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1. The basic financial statements (income statement, retained earnings statement and
the balance sheet) are prepared under the accrual basis. Under this basis revenue
is recorded when earned and expenses are recorded when incurred. These basic
financial statements were difficult for managers to utilize since you could
possibly have a high level of income but a low level of cash since under the
accrual basis concept, the revenue was recorded when earned and not when it was

2. Does net income under accrual basis equate to high levels of cash? NO Why?

(a) The revenue could be awaiting collection in the form of receivables on the
balance sheet

(b) Investment is made in plant and equipment will require the use of cash
but does not reduce income, since the equipment is an asset. When will
the cost of the equipment acquisition be recovered? The recovery of the
initial acquisition of the equipment begins, and the reduction of income
occurs, as the equipment is being depreciated.

(c) Cash received could be used to pay for additional inventory.
Inventory can remain in stock for up to two months or more, until it is
sold. Once the inventory is sold, the a receivable is created and this
receivable can remain outstanding (uncollected) for three months or
longer. As a result a company may have to wait five months or longer to
turn the initial investment in inventory back into cash when the receivable
is collected.

(d) Payment of liabilities for general operating expenses. The payment of the
liability reduces cash but does not reduce net income when paid.

3. Therefore a company could be profitable under accrual basis accounting and have
a significant cash flow problem.

4. Cash is the necessary element which runs the business. We need to know where
the cash comes from (sources, or inflows) and where it is spent (uses or outflows).

5. Presenting a comparative balance sheet and income statement does not show any
details of what occurred during the year. All we know is the beginning and
ending balances. We can derive a net change based upon dollar amount and
percentages but the details are not disclosed.

6. Therefore to obtain informative data relations to cash a separate statement must be
prepared and analyzed.

7. The statement is called the Statement of Cash Flows (SCF).

8. The SCF should detail results of a companies transactions classified in three
a. Operating activities
b. Investing activities
c. Financing activities

9. As part of the budgeting and planning process, budgeted financial statements and
the SCF should be prepared during the last quarter of the current year for the
forthcoming year.
This allows management to budget and predict the cash inflows and outflows on a
monthly basis.
The early identification of potential cash overages and/or shortages will allow
management to plan better.

If cash flow is slow:

a. Secure the availability of a revolving credit line for future use.

b. Try to meet with members of the accounting department and
discuss ways to improve cash flows such as
- acceleration of the collection of receivables
- deferral of payments of liabilities and expenses (however
you do not want to damage your credit rating on your
relationship with the vendors or suppliers by delaying
payments too long).
- Consider delaying acquisitions of capital equipment, etc.

c. If cash flows are available (based upon the budgeted data)
- consider the acquisition of plant and equipment
- investments in marketable equity securities short term
investments ( you do not want the cash to sit idle without
earning interest)
- ***give all the accountants huge bonuses (unfortunately
I am just kidding!!) ***

10. The actual reporting results per the SCF should be compared with the budgeted
statement and investigate unusual favorable or unfavorable variances in an effort
to increase operational efficiency.

11. When preparing the SCF what sources should be analyzed?
- Income statement
- Balance sheet (comparative)
- Retained earnings
- General ledger for specific details affecting accounts
detected by the examination of the appropriate financial
- Inquires of management
- Minutes of Board of Directors meetings

12. Who can utilize information processed by the SCF?
- Management
- Investors
- Creditors

13. The SCF can be prepared using the direct or indirect method.
NOTE: This method relates to the preparation of the SCF operating activities
The investing and financing section is completed the same way regardless if the
indirect or direct method is used.

14. Indirect Method:

a. Known as the reconciliation method

b. Starts with net income (accrual basis) and reconciles to cash provided or
used by operating activities.

c. Used by the majority of companies in annual reports (Accounting Trends
and Techniques).

d. Used by the majority of the companies that prepare annual reports as per
Accounting Trends and Techniques (Book which summarizes all the
reporting practices of the Fortune 100 Companies)


1. OPERATING ACTIVIES (Cash received and paid in the daily operations of the
- Cash effects of revenue and expense transactions
- Deal with the income statement accounts
- Included interest paid (on debt) and income taxes (to the
government) which enters in the determination of net
- Cash receipts from sales of good and services,
miscellaneous income
- Cash payments for inventory, wages, insurance, utilities,
- Changes in current asset and liability accounts from the
prior year.

Note: The majority of cash inflows should come from the operating activities section.
This indicates that the company is able to generate cash to satisfy its current operating

a. Investing in your own company
- Cash flows arising from purchases and disposals of plant
assets and/or investments (which are not considered as cash

b. Investing in another company
- Loans made to borrowers (other companies)
- Collection of loans made to others
- Sale of other companies interest bearing securities or
- Stock owned as an investment.

- Cash flows between an organization and its owners
(stockholders) and creditors who lend money to the
- Proceeds of borrowings from creditors
- Proceeds from issuance of stock and/or bonds
- Retirement of notes, bonds, mortgages
- Cash dividends paid to stockholders

- Repurchase of stock (treasury stock) and subsequent
- Withdrawals paid to owners
- Excludes interest paid on the debt

- NOTES: 1.The decision to finance the business through debt is a financing activity. However,
the cash to pay for the interest comes from operating activities.
2. Income taxes are paid from operating activities
3. Dividends received on investment activities

-The decision to purchase debt or equity securities is an investment activity.
However, the cash received from the investment used to run the operating activities of the

Schedule of Noncash Investing and Financing Activities

Used to report transactions that are investing and/or financing activities but do not bring
in or use up any cash. These transactions need to be reported because they will affect
cash flows in the future.

Examples include the following:
1. Purchasing plant assets by signing a note payable.

2. Purchasing a building through a mortgage loan

3. Exchanging stock for plant asset.

4. Issuing stock to retire debt

5. Converting preferred stock to common stock.

*** CASH EQUIVALENTS (must satisfy both criteria)
a. Investment readily convertible to a known amount of cash
b. Investment close to its maturity date so that the market value is not to
sensitive to interest rate changes

NOTES: (1) In general, only investments purchases within three
months of their maturity dates satisfy these criteria
(2) Examples include: short term investment in the US, treasury
bills, commercial paper (short term corporate notes payable)
and money market funds.
(3) Cash payments to purchase cash equivalents and cash
receipts from selling cash equivalents do not appear on the
statement of cash flows.