Statement of 
Cash Flows

CHAPTER 
5
Learning Objectives
After studying this chapter, you should be able to
•	Identify the purposes of the statement of cash flows
•	Classify activities affecting cash as operating, investing, or financing activities
•	Compute and interpret cash flows from financing activities
•	Compute and interpret cash flows from investing activities
•	Use the direct method to calculate cash flows from operations
Learning Objectives
After studying this chapter, you should be able to
•	Use the indirect method to explain the difference between net income and net cash provided by (used for) operating activities
•	Understand why depreciation is added to net income when using the indirect method for computing cash flow from operating activities
•	Show how the balance sheet equation provides a conceptual framework for the statement of cash flows
Overview
•	The purpose of the statement of cash flows is to
–	Report cash receipts and cash payments of an entity over a period of time
–	 Classify the cash flows as operating, investing, and financing activities
–	Detail the changes in the cash account on the balance sheet 

Overview
Purpose of the Cash Flow Statement
•	A statement of cash flows
–	Shows the relationship of net income to changes in cash balances
–	Helps to predict future cash flows
–	Evaluates how management generates and uses cash
–	Determines a company’s ability to pay interest, dividends, and debts when they are due
–	Identifies specific increases and decreases in a firm’s productive assets
Purpose of the Cash Flow Statement
•	The term “cash” also refers to cash equivalents
•	Cash equivalents are highly liquid short-term investments that a company can easily and quickly convert into cash
–	Money market funds
–	Treasury bills
Typical Activities Affecting Cash
•	Managers affect cash by three types of decisions:
–	Operating decisions
–	Financing decisions
–	Investing decisions
•	Operating decisions are concerned with the major day-to-day activities that generate revenues and expenses

Typical Activities Affecting Cash
•	Operating activities are transactions that affect the purchase, processing, and selling of a company’s products and services
–	Making sales
–	Collecting accounts receivable
–	Purchasing inventory
–	Paying accounts payable
•	The first major section of the statement of cash flows is labeled cash flows from operating activities
Typical Activities Affecting Cash
•	Financing decisions are concerned with how to obtain or repay cash
•	Financing activities are a company’s transactions that obtain resources from debt and equity transactions
–	Issuance of additional stock
–	Borrowing money from the bank
–	Repaying previous loans
•	The financing section on the statement is labeled cash flows from financing activities

Typical Activities Affecting Cash
•	Investing decisions include the choices to acquire or dispose of long-term productive assets or long-term investments
•	Investing activities are transactions that acquire or dispose of assets that are expected to provide services for more than one year
–	Purchasing or disposing of equipment
•	The investing section on the statement is labeled cash flows from investing activities

Typical Activities Affecting Cash
Preparing the 
Statement of Cash Flows
•	The following  two slides for Biwheels Company show the:
–	Changes in the balance sheet equation (transactions) during the first month of operations
–	Income statement for the first month of operations and the January 31 balance sheet
•	Notice that the cash balance increased from $0 to $351,000 during the month
Preparing the 
Statement of Cash Flows
Preparing the 
Statement of Cash Flows
Cash Flows from 
Financing Activities
•	Two general rules apply for identifying financing activities:
–	Increases in cash (cash inflows) stem from increases in long-term liabilities or paid-in capital
–	Decreases in cash (cash outflows) stem from decreases in long-term liabilities or paid-in capital
•	Biwheels had two such transactions in January:
–	Transaction 1: Initial investment, $400,000
–	Transaction 2: Loan from bank, $500,000
Cash Flows from 
Investing Activities
•	Two general rules apply for identifying investing activities:
–	Increases in cash (cash inflows) from decreases in long-lived assets, loans, and investments
–	Decreases in cash (cash outflows) stem from increases in long-lived assets, loans, and investments
•	There were two such transactions relating to store equipment in January:
–	Transaction 3: Acquire store equipment for cash, $15,000
–	Transaction 7: Sale of store equipment for cash, $1,000
Noncash Investing and 
Financing Activities
•	Sometimes financing and investing activities do not affect cash
•	Example: If Biwheels acquires $8,000 of store equipment by issuing common stock
–	The purchase of store equipment is an investing activity
–	The issuance of common stock is a financing activity
•	Companies must report such items in a schedule of noncash investing and financing activities

Cash Flow from Operating Activities
•	Direct method: 
–	Subtracts operating cash disbursements from operating cash collections
–	Is preferred by the FASB
•	Indirect method: 
–	Adjusts accrual-based net income from the income statement to reflect only cash receipts and disbursements
–	Is used by most U.S. companies

The Direct Method
•	Examining the cash column of Biwheels balance sheet equation, transactions 1, 2, 3, and 7 are financing and investing activities
•	The remaining transactions must be operating activities:
The Indirect Method
•	When the cash flow from a sale or outflow from an expense occurs in one accounting period and the revenue or expense occurs in another, net income differs from cash flows from operations
•	The indirect method highlights these differences by starting with net income, and adjusts it to cash flows from operating activities
•	Example: Depreciation is added back to net income because it is a noncash expense
The Indirect Method
•	Net income
–	Adjust for revenues and expenses not requiring cash
•	Add back depreciation
•	Other adjustments
–	Adjust for changes in noncash assets and liabilities relating to operating activities
•	Add decreases in assets
•	Deduct increases in assets
•	Add increases in liabilities
•	Deduct decreases in liabilities
The Indirect Method
Reconciliation Statement
•	The FASB requires direct-method statements to include a supplementary schedule reconciling net income to net cash provided by operations
•	In other words, companies that use the direct method must also prepare a report using the indirect method (reconciliation schedule)
•	As a result, most companies use the indirect method
Example of Statement of Cash Flows
The Importance of Cash Flow
•	The income statement matches revenues and expenses using accrual concepts and provides a measure of economic performance
•	The statement of cash flows explains changes in the cash account rather than owners’ equity
•	Free cash flow 
–	Is a measure of cash management performance
–	Refers to cash flows from operations less capital expenditures (and sometimes less dividends)