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quired financial statement although many companies on a cash basis, did not provide a complete and clear




When these journal entries are posted, the following trial balance results:


Silmaril, Inc.
Trial Balance
December 31, 2002

Debit Credit

Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,430
Accounts Receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800
Property, Plant, and Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,500
Accumulated Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 900
Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500
Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
Long-Term Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Common Stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,450
Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,560
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,500
Gain on Sale of Equipment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000
Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500
Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
Tax Expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450
Miscellaneous Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,200
Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $22,080 $22,080



To this point, this is all a review”journalizing transactions, posting journal entries, and
preparing a trial balance. From this trial balance, we can easily prepare an income statement
626 f627
The Statement Of Cash Flows Chapter 13
The Statement of Cash Flows




picture of a company™s ability to generate positive while experiencing serious cash flow problems that
cash flows. One reason is that APB Opinion No. 19 re- were not readily apparent from the information re-
quired that all investing and financing activities be re- ported in the funds statement. For example, ENDO-
ported in the statement, even those that did not affect LASE, a distributor of medical lasers, reported a 200%
cash or working capital. Another problem was that the increase in sales in one year. Unfortunately, due to
funds statement usually included two sections” poor collection performance, receivables increased at
sources (inflows) and uses (outflows) of funds. Thus, an even faster rate than sales, and much of the re-
the amount of working capital or cash provided or ported increase in revenues took the form of IOUs.
used by each major type of activity (operating, in- When many of these receivables were determined to
vesting, and financing) was not identified. be uncollectible, Endo-Lase had to restate its previ-
The limitations of the funds statement often made ously reported earnings. So, although reported earn-
it difficult to assess a company™s ability to generate ings appeared strong, Endo-Lase™s cash flows were
sufficient cash. Some companies were able to report actually negative, and eventually the company had to
favorable earnings in the income statement, even file for bankruptcy protection.




and a balance sheet; but our objective here is to prepare a statement of cash flows. With in-
formation from the Cash T-account, we can prepare a statement of cash flows. The Cash T-
account would contain the following information (journal entry reference numbers are in paren-
theses):


Cash

Beg. Bal. 300
(2) 14,000 (5) 8,100
(7) 500 (6) 1,700
(9) 450 (8) 200
(11) 180
(13) 3,200
(15) 440
End. Bal. 1,430


Our task at this point is simply to categorize each cash inflow and outflow as an operating,
investing, or financing activity. The inflows and outflows break down as follows:

Operating Activities:
Collections on account (2). . . . . . . . . . . . . . ...................... $14,000
Payments for inventory (5) . . . . . . . . . . . . . ...................... $ 8,100
Payments for miscellaneous expenses (13) . ...................... 3,200
Payment for interest (11) . . . . . . . . . . . . . . ...................... 180
Payment for taxes (15) . . . . . . . . . . . . . . . . ...................... 440 (11,920)
Cash flows from operating activities . . . . . . ...................... $ 2,080

Investing Activities:
Sold equipment (7) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 500
Purchased equipment (6) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,700)
Cash flows from investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,200)
627
f628 Part 4 The Statement Of Cash Flows
Other Dimensions of Financial Reporting


Financing Activities:
Issued stock (9). . . . . . . . . . . . . . . . ............................ $ 450
Paid debt (8) . . . . . . . . . . . . . . . . . . ............................ (200)
Cash flows from financing activities ............................ 250
Net increase in cash. . . . . . . . . . . . . . ............................ $ 1,130
Beginning cash balance . . . . . . . . . . . ............................ 300
Ending cash balance . . . . . . . . . . . . . ............................ $ 1,430



As you can see, if we have access to the detailed transaction data from the Cash T-account,
preparing a statement of cash flows involves determining the proper cash flow category (oper-
ating, investing, or financing) for each inflow or outflow and then properly formatting the state-
ment. More advanced accounting software programs allow financial statement preparers to cat-
egorize each cash inflow and outflow as an operating, investing, or financing activity and to
prepare a statement of cash flows with the press of a key. Once considered one of the most dif-
ficult parts of accounting, preparing a statement of cash flows has been greatly simplified as a
result of computer technology.
If information is properly coded when input into a computerized accounting system, the
preparation of a statement of cash flows is easy. As mentioned, the more advanced accounting
software facilitates this process. But what happens if an accounting system does not classify cash
transactions according to their activities? In the next section, we discuss how a statement of cash
flows is prepared if one does not have ready access to detailed cash inflow and outflow infor-
mation.




to summarize
If transactions are properly classified when input into the accounting system,
the preparation of a statement of cash flows is straightforward. Cash inflows
and outflows are segregated according to type of activity (operating, investing,
or financing), and a statement of cash flows is prepared based on that infor-
mation. As technology continues to advance, the preparation of a statement of
cash flows is becoming easier.




4 ANALYZING THE OTHER PRIMARY FINANCIAL
STATEMENTS TO PREPARE A STATEMENT OF
Analyze financial
statements to prepare a
CASH FLOWS
statement of cash flows.

If detailed cash flow information is not accessible, the preparation of a statement of cash
flows is more difficult. The income statement and comparative balance sheets must be ana-
lyzed to determine how cash was generated and how cash was used by a business. How can
we determine a company™s cash inflows and outflows by looking at balance sheets and an in-
come statement? The secret lies in remembering the basics of double-entry accounting: each
journal entry has two parts”a debit and a credit. In the case of the cash account, every time
Cash is debited, some other account is credited; every time Cash is credited, some other ac-
count is debited. If we don™t have access to the details of the cash account, we can infer those
details based on our knowledge of accounting and by analyzing changes in accounts other
than Cash.
628 f629
The Statement Of Cash Flows Chapter 13
The Statement of Cash Flows



For example, consider the accounts receivable account. A debit to that account means
what? Ninety-nine percent of the time, a debit to Accounts Receivable is associated with a
sale on account. A credit to Accounts Receivable means what? Most likely, cash was collected.
If we have the beginning and ending balances for the accounts receivable account (from com-
parative balance sheets) and sales for the period (from the income statement), we can infer
the cash collected for the period. Consider the information taken from Silmaril™s beginning
trial balance and the year-end trial balance relating to Accounts Receivable (remember, we are
assuming that the detailed journal entries are not available to us, only the resulting financial
statements):


Accounts Receivable

Beg. Bal. 2,500
Sales 13,500 Collections ?
End. Bal. 2,000


To reconcile the accounts receivable account, we can only assume that cash collections of
$14,000 occurred. With any other amount the account will not reconcile.3 In other words, we
can infer that the following journal entry must have been made:


Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000
Accounts Receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000



As you can see from this analysis, we don™t necessarily need the detailed cash account informa-
tion to prepare a statement of cash flows. We can use our knowledge of double-entry account-
ing to infer those details.
A similar analysis is conducted for every balance sheet account (except Cash). The
caution analyses draw on our knowledge of the relationship between the income statement and
balance sheet accounts and of what accounts are associated with operating, investing,
Every balance sheet account
and financing activities. Consider another example”Common Stock. First of all, we
(except Cash) must be analyzed
know that changes in the common stock account are considered financing activities.
to determine any cash flow ef-
Second, what do we know about credits to the common stock account? They typically
fects. Then those effects must
are associated with the issuance (sale) of stock. Debits to the common stock account?
be classified by activity.
They are associated with the retirement of common stock. Assume we are given com-
parative balance sheet information (transactions in a company™s own stock are not re-
flected on the income statement) relating to the common stock account of Silmaril, Inc., as
follows:


Beginning Balance Ending Balance

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000 $1,450



What would you infer about Silmaril™s cash flow activities relating to its common stock account?
Without any additional information, it would be safe to assume that the company sold stock



3 Some of you may be thinking that Accounts Receivable can be credited when accounts are written off. This
is true, and write-offs would affect our analysis. However, our purpose here is to understand the concepts. A
more complicated analysis including write-offs will be covered in an intermediate accounting class.
629
f630 Part 4 The Statement Of Cash Flows
Other Dimensions of Financial Reporting



for $450. If something out of the ordinary happened in the common stock account (like the re-
tirement of stock), that information would generally be available in the notes to the financial
statements and would be used to modify the analysis.
As an illustration of this type of complexity, consider Silmaril™s property, plant, and equipment
(PP&E) account. First of all, the PP&E account is associated with what type of cash flow activity?
Investing. Increases in property, plant, and equipment correspond to purchases of PP&E, and
fyi decreases relate to the sale of PP&E. Because the sale of PP&E is typically an out-of-the-
ordinary type of transaction, we could look at the notes to the financial statements for infor-
Buying and using PP&E would
mation relating to any sales. In the case of Silmaril, Inc., we find that equipment costing
be considered common activi-
$1,200, with accumulated depreciation of $800, was sold for $500. Based on this informa-
ties. Selling PP&E would be
tion, and using information from the comparative balance sheets, we can infer the purchases
considered less common.
made during the period as follows:


Property, Plant, and Equipment

Beg. Bal. 4,000
Purchases ? Sold 1,200
End. Bal. 4,500



How much PP&E was purchased during the period? The only amount that will reconcile the
PP&E account is $1,700. The journal entry would have been a debit to PP&E and a credit to
Cash. Again, we find that we don™t need the details of the cash account to be able to infer the
cash inflows and outflows for the company. Our knowledge of double-entry accounting allows
us to do a little detective work and infer what went on in the cash account.

A Six-Step Process for Preparing a Statement of Cash Flows
Is there a systematic method for analyzing the income statement and comparative balance sheets
to prepare a statement of cash flows? Yes, the following six-step process can be used in prepar-
ing a statement of cash flows:

1.Compute the change in the cash and cash-equivalent accounts for the period of the state-
ment. Seldom is one handed a check figure in real life, but such is the case when prepar-
ing a statement of cash flows. The statement of cash flows is not complete until you have
explained the change from the beginning balance in the cash account to the balance at
year-end.
2. Convert the income statement from an accrual-basis to a cash-basis summary of opera-
tions. This is done in three steps: (1) eliminate from the income statement those ex-
penses that do not involve cash (such noncash items would include depreciation ex-
noncash items Items in-
cluded in the determination pense that does not involve an outflow of cash in the current period even though income
of net income on an accrual
was reduced); (2) eliminate from the income statement the effects of nonoperating ac-
basis that do not affect
tivity items (such items include gains and losses on the sale of long-term assets and gains
cash; for example, depreci-
and losses associated with the retirement of debt); and (3) identify those current asset
ation and amortization.
and current liability accounts associated with the income statement accounts, and ad-
just those income statement accounts for the changes in the associated current assets and
current liabilities. For example, Sales will be adjusted for the change between the be-
ginning and ending balance in Accounts Receivable to derive the cash col-
Why must gains (losses) lections for the period. The final result will be cash flows from operating ac-
tivities.
on the sale of equipment be subtracted
3. Analyze the long-term assets to identify the cash flow effects of invest-
(added) when computing cash flows from
ing activities. Changes in property, plant, and equipment and in long-
operations? term investments may indicate that cash has either been spent or been
received.
630 f631
The Statement Of Cash Flows Chapter 13
The Statement of Cash Flows


4. Analyze the long-term debt and stockholders™ equity accounts to determine the cash
caution
flow effects of any financing transactions. These transactions could be borrowing or
Make sure that the total net repaying debt, issuing or buying back stock, or paying dividends.
cash flows from the statement 5. Prepare a formal statement of cash flows by classifying all cash inflows and outflows
(the sum of net cash flows from according to operating, investing, and financing activities. The net cash flows pro-
vided by (used in) each of the three main activities of an entity should be highlighted.
operating, investing, and fi-
The net cash flows amount for the period is then added (subtracted) from the be-
nancing activities) are equal to
ginning Cash balance to report the ending Cash balance.
the net increase (decrease) in
6. Report any significant investing or financing transactions that did not involve cash
cash as computed in step 1.
in a narrative explanation or in a separate schedule to the statement of cash flows.
This would include such transactions as the purchase of land by issuing stock or the
retirement of bonds by issuing stock.


An Illustration of the Six-Step Process
We will illustrate this six-step process for preparing the statement of cash flows using the infor-
mation from the Silmaril, Inc., example presented earlier. Remember that in this case we are as-
suming that we do not have access to the detailed cash flow information. Thus, we are going to
have to make inferences about cash flows by examining all other balance sheet and income state-
ment accounts other than the cash account.

STEP 1. COMPUTE THE CHANGE IN THE CASH AND CASH-EQUIVALENT AC-
COUNTS FOR THE PERIOD OF THE STATEMENT Recall that Silmaril began the year
with a Cash balance of $300 and ended with a Cash balance of $1,430. Thus, our objective in
preparing the statement of cash flows is to explain why the cash account changed by $1,130
during the year.

STEP 2. CONVERT THE INCOME STATEMENT FROM AN ACCRUAL BASIS TO A
CASH BASIS From the trial balance prepared at the end of the year, we can prepare the fol-
lowing income statement for Silmaril, Inc.:


Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $13,500
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,500
Miscellaneous expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,200
Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500
Income from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,800
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (200)
Gain on sale of equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
Income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,700
Tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,250



Our objective at this point is to convert the income statement to cash flows from oper-
ations. Recall that this involves three steps: (1) eliminating expenses not involving cash, (2)
eliminating the effects of nonoperating activities, and (3) adjusting the remaining figures from
an accrual basis to a cash basis. We will use a work sheet to track the adjustments that will
be made. The first two adjustments involve removing depreciation expense (because it does
not involve an outflow of cash) and eliminating the gain on the sale of the equipment (be-
cause the sale of equipment is an investing activity, the effect of which will be disclosed in
the investing activities section of the statement). The following work sheet reflects these ad-
justments:
631
f632 Part 4 The Statement Of Cash Flows
Other Dimensions of Financial Reporting



Income Cash Flows from
Statement Adjustments Operations

Sales $13,500
Cost of goods sold (8,000)
Miscellaneous
expenses (3,200)
Depreciation
expense (500) 500 (not a cash flow item) 0
Interest expense (200)
Gain on sale of
equipment 100 100 (not an operating activity) 0
Tax expense (450)
$ 1,250


Note that because depreciation expense was initially subtracted to arrive at net income,
caution our adjustment involves adding $500 back because no cash actually flowed out of the com-
pany relating to depreciation. The cash flow effect of the sale of the equipment should be
When equipment is initially
reflected in the investing activities section of the statement of cash flows. Therefore, the
purchased, the cash outflow is
effect of the gain must be removed from the operating activities section. Because the gain
reported as an investing activ-
was initially added, we must subtract $100 as an adjustment to remove the effects of this
ity. When the equipment is
investing activity from the operating activities section.
used, this use is recorded as de-
The adjustments now involve converting the remaining revenue and expense items
preciation and does not involve
from an accrual basis to a cash basis. Recall from our analysis earlier in this section that
any cash flow even though it is
the amount of cash collected from customers differed from sales for the period. In fact,
reported as an expense on the
collections exceeded sales by $500 (explaining how the accounts receivable account de-
income statement.
clined by $500). An adjustment must be made to increase the accrual-basis sales figure to
its cash-basis counterpart. We add $500 as illustrated below.

Cash Flows
Income from
Statement Adjustments Operations

Sales $13,500 500 (decrease in accounts receivable) $14,000
Cost of goods sold (8,000)
Miscellaneous
expenses (3,200)
Depreciation
expense (500) 500 (not a cash flow item) 0
Interest expense (200)
Gain on sale of
equipment 100 100 (not an operating activity) 0
Tax expense (450)
$ 1,250


Next, we turn our attention to Cost of Goods Sold. The statement of cash flows should
caution reflect the amount of cash paid for inventory during the period. We can compute that amount
by adjusting Cost of Goods Sold to reflect the inventory used this period but purchased last
Remember that Cost of Goods
period, as well as inventory that was purchased last period and paid for this period.
Sold is subtracted from Sales.
Because Inventory declined for the period from a beginning balance of $1,900 to an end-
Adding $100 serves to reduce
ing balance of $1,800, we must adjust Cost of Goods Sold to reflect that it includes inven-
the negative number, and sub-
tory that was purchased last period and used this period (explaining how the inventory bal-
tracting $200 makes the cost of
ance declined). To reduce Cost of Goods Sold, our adjustment involves adding $100. The
goods sold figure a larger neg-
resulting number represents the amount of inventory purchased during the year. A similar
ative number.
adjustment is made for the change in the balance in Accounts Payable and reflects the amount
of inventory paid for during the year. What event would cause Accounts Payable to decline?
632 f633
The Statement Of Cash Flows Chapter 13
The Statement of Cash Flows



Obviously, Accounts Payable would most likely decline because more was paid for this period than
was purchased this period. If more was paid for this period, we are required to subtract an addi-
tional $200 to reflect the additional cash outflow. The net effect of these two adjustments is to con-
vert the accrual-basis Cost of Goods Sold figure to the amount of inventory paid for during the
year. The following T-account analysis shows the net effect of these two adjustments:

Cash Inventory Accounts Payable Cost of Goods Sold

8,100C 8,000A
1,900 1,700
A
7,900B
8,000
B
8,100C
7,900
1,800 1,500

A
Cost of inventory sold during the period (from the income statement).
B
Inventory purchased during the period [solved for based on the beginning and ending Inventory balances and
the cost of goods sold (A)].
C
Inventory paid for during the period [solved for based on the beginning and ending Accounts Payable balances
and the inventory purchased during the period (B)].


Updating our work sheet results in the following:

Cash Flows
Income from
Statement Adjustments Operations

Sales $13,500 500 (decrease in accounts receivable) $14,000
Cost of goods sold (8,000) 100 (decrease in inventory) (8,100)
200 (decrease in accounts payable)
Miscellaneous
expenses (3,200)
Depreciation
expense (500) 500 (not a cash flow item) 0
Interest expense (200)
Gain on sale of
equipment 100 100 (not an operating activity) 0
Tax expense (450)
$ 1,250


Because neither a miscellaneous expenses payable account nor a prepaid expenses account
exists, we can safely assume that all the miscellaneous expenses were paid for in cash. Therefore,
there would be no adjustment.
Both Interest Expense and Tax Expense require adjustments similar to that done for Ac-
counts Payable and/or Inventory. Let™s first adjust Interest Expense from an accrual basis to a
cash basis. Note that Interest Payable increased from $0 at the beginning of the period to $20
at the end of the period. How would that happen? Obviously, if a payable account increases,
the company owes for products and services it has purchased or used. In this case what was used
is money. Interest expense for the period was $200, of which Silmaril has yet to pay $20. Thus,
the cash flow related to interest must be $180”requiring an adjustment of $20.
Tax Expense is adjusted in a similar fashion. Because the amount of taxes owed increased
from the beginning to the end of the period, Silmaril must have paid a lesser amount relating
to taxes than is reflected on the income statement. Reviewing the T-account for Taxes Payable
helps us see how that can be:

Taxes Payable

Beg. Bal. 40
Taxes paid Amount related
during the period ? to tax expense 450
End. Bal. 50
633
f634 Part 4 The Statement Of Cash Flows
Other Dimensions of Financial Reporting


As you can determine, the only amount that will balance the above T-account is $440”the
amount paid for taxes during the period. Because the income statement reflects expense of $450
related to taxes, yet the cash outflow was only $440, we must make an adjustment of $10. The
work sheet, with these final adjustments, appears as follows:


Cash Flows
Income from
Statement Adjustments Operations

Sales $13,500 500 (decrease in accounts receivable) $14,000
Cost of goods
sold (8,000) 100 (decrease in inventory) (8,100)
200 (decrease in accounts payable)
Miscellaneous
expenses (3,200) 0 (3,200)
Depreciation
expense (500) 500 (not a cash flow item) 0
Interest expense (200) 20 (increase in interest payable) (180)
Gain on sale of
equipment 100 100 (not an operating activity) 0
Tax expense (450) 10 (increase in taxes payable) (440)
$ 1,250 830 net adjustment $ 2,080



Note that the cash flows from operations figure obtained through an analysis of the income
statement accounts and current asset and current liability accounts is the same figure obtained
previously when we assumed access to the detailed cash account information. We should always
get the same answer when the question is the same””What were cash flows from operations?”

The Direct and Indirect Methods Our final task relating to cash flows from operations re-
lates to preparing the operating activities section of the statement of cash flows. At this point,
we have two alternatives”the indirect method or the direct method.
The indirect method begins with net income as reported on the income statement and
indirect method A method
of reporting net cash flows then details the adjustments made to arrive at cash flows from operations. For Silmaril, Inc., it
from operations that in-
involves beginning with the net income figure and then listing the adjustments from the work
volves converting accrual-
sheet. In other words, the following highlighted portions of the work sheet are used.
basis net income to a cash
basis.

Cash Flows
Income from
Statement Adjustments Operations

Sales $13,500 500 (decrease in accounts receivable) $14,000
Cost of goods
sold (8,000) 100 (decrease in inventory) (8,100)
200 (decrease in accounts payable)
Miscellaneous
expenses (3,200) 0 (3,200)
Depreciation
expense (500) 500 (not a cash flow item) 0
Interest expense (200) 20 (increase in interest payable) (180)
Gain on sale of
equipment 100 100 (not an operating activity) 0
Tax expense (450) 10 (increase in taxes payable) (440)
$ 1,250 830 net adjustment $ 2,080
634 f635
The Statement Of Cash Flows Chapter 13
The Statement of Cash Flows


The operating activities section is formatted as follows:
Operating Activities:
Net income . . . . . . . . . . . . . . . . . . . . ............................. $1,250
Add: Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $500
Decrease in accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500
Decrease in inventory . . . . . . . . ............................. 100
Increase in interest payable . . . . ............................. 20
Increase in taxes payable . . . . . ............................. 10
Less: Gain on sale of equipment . . . . ............................. (100)
Decrease in accounts payable . . ............................. (200) 830
Cash flows from operations. . . . . . . . ............................. $2,080

Using the direct method, the operating activities section of a statement of cash flows is, in
direct method A method of
reporting net cash flows effect, a cash-basis income statement. Unlike the indirect method, the direct method does not
from operations that shows start with net income. Instead, this method directly reports the major classes of operating cash
the major classes of cash
receipts and payments of an entity during a period. This information is obtained from the last
receipts and payments for a
column of the work sheet as follows:
period of time.



Cash Flows
Income from
Statement Adjustments Operations

Sales $13,500 500 (decrease in accounts receivable) $14,000
Cost of goods
sold (8,000) 100 (decrease in inventory) (8,100)
200 (decrease in accounts payable)
Miscellaneous
expenses (3,200) 0 (3,200)
Depreciation
expense (500) 500 (not a cash flow item) 0
Interest expense (200) 20 (increase in interest payable) (180)
Gain on sale of
equipment 100 100 (not an operating activity) 0
Tax expense (450) 10 (increase in taxes payable) (440)
$ 1,250 830 net adjustment $ 2,080



The resulting operating activities section, given below, looks a lot like the operating activities
section we prepared when we had access to the detailed cash flow information.

Operating Activities:
Collections from customers . . . . . . . . . .......................... $14,000
Payments for inventory . . . . . . . . . . . . .......................... $8,100
Payments for miscellaneous expenses . .......................... 3,200
Payments for interest . . . . . . . . . . . . . . .......................... 180
Payments for taxes . . . . . . . . . . . . . . . .......................... 440 (11,920)
Cash flows from operating activities. . . .......................... $ 2,080

Now that you have seen Note that the same amount of cash flows from operating activities is derived
both methods for preparing the operating using either the indirect method or the direct method.
activities section of the statement of cash
Why Two Methods? You may be wondering, “Why are there two methods for
flows, which method do you prefer? Which preparing a statement of cash flows when both methods always result in the
method do you think is used most often by same answer?” Good question. Each method has advantages and disadvantages.
Most companies prefer and use the indirect method because it is relatively easy
companies?
635
f636 Part 4 The Statement Of Cash Flows
Other Dimensions of Financial Reporting


to apply and reconciles the difference between net income and the net cash flows provided by
operations. Many users of financial statements favor the direct method because it reports the
sources of cash inflows and outflows directly without the potentially confusing adjustments to
net income. The accounting standard-setters considered the arguments for both methods, and
although they preferred the clarity of the direct method, they permitted either method to be
used. Because they can choose either method and already have to compute net income, ap-
proximately 95% of large U.S. corporations use the indirect method when preparing a state-
ment of cash flows.

Some Rules of Thumb Although all this analysis may seem complex, the guidelines below will
help you as you analyze accounts and prepare a statement of cash flows.


Direction of Change
Accounts during the Period Adjustment to Be Made

Current assets Increase Subtracted
Current assets Decrease Added
Current liabilities Increase Added
Current liabilities Decrease Subtracted



When current assets increase (decrease) during the period, the difference between the
caution
beginning and ending balances is subtracted (added) from the appropriate income state-
These guidelines will help you
ment account to arrive at cash flows for the period. As an example, if accounts receivable
to understand how certain ad- increase during the period, that means sales exceed collections and Sales on the income
justments are made, but they statement must be reduced to reflect the cash collected for the period. The reverse would
be true when accounts receivable decrease.
will not help you understand
In the case of current liabilities, an increase (decrease) requires that an adjustment be
why the adjustments are being
made to add (subtract) the difference between the beginning and ending balances. For ex-
made. To understand why, you
ample, when interest payable increases from the beginning to the end of the period, in-
must use your knowledge of
terest expense exceeds the cash paid during the period. Interest Expense must be reduced
accounting.
(by adding back) to reflect the cash paid during the period. Again, the reverse would be
true if interest payable were to decrease during the period. Exhibit 13-6 summarizes the
procedures for converting selected accounts from an accrual to a cash basis.

STEP 3. ANALYZE THE LONG-TERM ASSETS TO IDENTIFY THE CASH FLOWS
EFFECT OF INVESTING ACTIVITIES The only long-term asset account for Silmaril, Inc.,
is the property, plant, and equipment (PP&E) account with its associated accumulated depre-
ciation. The balance in the PP&E account increased by $500 during the period. What does an
increase in the PP&E account indicate? Obviously, something was purchased. If we had no ad-
ditional information, we would assume that PP&E was purchased by paying $500. But we do
have additional information. We know that PP&E was purchased during the period by paying
$1,700. With that information, we can prepare the following PP&E T-account:

Property, Plant, and Equipment

Beg. Bal. 4,000
Purchased 1,700 Sold ?
End. Bal. 4,500



To make the T-account balance, equipment must have been sold. What was the origi-
nal cost of the equipment that was sold? It must have been $1,200 (that is the only number
that will make the T-account balance). What was the accumulated depreciation associated
with the sold equipment? Let™s take a look at the accumulated depreciation T-account. En-
tries on the debit side of that account track the accumulated depreciation associated with
636 f637
The Statement Of Cash Flows Chapter 13
The Statement of Cash Flows



Guidelines for Converting from Accrual to Cash Basis
exhibit 13-6


Accrual Basis Adjustments Required Cash Basis

Beginning accounts receivable* 
Net sales Cash receipts


Ending accounts receivable* from customers

Other revenues
(e.g., rent and
interest):

Rent revenue Ending unearned rent Cash received


Beginning unearned rent for rent

Interest revenue Beginning interest receivable Cash received


Ending interest receivable for interest

Cost of goods sold Ending inventory


Beginning inventory Cash paid


Beginning accounts payable for inventory


Ending accounts payable

Operating expenses**
(e.g., insurance
and wages)
Insurance

expense Ending prepaid insurance Cash paid

Beginning prepaid insurance for insurance


Wages expense Beginning wages payable Cash paid

Ending wages payable for wages


Income tax Beginning income taxes
 Cash paid for

expense payable
income taxes

Ending income taxes payable 
Net cash flows
provided by (used in)
operating activities
* Net of allowance for uncollectible accounts.
**Excluding depreciation and other noncash items.




equipment that has been sold. Entries to the credit side are associated with depreciation ex-
pense for the period. Because we know depreciation expense for the period (from the income
statement), and we know the beginning and ending balances in the account (from the bal-
ance sheet), we can infer the accumulated depreciation associated with the equipment that
was sold.


Accumulated Depreciation

Beg. Bal. 1,200
Depreciation
Sold ? Expense 500
End. Bal. 900


The accumulated depreciation associated with the equipment that was sold must have been
$800. In addition, we know from the income statement that the sale resulted in a gain of $100.
With this information, we can infer that the following journal entry was made relating to the
sale of PP&E:
637
f638 Part 4 The Statement Of Cash Flows
Other Dimensions of Financial Reporting



Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500
Accumulated Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800
Property, Plant, and Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200
Gain on Sale of Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100


As you can see, we can determine the amount of cash received from the sale of PP&E by
monitoring the change in other related accounts on the income statement and balance sheet.
As Silmaril™s only investing activity related to the PP&E account, we have analyzed all the
changes in that account and are now ready to prepare the investing activities section of the state-
ment of cash flows. Had Silmaril bought or sold available-for-sale or held-to-maturity securities
during the year, we would need to analyze these accounts to determine any cash flow effects.
The investing activities section of the statement of cash flows for Silmaril, Inc., would be as fol-
lows:
Investing Activities:
Proceeds from the sale of property, plant, and equipment . . . . . . . . . . . . . $ 500
Purchased property, plant, and equipment . . . . . . . . . . . . . . . . . . . . . . . . . (1,700)
Cash flows from investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,200)


STEP 4. ANALYZE THE LONG-TERM DEBT AND STOCKHOLDERS™ EQUITY AC-
COUNTS TO DETERMINE THE CASH FLOW EFFECTS OF ANY FINANCING TRANS-
ACTIONS Consider long-term debt accounts. What would make them increase? What would
make them decrease? Obviously, these debt accounts would increase when a company borrows
more money (an inflow of cash) and decrease when the company pays back the debt (an out-
flow of cash). In the case of Silmaril, we observe that the company™s long-term debt account de-
clined from $2,200 to $2,000. Unless something unusual happened (such as additional debt was
issued and then some debt was repaid), we assume that the reason for the decrease was that cash
was used to reduce the liability.
In the case of stockholders™ equity accounts, we examine both the common stock and re-
tained earnings accounts for increases and decreases resulting from cash flows. The common
stock account will increase as a result of the sale of stock and decrease if any stock is repurchased
and retired. Because the common stock account increased by $450 during the period, we as-
sume that the increase resulted from the sale of stock. Again, if an unusual transaction had oc-
curred, information relating to the transaction would be available in the notes. Retained Earn-
ings increases from the recognition of net income (an operating activity) and decreases as a result
of net losses (also an operating activity) or through the payment of dividends (a financing ac-
tivity). In the case of Silmaril, Inc., because no dividends are disclosed on the trial balance, the
entire change in Retained Earnings results from net income; the cash flow effect has already been
included in operating activities.
Silmaril, Inc., would prepare the following information relating to its financing activities:
Financing Activities:
Proceeds from the sale of stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 450
Repayment of long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (200)
Cash flows from financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250


Based on our analysis
STEP 5. PREPARE A FORMAL STATEMENT OF CASH FLOWS
of all income statement and balance sheet accounts, we have identified all inflows and outflows
of cash for Silmaril, Inc., and categorized those cash flows based on the type of activity. The re-
sulting statement of cash flows (prepared using the direct method)4 would be as follows:



4 A statement of cash flows prepared using the indirect method is shown in the Review Problem on pages
644“646. The statement of cash flows for MICROSOFT, shown in Appendix A, was also prepared using the in-
direct method.
638 f639
The Statement Of Cash Flows Chapter 13
The Statement of Cash Flows


Operating Activities:
Collections from customers. . . . . . . . . .......................... $14,000
Payments for inventory. . . . . . . . . . . . .......................... $ 8,100
Payments for miscellaneous expenses .......................... 3,200
Payments for interest . . . . . . . . . . . . . .......................... 180
Payments for taxes . . . . . . . . . . . . . . . .......................... 440 (11,920)
Cash flows from operating activities . . .......................... $ 2,080

Investing Activities:
Proceeds from the sale of property, plant, and equipment . . . . . . . . . . . $ 500
Purchased property, plant, and equipment . . . . . . . . . . . . . . . . . . . . . . . (1,700)
Cash flows from investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,200)

Financing Activities:
Proceeds from the sale of stock . . . ............................ $ 450
Repayment of long-term debt . . . . . ............................ (200)
Cash flows from financing activities ............................ 250
Net increase in cash. . . . . . . . . . . . . . ............................ $ 1,130
Beginning cash balance . . . . . . . . . . . ............................ 300
Ending cash balance . . . . . . . . . . . . . ............................ $ 1,430


Additional disclosure is required in the notes to the financial statements depending on the
method used. Other disclosures required by FASB Statement No. 95 include the amounts paid
for interest and income taxes. When the indirect method is used to report cash flows from op-
erating activities, cash paid for interest and income taxes is disclosed as supplemental. When the
direct method is used to report cash flows from operating activities, these amounts are included
in the statement of cash flows.
An additional disclosure required when the direct method is used is a schedule reconciling
net income with net cash flows provided by (used in) operating activities. This schedule is, in
effect, the same as the operating activities section of a statement of cash flows prepared using
the indirect method.

STEP 6. REPORT ANY SIGNIFICANT INVESTING OR FINANCING TRANSACTIONS
THAT DID NOT INVOLVE CASH If Silmaril had any significant noncash transactions,
noncash transactions In-
vesting and financing activi- such as purchasing PP&E by issuing debt or trading Silmaril stock for that of another com-
ties that do not affect cash; pany, these transactions would be disclosed in the notes to the financial statements or in a sep-
if significant, they are dis-
arate schedule below the statement of cash flows. In this example, no such transactions oc-
closed below the statement
curred.
of cash flows or in the
notes to the financial state-
ments.



to summarize
The cash inflows and outflows of an organization must be analyzed and clas-
sified into one of three categories: operating, investing, and financing. Oper-
ating activities include those transactions that enter into the determination of
net income. The direct or the indirect method may be used to show the net
cash flows provided by (used in) operating activities. The indirect method
starts with net income, as reported on the income statement, and adds or sub-
tracts adjustments to convert accrual net income to net cash flows from op-
erations. Adjustments to net income are made for increases and decreases in
operating account balances, noncash items such as depreciation, and gains
and losses from the sale of assets. The direct method shows the major classes
of operating cash receipts and payments. The direct method requires analy-
sis of cash transactions or an analysis of accrual revenues and expenses in
639
f640 Part 4 The Statement Of Cash Flows
Other Dimensions of Financial Reporting



order to convert them to cash receipts and payments. Both methods produce
the same results, and either method is allowed under generally accepted ac-
counting principles. Investing activities involve the purchase or sale of long-
term assets like property, plant, and equipment or investment securities. Fi-
nancing activities include transactions in which cash is obtained from or paid
to owners and creditors.




5 USING INFORMATION FROM THE STATEMENT
OF CASH FLOWS TO MAKE DECISIONS
Use information from the
statement of cash flows to
make decisions.
To this point in the text, we have reviewed numerous financial statement analysis techniques
involving the income statement and the balance sheet. We have introduced and discussed ver-
tical and horizontal analysis, and we have used numerous ratios that were computed using num-
bers from the income statement and the balance sheet. We can also use information from the
statement of cash flows for analysis purposes.
Analysis using cash flow information is often restricted to examining the relationships among
the categories in the statement of cash flows. We do not perform vertical or horizontal analysis
because, unlike the balance sheet and income statement, there is no guarantee that a specific
number from the statement of cash flows will consistently serve as the denominator for scaling
purposes. For example, all balance sheet accounts are compared to total assets when preparing
a vertical analysis of the balance sheet. Why? The reason is that total assets is always going to
be the biggest number on the balance sheet. The same is true for the income statement. Rev-
enue is used because it is, in almost every case, the biggest number on the income statement. In
the case of the statement of cash flows, some years the cash flow from operations may be the
largest number on the statement. In subsequent years, that number may be negative. Thus, hor-
izontal and vertical analyses are rarely performed using the statement of cash flows because of
scaling problems.
Although the statement of cash flows, like the other financial statements, reports informa-
tion about the past, careful analysis of this information can help investors, creditors, and others
assess the amounts, timing, and uncertainty of future cash flows. Specifically, the statement helps
users answer questions such as how a company is able to pay dividends when it had a net loss,
or why a company is short of cash despite increased earnings. A statement of cash flows may
show, for example, that external borrowing or the issuance of capital stock provided the cash
from which dividends were paid even though a net loss was reported for that year. Similarly, a
company may be short on cash, even with increased earnings, because of increased inventory
purchases, plant expansion, or debt retirement.
Trends are often more important than absolute numbers for any one period. Accordingly,
cash flow statements usually are presented on a comparative basis. This enables users to analyze
a company™s cash flows over time.
Because companies are required to highlight cash flows from operating, investing, and fi-
nancing activities, a company™s operating cash flows and investing and financing policies can be
compared with those of other companies. We can learn much about a company by examining
patterns that appear among the three cash flow categories in the statement of cash flows. Ex-
hibit 13-7 shows eight possible cash flow patterns and provides some insight into what each cash
flow pattern indicates about the company.
Positive cash flows from operations are necessary if a company is to succeed over the long
term (patterns 1 through 4). The most common cash flow pattern is 2. Companies use cash
flows from operations to purchase fixed assets or to pay down debt. Growing companies follow
cash flow pattern 6. Cash is being borrowed to cover a shortage of cash from operations as well
as to purchase fixed assets. Most (about 80%) of the publicly traded companies in the United
States follow patterns 2, 4, and 6.
640 f641
The Statement Of Cash Flows Chapter 13
The Statement of Cash Flows



Analysis of Cash Flows Statement: Patterns
exhibit 13-7


CF from CF from CF from General
Operating Investing Financing Explanation

#1 Company is using cash
generated from operations,
from sale of assets, and from
financing to build up pile of
cash”very liquid company”
possibly looking for
acquisition.

#2 Company is using cash flows
generated from operations to
buy fixed assets and to pay
down debt or pay owners.

#3 Company is using cash from
operations and from sale of
fixed assets to pay down
debt or pay owners.

#4 Company is using cash from
operations and from
borrowing (or from owner
investment) to expand.

#5 Company™s operating cash
flow problems are covered
by sale of fixed assets, by
borrowing, or by stockholder
contributions.

#6 Company is growing rapidly,
but has shortfalls in cash
flows from operations and
from purchase of fixed assets
financed by long-term debt
or new investment.

#7 Company is financing
operating cash flow
shortages and payments to
creditors and/or stockholders
via sale of fixed assets.

#8 Company is using cash
reserves to finance operation
shortfall and pay long-term
creditors and/or investors.

Source: Michael T. Dugan, Benton E. Gup, and William D. Samson, “Teaching the Statement of Cash
Flows,” Journal of Accounting Education, Vol. 9, 1991, p. 36.




to summarize
Conducting financial statement analysis using information from the statement
of cash flows is more difficult than analyses using information from the income
statement and the balance sheet. The primary reason is that it is common for
641
f642 The Statement Of Cash Flows
Part 4 EOC Other Dimensions of Financial Reporting



cash flows for certain categories to be negative, thereby making interpretation
difficult. Nevertheless, an analysis of the relationships among the categories
on the statement of cash flows can provide insight into a company™s perfor-
mance.




review of learning objectives

Understand the purpose of a statement of cash flows. Prepare a simple statement of cash flows. If cash inflows
3
1 The statement of cash flows is one of the three primary and outflows can be categorized according to the activity
financial statements presented by companies in their annual (operating, investing, or financing) when entered into the ac-
reports. Its primary purpose is to provide information about counting system, the preparation of a statement of cash flows is
the cash receipts and payments of an entity during a period. straightforward. At the end of the period, inflows and outflows
The statement of cash flows also explains the changes in the are divided by category and type of cash flow, e.g., collections
balance sheet accounts and the cash effects of the accrual- from customers, payments for inventory, etc. A statement of cash
basis amounts reported in the income statement. flows then simply lists those inflows and outflows by activity.

Recognize the different types of information reported Analyze financial statements to prepare a statement
4
2 in the statement of cash flows. The statement of cash of cash flows. Often, detailed cash flow information is
flows reports an entity™s inflows and outflows of cash for a pe- not available. When that happens, the statement of cash flows
riod of time and reconciles the beginning and ending balances is prepared by analyzing comparative balance sheets and the
of cash and cash equivalents. income statement. A six-step process can be employed to as-
The inflows and outflows of cash should be classified and sist in the analysis. First, the change in the cash balance for
reported for three main categories: operating activities, investing the period is computed. Second, the income statement is con-
activities, and financing activities. Cash receipts and payments verted from an accrual basis to a cash basis. The result is cash
classified under operating activities generally include all items that flows from operating activities. Third, long-term assets are an-
enter into the determination of net income. Examples include alyzed to determine the cash flow effects of investing activi-
receipts from the sale of goods or services and from interest, and ties. Fourth, long-term liabilities and stockholders™ equity ac-
the payments for inventory, wages, utilities, taxes, and interest. counts are analyzed to determine the cash flow effects of
Investing activities include the purchase and sale of cer- financing activities. Fifth, a formal statement of cash flows is
tain securities (other than cash equivalents, which are included prepared. And sixth, significant noncash transactions are dis-
with cash), buildings and equipment, and other assets that gen- closed in the notes to the financial statements or in a separate
erally are not purchased for resale by the entity. Also included schedule at the bottom of the statement of cash flows.
are the making and collecting of loans.
Financing activities include obtaining and repaying cash Use information from the statement of cash flows to
5
from owners (equity financing) and from creditors (debt fi- make decisions. A careful analysis of the statement of cash
nancing). Selling stock, paying cash dividends, and borrowing flows will indicate shifts in a company™s operating, investing,
money, for example, are included under this category. and financing policies. The statement explains the change in the
Significant noncash transactions involving investing and cash balance during the period by identifying the inflows and
financing activities should be reported in a note or in a sepa- outflows of cash. This helps investors and creditors observe
rate schedule to the financial statements. Because such trans- trends related to a company™s use of operating income and to
actions do not involve cash flows, they should not be reported its use of external sources of capital such as the issuance of stock
in the statement of cash flows. An example would be the pur- or bonds. Used with the income statement and the balance sheet,
chase of land by the issuance of stock. the statement of cash flows is a valuable source of information.
642 f643
The Statement Of Cash Flows EOC Chapter 13
The Statement of Cash Flows




key terms and concepts

cash equivalents 619 indirect method 634 noncash transactions 639
direct method 635 investing activities 621 operating activities 619
financing activities 621 noncash items 630 statement of cash flows 618




review problems

Classifying Cash Flows Anna Dimetros is the bookkeeper for Russia Imports, Inc. (RII), a New York City“based com-
pany. Anna has collected the following cash flow information about RII for the most current
year of operations. The cash balance at the beginning of the year was $105,000.
Cash receipts:
Cash received from issuance of stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 50,000
Cash received from customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 252,300
Cash received from interest at bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,600
Cash received from borrowing at bank. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000
Total cash receipts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $331,900
Cash payments:
Cash paid for wages of employees. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $134,600
Cash paid to stockholders as dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,500
Cash paid to bank for interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,200
Cash paid to bank to repay earlier loan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Cash paid for taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,500
Cash paid for operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128,100
Cash paid for equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000
Total cash payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $323,900

Required: 1. From the information provided, classify the cash flows for Russia Imports, Inc., according
to operating, investing, and financing activities.
2. Determine the ending cash balance.

Solution Russia Imports, Inc.
Cash Flows
20XX

Cash flows from operating activities:
1.
Cash receipts from:
Customers . . . . . . . . . . . . . . . . . . . . . . . ................. $252,300
Bank (interest) . . . . . . . . . . . . . . . . . . . . ................. 4,600 $256,900
Cash payments to:
Employees (wages) . . . . . . . . . . . . . . . . ................. $134,600
Bank (interest) . . . . . . . . . . . . . . . . . . . . ................. 7,200
Government (taxes) . . . . . . . . . . . . . . . . ................. 23,500
Various entities (operating expenses) . . . ................. 128,100 293,400
Net cash flows used in operating activities ................. $ (36,500)

Cash flows from investing activities:
Cash payments to:
Purchase equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (15,000)
Net cash flows used in investing activities . . . . . . . . . . . . . . . . . $ (15,000)
(continued)
643
f644 The Statement Of Cash Flows
Part 4 EOC Other Dimensions of Financial Reporting


Cash flows from financing activities:
Cash receipts from:
Issuance of stock . . . . . . . . . . . . . . ..................... $ 50,000
Borrowing at bank . . . . . . . . . . . . . ..................... 25,000 $ 75,000
Cash payments to:
Stockholders (dividends) . . . . . . . . ........ . . . . . . . . . . . . . $ (5,500)
Repay earlier loan . . . . . . . . . . . . . ........ . . . . . . . . . . . . . (10,000) (15,500)
Net cash flows provided by financing activities . . . . . . . . . . . . . . $ 59,500
Total net cash flows for period . . . . . ........ . . . . . . . . . . . . . $ 8,000

2. Beginning cash balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $105,000
Total net cash flows for period . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000
Ending cash balance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $113,000*

*Alternatively, beginning balance ($105,000) receipts ($331,900) payments ($323,900) ending balance
($113,000).



Preparing a Statement of Snow Corporation produces clock radios. Comparative income statements and balance sheets
Cash Flows for the years ended December 31, 2003 and 2002, are presented.


Snow Corporation
Comparative Income Statements
For the Years Ended December 31, 2003 and 2002
2003 2002

Net sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $600,000 $575,000
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000 460,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000 $115,000
Operating expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66,000 60,000
Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 34,000 $ 55,000
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 3,000
Income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,000 $ 52,000
Income taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000 21,000
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 18,000 $ 31,000




Snow Corporation
Comparative Balance Sheets
December 31, 2003 and 2002
2003 2002

Assets
Current assets:
Cash and cash equivalents .................................. $ 11,000 $ 13,000
Accounts receivable (net). . .................................. 92,000 77,000
Inventory . . . . . . . . . . . . . . .................................. 103,000 92,000
Prepaid expenses . . . . . . . .................................. 6,000 5,000
Total current assets . . . . .................................. $212,000 $187,000
Property, plant, and equipment:
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ............. $ 69,000 $ 66,000
Machinery and equipment . . . . . . . . . . . . . . . . . . . . . . ............. 172,000 156,000
Accumulated depreciation, machinery and equipment . ............. (113,000) (102,000)
Total property, plant, and equipment . . . . . . . . . . . . ............. $128,000 $120,000
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ............. $340,000 $307,000

(continued)
644 f645
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The Statement of Cash Flows


2003 2002

Liabilities and Stockholders™ Equity
Current liabilities:
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 66,000 $ 78,000
Dividends payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 0
Income taxes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 5,000
Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 71,000 $ 83,000
Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75,000 42,000
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $146,000 $125,000
Stockholders™ equity:
Common stock, no par . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 26,000 $ 26,000
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168,000 156,000
Total stockholders™ equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $194,000 $182,000
Total liabilities and stockholders™ equity . . . . . . . . . . . . . . . . . . . . . . . $340,000 $307,000


The following additional information is available.
a. Dividends declared during 2003 were $6,000.
b. The market price per share of stock on December 31, 2003, was $14.50.
c. Equipment worth $16,000 was acquired by the issuance of a long-term note ($10,000) and
by paying cash ($6,000).
d. Land was acquired for $3,000 cash.
e. Depreciation of $11,000 was included in operating expenses for 2003.
f. There were no accruals or prepaid amounts for interest.
Required: Analyze the data provided to prepare a statement of cash flows. Use (1) the indirect method and
(2) the direct method to report cash flows from operating activities.
1. Indirect Method
Solution

Snow Corporation
Statement of Cash Flows (Indirect Method)
For the Year Ended December 31, 2003

Cash flows from operating activities:
Net income. . . . . . . . . . . . . . . . . . . . . . . . . .................... $ 18,000
Add (deduct) adjustments to cash basis:
Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000
Increase in accounts receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (15,000)
Increase in inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (11,000)
Increase in prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,000)
Decrease in accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (12,000)
Decrease in income taxes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,000)
Net cash flows used in operating activities . . . . . . . . . . . . . . . . . . . . . $(12,000)
Cash flows from investing activities:
Cash payments for:
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (3,000)
Machinery and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (6,000)
Net cash flows used in investing activities . . . . . . . . . . . . . . . . . . . . . (9,000)
Cash flows from financing activities:
Cash receipts from long-term borrowing. . . . . . . . . . . . . . . . . . . . . . . $ 23,000
Cash payments for dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (4,000)*
Net cash flows provided by financing activities. . . . . . . . . . . . . . . . . . 19,000
Net decrease in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (2,000)
Cash and cash equivalents at beginning of year. . . . . . . . . . . . . . . . . . . 13,000
Cash and cash equivalents at end of year . . . . . . . . . . . . . . . . . . . . . . . $ 11,000
(continued)
*Cash dividends declared ($6,000) less increase in dividends payable ($2,000).
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Part 4 EOC Other Dimensions of Financial Reporting


Supplemental disclosure:
Cash payments for:
Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,000
Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000
Noncash transaction:
Equipment was purchased by issuing a long-term note for $10,000.



The statement of cash flows for Snow Corporation shows that although reported net in-
come was positive for 2003, the net cash flows generated from operating activities were nega-
tive. Only by borrowing cash was Snow Corporation able to pay dividends and purchase land
and equipment. Even then the cash account decreased by $2,000 during the period.
2. Direct Method


Snow Corporation
Statement of Cash Flows (Direct Method)
For the Year Ended December 31, 2003

Cash flows from operating activities:
Cash receipts from customers. . . . . . . . . . . . .................... $585,000
Cash payments for:
Inventory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $523,000
Operating expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56,000
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000
Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000 (597,000)
Net cash flows used in operating activities . . . . . . . . . . . . . . . . . . . . $ (12,000)
Cash flows from investing activities:
Cash payments for:
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ................ $ (3,000)
Machinery and equipment . . . . . . . . . . . . . . . . . ................ (6,000)
Net cash flows used in investing activities. . . . . ................ (9,000)
Cash flows from financing activities:
Cash receipts from long-term borrowing . . . . . . . . . . . . . . . . . . . . . . $ 23,000
Cash payments for dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (4,000)
Net cash flows provided by financing activities . . . . . . . . . . . . . . . . . 19,000
Net decrease in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (2,000)
Cash and cash equivalents at beginning of year . . . . . . . . . . . . . . . . . . 13,000
Cash and cash equivalents at end of year . . . . . . . . . . . . . . . . . . . . . . . $ 11,000

Supplemental Disclosure*
Equipment was purchased by issuing a long-term note for $10,000.
*A schedule reconciling net income with net cash flow used by operating activities would also be presented, ei-
ther with the statement of cash flows or in the notes to the financial statements. The information provided in
the schedule is the same as the operating activities section of the statement of cash flows prepared using the
indirect method (see part 1).




discussion questions

1. What is the main purpose of a statement of cash flows? 3. Distinguish among cash flows from operating, investing,
2. What are cash equivalents, and how are they treated on and financing activities, providing examples for each
a statement of cash flows? type of activity.
646 f647
The Statement Of Cash Flows EOC Chapter 13
The Statement of Cash Flows


4. How are significant noncash investing and financing 8. How are depreciation and similar noncash items treated
transactions to be reported? on a statement of cash flows?
5. Describe the process of converting from accrual rev- 9. What supplemental disclosures are likely to be required
enues to cash receipts. in connection with a statement of cash flows?
6. Describe the six-step process that can be used to pre- 10. How might investors and creditors use a statement of
pare a statement of cash flows by analyzing the income cash flows?
statement and comparative balance sheets.
7. Distinguish between the indirect and direct methods of
reporting net cash flows provided by (used in) operating
activities.




discussion cases

CASE 13-1 SHOULD WE MAKE THE LOAN?
Save More, Inc., a discount department store, has applied to its bankers for a loan. Although
the company has been profitable, it is short of cash. The loan application includes the follow-
ing information about current assets, current liabilities, net income, depreciation expense, and
dividends for the past five years. (All numbers are rounded to the nearest thousand, with the
000s omitted.)


Dec. 31, Dec. 31, Dec. 31, Dec. 31, Dec. 31,
1998 1999 2000 2001 2002
Cash and cash equivalents . . . . . . . $ 5 $ 73 $ 10 $158 $ (189)
Accounts receivable (net) . . . . . . . . 403 555 516 576 654
Inventory . . . . . . . . . . . . . . . . . . . . 253 142 383 385 1,022
Accounts payable . . . . . . . . . . . . . . 19 17 281 253 52
Net income. . . . . . . . . . . . . . . . . . . 454 492 467 440 481
Depreciation expense . . . . . . . . . . . 50 50 55 60 60
Dividends paid . . . . . . . . . . . . . . . . 177 197 208 211 211



As a bank loan officer, you have been asked to review these figures in order to determine
whether the bank should loan money to Save More, Inc.
1. Compute the net cash flows from operations for the last four years.
2. What caused the sudden decrease in cash flows from operations?
3. What factors would you focus on and what additional information would you need be-
fore deciding whether to make the loan?


CASE 13-2 ANALYZING THE CASH POSITION OF GOOD TIME, INC.
The following data show the account balances of Good Time, Inc., at the beginning and end
of the company™s fiscal year:
647
f648 The Statement Of Cash Flows
Part 4 EOC Other Dimensions of Financial Reporting



Debits Aug. 31, 2003 Sept. 1, 2002
Cash and cash equivalents. . . . . . . . . . . . . . . . . . . . . . . . . . $ 88,200 $ 29,000
Accounts receivable (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 13,300
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,500 12,700
Prepaid insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,800 2,000
Long-term investments (cost equals market) . . . . . . . . . . . . 3,000 8,400
Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 33,000
Treasury stock (at cost) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 10,000
Cost of goods sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184,000
Operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93,500
Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,800
Loss on sale of equipment . . . . . . . . . . . . . . . . . . . . . . . . . . 500
Total debits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $461,300 $108,400

Credits
Accumulated depreciation”equipment . . . . . . . . . . . . . . . . $ 9,500 $ 9,000
Accounts payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,500 5,600
Interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 1,000
Income taxes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 4,000
Notes payable”long-term . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000 12,000
Common stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,000 50,000
Paid-in capital in excess of par. . . . . . . . . . . . . . . . . . . . . . . 16,000 15,000
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,800* 11,800
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352,000
Gain on sale of long-term investments. . . . . . . . . . . . . . . . . 1,000
Total credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $461,300 $108,400
*Preclosing balance



The following information concerning this year was also available:
a. All purchases and sales were on account.
b. Equipment with an original cost of $5,000 was sold for $1,500; a loss of $500 was rec-
ognized on the sale.
c. Among other items, the operating expenses included depreciation expense of $3,500; in-
terest expense of $1,400; and insurance expense of $1,200.
d. Equipment was purchased by issuing common stock and paying the balance ($6,000) in
cash.
e. Treasury stock was sold for $2,000 less than it cost; the decrease in stockholders™ equity
was recorded by reducing Retained Earnings.
f. No dividends were paid this year.
You are to examine Good Time™s cash position by:
1. Preparing schedules showing the amount of cash collected from accounts receivable, cash
paid for accounts payable, cash paid for interest, and cash paid for insurance.
2. Preparing a statement of cash flows for Good Time for the fiscal year 2003 using the di-
rect method.
3. Identifying the major reasons why Good Time™s cash and cash equivalents increased so
dramatically during the year.
4. Comment on whether the dividend policy seems appropriate under the current circum-
stances.

CASE 13-3 ANALYZING CASH FLOW PATTERNS
Paula Dalton is a security analyst for DJM, Inc. She claims that she can tell a great deal about
companies by analyzing their cash flow patterns. Specifically, she looks at the negative or posi-
648 f649
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The Statement of Cash Flows

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