Chapter 22 Econ 136c

What is the primary purpose of the statement of cash flows?

The statement of cash flows provides a detailed explanation of how a company's cash position changed during a period by reporting cash inflows and outflows from operating, investing, and financing activities. Its main purpose is to help users assess liquidity, solvency, and financial flexibility by showing how cash was generated and used.

Why do users need the statement of cash flows even when the income statement and balance sheet already exist?

Accrual accounting causes net income to differ from cash flow. Revenues and expenses may be recorded without corresponding cash inflows or outflows. The statement of cash flows reveals the company’s ability to generate actual cash, meet obligations, pay dividends, and finance operations—information not obtainable from the income statement or balance sheet alone.

What qualifies as a cash equivalent, and why is it included with cash?

Cash equivalents are highly liquid short‑term investments with original maturities of three months or less that are readily convertible to known amounts of cash and carry insignificant risk of value change. Examples include Treasury bills and commercial paper. They are included with cash because they function as near‑cash instruments for liquidity assessment.

What are operating activities under the statement of cash flows?

Operating activities represent the cash effects of transactions that enter into the determination of net income, such as cash received from customers and cash paid for operating expenses, interest, taxes, and salaries. These activities indicate the extent to which the company’s core operations are generating cash that sustains the business.

How does the indirect method compute net cash flow from operating activities?

The indirect method begins with net income and adjusts it for noncash revenues and expenses (such as depreciation and amortization), as well as changes in working capital accounts (such as accounts receivable, inventory, and payables). The process converts accrual‑based net income into the cash provided by operations.

Why must depreciation expense be added back to net income under the indirect method?

Depreciation reduces net income but does not involve an actual cash outflow. Since the statement of cash flows focuses exclusively on cash movements, depreciation must be added back to reverse its noncash effect on net income.

How does an increase in accounts receivable affect the operating section of the statement of cash flows?

An increase in accounts receivable indicates that more revenue was recorded on an accrual basis than was actually collected in cash. Therefore, it must be subtracted from net income under the indirect method.

How does an increase in accounts payable affect the operating section under the indirect method?

An increase in accounts payable means that expenses were recorded but not yet paid in cash. Therefore, cash outflows were lower than the expenses recognized in net income, and the increase should be added to net income.

What types of transactions belong in the investing activities section?

Investing activities include cash transactions involving long‑term assets and investments, such as purchasing or selling property, plant, and equipment, purchasing or selling investment securities (excluding trading securities), and lending or collecting principal on loans to others.

What types of transactions belong in the financing activities section?

Financing activities involve cash flows related to obtaining or repaying capital. Cash inflows include issuing stock or borrowing through notes and bonds. Cash outflows include repurchasing stock, repaying borrowed principal, and paying dividends.

How are significant noncash investing and financing transactions reported?

Significant noncash transactions—such as converting debt to equity, issuing stock to purchase assets, or exchanging nonmonetary assets—are not reported in the body of the statement of cash flows. Instead, they are disclosed in a separate supplemental schedule or in the notes, ensuring transparency without distorting cash flow totals.

What is the direct method of presenting cash flows from operating activities?

The direct method lists actual cash receipts and cash payments from operating activities, such as cash collected from customers, cash paid to suppliers, cash paid to employees, interest paid, and taxes paid. It converts accrual numbers into cash flows by reconstructing the income statement on a cash basis.

Why does the Financial Accounting Standards Board encourage the direct method?

The Financial Accounting Standards Board believes the direct method offers greater clarity to users by providing explicit details about sources and uses of operating cash. This enhanced transparency helps users better predict future cash flows compared to the indirect method, which focuses on reconciling net income to operating cash flows.

How do changes in inventory affect cash paid to suppliers under the direct method?

Cash paid to suppliers is calculated by adjusting cost of goods sold for changes in inventory and accounts payable. An increase in inventory indicates additional cash spending not reflected in cost of goods sold, so it increases cash paid to suppliers. A decrease in inventory reduces required cash outflows.

Why are unrealized gains or losses removed from net income when calculating operating cash flows?

Unrealized gains and losses affect net income but do not involve cash inflows or outflows. Therefore, they must be subtracted (for gains) or added back (for losses) when converting net income to net cash from operations under the indirect method to ensure only cash‑related items remain.

How does the equity method affect the operating section of the statement of cash flows?

Under the equity method, a company records its share of an investee’s earnings, increasing the investment account without generating cash. Therefore, this share of earnings must be subtracted from net income in the operating section. Dividends received from the investee, however, are reported as operating cash inflows.

What is the first step in preparing the statement of cash flows, and why is it important?

The first step is determining the change in cash by comparing beginning and ending cash balances. This ensures that the sum of net cash flows from operating, investing, and financing activities reconciles exactly to the actual change in the cash account.

Sample Problem: Given net income of $120,000, depreciation of $30,000, an increase in accounts receivable of $18,000, a decrease in inventory of $6,000, and an increase in accounts payable of $10,000, calculate net cash provided by operating activities using the indirect method.

Start with net income of $120,000. Add back depreciation of $30,000 to remove noncash expense. Subtract the $18,000 increase in accounts receivable because it represents revenue not collected in cash. Add the $6,000 decrease in inventory because it indicates less cash was used to purchase inventory. Add the $10,000 increase in accounts payable because expenses exceeded cash payments. Total: 120,000 + 30,000 - 18,000 + 6,000 + 10,000 = $148,000.

Sample Problem: Compute cash collected from customers using the direct method when sales revenue is $500,000, accounts receivable increased by $25,000, and allowance for doubtful accounts increased by $5,000.

Cash collected equals sales revenue minus the increase in gross accounts receivable. The change in the allowance does not affect the direct method. Therefore, cash collected is $500,000 - $25,000 = $475,000.

Sample Problem: Compute cash paid to suppliers using the direct method with cost of goods sold of $300,000, an increase in inventory of $12,000, and a decrease in accounts payable of $9,000.

Cash paid to suppliers equals cost of goods sold plus the increase in inventory (which represents additional purchases) plus the decrease in accounts payable (indicating cash payments exceeded purchases). Therefore, 300,000 + 12,000 + 9,000 = $321,000.

Sample Problem: Prepare the operating activities section of the statement of cash flows (indirect method). Net income is $90,000; depreciation is $22,000; accounts receivable decreased by $15,000; prepaid expenses increased by $4,000; accounts payable decreased by $7,000.

Start with net income of $90,000. Add depreciation of $22,000. Add the $15,000 decrease in accounts receivable because cash collected exceeded revenue earned. Subtract the $4,000 increase in prepaid expenses because additional cash was spent. Subtract the $7,000 decrease in accounts payable because more cash was paid than expenses recorded. Total: 90,000 + 22,000 + 15,000 - 4,000 - 7,000 = $116,000 net cash from operating activities.