Chapter 4

The Statement of Cash Flows

Textbook pages 178-222

Intermediate Accounting 1
Dr. Nafis Rahman

4-1
 Role of the Statement of Cash
Flows
Helps
Helps users
users assess
assess .. .. ..
 aa firm’s
firm’s ability
ability to
to generate
generate cash.
cash.
 aa firm’s
firm’s ability
ability to
to meet
meet its
its
obligations.
obligations.
 the
the reasons
reasons forfor differences
differences
between
between income
income and and associated
associated
cash
cash flows.
flows.
 the
the effect
effect of
of cash
cash andand noncash
noncash
investing
investing andand financing
financing activities
activities
on
on aa firm’s
firm’s financial
financial position.
position.
4-2
3
 Role of the Statement of Cash
Flows
Lists all cash inflows and
all cash outflows by
category: Operating,
Investing, and Financing

Explains the change in

cash during the period
Cash is King!
Required by IFRS Especially during
an economic
downturn 4-3
4
 Why do we want to know about
Cash?
Cash 100
A/R 90
Sales 190

While the Sales reported is $190, the actual cash

collected may be less than that. Bad Debt
Research shows that companies with a greater portion of accrual earnings
underperform in the subsequent years compared to companies with greater
portion of cash earnings. Investing in companies with high proportion of cash
earnings is a winning investment strategy (known as the accrual anomaly).
---Sloan 1996

Professional investors have traded away the accrual anomaly effect in recent
times.
5 4-4
 Income Statement vs Cash Flow
Statement
Income Statement reports net income calculated using
accrual accounting method.

Research shows that:

Current earnings have predicting ability of future earnings

far into the future (up to eight years)--Finger 1994

Earnings reported in Income Statements have greater

predictive power about a firm’s future operating cash
flows than current operating cash flows --- Dechow et al.
1998.

6 4-5
 Cash, Cash Equivalents, and
Restricted Cash
Cash Cash Equivalents
Resources • Short-term, highly liquid
immediately investments.
available to pay • Readily converted into cash,
obligations. with little or no risk of loss.
• Maturity date must not be
Restricted Cash longer than 3 months from
Cash set aside for date of purchase.
designated • Each company must establish
purposes. and disclose their policy
regarding which investments
are classified as cash
equivalents.
4-6
 Primary Elements of the
Statement of Cash Flows

Operating Activities Reconciliation of the Net

Increase or Decrease in
Cash with the Change in
Investing Activities the Balance of the Cash
Accounts

Financing Activities Significant Noncash

Investing and Financing
Activities are disclosed
in the notes to the
financial statements.
4-7
 IFRS Versus US GAAP—Classification
of Cash Flows
• Both IFRS and US GAAP require a statement of cash
flows with operating, investing, or financing classifications
• The biggest differences are in the classification of
dividends and interest received and paid.
IFRS US GAAP
(Dividends and interest Dividends received
Operating received and paid) Interest received
Activities Interest paid
or
Investing Dividends received
Activities Interest received

Financing Dividends paid Dividends paid

Activities Interest paid

4-8
 The Statement of Cash Flows
Operating Activities

Inflows from:

 sales to customers.

 interest and dividends
received from investments. +
Cash Flows
from
Outflows for:
Operating

 purchase of inventory.
Activities

 salaries, wages, and other
operating expenses.

 interest on debt.

 income taxes.
4-9
 Direct and Indirect Methods of
Reporting
Two Formats for Reporting Operating Activities

Direct Method Indirect Method

Reports the Starts with net

cash effects of income and
each operating converts to
activity cash basis

Note: Investing activities and Financing activities

are the same under these two formats: always
direct methods for them. 4-10
Investing Activities
Inflows from:
 sale of long-lived assets used in the
business.
 sale of investment securities
(shares and bonds of other firms).
 collection of nontrade receivables.
+
Cash
Cash Flows
Flows
from
from
Investing
Investing
Outflows for: Activities
Activities

 purchase of long-lived assets used _
in the business.

 purchase of investment securities
(shares and bonds of other firms).

 loans to other entities.
4-11
Financing Activities
(The company’s transactions with its owners and
creditors)
Inflows from:
 sale of shares to owners.
 borrowing from creditors
through notes, loans, + Cash
mortgages, and bonds. Flows
from
Outflows for: Financing
 To owners for the repurchase or _
reacquisition of shares previously sold.
 To owners in the form of dividends or other
Activities
distributions .
 To creditors for the repayment of the
principal amounts of debt.

4-12
 UNITED BRANDS CORPORATION
Statement of Cash Flows
For the Year Ended December 31, 2023
($ in millions)
Net profit Indirect Method $ 12
Cash Flows from Operating Activities: Adjustments for non-cash effects:
Cash Inflows: Direct Method Gain on sale of land (8)
From customers $ 98 Depreciation expense 3
From investment revenue 3
Loss on sale of equipment 2
Cash Outflows:
To suppliers of goods (50) Changes in operating assets and liabilities:
To employees (11) Increase in accounts receivable (2)
For interest (3) Decrease in inventory 4
For insurance expense (4)
Increase in accounts payable 6
For income taxes (11)
Net cash flows from operating activities $ 22 Increase in salaries payable 2
Cash Flows from Investing Activities: Decrease in discount on bonds payable 2
Sale of land 18 Decrease in prepaid insurance 3
Sale of equipment 5 Decrease in income tax payable (2)
Purchase of short-term investments (12)
Purchase of land (30)
Net cash flows from operating activities $ 22
Net cash flows from investing activities (19)
Cash Flows from Financing Activities:
Note X:
Retirement of bonds payable (15)
Issuance of ordinary shares 26 Noncash Investing and Financing Activities
Payment of cash dividends (5) Acquired $20 million of equipment by
Net cash flows from financing activities 6 issuing a 12%, five-year note.
Net increase in cash 9
Cash balance, January 1 20
Cash balance, December 31 $ 29
6 4-13
 Preparation of the
Statement of Cash Flows
• Information available to assist the statement preparer
includes:
– A statement of profit or loss for the year.
– Statements of financial position for both the current
and preceding years.
– Additional information about transactions that
caused changes in account balances during the year.

4-14
 Preparation of the
Statement of Cash Flows—Direct Method
• Preparing SCF is challenging because it is not
automatically linked to other three statements, which
involve accrual accounting (not cash-based accounting)

• We need to reconstruct the events and transactions that

caused cash to increase or decrease during the period.
This helps identify the operating, investing, and financing
activities to be reported.

• Two approaches to reconstructing the events &

transactions and calculating specific cash flows:
– Recreate summary journal entries (the spreadsheet method)
– Reconstruct T-accounts
4-15
 Skills required to prepare a Statement of
Cash Flows—Direct Method
1. Have a thorough understanding of the debit and credit system of
accounting

2. Familiarize yourself with all the accounts used in the company

financial statements

3. Setup ‘summary journal entries’ or T-accounts that capture the

changes that happened to the company during the year

4. Plug in the information from Profit & Loss Statement, Financial

Position Statement, and additional disclosures into your ‘summary
journal entries’ or T-accounts to pin down the exact amount of cash
flow related to a particular activity.

4-16
How to Prepare a Statement of Cash
Flows—Direct Method

We will learn as a group by constructing

a Statement of Cash Flows in class.

“Learning by Doing” is the best method

of learning accounting.
4-17
Comprehensive Review Exercise (Textbook page 214)
2023 2022

Continued to next page 

4-18
Comprehensive Review Exercise (Textbook page 214)

4-19
 Comprehensive Review Exercise (Let’s Solve in class)

Notice that certain items in Income Statements are purely accrual (non-cash)
expenses (for example, depreciation expense).
Losses and Gains from Long term assets are excluded (The entire transaction is
reflected in Investing Activities) . We don’t want double counting.

Income Statement Items Operating Cash Flow Items

(w1)
(w2)
(w3)

(w4)
(w5)
(w6)
(w7)
(w8)
4-20
Comprehensive Review Exercise: w1

We know that Sales Revenue = 200

Company receives Cash for some part (cash Sale), and the company
records Accounts Receivable (A/R) for the remaining part (Credit Sale)

Journal Entries for all changes in all the items Debit Credit
related to Sales Revenue & A/R

Debit cash --- increase or gain in Cash

Credit cash --- decrease or reduction in Cash 4-21
Comprehensive Review Exercise: w1

Alternatively, you can first analyze the impact of A/R using a T-Account for
A/R. That will also reveal the cash that must have been collected from
Sales.
For this exercise, you have to first assume that entire portion of the Sale
was credit sale. Essentially, a Cash sale is a credit sale where the
company could transfer their A/R to cash instantly.

(w1) Accounts Receivable

4-22
 Comprehensive Review Exercise: w2

Point (a). Revenue from Investment includes $ 3M of net income of

another firm (Beneficial Drill company owns a significant portion of that
other firm). But $3M was not received as cash dividend. The Long Term
Investment Account was debited instead.
-Let’s write out the accounts that are related to Investment Revenue.
-Then we will write summary journal entries to capture their change during
the year.
-We will then be able to pin down the cash from Investment Revenue.

Journal Entries (w2) Debit Credit

4-23
Comprehensive Review Exercise: w3

Point (b). Cash increased by $1M from Treasury Bill Investments

Notice that we do not know the exact amount of Treasury bills.

Journal Entries (w3) Debit Credit

Treasury Bills
Cash
Gain

4-24
Comprehensive Review Exercise: w4.T-Account Method
How much we cash did we pay to our suppliers for all the inventories we
purchased? Which T-Account(s) will answer this question?

(w4) …………………..T-Account

4-25
Comp. Review Exercise: w4. Journal Entry Method
How much we cash did we pay to our suppliers for all the inventories we
purchased?

We need to start out by listing all the accounts related to inventory. What
actions (changes in which accounts) increase or decrease inventory?

Journal Entries (w4) Debit Credit

4-26
Comprehensive Review Exercise. w5
Cash paid to employees

Journal Entries (w5) Debit Credit

4-27
Comprehensive Review Exercise. w6
Cash paid to insurance company

Journal Entries (w6) Debit Credit

4-28
 Comprehensive Review Exercise. w7

Bond is sold at discount if the cash payment of interests (Coupon payments) is

smaller than the interest expense.
Cash 600
Suppose you sell bond with a face value of Discount on Bond 400
$1000. But the market price of your bond Bonds Payable 1000
is only $600

Discount on Bond is a contra liability account (it behaves like an asset)

On the contrary, bonds paying a higher coupon rate than its interest expense are
sold at a premium. Bond Premium is a liability account

Journal Entries (w7) Debit Credit

Bond Interest Expense
Bond Interest Payable
Discount on Bond
Cash

4-29
Comprehensive Review Exercise. w8
Deferred Tax Liability is created when company has IFRS income, but
some portion of that income is not recognized for tax purpose in the current
year.

At this point, you just need to know that “Deferred Tax Liability” is a liability
account. When calculating cash paid for taxes, we will have to treat it in
the same way as we treat “Income Tax Payable”.

Journal Entries (w8) Debit Credit

4-30
Comprehensive Review Exercise
Let’s look back to the journal entries for the Cash items in steps 1
through 8.

A cash debit is an inflow (company gains cash). A cash credit is an

outflow (company spends the cash).

We did it!!

4-31
 Comprehensive Review Exercise

The income statement gives a rough template about the items

to be included in the “Cash Flows from Operating Activities”

But for “Cash from Investing Activities” and “Cash from

Financing Activities,” there is no such template

Instead,
1. you have to investigate changes in the long term assets, long
term liabilities, and the equity accounts from the previous year
to current year.
2. Make sure that all the additional information given have been
considered
Caution... some additional information might not have a
cash flow impact… they are included to confuse you!!)
4-32
 Comprehensive Review Exercise

Cash Flows from Investing Activities:

Item c. Machine’s original cost = 60, and it is half depreciated. Machine was
damaged by lightning (unnecessary information). Machine sold for $20M (Inflow
of cash)

Item e. Purchase of Long Term Investment worth $14 M (outflow or spending)

Item f. Land costing $30M purchased. $15M paid in Cash (outflow).

Item g. Purchase of New Equipment for $40 M (outflow)

[Refer to item c.]

[Refer to item e.]
[Refer to item f.]
[Refer to item g.]

4-33
 Comprehensive Review Exercise

Cash Flows from Financing Activities

Item h. Sold bonds for $20M at principal amount or at par value (meaning no
discount or premium). So the company also received exactly $20 M cash (cash
Inflow).

Item j. Paid cash dividends of $10 M (outflow).

Item k. Purchased treasury stocks for $7M (outflow). Purchasing treasury stock
is also called stock buy-back. It is similar to paying cash dividend. The
shareholders get some cash from the company.

[Refer to item h.]

[Refer to item j.]
[Refer to item k.]

4-34
 Comprehensive Review Exercise

Reconciling the net change in cash, beginning cash balance, ending cash
balance…. You hope that they match!!!

You also need to disclose major non-cash investing and financing activities

Remember that the company bought land for $30M, but paid only $15M in cash.
It issued a note payable for the remaining amount (item f).

4-35
 Indirect Method for Cash Flows from Operating
Activities: General Rules for Preparation
 Start with Net Income
 Add back depreciation expense, amortization expense and etc. The
company did not have to pay cash for the depreciation expense.
 Increase (decrease) in non-cash current assets, implying a deduction
(addition) from Net Income figure. The company had to pay cash to
increase its current assets… Increase in current assets  decrease in
cash.
 Increase (decrease) in current liabilities, implying an addition
(deduction) to Net Income. If company has an increase in current
liability balance, that means the company has is yet to pay the cash for
expenses that occurred… Increase in current liability  increase in cash.
 Remove the impact of “loss on sale of long term assets”, or “gain on
sale of long term assets”. We already account for the entire transaction
in the Investing Activities (no need to double count).
4-36
 General rules for indirect method
 An increase of $12 in accounts receivable

 Such an increase could be imagined as the following journal entry:

Accounts receivable $12

Sales revenue $12

 The “imagined” journal entry shows that the $12 increase in AR implies a non-
cash based sales revenue of $12, which in turn implies a non-cash
component of $12 in the reported net income! Therefore, we need to
DEDUCT $12 from net income.

 Similarly, the increase of $7 in accounts payable implies a non-cash expenses

and hence we add it back to net income for the calculation of cash flows

4-37
Indirect Method Exercise
Cemptex Corporation prepares its statement of cash flows using the indirect
method to report operating activities. Net income for 2013 financial year
was $624,000. Depreciation and amortization expense of $87,000 was
included with operating expenses in the income statement. The following
information describes the changes in current assets and current liabilities
other than cash:

 Decrease in accounts receivable $22,000

 Increase in inventories 9,200
 Increase in prepaid expenses 10,000
 Decrease in income taxes payable 14,000
 Increase in salaries payable 10,000

4-38
Indirect Method Exercise
 Start with Net Income, Add back depreciation expense.
 Increase (decrease) in non-cash current assets, implying a deduction
(addition) to Net Income.
 Increase (decrease) in current liabilities, implying an addition
(deduction) to Net Income.

4-39
Brief Exercise 1—Statement of Cash Flows
Tiger Enterprises
Statement of Profit & Loss
For the Year Ended December 31, 2023

4-40
 Tiger Enterprises
Statement of Financial Position

($ in thousands) Dec 31, 2023 Dec 31, 2022

Change

(80)
Identify which items are 40
current assets 30

Identify which items are

current liabilities

4-41
Brief Exercise 1

Question: Calculate the Net Cash from Operating Activities

for ‘Tiger Enterprises’ for the year ended December 31 2023
using the Indirect Method. Show your work.

Let’s solve it in class!! I will post the results in a separate

PowerPoint file.

4-42
Tiger Enterprises
Notice that we have no additional information besides the financial statements.

Hint: we need to know how to calculate the payment of dividends:

One more thing: the changes in Note Receivables (if any) are
classified as investing activities. The changes in Note payables, as
shown here, are financing activities. 4-43
Example (KRC Co.)

KRC Company’s financial statements for the year ended December

31, 2020, contained the following condensed information.
2020 2019 Change
Revenues from fees $ 840,000
Operating expenses 624,000
Depreciation expense 60,000
Loss on sale of equipment 26,000
Income before income tax 130,000
Income tax 40,000
Net income $ 90,000

Accounts receivable $ 37,000 $ 59,000 $ (22,000)

Accounts payable 46,000 31,000 15,000
Income taxes payable 4,000 8,500 (4,500)

4-44
Example (KRC Co)

Prepare the operating activities section of the statement of cash

flows using the indirect method (Step 2).

Cash flows from operating activities

Net income $ 90,000
Adjustment to reconcile net income
to net cash provided by operating activities:
Depreciation expense 60,000
Loss on sale of equipment 26,000
Decrease in accounts receivable 22,000
Increase in accounts payable 15,000
Decrease in income taxes payable (4,500)
Net cash provided by operating activities 208,500

Attention: in this case, we adjusted for the gain/loss from the sale of
fixed assets.

4-45
 In-Class Exercise: Construct a Statement of Cash Flows
---based on the following information

Basic Information: The company sustained a net loss for the year of $50,000;
The Total Change in Cash is $295,000

(a): Plant assets that had cost $25,000 six years ago and were being
depreciated on a straight-line basis over 10 years with no estimated scrap
value were sold for $5,300. (cash-flow effect for part (a) is calculated for you)

(b): During the year, 10,000 shares of common stock with a stated value of
$10 a share were issued for $33 a share. (Hint: Stated Value or Par Value is
irrelevant)

(c): Depreciation amounted to $22,000, and a gain of $9,000 was realized on

the sale of land for $39,000 cash.

(d): During the year, treasury stock costing $47,000 was purchased.
4-46
In-Class Exercise: Construct a Statement of Cash Flows
---based on the following information

(a): Plant assets that had cost $25,000 six years ago and were
being depreciated on a straight-line basis over 10 years with no
estimated scrap value were sold for $5,300.

Accumulated depreciation ([$25,000 / 10] x 6) 15,000

Book value at date of sale 10,000
Sale proceeds (5,300)
Loss on sale $ 4,700

4-47
In-Class Exercise: Construct a Statement of Cash Flows
---based on the following information
Statement of Cash Flows
Cash flow from operating activities
Net income (loss) $ (50,000)
Adjustment to reconcile net income to cash:
O Loss on sale 4,700
Depreciation expense 22,000
Gain on sale (9,000)
Cash from operations (32,300)
Cash flow from investing activities
I Sale of plant assets 5,300
Sale of land 39,000
Cash from investing activities 44,300
Cash flow from financing activities
F Sale of common stock 330,000
Purchase of company stock (47,000)
Cash from financing activities 283,000
Net Change in Cash $ 295,000
4-48