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"Using the Consolidated Statements of Ca...
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"Using the Consolidated Statements of Cash Flows on page 145, prepare a summary analysis for the year ending March 31, 2002.

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Chp 4 Reading.pdf

4

CHAPTER

Statement of Cash
Statement
Flows
Joan and Joe: A Tale of Woe
Joe added up profits and went to see Joan,
Assured of obtaining a much-needed loan.
When Joe arrived, he announced with good cheer:
My firm has had an outstanding year,
And now I need a loan from your bank.
Eyeing the statements, Joans heart sank
Your profits are fine, Joan said to Joe
But where, oh where, is your companys cash flow?
Im sorry to say: the answer is no.

L. FRASER
The statement of cash flows, required by Statement of Financial Accounting
Standards No. 95, represents a major step forward in accounting measurement and
disclosure because of its relevance to financial statement users. Ample evidence has
been provided over the years by firms of every conceivable size, structure, and
type of business operation that it is possible for a company to post a healthy net
income but still not have the cash needed to pay its employees, suppliers, and
bankers. The statement of cash flows, which replaced the statement of changes in
financial position in 1988, provides information about cash inflows and outflows during an accounting period. On the statement, cash flows are segregated by operating
activities, investing activities, and financing activities.1 The mandated focus on cash in
this statement results in a more useful document than its predecessor. A positive net
income figure on the income statement is ultimately insignificant unless a company
can translate its earnings into cash, and the only source in financial statements for
learning about cash generation is the statement of cash flows.
The objectives of this chapter are twofold: (1) to explain how the statement of
cash flows is prepared and (2) to interpret the information presented in the
1

ISBN: 0-536-48044-3

Financing and investing activities not involving cash receipts and paymentssuch as the exchange of debt
for stock or the exchange of propertyare reported in a separate schedule on the statement of cash flows.

117

Understanding Financial Statements, Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright 2007 by Pearson Education, Inc.

118

CHAPTER 4

Statement of Cash Flows

statement, including a discussion of the significance of cash flow from operations as
an analytical tool in assessing financial performance. Readers may legitimately
ask at this point why it is necessary to wade through the preparation of this
statement in order to understand and use the information it contains. This chapter
provides a more extensive treatment of the preparation of the statementits
underpinningsthan the chapters on the balance sheet, income statement, and
statement of stockholders equity. The reason for this approach is its extreme
EXHIBIT 4.1 R.E.C. Inc. Consolidated Statements of Cash Flows for the Years Ended
December 31, 2007, 2006, and 2005 (in Thousands)
2007

Cash Flows from Operating ActivitiesIndirect Method
Net income
Adjustments to reconcile net income to cash provided (used)
by operating activities
Depreciation and amortization
Deferred income taxes
Cash provided (used) by current assets and liabilities
Accounts receivable
Inventories
Prepaid expenses
Accounts payable
Accrued liabilities
Net cash provided (used) by operating activities
Cash Flows from Investing Activities
Additions to property, plant, and equipment
Other investing activities
Net cash provided (used) by investing activities
Cash Flows from Financing Activities
Sales of common stock
Increase (decrease) in short-term borrowings
(includes current maturities of long-term debt)
Additions to long-term borrowings
Reductions of long-term borrowings
Dividends paid
Net cash provided (used) by financing activities
Increase (decrease) in cash and marketable securities
Cash and marketable securities, beginning of year
Cash and marketable securities, end of year
Supplemental cash flow information:
Cash paid for interest
Cash paid for taxes

2005

9,394

$ 5,910

$ 5,896

3,998
208

$

2006

2,984
136

2,501
118

(610)
(10,272)
247
6,703
356
$ 10,024

(3,339)
(7,006)
295
(1,051)
(1,696)
($ 3,767)

(448)
(2,331)
(82)
902
(927)
$ 5,629

(14,100)
295
($ 13,805)

(4,773)
0
($ 4,773)

(3,982)
0
($ 3,982)

256
(30)
5,600
(1,516)
(1,582)
$ 2,728
($ 1,053)
10,386
$ 9,333

$

2,585
7,478

183

124

1,854
7,882
(1,593)
(1,862)
$ 6,464
($ 2,076)
12,462
$10,386

1,326
629
(127)
(1,841)
$ 111
$ 1,758
10,704
$12,462

$ 2,277
4,321

$ 1,274
4,706

The accompanying notes are an integral part of these statements.
ISBN: 0-536-48044-3

Understanding Financial Statements, Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright 2007 by Pearson Education, Inc.

CHAPTER 4

Statement of Cash Flows

119

importance as an analytical tool. Understanding the statement is greatly enhanced
by understanding how it is developed from the balance sheet and income statement; knowing the nuts and bolts helps the analyst utilize its disclosures to maximum effectiveness.
The Consolidated Statements of Cash Flows for R.E.C. Inc., shown in Exhibit 4.1,
will serve as the background for an explanation of how the statement is prepared and a
discussion of its usefulness for financial analysis.

Preparing a Statement of Cash Flows
Preparing the statement of cash flows begins with a return to the balance sheet, covered in Chapter 2. The statement of cash flows requires a reordering of the information
presented on a balance sheet. The balance sheet shows account balances at the end of
an accounting period, and the statement of cash flows shows changes in those same
account balances between accounting periods (see Figure 4.1). The statement is called
a statement of flows because it shows changes over time rather than the absolute dollar

FIGURE 4.1

How Cash Flows During an Accounting Period

Operating Activities
Inflows

Outflows

Revenue from sales of goods
Payments for purchase of inventory
Revenue from services
Payments for operating expenses (salaries,
Returns on equity securities (dividends)
rent, etc.)
Returns on interest-earning assets
Payments for purchases from suppliers
(interest)
other than inventory
Payments to lenders (interest)
Payments for taxes
Investing Activities
Inflows

Outflows

Revenue from sales of long-lived assets Acquisitions of long-lived assets
Returns from loans (principal) to others Loans (principal) to others
Revenue from sales of debt or equity
Purchases of debt or equity securities of
securities of other entities (except
other entities (except trading securities)
securities traded as cash equivalents)
Financing Activities
Inflows

Outflows

Proceeds from borrowing
Proceeds from issuing the firms own
equity securities

Repayments of debt principal
Repurchase of a firms own shares
Payment of dividends

ISBN: 0-536-48044-3

Total Inflows less Total Outflows = Change in cash for the accounting period

Understanding Financial Statements, Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright 2007 by Pearson Education, Inc.

120

CHAPTER 4

Statement of Cash Flows

amount of the accounts at a point in time. Because a balance sheet balances, the changes
in all of the balance sheet accounts balance, and the changes that reflect cash inflows
less the changes that result from cash outflows will equal the changes in the cash
account.
The statement of cash flows is prepared in exactly that way: by calculating the
changes in all of the balance sheet accounts, including cash; then listing the changes in
all of the accounts except cash as inflows or outflows; and categorizing the flows by
operating, financing, or investing activities. The inflows less the outflows balance to and
explain the change in cash.
In order to classify the account changes on the balance sheet, it is first necessary to
review the definitions of the four parts of a statement of cash flows:





Cash
Operating activities
Investing activities
Financing activities

Cash includes cash and highly liquid short-term marketable securities, also called
cash equivalents. Marketable securities are included as cash for R.E.C. Inc., because
they represent, as explained in Chapter 2, short-term highly liquid investments that can
be readily converted into cash. They include U.S. Treasury bills, certificates, notes, and
bonds; negotiable certificates of deposit at financial institutions; and commercial
paper. Some companies will separate marketable securities into two accounts: (1) cash
and cash equivalents and (2) short-term investments. When this occurs, the short-term
investments are classified as investing activities.
Operating activities include delivering or producing goods for sale and providing
services and the cash effects of transactions and other events that enter into the determination of income.
Investing activities include (1) acquiring and selling or otherwise disposing of
(a) securities that are not cash equivalents and (b) productive assets that are expected
to benefit the firm for long periods of time and (2) lending money and collecting on
loans.
Financing activities include borrowing from creditors and repaying the principal
and obtaining resources from owners and providing them with a return on the
investment.
With these definitions in mind, consider Exhibit 4.2, a worksheet for preparing the
statement of cash flows that shows comparative 2007 and 2006 balance sheet accounts
for R.E.C. Inc. Included in this exhibit is a column with the account balance changes
and the category (or categories) that applies to each account. Explanations of how
each account change is used in a statement of cash flow will be provided in subsequent
sections of this chapter.
(1)(2) Cash and marketable securities are cash. The changes in these two
accountsa net decrease of $1,053 thousand (decrease in marketable securities of $2,732 thousand less increase in cash of $1,679 thousand)will be
explained by the changes in all of the other accounts. This means that for the
year ending 2007, the cash outflows have exceeded the cash inflows by $1,053
thousand.
ISBN: 0-536-48044-3

Understanding Financial Statements, Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright 2007 by Pearson Education, Inc.

CHAPTER 4

Statement of Cash Flows

121

EXHIBIT 4.2 R.E.C. Inc. Worksheet for Preparing Statement of Cash Flows (in Thousands)

2007

Assets
(1) Cash
(2) Marketable securities
(3) Accounts receivable (net)
(4) Inventories
(5) Prepaid expenses
(6) Property, plant, and equipment
(7) Accumulated depreciation and amortization
(8) Other assets
Liabilities and Stockholders Equity
Liabilities
(9) Accounts payable
(10) Notes payablebanks
(11) Current maturities of long-term debt
(12) Accrued liabilities
(13) Deferred income taxes
(14) Long-term borrowings
Additions to long-term borrowings
Reductions of long-term borrowings
Net change in long-term debt
Stockholders Equity
(15) Common stock
(16) Additional paid-in capital
(17) Retained earnings
(a) Net income
(b) Dividends paid
Net change in retained earnings

2006

$ 4,061
5,272
8,960
47,041
512
40,607
(11,528)
373

$ 2,382
8,004
8,350
36,769
759
26,507
(7,530)
668

CHANGE
(20072006)

1,679
(2,732)
610
10,272
(247)
14,100
(3,998)
(295)

Cash
Cash
Operating
Operating
Operating
Investing
Operating
Investing

7,591
6,012
1,516
5,313
635

6,703
(398)
368
356
208

Operating
Financing
Financing
Operating
Operating

21,059

16,975

5,600
(1,516)
$ 4,084

Financing

4,803
957

4,594
910

14,294
5,614
1,884
5,669
843

$40,175

$32,363

$

CATEGORY

209
47
9,394
(1,582)
$ 7,812

Financing
Financing
Operating
Financing

ISBN: 0-536-48044-3

(3)(4)(5) Accounts receivable, inventories, and prepaid expenses are all
operating accounts relating to sales of goods, purchases of inventories, and
payments for operating expenses.
(6) The net increase in property, plant, and equipment is an investing
activity reflecting purchases of long-lived assets.
(7) The change in accumulated depreciation and amortization is classified
as operating because it will be used as an adjustment to operating expenses or
net income to determine cash flow from operating activities.
(8) Other assets are holdings of land held for resale, representing an investing
activity.
(9) Accounts payable is an operating account because it arises from
purchases of inventory.

Understanding Financial Statements, Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright 2007 by Pearson Education, Inc.

122

CHAPTER 4

Statement of Cash Flows

(10) (11) Notes payable and current maturities of long-term debt result
from borrowing (debt principal), a financing activity.
(12) Accrued liabilities are operating because they result from the accrual
of operating expenses such as wages, rent, salaries, and insurance.
(13) The change in deferred income taxes is categorized as operating because
it is part of the adjustment of tax expense to calculate cash flow from operating
activities.
(14) The change in long-term debt, principal on borrowings, is a financing
activity.
(15)(16) Common stock and paid-in capital are also financing activities
because the changes result from sales of the firms own equity shares.
(17) The change in retained earnings, as explained in Chapter 3, is the product
of two activities: (a) net income for the period, which is operating; and (b) the
payment of cash dividends, which is a financing activity.
The next step is to transfer the account changes to the appropriate area of a statement of cash flows.2 In doing so, a determination must also be made of what constitutes
an inflow and what constitutes an outflow when analyzing the change in an account
balance. The following table should help:
Inflow
Asset account
Liability account
Equity account

Outflow
Asset account
Liability account
Equity account

The table indicates that a decrease in an asset balance and an increase in liability
and equity accounts are inflows.3 Examples from Exhibit 4.2 are the decrease in other
assets (cash inflow from the sale of property not used in the business), the increase in
long-term debt (cash inflow from borrowing), and the increase in common stock and
additional paid-in capital (cash inflow from sales of equity securities). Outflows are
represented by the increase in inventories (cash outflow to purchase inventory) and
the decrease in notes payable (cash outflow to repay borrowings).
Note that accumulated depreciation appears in the asset section but actually is a
contra-asset or credit balance account because it reduces the amount of total assets.
Accumulated depreciation is shown in parentheses on the balance sheet and has the
same effect as a liability account.
Another complication occurs from the impact of two transactions in one account.
For example, the net increase in retained earnings has resulted from the combination of
net income for the period, which increases the account, and the payment of dividends,
which reduces the account. Multiple transactions can also affect other accounts, such as
property, plant, and equipment if a firm both acquires and sells capital assets during the
period, and debt accounts if the firm both borrows and repays principal.
2

Several alternative formats can be used for presenting the statement of cash flows, provided that the
statement is reconciled to the change in cash and shows cash inflows and outflows from operating,
financing, and investing activities.
3
In accounting terminology, an inflow results from the decrease in a debit balance account or an increase
in a credit balance account; an outflow results from the increase in a debit balance account or the
decrease in a credit balance account.
ISBN: 0-536-48044-3

Understanding Financial Statements, Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright 2007 by Pearson Education, Inc.

CHAPTER 4

Statement of Cash Flows

123

Calculating Cash Flow From Operating Activities
The R.E.C. Inc. Consolidated Statements of Cash Flows begins with cash flow from
operating activities. This represents the cash generated internally. In contrast, investing and financing activities provide cash from external sources. Firms may use one
of two methods prescribed by the Financial Accounting Standards Board (FASB)
for calculating and presenting cash flow from operating activities: the direct method
and the indirect method. The direct method shows cash collections from customers,
interest and dividends collected, other operating cash receipts, cash paid to suppliers
and employees, interest paid, taxes paid, and other operating cash payments. The
indirect method starts with net income and adjusts for deferrals; accruals; noncash
items, such as depreciation and amortization; and nonoperating items, such as gains
and losses on asset sales. The direct and indirect methods yield identical figures for
net cash flow from operating activities because the underlying accounting concepts
are the same. According to Accounting Trends and Techniques, 593 firms out of 600
used the indirect method in 2003.4 The indirect method is illustrated and explained
for R.E.C. Inc. in the chapter and the direct method is illustrated in the appendix to
this chapter.
Indirect Method
Exhibit 4.3 illustrates the steps necessary to convert net income to cash flow from operating activities. The steps shown in Exhibit 4.3 will be used to explain the calculation of cash
flow from operating activities for R.E.C. Inc. using the indirect method. Exhibit 4.3
includes some adjustments not present for R.E.C. Inc.
R.E.C. Inc. Indirect Method
Net income
Adjustments to reconcile net income to cash provided by operating activities:
Depreciation and amortization expense
Increase in deferred tax liability
Cash provided (used) by current assets, liabilities
Increase in accounts receivables
Increase in inventory
Decrease in prepaid expenses
Increase in accounts payable
Increase in accrued liabilities
Net cash flow from operating activities

$ 9,394
3,998
208
(610)
(10,272)
247
6,703
356
$10,024

Depreciation and amortization are added back to net income because they
reflect the recognition of a noncash expense. Remember that depreciation represents a cost allocation, not an outflow of cash. The acquisition of the capital asset was
recognized as an investing cash outflow (unless it was exchanged for debt or stock) in
4

ISBN: 0-536-48044-3

Accounting Trends and Techniques, American Institute of Certified Public Accountants, 2004.

Understanding Financial Statements, Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright 2007 by Pearson Education, Inc.

124

CHAPTER 4

Statement of Cash Flows

EXHIBIT 4.3 Net Cash Flow from Operating
ActivitiesIndirect Method

Net income*
Noncash/Nonoperating revenue and expense included in income:
Depreciation, amortization, depletion expense for period
Increase in deferred tax liability
Decrease in deferred tax liability
Decrease in deferred tax asset
Increase in deferred tax asset
Increase in investment account from equity income**
Decrease in investment account from equity income***
Gain on sale of assets
Loss on sale of assets
Cash provided (used) by current assets and liabilities
Decrease in accounts receivable
Increase in accounts receivable
Decrease in inventory
Increase in inventory
Decrease in prepaid expenses
Increase in prepaid expenses
Decrease in interest receivable
Increase in interest receivable
Increase in accounts payable
Decrease in accounts payable
Increase in accrued liabilities
Decrease in accrued liabilities
Increase in deferred revenue
Decrease in deferred revenue
Net cash flow from operating activities
*Before extraordinary items, accounting changes, discontinued operations.
**Amount by which equity income exceeds cash dividends received.
***Amount by which cash dividends received exceed equity income recognized.

the statement of cash flows for the period in which the asset was acquired. So depreciation itself does not require any outflow of cash in the year it is recognized.
Deducting depreciation expense in the current years statement of cash flows would
be double counting. Amortization is similar to depreciationan expense that enters
into the determination of net income but that does not require an outflow of cash.
Depletion would be handled in the same manner as depreciation and amortization.
The depreciation and amortization expense for R.E.C. Inc. in 2007 is equal to the
change in the balance sheet accumulated depreciation and amortization account.
ISBN: 0-536-48044-3

Understanding Financial Statements, Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright 2007 by Pearson Education, Inc.

CHAPTER 4

Statement of Cash Flows

125

If the firm had dispositions of capital assets during the accounting period, however,
the balance sheet change would not equal the expense recognition for the period
because some of the account change would have resulted from the elimination
of accumulated depreciation for the asset that was removed. The appropriate figure
to subtract would be depreciation and amortization expense from the earnings
statement.
The deferred tax liability account, as discussed in Chapter 2, reconciles the difference
between tax expense recognized in the calculation of net income and the tax expense
actually paid. The increase in the liability account for R.E.C. Inc. is added back to net
income because more tax expense was recognized in the calculation of net income than
was actually paid for taxes.
The increase in accounts receivable is deducted because more sales revenue has been
included in net income than has been collected in cash from customers.
The increase in inventory is subtracted because R.E.C. Inc. has purchased more
inventory than has been included in cost of goods sold. Cost of goods sold used in calculating net income includes only the inventory actually sold.
The decrease in prepaid expenses is added back because the firm has recognized an
expense in the current period for which cash was paid in an earlier period, on a net basis.
The increase in accounts payable is added because less has been paid to suppliers for
purchases of inventory than was included in cost of goods sold.
The increase in accrued liabilities is an addition to net income because it reflects the
recognition of expense, on a net basis, prior to the payment of cash.
There are other potential adjustments, not required for R.E.C. Inc., that enter into
the net income adjustment for noncash expense and revenues. One such item is the
recognition of investment income from unconsolidated subsidiaries by the equity
method of accounting, discussed in Chapter 3. When a company uses the equity
method, earnings can be recognized in the income statement in excess of cash actually
received from dividends, or the reverse can occur, for example, in the case of a loss
recorded by an investee. For a firm using the equity method, there would be a deduction from net income for the amount by which investment income recognized
exceeded cash received. Other potential adjustment items include changes relating to
deferred income, deferred expense, the amortization of bond discounts and premiums, extraordinary items, and gains or losses on sales of long-lived assets.
Although gains and losses from asset sales are included in the calculation of net
income, they are not considered an operating activity. A gain should be deducted from
net income, and a loss should be added to net income to determine cash flow from
operating activities. The entire proceeds from sales of long-lived assets are included as
cash inflows from investing.

Cash Flow from Investing Activities

ISBN: 0-536-48044-3

Additions to property, plant, and equipment represent a net addition to R.E.C. Inc.s
buildings, leasehold improvements, and equipment, a cash outflow of $14.1 million.
Other investing activities for R.E.C. Inc. result from a decrease in the other assets
account on the balance sheet, which represent holdings of investment properties. The
sale of these assets has provided a cash inflow of $295 thousand.

Understanding Financial Statements, Eighth Edition, by Lyn M. Fraser and Aileen Ormiston. Published by Prentice Hall. Copyright 2007 by Pearson Education, Inc.

126

CHAPTER 4

Statement of Cash Flows

Cash Flow from Financing Activities
As a result of the exercise of stock options, R.E.C. Inc. issued new shares of stock
during 2007. The total cash generated from stock sales amounted to $256 thousand.
Note that two accounts on the balance sheetcommon stock and additional paid-in
capitalcombine to explain this change:
Common stock
Additional paid-in capital

$209
47
$256

Inflow
Inflow
Total Inflow

The two accountsnotes payable to banks and current maturities of long-term
debt (carried as a current liability since the principal is payable within a year)jointly
explain R.E.C. Inc.s net reduction in sh...

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Accounting - 7982987.doc

The corporation earned net income of $825,413 during 2002. The depreciation & amortization
cost was amount to $376763 and the net cash generated by the operating activities was $476,024.
The...

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