Module 14 - Statement of Cash Flows

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

To provide information about a company’s cash receipts and cash payments during a period.

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

To provide cash-basis information about a company’s operating, investing, and financing activities during a period.

What does the statement of cash flows reconcile?

It reconciles the beginning cash balance and the ending cash balance by explaining the net increase or decrease in cash during the period.

What are the three sections of the statement of cash flows?

1. Operating activities
2. Investing activities
3. Financing activities

What is the basic cash reconciliation formula used in the statement of cash flows?

Ending Cash = Beginning Cash + Net Change in Cash

What is the formula for net change in cash?

Net Change in Cash = Operating + Investing + Financing

Which section of the statement of cash flows appears first?

The operating activities section always appears first, followed by investing and then financing activities.

What general rule helps classify a cash flow as operating?

If the item enters into the determination of net income, it is generally classified as an operating activity.

Why is the operating activities section considered especially important?

It shows the cash provided by a company’s core operations and is often viewed as the best measure of whether the company can continue as a going concern.

Why can net income differ from net cash provided by operating activities?

Because net income is based on accrual accounting, which includes noncash expenses, estimates, deferrals, and revenues/expenses recognized before or after cash changes hands.

What are typical cash inflows in operating activities?

• Cash received from customers

• Interest revenue received

• Dividends received

What are typical cash outflows in operating activities?

• Cash paid to suppliers

• Cash paid to employees

• Cash paid for operating expenses

• Cash paid for interest

• Cash paid for taxes

What are typical cash inflows in investing activities?

• Sale of property, plant, and equipment

• Sale of debt or equity investments

• Collection of principal on loans to others

What are typical cash outflows in investing activities?

• Purchase of property, plant, and equipment

• Purchase of debt or equity investments

• Loans made to others

What are typical cash inflows in financing activities?

• Issuance of common stock

• Issuance of preferred stock

• Issuance of bonds

• Issuance of notes payable

What are typical cash outflows in financing activities?

• Payment of cash dividends

• Repayment of long-term debt

• Repurchase of common stock (treasury stock)

How is interest paid classified under the textbook rules used in this chapter?

Interest paid is classified as an operating activity, not financing, because interest expense enters into the determination of net income.

How is interest received classified under the textbook rules used in this chapter?

Interest received is classified as an operating activity because interest revenue enters into the determination of net income.

How are dividends paid classified?

Dividends paid are financing cash outflows.

How are dividends received classified?

Dividends received are operating cash inflows.

How is the sale of equipment classified in the statement of cash flows?

The cash received from selling equipment is classified as an investing activity.

How is debt repayment classified in the statement of cash flows?

Repayment of debt is a financing cash outflow.

What is the starting point under the indirect method?

The indirect method starts with net income and converts it to net cash provided by (or used by) operating activities.

What is the core indirect method formula?

Net Cash from Operating Activities =

Net Income

+ Noncash expenses

− Gains

+ Losses

± Working capital changes

What kinds of items are added back to net income under the indirect method?

Add back:

• Depreciation expense

• Amortization expense

• Other noncash expenses

• Losses

• Decreases in current assets

• Increases in current liabilities

What kinds of items are subtracted from net income under the indirect method?

Subtract:

• Gains

• Increases in current assets

• Decreases in current liabilities

What is the sign rule for current asset changes under the indirect method?

Increase in current asset → subtract

Decrease in current asset → add

What is the sign rule for current liability changes under the indirect method?

Increase in current liability → add

Decrease in current liability → subtract

How is an increase in accounts receivable handled under the indirect method?

An increase in accounts receivable is subtracted from net income because revenue recognized exceeded cash collected.

How is a decrease in accounts receivable handled under the indirect method?

A decrease in accounts receivable is added to net income because cash collected exceeded revenue recognized.

How is an increase in inventory handled under the indirect method?

An increase in inventory is subtracted from net income because cash was used to purchase inventory that has not yet been fully expensed.

How is a decrease in inventory handled under the indirect method?

A decrease in inventory is added to net income because the company expensed more inventory than it purchased in the period.

How is an increase in prepaid expenses handled under the indirect method?

An increase in prepaid expenses is subtracted from net income because cash was paid but the expense has not yet been recognized.

How is a decrease in prepaid expenses handled under the indirect method?

A decrease in prepaid expenses is added to net income because expense was recognized without a new cash payment in the current period.

How is an increase in accounts payable handled under the indirect method?

An increase in accounts payable is added to net income because expenses recognized exceeded cash paid.

How is a decrease in accounts payable handled under the indirect method?

A decrease in accounts payable is subtracted from net income because cash paid exceeded expense recognized.

How is an increase in accrued liabilities handled under the indirect method?

An increase in accrued liabilities is added to net income because the company recognized expense without paying all of it in cash.

How is a decrease in accrued liabilities handled under the indirect method?

A decrease in accrued liabilities is subtracted from net income because cash paid exceeded expense recognized.

How is depreciation handled under the indirect method?

Depreciation expense is added back to net income because it is a noncash expense.

How is amortization of intangible assets handled under the indirect method?

Amortization expense is added back to net income because it is a noncash expense.How is a gain on sale of equipment handled under the indirect method?

How is a gain on sale of equipment handled under the indirect method?

A gain is subtracted from net income because the gain increased net income, but the full cash proceeds from the sale are reported in the investing section.

How is a loss on sale of equipment handled under the indirect method?

A loss is added to net income because the loss reduced net income, but the full cash proceeds from the sale are reported in the investing section.

What is the starting structure of the direct method operating section?

The direct method reports:

• Cash receipts from operations
  minus

• Cash payments for operations
  to arrive at net cash provided by (or used by) operating activities.

What is the formula for cash receipts from customers under the direct method?

Cash Receipts from Customers =

Sales Revenue

− Increase in Accounts Receivable

+ Decrease in Accounts Receivable

What is the formula for purchases when converting COGS to cash paid to suppliers?

Purchases =

COGS

+ Increase in Inventory

− Decrease in Inventory

What is the formula for cash paid to suppliers under the direct method?

Cash Paid to Suppliers =

Purchases

− Increase in Accounts Payable

+ Decrease in Accounts Payable

What is the combined shortcut formula for cash paid to suppliers?

Cash Paid to Suppliers =

COGS

+ Inventory Increase

− Inventory Decrease

− A/P Increase

+ A/P Decrease

What is the formula for cash paid for operating expenses under the direct method?

Cash Paid for Operating Expenses =

Operating Expenses

− Noncash Expenses

+ Increase in Prepaids

− Decrease in Prepaids

− Increase in Accrued Liabilities

+ Decrease in Accrued Liabilities

What is the formula for cash taxes paid?

Cash Taxes Paid =

Income Tax Expense

+ Decrease in Taxes Payable

− Increase in Taxes Payable

What is the formula for cash interest paid when interest payable exists?

Cash Interest Paid =

Interest Expense

+ Decrease in Interest Payable

− Increase in Interest Payable

What is a major direct method trap involving depreciation and amortization?

Depreciation and amortization are noncash expenses, so they must be removed from operating expenses when computing cash paid for operating expenses.

What is a major direct method trap involving service companies?

A service company typically does not require a “cash paid to suppliers for inventory” computation because it usually does not have COGS/inventory in the same way a merchandising company does.

What subtotal does Wiley often expect in a direct method operating section?

Wiley often expects a subtotal for total cash payments before the final line Net Cash Provided by Operating Activities.

What formula is used to reconstruct purchases of property, plant, and equipment?

Ending PPE = Beginning PPE + Purchases − Cost of PPE Sold

How do you solve the PPE formula for purchases?

Purchases = Ending PPE − Beginning PPE + Cost of PPE Sold

What formula is used to reconstruct ending accumulated depreciation?

Ending Accumulated Depreciation =

Beginning Accumulated Depreciation

+ Depreciation Expense

− Accumulated Depreciation Removed on Sale

How do you solve for depreciation expense when an asset was sold?

Depreciation Expense =

Ending Accumulated Depreciation

− Beginning Accumulated Depreciation

+ Accumulated Depreciation Removed on Sale

How do you calculate accumulated depreciation removed on a sold asset if the problem says the asset was X% depreciated?

Accumulated Depreciation Removed =

Cost of Asset × % Depreciated

How do you calculate the book value of an asset sold?

Book Value = Cost of Asset − Accumulated Depreciation Removed

What is the formula for cash received when an asset is sold at a gain?

Cash Received = Book Value + Gain

What is the formula for cash received when an asset is sold at a loss?

Cash Received = Book Value − Loss

What is a major trap when reconstructing depreciation from accumulated depreciation?

Do not assume that the change in accumulated depreciation equals depreciation expense if any asset was sold. You must add back the accumulated depreciation removed on the sold asset.

What is a major trap when reconstructing cash proceeds from an asset sale?

Do not mistake the decrease in the asset account for the cash received. The asset account decrease gives the book value removed or cost removed, not necessarily the cash proceeds.

What formula links beginning retained earnings, net income, ending retained earnings, and dividends declared?

Ending Retained Earnings =

Beginning Retained Earnings

+ Net Income

− Dividends Declared

How do you solve for dividends declared using retained earnings?

Dividends Declared =

Beginning Retained Earnings

+ Net Income

− Ending Retained Earnings

What formula converts dividends declared into dividends paid if dividends payable changed?

Dividends Paid =

Dividends Declared

− Increase in Dividends Payable

+ Decrease in Dividends Payable

What is the conceptual rule for dividends payable when converting declared dividends to dividends paid?

• Increase in Dividends Payable → subtract from dividends declared because not all declared dividends were paid in cash

• Decrease in Dividends Payable → add because cash paid exceeded current-year declared dividends

What formula reconstructs debt activity for loans or bonds?

Ending Debt = Beginning Debt + Debt Issued − Debt Repaid

How do you solve the debt formula for debt repaid?

Debt Repaid = Beginning Debt + Debt Issued − Ending Debt

What is a financing-section trap involving noncash debt issuance?

If debt was issued in exchange for an asset rather than for cash, that issuance is noncash and must be excluded from the financing cash flow amount.

What is a significant noncash investing and financing activity?

A significant noncash investing and financing activity is a transaction that affects investing and/or financing but does not involve cash, such as issuing stock for land or issuing bonds for equipment.

Where do significant noncash investing and financing activities go on the statement of cash flows?

They are not included in the main operating, investing, or financing sections. They are disclosed separately, usually at the bottom of the statement or in a note.

What is the journal entry pattern when stock is issued for a noncash asset?

Debit Asset (at fair value)

Credit Common Stock (par value)

Credit Additional Paid-In Capital (difference)

When stock is issued for a noncash asset, what value should generally be used?

Use the fair value of the asset received or the stock issued, whichever is more clearly determinable. In the questions we worked, the fair value of the land was used when stock was issued for land.

What is the cash effect when stock is issued for land?

No effect on cash. It is a noncash investing and financing activity.

What is a common Wiley trap involving a noncash asset purchase?

Students often incorrectly place the transaction in the investing or financing section even though no cash changed hands. The correct treatment is separate disclosure only.

What is a Wiley trap involving inventory in an indirect method problem?

If beginning and ending inventory are given, Wiley often expects you to compute the inventory change and include it in the operating section adjustment.

What is a Wiley trap involving the labels “Net Cash Provided by” and “Net Cash Used by”?

Do not choose the label first. Compute the section total first:

• If positive → Provided

• If negative → Used

What is a Wiley trap involving gains and losses?

A gain or loss often has two effects:

1. It affects the operating section under the indirect method

2. The related cash proceeds belong in the investing section

What is a Wiley trap involving short-term investments?

Even though short-term debt investments may be current assets, the problem format may still classify their purchase or sale as investing activities, especially if the form specifically gives “purchase of investments” or “sale of investments” in the investing section.

What is a Wiley trap involving direct method operating expenses?

Wiley may bury depreciation and amortization inside operating expenses. You must remove them before converting expenses to cash paid for operating expenses.

What is a Wiley trap involving gains on sale of investments or equipment?

If a gain is given, the balance sheet change often reflects book value removed, not cash received. You must calculate cash proceeds separately using the gain.

How to classify a single cash flow item?

1. Ask: Did cash change? If no → noncash disclosure

2. If yes, ask: Does it affect net income? If yes → usually operating

3. If it involves long-term assets/investments → investing

4. If it involves debt/equity/dividends → financing

How to build an indirect method operating section?

1. Start with net income

2. Add back depreciation, amortization, and other noncash expenses

3. Subtract gains and add losses

4. Adjust for changes in current assets and current liabilities

5. Sum adjustments

6. Compute net cash provided by (or used by) operating activities

How to build a direct method operating section for a merchandising company?

1. Compute cash receipts from customers using sales and A/R

2. Compute purchases using COGS and inventory

3. Convert purchases to cash paid to suppliers using A/P

4. Compute cash paid for operating expenses by removing noncash expenses and adjusting prepaids/accruals

5. Compute cash taxes paid

6. Subtotal total cash payments

7. Subtract total cash payments from cash receipts to get net operating cash flow

How to build a direct method operating section for a service company?

1. Compute cash receipts from customers using service revenue and A/R

2. Compute cash paid for operating expenses by removing noncash expenses and adjusting prepaids/accruals

3. Compute cash taxes paid

4. Compute cash interest paid, if needed

5. Subtotal total cash payments

6. Subtract total cash payments from cash receipts to get net operating cash flow

How to reconstruct cash proceeds from sale of equipment?

1. Find the cost of equipment sold

2. Find accumulated depreciation removed

3. Compute book value

4. Use the gain/loss formula:

   • gain → cash = book value + gain

   • loss → cash = book value − loss

What are the step-by-step instructions for reconstructing depreciation expense when equipment was sold?

1. Compute accumulated depreciation removed on sold equipment

2. Use: Depreciation = Ending AD − Beginning AD + AD removed

3. Use that depreciation in the operating section (indirect) or remove it from expenses (direct)

How to find cash purchase of plant assets when part of the acquisition was noncash?

1. Compute the total increase in the plant asset account

2. Add back cost of any sold assets if necessary

3. Remove any noncash acquisition amount

4. The remainder is the cash purchase of plant assets

How to find cash dividends paid when retained earnings and dividends payable are involved?

1. Use retained earnings to compute dividends declared

2. Adjust for dividends payable change

3. Result = cash dividends paid

How to build a full statement of cash flows?

• Compute change in cash first

• Build operating section

• Build investing section

• Build financing section

• Check that: Operating + Investing + Financing = Change in Cash

• Reconcile beginning and ending cash

• Disclose any significant noncash investing and financing activities

What should you do first in a full statement of cash flows problem to help catch errors later?

Compute the change in cash first: Ending Cash − Beginning Cash

This gives you the target your statement must match.

What is the best debugging process if your full statement of cash flows does not reconcile to the cash change?

Recheck, in this order:

1. Inventory adjustment

2. Depreciation / amortization

3. Gains/losses and cash proceeds

4. Noncash stock/debt issuance

5. Taxes payable / accrued liabilities / prepaids

6. Whether a “Provided” vs “Used” label should switch

If you see “Gain on sale of equipment,” what should you immediately think?

• Subtract the gain in the indirect operating section

• Reconstruct cash proceeds for the investing section using: Cash = Book Value + Gain

If you see “Equipment sold and was 70% depreciated,” what should you immediately think?

1. Compute accumulated depreciation removed

2. Compute book value

3. Reconstruct depreciation expense using accumulated depreciation

4. Reconstruct cash proceeds using any gain/loss given

If you see “issued stock for land,” what should you immediately think?

• Journal entry: debit land, credit common stock and APIC

• Cash effect: none

• Statement of cash flows treatment: noncash investing and financing activity disclosed separately

If you see beginning and ending inventory in a direct method problem, what should you immediately think?

Use inventory to convert COGS into purchases, then convert purchases into cash paid to suppliers.

If you see beginning and ending inventory in an indirect method problem, what should you immediately think?

Compute the inventory change and adjust net income:

• Increase in inventory → subtract

• Decrease in inventory → add

If you see an increase in receivables, what should you immediately think?

• Indirect method → subtract from net income

• Direct method → subtract from revenue when computing cash collected

If you see an increase in accounts payable, what should you immediately think?

• Indirect method → add to net income

• Direct method → subtract from purchases when computing cash paid to suppliers