The Income Statement and Statement of Cash Flows

THE STATEMENT OF CASH FLOWS

Purpose of the Statement of Cash Flows

The purpose of the statement of cash flows is to identify the sources and uses of cash and
the change in cash from the beginning to the end of the accounting period. The sources
(cash receipts) and uses (cash disbursements) are classified into three categories.
1. Operating Activities: Cash receipts from sales and cash disbursements for cost of
goods sold and operating expenses that are incurred to generate the sales. For
financial accounting purposes operating activities include the receipt of dividends
and interest and the payment of interest.
2. Investing Activities: Cash paid for the acquisition of fixed assets and investments
and cash received from their disposition.
3. Financing Activities: Cash received from the issuance of debt or equity financing
and cash paid for the retirement of financing as well as the payment of dividends.

Content and Format of the Statement of Cash Flows

The basic format of the statement of cash flows is as follows:

Cash flows from operating activities $

Cash flows from investing activities $
Cash flows from financing activitie $
Net increase (decrease in cash for the year) $
Beginning cash balance $
Ending cash balance $

Preparation of the Statement of Cash Flows

There are two approaches to preparing the statement of cash flows. In the direct method
operating activities are presented as total cash receipts from sales and cash disbursements
for cost of sales and other operating activities. In the indirect method operating
activities are a reconciliation of net income. In this course we will be using the indirect
method.

Cash flows from operating activities:

Net income $
Add: Noncash charges $
Increases in current liabilities $
Decreases in current assets $
Less: Increases in current assets $
Decreases in current liabilities $
Add: Losses from investing or financing activities $
Less: Gains from investing or financing activities $ $
Net cash provided by (used by) operating activities $

E:\Teaching\3321\web\module2\c4\tnotes\c4b.doc 1/31/2007 1
The Income Statement and Statement of Cash Flows

Use of the Cash Flows Worksheet

Using the cash flows worksheet simplifies the process of preparing a statement of cash
flows. We will be using a cash flows worksheet to complete the exercises assigned in
this lesson.

The worksheet starts with a listing of the beginning and ending balances of each account
on the balance sheet. We then examine changes in each account and enter those amounts
in a multi-column worksheet. For example, Spencer Company had a cash balance of
$70,000 at the beginning of 2002 and a cash balance of $100,000 at the end of the year.
The change in cash of $30,000 needs to be separated into operating activities, investing
activities and financing activities. The work sheet is our starting point to complete this
task.

Spencer Company
Cash Flow Worksheet
For the year ended December 31, 2002

Changes in Cash
2002 2001 Increase Decrease
Cash 100,000 70,000 30,000

Accounts receivable 50,000 60,000 10,000

Investments 30,000 60,000 30,000
Equipment 300,000 250,000 50,000
Less: Accumulated depreciation (110,000) (90,000) 20,000
Current liabilities (50,000) (60,000) 10,000
Capital stock (160,000) (160,000)
Retained earnings (160,000) (130,000) 30,000
- - 90,000 60,000
Increase in cash 30,000
60,000 60,000

In analyzing the changes in cash we can see from the work sheet the increases in current
assets result in decreases in cash. If we make sales on credit the amounts are included in
net income but are not reflected in the cash account. Likewise when we pay down our
current liabilities this uses cash which is not reflected in the net income amount. Once
we have reconciled the increases and decreases in cash as a result of changes in the
account balances we are ready to examine the income statement.

In this case the company had net income of $60,000. Also included in the income
statement was a loss on the sale of investments. The change in the investments account
reflects the original cost of the investment that was sold. In analyzing the accounts we
also discover that dividends were declared and paid in the amount of $30,000 during the

E:\Teaching\3321\web\module2\c4\tnotes\c4b.doc 1/31/2007 2
The Income Statement and Statement of Cash Flows

year. With this information on hand we can now extend the work sheet. The following
shows the extensions to the Operating Activities columns (items shaded in green).

Spencer Company
Cash Flow Worksheet
For the year ended December 31, 2002

Changes in Cash Operating

Increase Decrease Increase Decrease
Cash 30,000

Accounts receivable 10,000 10,000

Investments 30,000
Equipment 50,000
Less: Accumulated depreciation 20,000 20,000
Current liabilities 10,000 10,000
Capital stock
Retained earnings 30,000
90,000 60,000
Increase in cash 30,000
60,000 60,000

Analysis of retained earnings:

Net income 60,000
Dividends paid
Loss on sale of investments 10,000
100,000 10,000
Changes in cash flow 30,000 90,000
10,000 10,000

The extension to operating activities includes the extension of changes in current assets
and current liabilities as well as non-cash charges to net income such as depreciation
expense. We were not given any information regarding the disposition of fixed assets
with accumulated depreciation so therefore the change in accumulated depreciation is the
depreciation expense charged to net income for the year.

Rather than analyzing the changes in the retained earnings account on a single line we
have expanded the analysis in the section below the balance sheet accounts (items shaded
in pink). We start with net income which is the starting point for the operating activities
and add back the loss on sale of investments. The amount is included in net income on
the income statement but belongs in the investing activities section of the cash flow
statement. We can think of this as just a transfer from one section to another.

E:\Teaching\3321\web\module2\c4\tnotes\c4b.doc 1/31/2007 3
The Income Statement and Statement of Cash Flows

After extending all of the information to the operating activities portion of the work sheet
we foot the columns and calculate a cash inflow of $100,000 and a cash outflow of
$10,000 to give us a net cash inflow for the year of $90,000 (items shaded in yellow).
This information will be transcribed to the statement of cash flows.

We repeat the process for the investing activities section of the cash flow statement
(items shaded in blue). The following is the extension for Spencer Company.

Spencer Company
Cash Flow Worksheet
For the year ended December 31, 2002

Changes in Cash Investing

Increase Decrease Increase Decrease
Cash 30,000

Accounts receivable 10,000

Investments 30,000 30,000
Equipment 50,000 50,000
Less: Accumulated depreciation 20,000
Current liabilities 10,000
Capital stock
Retained earnings 30,000
90,000 60,000
Increase in cash 30,000
60,000 60,000

Analysis of retained earnings:

Net income
Dividends paid
Loss on sale of investments 10,000
30,000 60,000
Changes in cash flow 30,000 30,000
30,000 30,000

The disposition of the investment resulted in a loss. If we combine this loss with the
original basis in the investment we will be able to derive the cash received from the
disposition of the investment. In this case we received $20,000 in cash from the sale of
the investment.

Selling price $20,000

Original cost 30,000
Loss on disposition $10,000

E:\Teaching\3321\web\module2\c4\tnotes\c4b.doc 1/31/2007 4
The Income Statement and Statement of Cash Flows

The other transaction that will be reported in the cash flow statement is the purchase of
equipment in the amount of $50,000. By footing the columns of the investing activities
we see that there was $30,000 in cash outflow for the accounting period.

Once the amounts are extended to the financing columns of the work sheet we can
conduct an analysis of cash flow from financing activities (items shaded in orange). The
following is an excerpt from the original work sheet for Spencer Company.

Spencer Company
Cash Flow Worksheet
For the year ended December 31, 2002

Changes in Cash Financing

Increase Decrease Increase Decrease
Cash 30,000

Accounts receivable 10,000

Investments 30,000
Equipment 50,000
Less: Accumulated depreciation 20,000
Current liabilities 10,000
Capital stock
Retained earnings 30,000
90,000 60,000
Increase in cash 30,000
60,000 60,000

Analysis of retained earnings:

Net income
Dividends paid 30,000
Loss on sale of investments
- 30,000
Changes in cash flow 30,000 30,000
- -

In this example the only financing activity is the declaration and payment of dividends.
Therefore the cash outflow from financing activities was $30,000 for the year.

Using Excel a cash flow statement can be prepared by linking the items on the cash flow
work sheet to a separate page where the cash flow statement is formatted. The following
is the completed cash flow statement for Spencer Company.

E:\Teaching\3321\web\module2\c4\tnotes\c4b.doc 1/31/2007 5
The Income Statement and Statement of Cash Flows

Spencer Company
Statement of Cash Flows
For the year ended December 31, 2002

Cash flows from operating activties

Net income $60,000
Adjustments to reconcile net income to net cash provided by
operating activities
Depreciation $20,000
Decrease in accounts receivable 10,000
Decrease in accrued liabilities (10,000)
Loss on sale of investments 10,000 30,000
Net cash provided by operating activities 90,000

Cash flows from investing activities

Sale of investments 20,000
Purchase of equipment (50,000)
Net cash used in investing activities (30,000)

Cash flows from financing activities

Dividends paid (30,000)
Net cash used in financing activities (30,000)

Net increase increase in cash 30,000

Cash at beginning of year 70,000
Cash at end of year $100,000

Noncash Investing and Financing Activities

A separate disclosure is made at the bottom of the cash flow statement identifying any
significant investing or financing activities that were executed without any cash changing
hands. We will explore how this is handled on the cash flow work sheet and as well as
the disclosure in the statement when we reexamine this subject in Chapter 22.

E:\Teaching\3321\web\module2\c4\tnotes\c4b.doc 1/31/2007 6