Effects Operating, Investing, Financing

Activities on Cash Flows

ACCO UNTI NG FO R M AN AGERS

Statement of Cash Flows

PUTTU GURU PRASAD

FACULTY MEMBER
INC GUNTUR
pgp4149@gmail.com
 Learning Objectives
1. Understand why using the accrual basis
of accounting to prepare the balance
sheet and income statement creates the
need for a statement of cash flows.
2. Understand the types of transactions
that result in cash flows from operating,
investing, and financing activities.
3. Develop an ability to prepare a
statement of cash flows from a
comparative balance sheet and income
statement.
 Learning Objectives

1. Distinguish between the direct and

indirect methods of reporting and
analyzing cash flows from operations.
2. Develop an ability to analyze the
statement of cash flows, including the
relation among cash flows from
operating , investing, and financing
activities for businesses in various
stages of their growth.
 Chapter Outline
1. Need for a Statement of Cash Flows
2. Overview of the Statement of Cash Flows
3. Preparing the Statement of Cash Flows
– Direct and indirect methods

– T-account approach

4. An international perspective
5. Using Information in the Statement of
Cash Flows
6. Ethical Issues and The Statement of Cash
Flows
Chapter Summary
 Statement of Cash Flows

The statement of cash flows …

b) explains the reasons for a change in
cash.
c) classifies the reasons for the
change as an operating, investing
or financing activity.
d) reconciles net income with cash
flow from operations.
Three Classifications of Cash
Flows
♦ Operations –
cash flows related to selling goods and
services; that is, the principle business of the
firm.
2. Investing –
cash flows related to the acquisition or sale of
noncurrent assets.
3. Financing –
long term and short term cash flows related to
liabilities and owners’ equity; dividends are a
financing cash outflow.
 Example
of a
Statement
of Cash
Flows

Exhibit 4.1
 Preparing the Statement of Cash
Flows
Firms could prepare the cash flow statement
directly from the cash account. Most,
however, find it more efficient to prepare
the cash flow statement from the balance
sheet and income statement.
b) Direct and indirect methods.
c) Algebraic formulation will present the
underlying concept of Statement of cash
flows.
d) There are two approaches to producing
the cash flow statement: columnar
worksheet and t-account worksheet.
 Define Direct and Indirect Method
 Direct method
of presentation calculates cash flow from
operations by subtracting cash disbursements to
supplies, employees, and others from cash
receipts from customers.
 The indirect method
calculates cash flow from operations by adjusting
net income for noncash revenues and expenses.
 Most firms present their cash flows using
the indirect method.
 Algebraic Formulation
Recall the basic accounting equation:
Assets = Liabilities + Shareholders’ Equity
or A = L + SE
Assets are either cash (C) or non cash
assets (N$A), so
C + N$A = L + SE
∆ C + ∆ N$A = ∆ L + ∆ SE
Where ∆ means the change in the balance,
Rearranging gives the basic equation for
the statement of cash flows:
∆ C = ∆ L + ∆ SE - ∆ N$A
Algebraic Formulation (Cont.)
C = ∆ L + ∆ SE - ∆ N$A
 The change in cash, ∆ C, is the increase
or decrease in the cash account.
 This amount must equal changes in
liabilities plus changes in shareholders’
equity minus changes in assets other
than cash.
 Thus, we can identify the causes in the
change in the cash account by studying
the changes in non-cash accounts.
Two Approaches to Producing
the Cash Flow Statement

The basic formula can be

implemented using either of two
approaches:
 Columnar worksheet -- changes in
balance sheet accounts are
classified by definition using a
multicolumn worksheet.
 T-Account worksheet -- changes
are classified by analysis of the t-
 Columnar Worksheet
 Works well for relatively simple
situations involving few
transactions.
 Enhances understanding of the cash
flow statement.
 Does not work as well as the T-
account method when the number
and complexity of transactions
increases.
 Columnar Worksheet (Cont.)
Begin with a comparative balance sheet.
2. Compute the change in each balance
sheet account.
3. Classify each change as operating,
investing or financing activity.
4. Make any needed adjustments (for
example, for a sale of a long-lived
asset).
5. Recast the classified changes in the
form of a cash flow statement.
 Noncash Expenses
 Noncash expenses, such as
depreciation expense, are added
back.

 Items that are truly not sources of

cash, even though they are
associated with cash inflows;
rather, a reversal of the accrual
process that required the
expenses to be recognized without
regard for the cash flow.
 Changes in Specific Accounts

increase decrease
If noncash assets If noncash assets
Non- are increased, are decreased,
cash then cash was spent, then they provided cash
Asset so cash is an outflow, so cash is an inflow,
s negative sign. positive sign.
If liab. or S.E. If liab. or S.E.
Liabilities increased, then cash decreased, then cash
and was obtained, was spent,
Shareholders’ so cash in an inflow, so cash in an outflow,
Equity positive sign. negative sign.
 T-account Worksheet
 The columnar works well when the change in
each balance sheet account affects only one
of the three types of activities. It becomes
cumbersome for more complex (and realistic)
situations.
 The T-account approach is a direct extension
of T-accounts - facilitates analysis of a
transaction which involves more than one
activity.
 For example, the change in Retained Earnings
can be due to both net income (operating
activity) and dividends (financing activity).
 T-account Worksheet
1. Obtain beginning and ending balance
sheets.
2. Prepare a T-account worksheet with a
master account, cash, divided into
operating, investing and financing sections.
3. Explain the change in the master cash
account by reconstructing the original
entries in a summary form.
4. Make any necessary adjustments.
5. Recast the master account in the format of
a cash flow statement.
 T-account Worksheet (Cont.)
Various Balance Sheet Accounts Cash

beginning beginning
balance balance
###### 3. this
ending 2. these are Operations part of the
balance offset by an #### cash
1. adjustments are opposite entry Investing account
made to all balance in the cash becomes
sheet accounts to account. Financing the cash
bring the beginning flow
balance to the ending ending statement.
balance. balance
Effects of Sale of Long-Term Assets
on Cash Flows
 A few transactions complicate the derivation of a
cash flow statement from a comparative balance
sheet, for example, the sale of a long-term (or
fixed) asset.
 Recall the journal entry for the sale of an asset:

Cash ###
Accumulated Depreciation ###
Asset ###
Gain (or loss) on sale ###
 Sale of an Asset (Cont.)
 Each of the four parts of the above journal entry
require an adjustment in the cash flow statement.
 The first line, cash, adds a line to the investing section.
 The second line, a debit to accumulated depreciation,
increases the depreciation expense above the change
in the change in the accumulated depreciation account.
 The third line, a credit to the asset, increases the
amount of cash invested in long-lived assets above the
change in the fixed asset accounts.
 The fourth line, a gain or loss, is reversed out in the
operating sections since this is not a cash flow.
Comparison of Cash Flow to Net
Income
 Net income is an accrual based concept and
purports to show the long-term.
 Cash flows purport to show the short term.
 Consider the outlook for both short-term and
long-term and consider that each is either good
or poor.
 A strong growing firm would show both good
long-term and good short-term outlooks.
 A failing firm would show both poor long-term
and poor short term outlooks.
 What about a firm with good cash flows (short-
term) but poor net income (long-term)?
 What about a firm with poor cash flows (short-
term) but good net income (long-term)?
 An International Perspective
 The International Accounting
Standards Board (IAS No. 7)
recommends but does not require
a statement of cash flows.

 An approximation to a cash flow

statement can be prepared from a
comparative balance sheet with
some additional information.
 Chapter Summary
 The statement of cash flows is presented.
It reports the effects on cash flows of a
firm’s operating, investing and financing
activities.
 This information helps understand:
1. How operations affect liquidity,
2. The level of capital expenditures needed to
support growth, and
3. The major changes in financing.
 Two methods are presented to produce a
cash flow statement from a comparative
balance sheet.