REVIEW OF CHAPTER 18  

Purpose of the Statement of Cash Flows

1.     (S.O. 1) The fourth basic financial statement is the statement of cash flows.  The primary purpose of the statement is to provide information about  an entity's cash receipts and cash payments during a period.

2.     The statement of cash flows is generally prepared using "cash and cash equivalents" as its basis.  Cash equivalents are short-term, highly liquid investments.

Classification of Cash Flows

3.     (S.O. 2)  The statement of cash flows classifies cash receipts and cash payments by:

         a.     Operating activities which include cash effects of transactions that create revenues and expenses and thus enter into the determination of net income.

         b.     Investing activities which include (1) acquiring and disposing of investments and productive long-lived assets, and (2) lending money and collecting the loans.

         c.     Financing activities which involve liability and stockholders' equity items and include (1) obtaining cash from issuing debt and repaying the amounts borrowed, and (2) obtaining cash from stockholders and providing them with a return on their investment.

4.     Significant noncash transactions will include the conversion of bonds into common stock and the acquisition of assets through the issuance of bonds or capital stock.  These transactions are individually reported at the bottom of the statement of cash flows or they may appear in a separate note or Supplementary Schedule to the financial statements.

General Format

5.     The three classes of activities constitute the general format of the statement with the operating activities section appearing first, followed by the investing activities and financing activities sections.

         a.     The net cash provided or used by each activity is totaled to show the net increase (decrease) in cash for the period.

         b.     The net change in cash for the period is then added to or subtracted from the beginning-of-the-period cash balance.

         c.     Finally, any significant noncash investing and financing activities are reported in a separate schedule at the bottom of the statement.

6.     The information in the statement of cash flows should help investors to assess the

         a.     entity's ability to generate future cash flows.

         b.     entity's ability to pay dividends and meet obligations.

         c.     reasons for the difference between net income and net cash flow from operating activities.

         d.     cash investing and financing transactions during the period.

7.     The statement of cash flows is not prepared from the adjusted trial balance.  The information to prepare this statement usually comes from three sources:  (a) a comparative balance sheet, (b) the current income statement, and (c) additional information.

The Major Steps

8.     The major steps in preparing the statement are:

         a.     Determine the net increase/decrease in cash.  This step is straightforward because the difference between the beginning and ending cash balance can be easily computed from an examination of the comparative balance sheets.

         b.     Determine net cash provided/used by operating activities.  This step involves analyzing not only the current year's income statement, but also comparative balance sheets and selected additional data.

         c.     Determine net cash provided/used by investing and financing activities.  All other changes in the balance sheet accounts must be analyzed to determine their effect on cash.

9.     In performing step 2, the operating activities section must be converted from an accrual basis to a cash basis. This may be done by either the indirect method or the direct method.

         a.     Both methods arrive at the same total amount for "net cash provided by operations" but they differ in disclosing the items that comprise the total amount.

         b.     The indirect method is used extensively in practice.

         c.     The FASB has expressed a preference for the direct method.

The Indirect Method

10.     (S.O. 3)  The following points 11 through 16 explain and illustrate the indirect method.

The First Step--Indirect

11.     To prepare a statement of cash flows, the first step is determining the net increase or decrease in cash.  This is simply the difference between cash at the beginning of the year and cash at the end of the year.

The Second Step--Indirect

12.     The second step is to determine net cash provided/used by operating activities.

         a.     Under generally accepted accounting principles the accrual basis of accounting is used which results in recognizing revenues when earned and expenses when incurred.

         b.     In order to determine cash provided from operations it is necessary to report revenues and expenses on a cash basis.  This is determined by adjusting net income for items that did not affect cash.

13.     The operating section of the statement of cash flows should (a) begin with net income, (b) add (or deduct) items not affecting cash, and (c) show net cash provided by operating activities.

14.     In determining net cash provided by operating activities,

         a.     increases in specific current assets other than cash are deducted from net income, and decreases are added to net income.

         b.     increases in specific current liabilities are added to net income, and decreases are deducted from net income.

         c.     expenses for depreciation, amortization, and depletion and a loss on a sale of equipment are added to net income, and a gain on a sale of equipment is deducted from net income.

The Third Step--Indirect

15.     The third step, net cash provided/used by investing and financing activities is generally determined from changes in noncurrent accounts reported in the comparative balance sheet and selected additional data.

         a.     If the account, Land, increases $50,000 and the transaction data indicates that land was purchased for cash, a cash outflow from an investment activity has occurred.

         b.     If the account, Common Stock, increases $100,000 and the transaction data indicates that additional capital stock was issued for cash, a cash inflow from a financing activity has resulted.

16.     The redemption of debt and the retirement or reacquisition of capital stock is a cash outflow from a financing activity.

The Direct Method

17.     (S.O. 4)  The following points 18 through 25 explain and illustrate the direct method.

The First Step--Direct

18.     The first step is to determine the net increase or decrease in cash by determining the difference between cash at the beginning of the year and cash at the end of the year.

The Second Step--Direct

19.     The second step is to determine net cash provided/used by operating activities by adjusting each item in the income statement from the accrual basis to the cash basis.

         a.     If the income statement shows revenue of $120,000 and accounts receivable (net) increased $20,000 during the year, cash revenue is $100,000 ($120,000 - $20,000).

         b.     If the income statement reports operating expenses of $60,000 but accounts payable have increased $12,000 during the year, cash operating expenses are $48,000 ($60,000 - $12,000).

20.     In the operating activities section, only major classes of cash receipts and cash payments are reported as follows:

         a.     Cash receipts from (1) sales of goods and services to customers and (2) interest and dividends on loans and investments.

         b.     Cash payments (1) to suppliers, (2) to employees, (3) for operating expenses, (4) for interest, and (5) for taxes.

21.     The formula for computing cash receipts from customers is:

22.     The formula for computing cash payments to suppliers is:

23.     The formula for computing cash payments for operating expenses is:

24.     The formula for computing cash payments for income taxes is:

The Third Step--Direct

25.     The third step, net cash provided/used by investing and financing activities is generally determined from changes in noncurrent accounts reported in the comparative balance sheet and selected additional data.

Analysis of the Statement of Cash Flows

26.     (S.O. 5)  Three ratios that are used to assist in the analysis of the Statement of Cash Flows are (1) the current cash debt coverage ratio, (2) the cash return on sales ratio, and (3) the cash debt coverage ratio.

Use of a Work Sheet

*27.   (S.O. 6)  A work sheet may be used to assemble and classify the data that will appear on the statement of cash flows.  The work sheet is divided into two parts:

         a.     Balance sheet accounts with columns for (1) end of last year balances, (2) reconciling items (debit and credit), and end of current year balances.

         b.     Statement of cash flows effects with debit and credit columns.  This part of the work sheet consists of the operating, investing, and financing sections.

*28.   The following guidelines are important in using a work sheet.

         a.     In the balance sheet section, accounts with debit balances are listed separately from those with credit balances.

         b.     In the cash flow effects section, inflows of cash are entered as debits in the reconciling columns and outflows of cash are entered as credits in the reconciling columns.

         c.     The reconciling items shown in the work sheet are not entered in any journal or posted to any account.

*29.   The steps in preparing a work sheet are:

         a.     Enter the balance sheet accounts and their beginning and ending balances in the balance sheet accounts section.

         b.     Enter the data that explains the changes in the balance sheet accounts (other than cash) and their effects on the statement of cash flows in the reconciling columns of the work sheet.

         c.     Enter the increase or decrease in cash on the Cash line and at the bottom of the work sheet.  This entry should enable the totals of the reconciling columns to be in agreement.

*30.      The statement of cash flows is prepared entirely from the data that appears in the work sheet under Statement of Cash Flows Effects.