Statement of cash flows

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Statement of Cash Flows

I. Purpose of the statement

The statement of cash flows reports the cash effects of a company's operations for a period of time. The main purpose is to provide financial information about the cash receipts and cash payments of a business for a specific period of time. This helps investors, creditors and other external users about a company’s cash position. The statement shows the cash effects of a company's operating, investing, and financing activities. The statement of cash flows indicates the net increase or decrease in cash during the period as well as the ending cash balance.

It helps to answer some questions such as,

  • where did cash come from during the period,
  • how was the cash used,
  • what was the change in cash balance during the period?

II. Historical background of the statement

In 1971, the Financial Accounting Standards Board (FASB) made it mandatory under Generally Accepted Accounting Principles (GAAP) for firms to report sources and uses of funds. Since the term ‘funds’ was unclear, FASB required firms to provide cash flow statements. This occurred in 1987 under FASB Statement No. 95. The International Accounting Standards Board’s required firms to provide cash flow statements, which was put into effect in 1994. It is under International Accounting Standard 7 (IAS 7).

III. Methods of calculating the statement

There are two ways to calculate the statement of cash flows. One is the indirect method and the other is the direct method. FASB prefers that firms use the direct method, but a large majority of firms use the indirect method. A major difference between the indirect method and direct method involves presentation of cash flows from operating activities. Under the indirect method, cash flows from operating activities are derived from net income. Under the direct method, specific cash flows from operating activities are reported.

A. The indirect method

The indirect method begins with net income and converts it to net cash flow from operating activities. The indirect method adjusts net income for items that affected reported net income but did not affect cash. To calculate net cash flow from operating activities, a firm adds back noncash charges in the income statement and deducts noncash credits to net income.

B. The direct method

The direct method reports net cash flow from operating activities as major classes of operating cash receipts (cash collected from customers and cash received from dividends and interest) and cash disbursements. (cash paid to suppliers, employees, creditors, etc). Firms calculate net cash provided by operating activities by adjusting each item in the income statement from the accrual basis to the cash basis. Many firms use the account analysis technique to filter cash-flow data from accrual basis data. To solve: Sales + decrease in Accounts Receivable OR Sales – increase in Accounts Receivable. This equation solves the cash receipts from customers under the direct method.

IV. Cash flow activities

A. Operating activities

Operating activities include the cash effects of transactions that create revenues and expenses. This includes cash receipts from sales of products and payments to suppliers and employees. It also includes receipts on the sales of loans, dividends received, tax and interest payments made.

How to Determine Net Cash Flow from Operating Activities:

Net Income Plus: Depreciation and amortization Losses Decreases in noncash current assets Increases in current liabilities Less: Gains Increases in noncash current assets Decreases in current liabilities Equals: Net Cash Flow from Operating Activities

Depreciation and amortization are added to net income because they are noncash expenses. Gains and losses are adjusted to net income because they are nonreporting items. Changes in current accounts require adjustments to net income because they reflect the differences between revenues and expenses and the related operating cash flows.

Operating activities should be a firm’s primary source of cash. There is a limit on the amount of cash that a firm can raise from investing and financing activities.

B. Investing activities

Investing activities include cash flow from acquiring and disposing of investments and property, plant, and equipment. It also includes collections on loans for selling and payments on loans for collecting another company's debt instruments.

C. Financing activities

Financing activities include obtaining cash from issuing debt and repaying the amounts borrowed. It also includes obtaining cash from stockholders and providing them with a return on their investment in the form of dividend payments.

V. An example for computing the statement of cash flows under the indirect method:

The following is needed to calculate the statement of cash flows:
1. A company's comparative balance sheet
2. Additional information from the income statement and accounting records

  • = a few hints for calculating the statement of cash flows

Comparative balance sheet of Company X at December 31, 2000 and 1999:

Dec. 31, 2000 Dec. 31, 1999 “Change in”
Cash $184,200 $124,600 59,600 increase
Accounts Receivable 202,800 148,700 54,100 increase
Inventories 250,500 275,000 24,500 decrease
Prepaid expenses 5,400 4,500 900 increase
Land 85,000 85,000
Buildings 575,000 465,000 110,000 increase
Accum. Depr—Building (192,000) (168,000) 24,000 decrease
Machinery & Equipment 345,800 345,800
Accum. Depr—Machine & Equip. (134,000) (99,000) 35,000 decrease
Patents 39,500 45,000 5,500 decrease
Totals $1,362,200 $1,226,600
Liabilities and Stockholders’ Equity
Accounts payable $114,500 $132,400 17,900 decrease
Dividends payable 14,500 12,000 2,500 increase
Salaries payable 8,900 10,900 2,000 decrease
Mortgage note payable, due 2001 65,000 65,000 increase
Bonds payable 105,000
Common stock, $1 par 25,000 20,000 5,000 increase
Paid in capital in excess of par –common stock 150,000 50,000 100,000 increase
Retained earnings 984,300 896,300 88,000 increase
Totals $1,362,200 $1,226,600

The income statement and the accounting records revealed the following additional information applicable to 2000:

a. Net income, $115,500

  • (beginning number under operating activities in statement of cash flow)

b. Depreciation expense reported on the income statement: buildings, $24,000; machinery and equipment $35,000.

  • (deprecation expenses are added to net income in the statement of cash flow)

c. Patent amortization reported on the income statement, $5,500.

  • (amortization is also added to net income in the statement of cash flow)

d. A building was constructed for $110,000.

  • (paid for by cash; represents a decrease in cash in the investing activities)

e. A mortgage note for $65,000 was issued for cash.

  • (cash received; represents an increase in cash in the financing activities)

f. 5,000 shares of common stock were issued at $21 in exchange for the bonds payable.

  • (noncash event; no effect on the statement of cash flow)

g. Cash dividends declared and paid, $27,500.

  • (must subtract 2,500 from 27,500 to get 25,000 actual cash dividends paid. 2,500 comes from the “change in” column and it represents 2,500 dividends not yet paid. 25,000 represents a decrease in cash in the financing activities)

  • First mark next to each asset and liability either: current asset, current liability, noncash event, investment or financing activity.
  • Current assets are added into cash flow if there was a decrease in the “change in” column. Current assets are subtracted from cash flow if there was an increase in the “change in” column. Current liabilities are added into cash flow if there was an increase in the “change in” column and are subtracted if there was a decrease in the “change in” column. Current assets move in opposite directions, where as the current liabilities move in the same direction.
  • Also set up a “change in” column next to the beginning and ending balances and calculate the differences. Mark if it was a decrease or increase. (Shown in table above).
  • All depreciation and amortization expenses are added into cash flow.
  • The net change in cash should equal the amount of cash in the “change in” column that you created.

Company X
Statement of Cash Flow
Year End December 31, 2000
Operating Activity
Net Income $115,500
Add: Depreciation Expense—Building $24,000
Depreciation Expense—Machine 35,000
Amortization Expense—Patent 5,500 89,000
Subtract: Accounts Receivable (increase) 54,100
Prepaid Expense (increase) 900
Salaries Payable (decrease) 2,000
Accounts Payable (decrease) 17,900 (74,900)
Net cash from operating activity 129,600
Investing Activity
Purchase of building $110,000
Net cash used for investing activities (110,000)
Financing Activity
Issued mortgage for cash $65,000
Payment of cash dividends (25,000)
Net cash from financing activities 40,000
Net change in cash $59,600
Beginning cash balance $124,600
Ending cash balance $184,200