Statement of cash flows

Eduzendium article

Statement of Cash Flows

I. Purpose of the statement

The statement of cash flows reports the cash effects of a company's operations for a period of time. The main purpose is to provide financial information about the cash receipts and cash payments of a business for a specific period of time. This helps investors, creditors and other external users about a company’s cash position. The statement shows the cash effects of a company's operating, investing, and financing activities. The statement of cash flows indicates the net increase or decrease in cash during the period as well as the ending cash balance.

It helps to answer some questions such as,

• where did cash come from during the period,
• how was the cash used,
• what was the change in cash balance during the period?

II. Historical background of the statement

In 1971, the Financial Accounting Standards Board (FASB) made it mandatory under Generally Accepted Accounting Principles (GAAP) for firms to report sources and uses of funds. Since the term ‘funds’ was unclear, FASB required firms to provide cash flow statements. This occurred in 1987 under FASB Statement No. 95. The International Accounting Standards Board’s required firms to provide cash flow statements, which was put into effect in 1994. It is under International Accounting Standard 7 (IAS 7).

III. Methods of calculating the statement

There are two ways to calculate the statement of cash flows. One is the indirect method and the other is the direct method. FASB prefers that firms use the direct method, but a large majority of firms use the indirect method. A major difference between the indirect method and direct method involves presentation of cash flows from operating activities. Under the indirect method, cash flows from operating activities are derived from net income. Under the direct method, specific cash flows from operating activities are reported.

A. The indirect method

The indirect method begins with net income and converts it to net cash flow from operating activities. The indirect method adjusts net income for items that affected reported net income but did not affect cash. To calculate net cash flow from operating activities, a firm adds back noncash charges in the income statement and deducts noncash credits to net income.

B. The direct method

The direct method reports net cash flow from operating activities as major classes of operating cash receipts (cash collected from customers and cash received from dividends and interest) and cash disbursements. (cash paid to suppliers, employees, creditors, etc). Firms calculate net cash provided by operating activities by adjusting each item in the income statement from the accrual basis to the cash basis. Many firms use the account analysis technique to filter cash-flow data from accrual basis data. To solve: Sales + decrease in Accounts Receivable OR Sales – increase in Accounts Receivable. This equation solves the cash receipts from customers under the direct method.

IV. Cash flow activities

A. Operating activities

Operating activities include the cash effects of transactions that create revenues and expenses. This includes cash receipts from sales of products and payments to suppliers and employees. It also includes receipts on the sales of loans, dividends received, tax and interest payments made.

How to Determine Net Cash Flow from Operating Activities:

Net Income Plus: Depreciation and amortization Losses Decreases in noncash current assets Increases in current liabilities Less: Gains Increases in noncash current assets Decreases in current liabilities Equals: Net Cash Flow from Operating Activities

Depreciation and amortization are added to net income because they are noncash expenses. Gains and losses are adjusted to net income because they are nonreporting items. Changes in current accounts require adjustments to net income because they reflect the differences between revenues and expenses and the related operating cash flows.

Operating activities should be a firm’s primary source of cash. There is a limit on the amount of cash that a firm can raise from investing and financing activities.

B. Investing activities

Investing activities include cash flow from acquiring and disposing of investments and property, plant, and equipment. It also includes collections on loans for selling and payments on loans for collecting another company's debt instruments.

C. Financing activities

Financing activities include obtaining cash from issuing debt and repaying the amounts borrowed. It also includes obtaining cash from stockholders and providing them with a return on their investment in the form of dividend payments.

V. An example for computing the statement of cash flows under the indirect method:

The following is needed to calculate the statement of cash flows:
1. A company's comparative balance sheet
2. Additional information from the income statement and accounting records

• = a few hints for calculating the statement of cash flows

Comparative balance sheet of Company X at December 31, 2000 and 1999:

	Dec. 31, 2000	Dec. 31, 1999	“Change in”
Assets
Cash	$184,200	$124,600	59,600 increase
Accounts Receivable	202,800	148,700	54,100 increase
Inventories	250,500	275,000	24,500 decrease
Prepaid expenses	5,400	4,500	900 increase
Land	85,000	85,000
Buildings	575,000	465,000	110,000 increase
Accum. Depr—Building	(192,000)	(168,000)	24,000 decrease
Machinery & Equipment	345,800	345,800
Accum. Depr—Machine & Equip.	(134,000)	(99,000)	35,000 decrease
Patents	39,500	45,000	5,500 decrease
Totals	$1,362,200	$1,226,600
Liabilities and Stockholders’ Equity
Accounts payable	$114,500	$132,400	17,900 decrease
Dividends payable	14,500	12,000	2,500 increase
Salaries payable	8,900	10,900	2,000 decrease
Mortgage note payable, due 2001	65,000		65,000 increase
Bonds payable		105,000
Common stock, $1 par	25,000	20,000	5,000 increase
Paid in capital in excess of par –common stock	150,000	50,000	100,000 increase
Retained earnings	984,300	896,300	88,000 increase
Totals	$1,362,200	$1,226,600

The income statement and the accounting records revealed the following additional information applicable to 2000:

a. Net income, $115,500

• (beginning number under operating activities in statement of cash flow)

b. Depreciation expense reported on the income statement: buildings, $24,000; machinery and equipment $35,000.

• (deprecation expenses are added to net income in the statement of cash flow)

c. Patent amortization reported on the income statement, $5,500.

• (amortization is also added to net income in the statement of cash flow)

d. A building was constructed for $110,000.

• (paid for by cash; represents a decrease in cash in the investing activities)

e. A mortgage note for $65,000 was issued for cash.

• (cash received; represents an increase in cash in the financing activities)

f. 5,000 shares of common stock were issued at $21 in exchange for the bonds payable.

• (noncash event; no effect on the statement of cash flow)

g. Cash dividends declared and paid, $27,500.

• (must subtract 2,500 from 27,500 to get 25,000 actual cash dividends paid. 2,500 comes from the “change in” column and it represents 2,500 dividends not yet paid. 25,000 represents a decrease in cash in the financing activities)

• First mark next to each asset and liability either: current asset, current liability, noncash event, investment or financing activity.

• Current assets are added into cash flow if there was a decrease in the “change in” column. Current assets are subtracted from cash flow if there was an increase in the “change in” column. Current liabilities are added into cash flow if there was an increase in the “change in” column and are subtracted if there was a decrease in the “change in” column. Current assets move in opposite directions, where as the current liabilities move in the same direction.

• Also set up a “change in” column next to the beginning and ending balances and calculate the differences. Mark if it was a decrease or increase. (Shown in table above).

• All depreciation and amortization expenses are added into cash flow.

• The net change in cash should equal the amount of cash in the “change in” column that you created.

	Company X Statment of Cash Flow Year End December 31, 2000
Operating Activity
Net Income			$115,500
Add:	Depreciation Expense—Building	$24,000
	Depreciation Expense—Machine	35,000
	Amortization Expense—Patent	5,500	89,000
Subtract:	Accounts Receivable (increase)	54,100
	Prepaid Expense (increase)	900
	Salaries Payable (decrease)	2,000
	Accounts Payable (decrease)	17,900	(74,900)
Net cash from operating activity			129,600
Investing Activity
	Purchase of building	$110,000
Net cash used for investing activities			(110,000)
Financing Activity
	Issued mortgage for cash	$65,000
	Payment of cash dividends	(25,000)
Net cash from financing activities			40,000
	Net change in cash		$59,600
	Beginning cash balance		$124,600
	Ending cash balance		$184,200