This chapter covers preparation of statement of cash flows using indirect and direct method.
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Corporate investors and potential investors seek information about a company’s financial position, results of operations, and cash flows. Chapter 23 describes the significance of the statement of cash flows and all aspects of its preparation. Numerous examples are included which assist in an understanding of how the statement is prepared and presented.
Purpose and Usefulness of the Statement of Cash Flows
The information in a statement of cash flows should help investors, creditors, and others to assess: (1) the entity’s ability to generate future cash flows; (2) the entity’s ability to pay dividends and meet obligations; (3) the reasons for the difference between net income and net cash flow from operating activities; and (4) the cash and noncash investing and financing transactions during the period. The required presentation of the statement of cash flows provides financial statement users with information about the major sources and uses of cash during the fiscal period.
Classification of Cash Flows
The statement of cash flows classifies cash receipts and cash payments by operating, investing, and financing activities. Operating activities include all transactions and events that are not investing and financing activities. Operating activities include the cash effects of transactions that enter into the determination of net income, such as cash receipts from sales of goods and services, and cash payments to suppliers and employees for acquisitions of inventory and expenses. Operating activities involve income determination items.
Investing activities include (a) making and collecting loans, and (b) acquiring and disposing of investments and productive long-lived assets. Investing activities involve cash flows generally resulting from changes in long-term asset items.
Financing activities involve liability and stockholders’ equity items and include (a) obtaining cash from creditors and repaying the amounts borrowed, and (b) obtaining capital from owners and providing them with a return on, and return of, their investment. Financing activities involve cash flows generally resulting from changes in long-term liability and stockholders’ equity items.
The typical cash receipts and cash payments of a business entity classified according to operating, investing, and financing activities are shown below.
From sales of goods or services.
From returns on loans (interest) and on equity securities (dividends).
To suppliers for inventory.
To employees for services.
To government for taxes.
To lenders for interest.
To others for expenses.
From sale of property, plant, and equipment.
From sale of debt or equity securities of other entities.
From collection of principal on loans to other entities.
To purchase property, plant, and equipment.
To purchase debt or equity securities of other entities.
To make loans to other entities.
From sale of equity securities.
From issuance of debt (bonds and notes).
To stockholders as dividends.
To redeem long-term debt or reacquire capital stock.
Some cash flows relating to investing or financing activities are classified as operating activities. For example, receipts of investment income (interest and dividends) and payments of interest to lenders are classified as operating activities. Conversely, some cash flows relating to operating activities are classified as investing or financing activities. For example, the cash received from the sale of property, plant, and equipment at a gain, although reported in the income statement, is classified as an investing activity, and the effect of the related gain is not included in net cash flow from operating activities. Likewise
a gain or loss on the payment of debt is generally part of the cash outflow related to the repayment of the principal amount borrowed and, therefore, is a financing activity.
Preparing the Statement of Cash Flows
The information used to prepare the statement of cash flows generally comes from three major sources: (a) comparative balance sheets, (b) the current income statement, and (c) selected transaction data. Actual preparation of the statement of cash flows involves three steps:
Determine the change in cash. The difference between the beginning and ending cash balance can be easily computed from an examination of the comparative balance sheets.
Determine the net cash flow from operating activities. This procedure involves analyzing not only the current year’s income statement, but also comparative balance sheets, as well as selected transaction data.
Determine the net cash flows from investing and financing activities. All other changes in the balance sheet accounts must be analyzed to determine their effect
To compute net cash flows from operating activities. It is necessary to report revenues and expenses on a cash basis. This is done by eliminating the effects of income statement transactions that did not result in a corresponding increase or decrease in cash. The conversion of accrual-based net income to net cash flow from operating activities may be done through either the direct method or the indirect method.
While the FASB encourages the use of the direct method when preparing the statement of cash flows, use of the indirect method is also permitted. However, if the direct method is used the FASB requires that a reconciliation of net income to net cash flow from operating activities shall be provided in a separate schedule. Therefore, under either method, the indirect (reconciliation) approach must be presented. The text book includes comprehensive illustrations which provide a detailed explanation of the preparation and presentation of the statement of cash flows.
When non-cash current asset accounts increase and non-cash current liability accounts decrease, the change is subtracted from net income.
When non-cash current asset accounts decrease, and non-cash current liability accounts increase, the change is subtracted from net income.
Non-cash items such as depreciation, amortization, and losses are added to net income, while gains are subtracted.
The schedule shown below presents the common types of adjustments that are made to net income to arrive at net cash flow provided by operating activities under the indirect method.
Additions to Net Income
Amortization of intangibles and deferred charges.
Amortization of bond discount.
Increase in deferred income tax liability.
Loss on investment in common stock using equity method.
Loss on sale of plant assets.
Loss on impairment of assets.
Decrease in receivables.
Decrease in inventories.
Decrease in prepaid expenses.
Increase in accounts payable.
Increase in accrued liabilities.
Deductions from Net Income
Amortization of bond premium.
Decrease in deferred income tax liability.
Income on investment in common stock using equity method.
Gain on sale of plant assets.
Increase in receivables.
Increase in inventories.
Increase in prepaid expenses.
Decrease in accounts payable.
Decrease in accrued liabilities.
Investing and Financing Activities
Investing activities include the analysis of all long-term asset accounts to determine any cash flow effects. The following are common investing cash flow effects, though non-cash effects may possibly cause the same effects in the long-term asset accounts.
- A purchase of land will appear as an increase in the land account and will appear as an investing cash outflow.
- A sale of land will appear as a decrease in the land account and will be reported as an investing cash inflow. However, the change in the land account is rarely the same amount as the cash flow effect, as a gain or loss may result.
- A purchase of a depreciable asset such as equipment or a building will appear as an increase in the equipment or building account and will appear as an investing cash outflow.
- A sale of a depreciable asset such as equipment or a building will appear as an decrease in the equipment or building account and a decrease in the accumulated depreciation account. The net book value change will rarely equal the cash flow effect, as a gain or loss will usually result.
- A sale of an investment in stock or bonds of another company will appear as a decrease in the investment account and will be reported as an investing cash inflow. However, a gain or loss often results from the sale that causes the cash flow amount to differ from the change in the long-term asset account.
- A purchase of an investment in stock or bonds of another company will appear as an increase in the investment account and will be reported as an investing cash outflow.
- Financing activities include the analysis of all long-term liabilities, all stock accounts, dividends payable, and some short-term notes payable to determine any cash flow effects. The following are common financing cash flow effects, though non-cash effects may possibly cause the same effects in the respective accounts.
- An issuance of long-term debt, including bonds and notes payable, will appear as an increase in these accounts and will be reported as a financing cash inflow.
- A payment or liquidation of long-term bonds or notes payable will appear as a decrease in the long-term obligation accounts and will be reported as a financing cash outflow. However, the book value of the obligation must be considered as well (e.g., discounts and premiums.)
- The decrease in retained earnings often represents the declaration of cash dividends and must be analyzed together with the dividends payable account and the effect of net income on retained earnings in order to determine if cash dividends were paid, which are reported as a financing cash outflow.
- The issuance of capital stock will appear as an increase in the respective stock accounts and related additional paid-in capital accounts. Stock issuances in exchange for cash are reported as financing cash inflows.
Sources of Information for the Statement of Cash Flows
Important sources of information in the preparation of the statement of cash flows are these:
- Comparative balance sheets provide the basic information from which to prepare the statements. Additional information obtained from analyses of specific accounts is also included.
- An analysis of the Retained Earnings account is necessary. The net increase or decrease in Retained Earnings without any explanation is a meaningless amount in the statement. Without explanation, it might represent the effect of net income, dividends declared, or prior period adjustments.
- The statement includes all changes that have passed through cash or have resulted in an increase or decrease in cash.
- Write-downs, amortization charges, and similar “book” entries, such as depreciation of plant assets, represent neither inflows nor outflows of cash because they have no effect on cash. To the extent that they have entered into the determination of net income, however, the company must add them back to or subtract them from net income, to arrive at net cash provided (used) by operating activities.
Minimum disclosure requirements for companies using the direct method include the following:
- Cash collected from customers.
- Interest and dividends received.
- Other operating cash receipts, if any.
- Cash paid to employees and suppliers of goods and services.
- Interest paid.
- Income taxes paid.
- Other operating cash payments, if any.
Use of the indirect method requires separate disclosure of changes in inventory, receivables, and payables relating to operating activities. Such disclosures are required for the purpose of aiding users in approximating the direct method.
Direct versus Indirect Method
Under the direct method (also called the income statement method) cash revenues and expenses are determined. The difference between these two amounts represents net cash flows from operating activities. In essence, the direct method results in the presentation of a cash basis income statement. Under the indirect method (also called the reconciliation method), computation of net cash flows from operating activities begins with net income. This accrual-based amount is then converted to net cash provided by operating activities by adding back noncash expenses and charges and deducting noncash revenues.
The principal advantage of the direct method is that it shows operating cash receipts and payments. Supporters contend that this is useful in estimating future cash flows and in assessing an entity’s ability to (a) generate sufficient cash flow from operations for the payment of debt, (b) reinvest in its operations, and (c) make distributions to owners.
Proponents of the indirect method cite the fact that it focuses on the difference between net income and net cash flow from operations as its principal advantage. Also, supporters of the indirect method contend that users are more familiar with the method and it is less costly to present the statement of cash flows using this method.
Special Problems in Statement Preparation
Some items that relate to various aspects of the statement of cash flows require special attention when preparing the statement of cash flows.
Depreciation and amortization. Depreciation expense is added back to net income to arrive at net cash provided by operating activities. Likewise, amortization of limited-life intangible assets, deferred costs, and bond premium or discount are also adjustments to net income.
Pension benefit costs. The difference between the pension expense recorded during the period and the amount of cash funded for the pension plan is an adjustment to net income in arriving at net cash provided by operating activities.
Deferred income taxes. Changes in deferred income taxes affect net income, but have no effect on cash. An increase in deferred income taxes decreases net income but not cash, and therefore is added back to net income.
Equity method of accounting. The net increase in the investment account increases net income but does not affect cash flow. The net increase is deducted from net income to arrive at net cash flow from operating activities.
Gains and losses. Because a gain on the sale of plant assets is reported in the statement of cash flows as part of the cash proceeds from the sale of the assets under investing activities, the gain is deducted from net income to avoid double counting.
A loss on sale is added back to net income, and the full cash proceeds is included under investing activities.
Stock options. For share-based compensation plans, companies are required to use the fair value method to determine compensation cost. Compensation expense is recorded during the period(s) in which an employee performs the service if a company has a stock option plan. This expense is recorded by debiting compensation expense and crediting a stockholders’ equity account. Thus, net income is increased by the amount of compensation expense in computing net cash provided by operating activities.
Unusual and infrequent items. Cash flows from unusual and infrequent transactions and other events whose effects are included in net income, but which are not related to operations, are reported as either investing or financing activities.
Accounts receivable (net). An increase in the Allowance for Doubtful Accounts is added back to net income to arrive at net cash provided by operating activities. This is due to the fact that the increase in the allowance results in a charge to bad debts expense (a noncash expense).
Other working capital changes. Some changes in working capital, although they affect cash, do not affect net income. Generally, these are investing or financing activities of a current nature such as the purchase of short-term investments (trading and available- for-sale securities).
Net losses. If a company reports a net loss instead of net income, the net loss is adjusted for those items that do not result in a cash inflow or outflow. As a result of such adjustments, the net loss is often accompanied in a positive cash flow from operating activities.
Significant noncash transactions. Significant noncash investing and financing activities (such as purchasing an asset by assuming long-term debt), if material in amount, are disclosed in a separate schedule or narrative disclosure. These items are not to be incorporated in the statement of cash flows.