CHAPTER 14 The Statement of Cash Flows

SYNOPSIS

In this chapter, the author provides a comprehensive discussion of the statement of cash flows.
The author discusses (1) the rationale for the statement; (2) using the statement of cash flows to
evaluate companies; (3) how the statement complements the income statement and balance
sheet; (4) the incentives management has to manipulate cash flows; and (5) the mechanics of
preparing the statement of cash flows. Preparing the statement of cash flows focuses on
inferring the cash inflows and outflows of transactions from two balance sheets and an income
statement.

The ethics vignette considers a company in weak financial condition that manages the timing of
its cash receipts and payments to manipulate its reported cash flows (especially from
operations) in an effort to delay signalling that weakness to the public.

The internet research exercise examines the 2008 cash flow statements of General Motors in
the 10K financial statement and reviews the many drains on cash flow this company
experiences as it spiralled down into bankruptcy.

The following key points are emphasized in Chapter 14:

1. The structure and format of the statement of cash flows.

2. Cash flows from operating, investing, and financing activities.

3. How the statement of cash flows complements the other financial statements and how it
can be used by those interested in the financial condition of a company.

4. Important investing and financing transactions that do not appear on the statement of cash
flows and how they are reported.

5. Economic consequences associated with the statement of cash flows.

6. Preparing a statement of cash flows from the information contained in two balance sheets,
an income statement, and a statement of retained earnings.

TEXT/LECTURE OUTLINE
The statement of cash flows.

I. Purpose.

A. The definition of cash.

1. Cash only—coin, currency, money orders, certified checks, cashiers' checks,

personal checks, bank drafts, and so forth.

2. Cash plus cash equivalents—usually defined as investments, such as

commercial paper, that have maturities of less than three months.

B. To provide information about the cash flows during the period associated with
operating activities, investing activities, and financing activities.

II. A general description of the statement of cash flows.

A. The change in cash can be explained by summarizing the cash flows from
operating and capital transactions.

1. Operating transactions are associated with acquiring and selling inventories

and services. That is, those activities that are part of the company's ongoing
central activities. In general, items included on the income statement are
considered to be operating activities.

2. Capital transactions.

a) Investing activities—associated with purchasing and selling nonoperating

(i.e., noncurrent) assets. Investing activities include purchasing or selling
long-lived assets, long-term investments, and intangible assets.

b) Financing activities—associated with cash flows from nonoperating debt

and shareholders' equity. Financing activities include issuing long-term
debt or equity shares, retiring long-term debt, repurchasing equity shares,
and paying cash dividends.

B. Methods to use in preparing the statement of cash flows.

1. Direct method.

a) Cash inflows and outflows from operating activities can be traced directly
to the cash account in the general ledger. The actual cash inflow and
outflow associated with each income statement item is disclosed on the
face of the statement of cash flows.

b) Accrual income statement amounts are reported in the body of the

statement of cash flows at their cash amounts. That is, the actual cash
inflows and cash outflows from individual operating activities are reported
on the face of the statement of cash flows.
c) A schedule that reconciles net income to net cash flow from operating
activities must accompany the statement of cash flows.

2. Indirect method.
 a) Cash flows from operating activities are computed indirectly by adjusting
net income.

b) Net income is adjusted from an accrual amount to net cash flow from
operating activities on the face of the statement of cash flows. Accrual net
income is adjusted for noncash charges to noncurrent accounts and
changes in current accounts other than cash.

3. The choice of methods only affects the way that net cash flow from operating
activities is disclosed.

a) The dollar amount reported for net cash flow from operating activities is
identical under the direct and indirect methods.

b) The presentation of the investing activities and financing activities is

identical under the direct and indirect methods.

III. How the statement of cash flows can be used.

A. Assessing a company's ability to generate cash.

1. The strength of a company's operating activities.

2. Financial flexibility—a company's capacity to borrow, issue equity, and sell

nonoperating assets.

B. Analyzing the statement of cash flows.

C. The importance of cash from operating activities.

D. The importance of significant noncash transactions.

IV. The statement of cash flows: economic consequences.

A. Importance of cash flow information in assessing potential investments.

B. Incentives to window dress the statement of cash flows.

C. Ease of manipulating cash flows.

D. Reasons not to manipulate cash flows.

V. Deriving cash flows from accrual financial statements.

A. Cash provided (used) by operating activities.

B. Cash provided (used) by investing activities.

C. Cash provided (used) by financing activities.

VI. The complete statement of cash flows

A. The direct method.

B. The indirect method.

 VII. Analyzing the statement of cash flows

A. Summarizing the cash effects of operating transactions.

B. Summarizing the cash effects of investing and financing transactions.

C. Two additional observations.

1. Cash is king.

2. Inconsistency attributable to consolidated financial statements.

VII. International perspective.

IX. Review problem.

X. Ethics in the real world.

XI. Internet research exercise.

LECTURE TIPS

1. Students have the greatest difficulty converting from accrual dollar amounts to cash flows,
particularly in deciding (1) which balance sheet accounts are related to specific income
statement accounts and (2) how the accounts interrelate. End-of-chapter exercises 14–5, 14–
12 through 14–16, and problems 14–8 through 14–11 are useful to demonstrate the process.
Exercises 14–17 through 14–21 further emphasize determination of cash flow from operations
under both the direct and indirect methods.

2. Some students have trouble classifying transactions as operating, investing, or financing

activities. Care should be taken in explaining the distinctions between the different types of
transactions and several examples should be provided. End-of-chapter exercises 14–1 and
14–2 and problems 14–1, 14–2, 14–3, and 14–5 provide useful practice on the subject.
OUTSIDE ASSIGNMENT OPPORTUNITIES

Group study of statements of cash flows both across time and within and across industries
(continuing assignment for Chapters 6–14)

1. Using the most recent annual report of a major public company in one of the four general
industry groupings, identify or compute the items listed below for the two most recent years.
Compare the items across time. Relate your findings to the economic characteristics and
current conditions in the industry and the company’s strategy for competing. Prepare a
written summary of your findings. Report findings in a class discussion session in which
comparisons will be made both across time and within and across industries.
Net income
Cash flow from operating activities
Cash flow from investing activities
Cash flow from financing activities
Net change in cash
Method (direct or indirect)
Nature of significant noncash transactions

Financial statement analysis using cash flow ratios (repeat of suggestion in Chapter 5)

2. Obtain and read the Giacomino-Mielke article on cash flow ratios referenced below. 1
Compute the nine ratios presented therein for Wal-Mart on a comparative basis for two
years using its financial statements in Appendix A and evaluate the results.

Comparative study of cash flow statements: a foreign company compared to a U.S. company

3. Obtain a recent annual report for a publicly held foreign company. Compare the form,
content, and terminology used in its cash flow statement to that of a U.S. public company
(preferably one in the same industry). Report your findings in writing and/or in a brief
presentation to the class.

ANSWERS TO IN-TEXT DISCUSSION QUESTIONS

591.The differences between net income and cash flow from operations fall into two categories:
(1) noncash charges to noncurrent accounts, and (2) changes in current accounts other than
cash and securities. In the case of Starbucks for 2012 the main positive addition in the operating
section of the statement of cash flows is depreciation. This noncash expense is added back on
the statement of cash flows. This positive adjustment to net income is offset by increases to
current assets such as receivables and inventories which are negative adjustments to cash in
the operating activities section of the statement of cash flows.

592.Cash equivalents, such as commercial paper and other debt investments with original
maturities of less than three months, can quickly and easily be converted into cash, and are so
like cash, that they are combined with cash as a single number on the balance sheet and not
carried as marketable securities. The cash flow statement explains changes in cash and cash
equivalents.

1
Don E. Giacomino and David E. Mielke, “Cash Flows: Another Approach to Ratio Analysis,” Journal of
Accountancy, March 1993, pp. 55–58.
593.If depreciation appears in the operating section of the statement of cash flows, Biomet is
using the indirect method. The indirect method employs a reconciliation process, which begins
with net income, and then adjusts net income for noncash items, such as depreciation, in
arriving at cash flow from operations. Depreciation was deducted in arriving at net income, but
did not require the use of cash, and therefore is added back to net income. The direct method,
by contrast, does not reflect depreciation, because the direct method only includes those items
that directly involve cash inflows and outflows.

594.An analyst would learn more about changes in the cash account from the direct method.
Even when the direct method is used, the indirect or reconciliation approach must be disclosed.
This is useful to analysts in evaluating the company’s components of net income that do not
involve cash flows, and helps to evaluate the quality of reported earnings.

596.Nike’s operating cash flows was highest and 2010 and was similar in 2011 and 2012, but
was significantly positive in all three years. This allowed management to make investments in
2010 and 2011, as evidenced by negative investing cash flows. Nike also has negative cash
flows in financing all three years meaning that Nike is reducing debt and/or reducing outstanding
equity through use of its positive operating cash flows.

596.Cash and equivalents increased each year from 2010 to 2012. Profitability was highest in
2012, with income in 2010 being higher than that in 2011. Positive cash flows in operating
activities in all three years are being used to increase investments in 2011 and 2012. Cash
flows from financing activities are also negative in all three years representing a pay down of
debt by management.

597.In 2012 Yahoo!’s net income exceeded cash from operations. This is somewhat unusual.
Because depreciation charges reduce net income but not cash flows from operations, it is more
common for cash flows from operations to exceed net income. In 2012 this was due to a
decrease in short term liabilities which is a use of operating cash. The prior year was more in
line with what would be considered normal.

597.Reported net income over time means little unless it finds its way into the cash account. An
analyst needs to assess the quality of earnings by understanding how the cash flows from
operations relate to reported net income. This process helps the analyst identify possible
misstatements and to identify negative trends in financial management.

599.Net income is more difficult to predict because it incorporates many variables, judgments,
and estimates that can affect measurement of reported results. Cash flows on the other hand
reflect what actually went through a company’s bank account. Even though cash flow reporting
can be manipulated for a single period, cash flows viewed over time give a clearer picture of
future trends.

611.The impairment charges and depreciation/amortization items were deductions (expenses)

subtracted against revenues in arriving at net income. These items, however, but did not require
the use of cash in the current period. Accordingly, using the indirect or reconciliation approach,
the items were added back in arriving at cash flow from operations. The gains on sales of
investments increased net income, but their effect on cash flow is not found in the operating
section of the statement of cash flows and therefore has to be backed out (subtracted) in
reconciling net income to operating cash flows

612. United Continental Holdings, Inc. must have raised a substantial amount of cash through
issuance of debt or equity capital, which would be reflected as a cash inflow from financing
activities in the statement of cash flows, and would also appear as long term liabilities or
shareholders’ equity in the balance sheet.
612.Based on the information given, it would appear that the overall operations of Cisco
Systems expanded in 2012. Accordingly, one would expect that the change in receivables
would have been greater than for the previous year because of the increased level of business
activity.

613.The adjustments for foreign currency exchange rate changes were positive and negative
during this time frame. Over the three years the total was a net reduction in cash. The items
reflect gains and losses from converting transactions conducted in foreign currencies into U.S.
dollar amounts in order to prepare financial statements (in dollars) for a company that does
business in multiple currencies.

CHARACTERISTICS OF END-OF-CHAPTER ASSIGNMENTS

Item Difficulty Description

Brief Exercises:
BE14–1 E The indirect presentation
BE14–2 E Cash vs. accruals
BE14–3 M Inferring inventory transactions
BE14–4 M Interpreting the statement of cash flows
BE14–5 M Analysis of cash flow vs. profitability
Exercises:
E14–1 E Classifying transactions
E14–2 E Operating, investing, or financing activity?
E14–3 M Cash management policies across companies
E14–4 M Cash management across companies
E14–5 E Transactions’ effects on cash flow
E14–6 E Matching of accounts-cash flow calculations
E14–7 M Cash from operating activities
E14–8 M Preparing a statement of cash flows from original transactions
E14–9 M Preparing a statement of cash flows from the cash account
E14–10 M Computing cash outflows from accrual information
E14–11 H Reconstructing a transaction and its cash effect
E14–12 M Computing cash flows from accrual numbers
E14–13 M Computing cash provided by operations from accrual information
E14–14 M Preparing a statement of cash flows from statement information
E14–15 M Preparing a statement of cash flows from statement information
E14–16 H Computing net income from cash provided by operating activities
E14–17 M Preparing the operating section of the statement of cash flows:
direct and indirect methods
E14–18 M Preparing the operating section of the statement of cash flows:
direct and indirect methods
E14–19 M Preparing the operating section of the statement of cash flows:
direct and indirect methods
E14–20 M Preparing the operating section of the statement of cash flows:
direct and indirect methods
E14–21 H Preparing the operating section of the statement of cash flows:
direct and indirect methods
E14–22 H Preparing the operating section of the statement of cash flows:
direct and indirect methods
E14–23 M Operating section of the statement of cash flow - IFRS
Problems:
P14–1 E Placing transactions on the statement of cash flows
P14–2 E Placing transactions on the statement of cash flows
P14–3 E Classifying transactions and their cash effects
P14–4 M Comparing cash flow policies across companies
P14–5 E Classifying transactions and their cash effects
P14–6 M A company's cash management policy across time
P14–7 M Cash management across time
P14–8 H Deriving the cash effects of investing transactions
P14–9 H Deriving the cash generated from a common stock issuance
P14–10 H Converting cash flow numbers to accrual numbers and vice versa
P14–11 H Reconciling the income statement, the direct method, and the
indirect method
P14–12 M Manipulating dollar amounts on the statement of cash flows
P14–13 M Preparing a statement of cash flows from statement information
P14–14 H Paying short-term debts: effects on working capital, the current
ratio, and the statement of cash flows
P14–15 H Preparing the statement of cash flows and reconciling the
operating section with the income statement
P14–16 H Preparing the statement of cash flows from two balance sheets
and an income statement; book losses and amortized discounts
P14–17 H Preparing the statement of cash flows from two balance sheets
and an income statement; book gains and amortized premiums
P14–18 H Preparing the statement of cash flows and using it to set dividend
policy
P14–19 H Comprehensive Problem: Preparing a complete set of financial
statements from a set of original transactions

Issues for discussion:

ID14–1 M Using the cash flow statement to spot earnings quality problems
ID14–2 M Equity in unconsolidated affiliates
ID14–3 M Accrual and cash flow accounting
ID14–4 M Analyzing the operating section of the statement of cash flows
ID14–5 E Misunderstandings in the financial press
ID14–6 H Analyzing the statement of cash flows
ID14–7 H Analyzing an IFRS-based statement of cash flows
ID14–8 M Cash management profiles across time–a mature firm
ID14–9 M Cash management profile-a growth firm
ID14-10 M Acquisitions and cash flow
ID14–11 M The annual report of Google