85,000 − $5,000). Because no taxes payable exist at the end of the year, the company must have paid $6,000 income tax expense for 2015 in cash during the year. Tax Consultants computes net cash flow from operating activities as shown in Illustration 23-18.

ILLUSTRATION 23-18
Computation of Net Cash Flow from Operating Activities, Year 1—Direct Method

“Net cash provided by operating activities” is the equivalent of cash basis net income. (“Net cash used by operating activities” is equivalent to cash basis net loss.)

The IASB encourages use of the direct method and permits use of the indirect method. Yet, if the direct method is used, the Board requires that companies provide in a separate schedule a reconciliation of net income to net cash flow from operating activities. Therefore, under either method, companies must prepare and report information from the indirect (reconciliation) method.

Direct Method–An Example

Under the direct method, the statement of cash flows reports net cash flow from operating activities as major classes of operating cash receipts (e.g., cash collected from customers and cash received from interest and dividends) and cash disbursements (e.g., cash paid to suppliers for goods, to employees for services, to creditors for interest, and to government authorities for taxes).

We illustrate the direct method here in more detail to help you understand the difference between accrual-based income and net cash flow from operating activities. This example also illustrates the data needed to apply the direct method. Drogba Company, which began business on January 1, 2015, has the following selected statement of financial position information.

ILLUSTRATION 23-19
Statement of Financial Position Accounts, Drogba Co.

Drogba's December 31, 2015, income statement and additional information are as follows.

ILLUSTRATION 23-20
Income Statement, Drogba Co.

Under the direct method, companies compute net cash provided by operating activities by adjusting each item in the income statement from the accrual basis to the cash basis. To simplify and condense the operating activities section, only major classes of operating cash receipts and cash payments are reported. As Illustration 23-21 shows, the difference between these major classes of cash receipts and cash payments is the net cash provided by operating activities.

ILLUSTRATION 23-21
Major Classes of Cash Receipts and Payments

An efficient way to apply the direct method is to analyze the revenues and expenses reported in the income statement in the order in which they are listed. The company then determines cash receipts and cash payments related to these revenues and expenses. In the following sections, we present the direct method adjustments for Drogba Company in 2016, to determine net cash provided by operating activities.

Cash Receipts from Customers. The income statement for Drogba Company reported revenues from customers of €780,000. To determine cash receipts from customers, the company considers the change in accounts receivable during the year.

When accounts receivable increase during the year, revenues on an accrual basis are higher than cash receipts from customers. In other words, operations led to increased revenues, but not all of these revenues resulted in cash receipts. To determine the amount of cash receipts, deduct the amount of the increase in accounts receivable from the total sales revenues. Conversely, a decrease in accounts receivable is added to sales revenues because cash receipts from customers then exceed sales revenues.

For Drogba, accounts receivable increased €15,000. Thus, cash receipts from customers were €765,000, computed as follows.

Drogba could also determine cash receipts from customers by analyzing the Accounts Receivable account, as shown below.

Illustration 23-22 shows the relationships between cash receipts from customers, revenues from sales, and changes in accounts receivable.

ILLUSTRATION 23-22
Formula to Compute Cash Receipts from Customers

Cash Payments to Suppliers. Drogba Company reported cost of goods sold on its income statement of €450,000. To determine cash payments to suppliers, the company first finds purchases for the year, by adjusting cost of goods sold for the change in inventory. When inventory increases during the year, purchases this year exceed cost of goods sold. As a result, the company adds the increase in inventory to cost of goods sold, to arrive at purchases.

In 2016, Drogba Company's inventory increased €160,000. The company computes purchases as follows.

After computing purchases, Drogba determines cash payments to suppliers by adjusting purchases for the change in accounts payable. When accounts payable increase during the year, purchases on an accrual basis are higher than they are on a cash basis. As a result, it deducts from purchases the increase in accounts payable to arrive at cash payments to suppliers. Conversely, if cash payments to suppliers exceed purchases, Drogba adds to purchases the decrease in accounts payable. Cash payments to suppliers were €550,000, computed as follows.

Drogba also can determine cash payments to suppliers by analyzing Accounts Payable, as shown below.

Illustration 23-23 shows the relationships between cash payments to suppliers, cost of goods sold, changes in inventory, and changes in accounts payable.

ILLUSTRATION 23-23
Formula to Compute Cash Payments to Suppliers

Cash Payments for Operating Expenses. Drogba reported operating expenses of €160,000 on its income statement. To determine the cash paid for operating expenses, it must adjust this amount for any changes in prepaid expenses and accrued expenses payable.

For example, when prepaid expenses increased €8,000 during the year, cash paid for operating expenses was €8,000 higher than operating expenses reported on the income statement. To convert operating expenses to cash payments for operating expenses, the company adds to operating expenses the increase of €8,000. Conversely, if prepaid expenses decrease during the year, Drogba deducts from operating expenses the amount of the decrease.

Drogba also must adjust operating expenses for changes in accrued expenses payable. When accrued expenses payable increase during the year, operating expenses on an accrual basis are higher than they are on a cash basis. As a result, the company deducts from operating expenses an increase in accrued expenses payable, to arrive at cash payments for operating expenses. Conversely, it adds to operating expenses a decrease in accrued expenses payable because cash payments exceed operating expenses.

Drogba's cash payments for operating expenses were €148,000, computed as follows.

The relationships among cash payments for operating expenses, changes in prepaid expenses, and changes in accrued expenses payable are shown in Illustration 23-24.

ILLUSTRATION 23-24
Formula to Compute Cash Payments for Operating Expenses

Note that the company did not consider depreciation expense because it is a non-cash charge.

Cash Payments for Income Taxes. The income statement for Drogba shows income tax expense of €48,000. This amount equals the cash paid. How do we know that? Because the comparative statement of financial position indicated no income taxes payable at either the beginning or end of the year.

Summary of Net Cash Flow from Operating Activities–Direct Method

The following schedule summarizes the computations illustrated above.

ILLUSTRATION 23-25
Accrual Basis to Cash Basis

Illustration 23-26 shows the presentation of the direct method for reporting net cash flow from operating activities for the Drogba Company example.

ILLUSTRATION 23-26
Operating Activities Section—Direct Method, 2016

If Drogba uses the direct method to present the net cash flow from operating activities, it is required to provide in a separate schedule the reconciliation of net income to net cash provided by operating activities. The reconciliation assumes the identical form and content of the indirect method of presentation, as shown below.

ILLUSTRATION 23-27
Reconciliation of Net Income to Net Cash Provided by Operating Activities, 2016

SPECIAL PROBLEMS IN STATEMENT PREPARATION

We discussed some of the special problems related to preparing the statement of cash flows in connection with the preceding illustrations. Other problems that arise with some frequency in the preparation of this statement include the following.

1. 1. Adjustments to net income.
2. 2. Accounts receivable (net).
3. 3. Other working capital changes.
4. 4. Net loss.
5. 5. Disclosures.

Adjustments to Net Income

Depreciation and Amortization

Depreciation expense is the most common adjustment to net income that companies make to arrive at net cash flow from operating activities. But there are numerous other non-cash expense or revenue items. Examples of expense items that companies must add back to net income are the amortization of limited-life intangible assets, such as patents, and depletion of mineral resources. These charges to expense involve expenditures made in prior periods that a company amortizes currently. These charges reduce net income without affecting cash in the current period.

Also, amortization of bond discount or premium on long-term bonds payable affects the amount of interest expense. However, neither changes cash. As a result, a company should add back discount amortization and subtract premium amortization from net income to arrive at net cash flow from operating activities.

Postretirement Benefit Costs

If a company has postretirement costs such as an employee pension plan, chances are that the pension expense recorded during a period will either be higher or lower than the cash funded. It will be higher when there is an unfunded liability and will be lower when there is a prepaid pension cost. When the expense is higher or lower than the cash paid, the company must adjust net income by the difference between cash paid and the expense reported in computing net cash flow from operating activities.

Change in Deferred Income Taxes

Changes in deferred income taxes affect net income but have no effect on cash. For example, Baytex Energy Corp. (CAN) reported an increase in its liability for deferred taxes of approximately $107,598,000. This change in the liability increased tax expense and decreased net income, but did not affect cash. Therefore, Baytex added back $107,598,000 to net income on its statement of cash flows.

Equity Method of Accounting

Another common adjustment to net income is a change related to an investment in ordinary shares when recording income or loss under the equity method. Recall that under the equity method, the investor (1) debits the investment account and credits revenue for its share of the investee's net income, and (2) credits dividends received to the investment account. Therefore, the net increase in the investment account does not affect cash flows. A company must deduct the net increase from net income to arrive at net cash flow from operating activities.

Assume that Victor Co. owns 40 percent of Milo Inc. During the year, Milo reports net income of $100,000 and pays a cash dividend of $30,000. Victor reports this in its statement of cash flows as a deduction from net income in the following manner—Equity in earnings of Milo, net of dividends, $28,000 [($100,000 − $30,000) × 40%].

Losses and Gains

Realized Losses and Gains. In the illustration for Tax Consultants, the company experienced a loss of $2,000 from the sale of equipment. The company added this loss to net income to compute net cash flow from operating activities because the loss is a non-cash charge in the income statement.

If Tax Consultants experiences a gain from a sale of equipment, it too requires an adjustment to net income. Because a company reports the gain in the statement of cash flows as part of the cash proceeds from the sale of equipment under investing activities, it deducts the gain from net income to avoid double-counting—once as part of net income and again as part of the cash proceeds from the sale.

To illustrate, assume that Tax Consultants had land with a carrying value of $200,000, which was condemned by the provincial government for a highway project. The condemnation proceeds received were $205,000, resulting in a gain of $5,000. In the statement of cash flows (indirect method), the company would deduct the $5,000 gain from net income in the operating activities section. It would report the $205,000 cash inflow from the condemnation as an investing activity, as follows.

Unrealized Losses and Gains. Unrealized losses and gains generally occur for debt investments not held for collection and for equity investments. For example, assume that AB InBev (BEL) purchases the following two security investments on January 10, 2015.

1. 1. Debt investment for €1 million that is classified as trading. During 2015, the debt investment has an unrealized holding gain of €110,000 (recorded in net income).
2. 2. Equity investment for €600,000 that is non-trading in nature. During 2015, the non-trading equity investment has an unrealized holding loss of €50,000 (recorded in other comprehensive income).

For AB InBev, the unrealized holding gain of €110,000 on the debt investment increases net income but does not increase net cash flow from operating activities. As a result, the unrealized holding gain of €110,000 is deducted from net income to compute net cash flow from operating activities.

On the other hand, the unrealized holding loss of €50,000 that AB InBev incurs on the non-trading equity investment does not affect net income or cash flows—this loss is reported in the other comprehensive income section. As a result, no adjustment to net income is necessary in computing net cash flow from operating activities.

Thus, the general rule is that unrealized holding gains or losses that affect net income must be adjusted to determine net cash flow from operating activities. Conversely, unrealized holding gains or losses that do not affect net income are not adjusted to determine net cash flow from operating activities.⁴

Share-Based Compensation

Recall for share-based compensation plans that companies are required to use the fair value method to determine total compensation cost. The compensation cost is then recognized as an expense in the periods in which the employee provides services. When Compensation Expense is debited, Share Premium—Options is often credited. Cash is not affected by recording the expense. Therefore, the company must increase net income by the amount of compensation expense from share options in computing net cash flow from operating activities.

To illustrate how this information should be reported on a statement of cash flows, assume that First Wave Inc. grants 5,000 options to its CEO, Ann Johnson. Each option entitles Johnson to purchase one share of First Wave's £1 par value ordinary shares at £50 per share at any time in the next two years (the service period). The fair value of the options is £200,000. First Wave records compensation expense in the first year as follows.

In addition, if we assume that First Wave has a 35 percent tax rate, it would recognize a deferred tax asset of £35,000 (£100,000 × 35%) in the first year, as follows.

Therefore, on the statement of cash flows for the first year, First Wave reports the following (assuming a net income of £600,000).

As shown in First Wave's statement of cash flows, it adds the share-based compensation expense to net income because it is a non-cash expense. The increase in the deferred tax asset and the related reduction in income tax expense increase net income. Although the negative income tax expense increases net income, it does not increase cash. Therefore, it should be deducted. Subsequently, if Ann Johnson exercises her options, Third Wave reports “Cash provided by exercise of share options” in the financing section of the statement of cash flows.⁵

Accounts Receivable (Net)

Up to this point, we assumed no allowance for doubtful accounts—a contra account—to offset accounts receivable. However, if a company needs an allowance for doubtful accounts, how does that allowance affect the company's determination of net cash flow from operating activities? For example, assume that Redmark Co. reports net income of €40,000. It has the accounts receivable balances, as shown in Illustration 23-28.

ILLUSTRATION 23-28
Accounts Receivable Balances, Redmark Co.

Indirect Method

Because an increase in Allowance for Doubtful Accounts results from a charge to bad debt expense, a company should add back an increase in Allowance for Doubtful Accounts to net income to arrive at net cash flow from operating activities. Illustration 23-29 shows one method for presenting this information in a statement of cash flows.

ILLUSTRATION 23-29
Presentation of Allowance for Doubtful Accounts—Indirect Method

As we indicated, the increase in the Allowance for Doubtful Accounts balance results from a charge to bad debt expense for the year. Because bad debt expense is a non-cash charge, a company must add it back to net income in arriving at net cash flow from operating activities.

Instead of separately analyzing the allowance account, a short-cut approach is to net the allowance balance against the receivable balance and compare the change in accounts receivable on a net basis. Illustration 23-30 shows this presentation.

ILLUSTRATION 23-30
Net Approach to Allowance for Doubtful Accounts—Indirect Method

This short-cut procedure works also if the change in the allowance account results from a write-off of accounts receivable. This reduces both Accounts Receivable and Allowance for Doubtful Accounts. No effect on cash flows occurs. Because of its simplicity, use the net approach for your homework assignments.

Direct Method

If using the direct method, a company should not net Allowance for Doubtful Accounts against Accounts Receivable. To illustrate, assume that Redmark Co.'s net income of €40,000 consisted of the following items.

ILLUSTRATION 23-31
Income Statement, Redmark Co.

If Redmark deducts the €9,000 increase in accounts receivable (net) from sales for the year, it would report cash sales at €91,000 (€100,000 − €9,000) and cash payments for operating expenses at €60,000. Both items would be misstated: Cash sales should be reported at €85,000 (€100,000 − €15,000), and total cash payments for operating expenses should be reported at €54,000 (€60,000 − €6,000). Illustration 23-32 shows the proper presentation.

ILLUSTRATION 23-32
Bad Debts—Direct Method

An added complication develops when a company writes off accounts receivable. Simply adjusting sales for the change in accounts receivable will not provide the proper amount of cash sales. The reason is that the write-off of the accounts receivable is not a cash collection. Thus, an additional adjustment is necessary.

Other Working Capital Changes

Up to this point, we showed how companies handled all of the changes in working capital items (current asset and current liability items) as adjustments to net income in determining net cash flow from operating activities. You must be careful, however, because some changes in working capital, although they affect cash, do not affect net income. Generally, these are investing or financing activities of a current nature.

One activity is the purchase of short-term non-trading equity investments. For example, the purchase of short-term non-trading equity investments for ¥5,000,000 cash has no effect on net income, but it does cause a ¥5,000,000 decrease in cash. A company reports this transaction as a cash flow from investing activities as follows.

Another example is the issuance of a short-term non-trade note payable for cash. This change in a working capital item has no effect on income from operations, but it increases cash by the amount of the note payable. For example, a company reports the issuance of a ¥10,000,000 short-term, non-trade note payable for cash in the statement of cash flows as follows.

Another change in a working capital item that has no effect on income from operations or on cash is a cash dividend payable. Although a company will report the cash dividends when paid as a financing activity, it does not report the declared but unpaid dividend on the statement of cash flows.

Net Losses

If a company reports a net loss instead of a net income, it must adjust the net loss for those items that do not result in a cash inflow or outflow. The net loss, after adjusting for the charges or credits not affecting cash, may result in a negative or a positive cash flow from operating activities.

For example, if the net loss is £50,000 and the total amount of charges to add back is £60,000, then net cash provided by operating activities is £10,000. Illustration 23-33 shows this computation.

ILLUSTRATION 23-33
Computation of Net Cash Flow from Operating Activities—Cash Inflow

If the company experiences a net loss of £80,000 and the total amount of the charges to add back is £25,000, the presentation appears as follows.

ILLUSTRATION 23-34
Computation of Net Cash Flow from Operating Activities—Cash Outflow

Although not illustrated in this chapter, a negative cash flow may result even if the company reports a net income.

Disclosures

Significant Non-Cash Transactions

Because the statement of cash flows reports only the effects of operating, investing, and financing activities in terms of cash flows, it omits some significant non-cash transactions and other events that are investing or financing activities. Among the more common of these non-cash transactions that a company should report or disclose in some manner are the following.

1. 1. Acquisition of assets by assuming liabilities (including finance lease obligations) or by issuing equity securities.
2. 2. Exchanges of non-monetary assets.
3. 3. Refinancing of long-term debt.
4. 4. Conversion of debt or preference shares to ordinary shares.
5. 5. Issuance of equity securities to retire debt.

Investing and financing transactions that do not require the use of cash are excluded from the statement of cash flows. [6] If material in amount, these disclosures may be either narrative or summarized in a separate schedule. This schedule may appear in a separate note or supplementary schedule to the financial statements.⁶ Illustration 23-35 (on page 1210) shows the presentation of these significant non-cash transactions or other events in a separate schedule in the notes to the financial statements.

ILLUSTRATION 23-35
Note Presentation of Non-Cash Investing and Financing Activities

Companies do not generally report certain other significant non-cash transactions or other events in conjunction with the statement of cash flows. Examples of these types of transactions are share dividends, share splits, and restrictions on retained earnings. Companies generally report these items, neither financing nor investing activities, in conjunction with the statement of changes in equity or schedules and notes pertaining to changes in equity accounts.

Special Disclosures

IAS 7 indicates that cash flows related to interest received and paid, and dividends received and paid, should be separately disclosed in the statement of cash flows. [7] Each item should be classified in a consistent manner from period to period as operating, investing, or financing cash flows. As indicated earlier, for homework purposes classify interest received and paid and dividends received as part of cash flows from operating activities and dividends paid as cash flows from financing activities. The justification for reporting the first three items in cash flows from operating activities is that each item affects net income. Dividends paid, however, do not affect net income and are often considered a cost of financing.

Companies should also disclose income taxes paid separately in the cash flows from operating activities unless they can be separately identified as part of investing or financing activities. While tax expense may be readily identifiable with investing or financing activities, the related tax cash flows are often impracticable to identify and may arise in a different period from the cash flows of the underlying transaction. Therefore, taxes paid are usually classified as cash flows from operating activities. IFRS requires that the cash paid for taxes, as well as cash flows from interest and dividends received and paid, be disclosed. The category (operating, investing, or financing) in which each item was included must be disclosed as well.

An example of such a disclosure from the notes to Daimler's (DEU) financial statement is provided in Illustration 23-36.

ILLUSTRATION 23-36
Note Disclosure of Interest, Taxes, and Dividends

Other companies choose to report these items directly in the statement of cash flows. In many cases, companies start with income before income taxes and then show income taxes paid as a separate item. In addition, they often add back interest expense on an accrual basis and then subtract interest paid. Reporting these items in the operating activites section is shown for Wáng Company in Illustration 23-37.

ILLUSTRATION 23-37
Reporting of Interest, Taxes, and Dividends in the Operating Section

Companies often provide a separate section to identify interest and income taxes paid.

USE OF A WORKSHEET

When numerous adjustments are necessary or other complicating factors are present, companies often use a worksheet to assemble and classify the data that will appear on the statement of cash flows. The worksheet is merely a device that aids in the preparation of the statement. Its use is optional. Illustration 23-38 shows the skeleton format of the worksheet for preparation of the statement of cash flows using the indirect method.

ILLUSTRATION 23-38
Format of Worksheet for Preparation of Statement of Cash Flows

The following guidelines are important in using a worksheet.

1. 1. In the statement of financial position accounts section, list accounts with debit balances separately from those with credit balances. This means, for example, that Accumulated Depreciation is listed under credit balances and not as a contra account under debit balances. Enter the beginning and ending balances of each account in the appropriate columns. Then, enter the transactions that caused the change in the account balance during the year as reconciling items in the two middle columns.

   After all reconciling items have been entered, each line pertaining to a statement of financial position account should foot across. That is, the beginning balance plus or minus the reconciling item(s) must equal the ending balance. When this agreement exists for all statement of financial position accounts, all changes in account balances have been reconciled.

2. 2. The bottom portion of the worksheet consists of the operating, investing, and financing activities sections. Accordingly, it provides the information necessary to prepare the formal statement of cash flows. Enter inflows of cash as debits in the reconciling columns, and outflows of cash as credits in the reconciling columns. Thus, in this section, a company would enter the sale of equipment for cash at book value as a debit under inflows of cash from investing activities. Similarly, it would enter the purchase of land for cash as a credit under outflows of cash from investing activities.
3. 3. Do not enter in any journal or post to any account the reconciling items shown in the worksheet. These items do not represent either adjustments or corrections of the statement of financial position accounts. They are used only to facilitate the preparation of the statement of cash flows.

Preparation of the Worksheet

The preparation of a worksheet involves the following steps.

To illustrate the preparation and use of a worksheet and to illustrate the reporting of some of the special problems discussed in the prior section, we present a comprehensive example for Satellite Corporation. Again, the indirect method serves as the basis for the computation of net cash provided by operating activities. Illustrations 23-39 and 23-40 (on pages 1214 and 1215) present the statement of financial position, combined statement of income and retained earnings, and additional information for Satellite Corporation. The discussion that follows these financial statements provides additional explanations related to the preparation of the worksheet.

Analysis of Transactions

The following discussion explains the individual adjustments that appear on the worksheet in Illustration 23-41 (page 1219). Because cash is the basis for the analysis, Satellite reconciles the cash account last. Because income is the first item that appears on the statement of cash flows, it is handled first.

Change in Retained Earnings

Net income for the period is HK$117,000. The entry for it on the worksheet is as follows.

Satellite reports net income on the bottom section of the worksheet. This is the starting point for preparation of the statement of cash flows (under the indirect method).

A share dividend and a cash dividend also affected retained earnings. The retained earnings statement reports a share dividend of HK$15,000. The worksheet entry for this transaction is as follows.

ILLUSTRATION 23-39
Comparative Statement of Financial Position, Satellite Corporation

The issuance of share dividends is not a cash operating, investing, or financing item. Therefore, although the company enters this transaction on the worksheet for reconciling purposes, it does not report it in the statement of cash flows.

The HK$6,000 cash dividend paid represents a financing activity cash outflow. Satellite makes the following worksheet entry:

The company reconciles the beginning and ending balances of retained earnings by entry of the three items above.

ILLUSTRATION 23-40
Income and Retained Earnings Statements, Satellite Corporation

Accounts Receivable (Net)

The increase in accounts receivable (net) of HK$53,000 represents adjustments that did not result in cash inflows during 2016. As a result, the company would deduct from net income the increase of HK$53,000. Satellite makes the following worksheet entry.

Inventory

The increase in inventory of HK$152,000 represents an operating use of cash. The incremental investment in inventory during the year reduces cash without increasing the cost of goods sold. Satellite makes the following worksheet entry.

Prepaid Expense

The decrease in prepaid expenses of HK$500 represents a charge in the income statement for which there was no cash outflow in the current period. Satellite should add that amount back to net income through the following entry.

Equity Investment in Porter Co. (Equity Method)

Satellite's investment in the shares of Porter Co. increased HK$3,500. This amount reflects Satellite's share of net income earned by Porter (its equity investee) during the current year. Although Satellite's revenue, and therefore its net income, increased HK$3,500 by recording Satellite's share of Porter Co.'s net income, no cash (dividend) was provided. Satellite makes the following worksheet entry.

Land

Satellite purchased land in the amount of HK$60,000 through the issuance of a long-term note payable. This transaction did not affect cash. It is a significant non-cash investing/financing transaction that the company would disclose in the accompanying notes. Satellite makes the following entry to reconcile the worksheet.

In addition to the non-cash transaction involving the issuance of a note to purchase land, the Land account was decreased by the condemnation proceedings. The following worksheet entry records the receipt of HK$18,500 for land having a book value of HK$10,500.

In reconciling net income to net cash flow from operating activities, Satellite deducts from net income the gain of HK$8,000. The reason is that the transaction that gave rise to the gain is an item whose cash effect is already classified as an investing cash inflow. The Land account is now reconciled.

Equipment and Accumulated Depreciation–Equipment

An analysis of Equipment and Accumulated Depreciation—Equipment shows that a number of transactions have affected these accounts. The company purchased equipment in the amount of HK$53,000 during the year. Satellite records this transaction on the worksheet as follows.

In addition, Satellite sold at a loss of HK$1,500 equipment with a book value of HK$5,500. It records this transaction as follows.

The proceeds from the sale of the equipment provided cash of HK$4,000. In addition, the loss on the sale of the equipment has reduced net income but did not affect cash. Therefore, the company adds back to net income the amount of the loss, in order to accurately report cash provided by operating activities.

Satellite reported depreciation on the equipment at HK$11,500 and recorded it on the worksheet as follows.

The company adds depreciation expense back to net income because that expense reduced income but did not affect cash.

Finally, the company made a major repair to the equipment. It charged this expenditure, in the amount of HK$11,000, to the Equipment account. This expenditure required cash, and so Satellite makes the following worksheet entry.

After adjusting for the foregoing items, Satellite has reconciled the balances in the Equipment and related Accumulated Depreciation—Equipment accounts.

Building Depreciation and Amortization of Trademarks

Depreciation expense on the buildings of HK$3,100 and amortization of trademarks of HK$2,400 are both expenses in the income statement that reduced net income but did not require cash outflows in the current period. Satellite makes the following worksheet entry.

Other Non-Cash Charges or Credits

Analysis of the remaining accounts indicates that changes in the Accounts Payable, Accrued Liabilities, Income Taxes Payable, Bonds Payable, and Deferred Tax Liability balances resulted from charges or credits to net income that did not affect cash. The company should individually analyze each of these items and enter them in the worksheet. The following compound entry summarizes these non-cash, income-related items.

Share Capital–Ordinary and Related Accounts

Comparison of the Share Capital—Ordinary and the Share Premium—Ordinary balances shows that transactions during the year affected these accounts. First, Satellite issues a share dividend of 2 percent to shareholders. As the discussion of worksheet entry (2) indicated, no cash was provided or used by the share dividend transaction. In addition to the shares issued via the share dividend, Satellite sold ordinary shares at HK$16 per share. The company records this transaction as follows.

Also, the company purchased its ordinary shares in the amount of HK$17,000. It records this transaction on the worksheet as follows.

Final Reconciling Entry

The final entry to reconcile the change in cash and to balance the worksheet is shown below. The HK$7,000 amount is the difference between the beginning and ending cash balance.

Once the company has determined that the differences between the beginning and ending balances per the worksheet columns have been accounted for, it can total the reconciling transactions columns, and they should balance. Satellite can prepare the statement of cash flows entirely from the items and amounts that appear at the bottom of the worksheet under “Statement of Cash Flows Effects,” as shown in Illustration 23-41.

ILLUSTRATION 23-41
Completed Worksheet for Preparation of Statement of Cash Flows, Satellite Corporation

Preparation of Final Statement

Illustration 23-42 presents a formal statement of cash flows prepared from the data compiled in the lower portion of the worksheet.

ILLUSTRATION 23-42
Statement of Cash Flows, Satellite Corporation

KEY TERMS

cash equivalents, 1184

direct method, 1198

financing activities, 1183

indirect method, 1188

investing activities, 1183

operating activities, 1183

significant non-cash transactions, 1209

statement of cash flows, 1182

Describe the purpose of the statement of cash flows. The primary purpose of the statement of cash flows is to provide information about cash receipts and cash payments of an entity during a period. A secondary objective is to report the entity's operating, investing, and financing activities during the period.

Identify the major classifications of cash flows. Companies classify cash flows as follows. (1) Operating activities—transactions that result in the revenues, expenses, gains, and losses that determine net income. (2) Investing activities—lending money and collecting on those loans, and acquiring and disposing of investments, plant assets, and intangible assets. (3) Financing activities—obtaining cash from creditors and repaying loans, issuing and reacquiring share capital, and paying cash dividends.

Prepare a statement of cash flows. Preparing the statement involves three major steps. (1) Determine the change in cash. This is the difference between the beginning and the ending cash balance shown on the comparative statements of financial position. (2) Determine the net cash flow from operating activities. This procedure is complex; it involves analyzing not only the current year's income statement but also the comparative statements of financial position and the selected transaction data. (3) Determine cash flows from investing and financing activities. Analyze all other changes in the statement of financial position accounts to determine the effects on cash.

Differentiate between net income and net cash flow from operating activities. Companies must adjust net income on an accrual basis to determine net cash flow from operating activities because some expenses and losses do not cause cash outflows, and some revenues and gains do not provide cash inflows.

Determine net cash flows from investing and financing activities. Once a company has computed the net cash flow from operating activities, the next step is to determine whether any other changes in statement of financial position accounts caused an increase or decrease in cash. Net cash flows from investing and financing activities can be determined by examining the changes in non-current statement of financial position accounts.

Identify sources of information for a statement of cash flows. The information to prepare the statement usually comes from three sources. (1) Comparative statements of financial position. Information in these statements indicates the amount of the changes in assets, liabilities, and equities during the period. (2) Current income statement. Information in this statement is used in determining the cash provided by operations during the period. (3) Selected transaction data. These data from the general ledger provide additional detailed information needed to determine how cash was provided or used during the period.

Contrast the direct and indirect methods of calculating net cash flow from operating activities. Under the direct approach, companies calculate the major classes of operating cash receipts and cash disbursements. Presentation of the direct approach of reporting net cash flow from operating activities takes the form of a condensed cash-basis income statement. The indirect method adds back to net income the non-cash expenses and losses and subtracts the non-cash revenues and gains.

Discuss special problems in preparing a statement of cash flows. These special problems are (1) adjustments to net income, (2) accounts receivable (net), (3) other working capital changes, (4) net loss, and (5) disclosures.

Explain the use of a worksheet in preparing a statement of cash flows. When numerous adjustments are necessary or other complicating factors are present, companies often use a worksheet to assemble and classify the data that will appear on the statement of cash flows. The worksheet is merely a device that aids in the preparation of the statement. Its use is optional.

1. 1. What is the purpose of the statement of cash flows? What information does it provide?
2. 2. Of what use is the statement of cash flows?
3. 3. Differentiate between investing activities, financing activities, and operating activities.
4. 4. What are the major sources of cash (inflows) in a statement of cash flows? What are the major uses (outflows) of cash?
5. 5. Identify and explain the major steps involved in preparing the statement of cash flows.
6. 6. Identify the following items as (1) operating, (2) investing, or (3) financing activities: purchase of land, payment of dividends, cash sales, and purchase of treasury shares.
7. 7. Unlike the other major financial statements, the statement of cash flows is not prepared from the adjusted trial balance. From what sources does the information to prepare this statement come, and what information does each source provide?
8. 8. Why is it necessary to convert accrual-based net income to a cash basis when preparing a statement of cash flows?
9. 9. Differentiate between the direct method and the indirect method by discussing each method.
10. 10. Broussard Company reported net income of $3.5 million in 2015. Depreciation for the year was $520,000, accounts receivable increased $500,000, and accounts payable increased $300,000. Compute net cash flow from operating activities using the indirect method.
11. 11. Collinsworth Co. reported sales on an accrual basis of £100,000. If accounts receivable increased £30,000 and the allowance for doubtful accounts increased £9,000 after a write-off of £2,000, compute cash sales.
12. 12. Your roommate is puzzled. During the last year, the company in which she is a shareholder reported a net loss of $675,000, yet its cash increased $321,000 during the same period of time. Explain to your roommate how this situation could occur.
13. 13. The board of directors of Gifford Corp. declared cash dividends of £260,000 during the current year. If dividends payable was £85,000 at the beginning of the year and £90,000 at the end of the year, how much cash was paid in dividends during the year?
14. 14. Explain how the amount of cash payments to suppliers is computed under the direct method.
15. 15. The net income for Letterman Company for 2015 was €320,000. During 2015, depreciation on plant assets was €124,000, amortization of patent was €40,000, and the company incurred a loss on sale of plant assets of €21,000. Compute net cash flow from operating activities.
16. 16. Each of the following items must be considered in preparing a statement of cash flows for Blackwell Inc. for the year ended December 31 2015, Indicate how each item is to be shown in the statement, if at all.

    (a) Plant assets that had cost $18,000 6½ years before and were being depreciated on a straight-line basis over 10 years with no estimated residual value were sold for $4,000.

    (b) During the year, 10,000 ordinary shares with a stated value of $20 a share were issued for $41 a share.

    (c) Uncollectible accounts receivable in the amount of $22,000 were written off against Allowance for Doubtful Accounts.

    (d) The company sustained a net loss for the year of $50,000. Depreciation amounted to $22,000, and a gain of $9,000 was realized on the sale of non-trading equity investments for $38,000 cash.

17. 17. Classify the following items as (1) operating, (2) investing, (3) financing, or (4) significant non-cash investing and financing activities, using the direct method.

    (a) Cash payments to employees.

    (b) Redemption of bonds payable.

    (c) Sale of building at book value.

    (d) Cash payments to suppliers.

    (e) Exchange of equipment for furniture.

    (f) Issuance of preference shares.

    (g) Cash received from customers.

    (h) Purchase of treasury shares.

    (i) Issuance of bonds for land.

    (j) Payment of dividends.

    (k) Purchase of equipment.

    (l) Cash payments for operating expenses.

18. 18. Silva Rojas and Hans Jensen were discussing the statement of cash flows of Liu Co. In the notes to the statement of cash flows was a schedule entitled “Non-cash investing and financing activities.” Give three examples of significant non-cash transactions that would be reported in this schedule.
19. 19. During 2015, Simms Company redeemed ¥2,000,000 of bonds payable for ¥1,880,000 cash. Indicate how this transaction would be reported on a statement of cash flows, if at all.
20. 20. What are some of the arguments in favor of using the indirect (reconciliation) method as opposed to the direct method for reporting a statement of cash flows?
21. 21. Why is it desirable to use a worksheet when preparing a statement of cash flows? Is a worksheet required to prepare a statement of cash flows?
22. 22. Briefly describe some of the similarities and differences between IFRS and U.S. GAAP with respect to cash flow reporting.
23. 23. Explain how the accounting for interest received and paid in a statement of cash flows may differ between IFRS and U.S. GAAP.
24. 24. What are some of the key obstacles for the IASB and FASB in their convergence project for the statement of cash flows?

BE23-4 Bloom Corporation had the following 2015 income statement.

BE23-5 Use the information from BE23-4 for Bloom Corporation. Prepare the cash flows from operating activities section of Bloom's 2015 statement of cash flows using the indirect method.

BE23-9 Loveless Corporation had the following 2015 income statement.

E23-2 (Statement Presentation of Transactions—Indirect Method) Each of the following items must be considered in preparing a statement of cash flows (indirect method) for Granderson Inc. for the year ended December 31, 2015.

E23-3 (Preparation of Operating Activities Section—Indirect Method, Periodic Inventory) The income statement of Rodriquez Company is shown below.

E23-4 (Preparation of Operating Activities Section—Direct Method) Data for the Rodriquez Company are presented in E23-3.

E23-5 (Preparation of Operating Activities Section—Direct Method) Norman Company's income statement for the year ended December 31, 2015, contained the following condensed information.

E23-6 (Preparation of Operating Activities Section—Indirect Method) Data for Norman Company are presented in E23-5.

E23-7 (Computation of Operating Activities—Direct Method) Presented below are two independent situations.

E23-8 (Schedule of Net Cash Flow from Operating Activities—Indirect Method) Messner Co. reported €145,000 of net income for 2015. The accountant, in preparing the statement of cash flows, noted several items occurring during 2015 that might affect cash flows from operating activities. These items are listed below.

E23-10 (Classification of Transactions) Following are selected statement of financial position accounts of Sander Bros. Corp. at December 31, 2015 and 2014, and the increases or decreases in each account from 2014 to 2015. Also presented is selected income statement information for the year ended December 31, 2015, and additional information.

E23-12 (SCF—Direct Method) Data for Fairchild Company are presented in E23-11.

E23-13 (SCF—Direct Method) Andrews Inc., a greeting card company, had the following statements prepared as of December 31, 2015.

E23-16 (Cash Provided by Operating, Investing, and Financing Activities) The statement of financial position data of Yang Company at the end of 2015 and 2014 follow (amounts in thousands).

E23-18 (Partial SCF—Indirect Method) The accounts below appear in the ledger of Popovich Company.

P23-1 (SCF—Indirect Method) The following is Sullivan Corp.'s comparative statement of financial position accounts at December 31, 2015 and 2014, with a column showing the increase (decrease) from 2014 to 2015.

P23-2 (SCF—Indirect Method) The comparative statements of financial position for Hinckley Corporation include the information shown on page 1236.

P23-3 (SCF—Direct Method) Mortonson Company has not yet prepared a formal statement of cash flows for the 2015 fiscal year. Comparative statements of financial position as of December 31, 2014 and 2015, and a statement of income and retained earnings for the year ended December 31, 2015, are presented as follows.

P23-4 (SCF—Direct Method) Michaels Company had available at the end of 2015 the following information.

P23-5 (SCF—Indirect Method, and Net Cash Flow from Operating Activities, Direct Method) Comparative statement of financial position accounts of Marcus Inc. are presented below.

P23-6 (SCF—Direct and Indirect Methods from Comparative Financial Statements) Chapman Company, a major retailer of bicycles and accessories, operates several stores and is a publicly traded company. The comparative statement of financial position and income statement for Chapman as of May 31, 2015, are as follows. The company is preparing its statement of cash flows.

P23-7 (SCF—Direct and Indirect Methods) Comparative statement of financial position accounts of Shi Company are presented below.

P23-8 (Indirect SCF) Greco Corporation has contracted with you to prepare a statement of cash flows. The controller has provided the following trial balance information.

CA23-1 (Analysis of Improper SCF) The following statement was prepared by Maloney Corporation's accountant.

CA23-2 (SCF Theory and Analysis of Improper SCF) Teresa Ramirez and Lenny Traylor are examining the following statement of cash flows for Panaka Clothing Store's first year of operations.

CA23-4 (Analysis of Transactions' Effect on SCF) Each of the following items must be considered in preparing a statement of cash flows for Boer Fashions Inc. for the year ended December 31, 2015.

CA23-6 (Cash Flow Reporting) Brockman Guitar Company is in the business of manufacturing top-quality, steel-string folk guitars. In recent years, the company has experienced working capital problems resulting from the procurement of factory equipment, the unanticipated buildup of receivables and inventories, and the payoff of a balloon mortgage on a new manufacturing facility. The founder and president of the company, Barbara Brockman, has attempted to raise cash from various financial institutions, but to no avail because of the company's poor performance in recent years. In particular, the company's lead bank, First Financial, is especially concerned about Brockman's inability to maintain a positive cash position. The commercial loan officer from First Financial told Barbara, “I can't even consider your request for capital financing unless I see that your company is able to generate positive cash flows from operations.”