Chapter 13

Statement of Cash Flows

Accounting Theory© 2012 SAGE Publications, Inc.

Lecture
1. Statement of Changes in Financial Position.
2. Motivation for a Statement of Cash Flows.
3. The cash flow statement and the nonarticulation
problem that arises when using the indirect method.
4. Classification problems that exist in the FASB’s
trichotomy of operating, investing, and financing
activities.
5. Analytical usefulness of the cash flow statement for
different users.
6. Free cash flows, what are they?

Accounting Theory© 2012 SAGE Publications, Inc.

Statement of Changes in Financial Position (SCFP)

SCFP is the successor to a prior financial

statement, the funds flow statement.
SCFP reported changes in assets, liabilities, and
owners’ equities account balances.
It was recommended, but not required for
inclusion in the annual report until 1971.
Objectives of SCFP per APB Opinion No. 19
 Disclosure of changes in financial position
 Summarize financing and investing activity
 Report funds flow from operations

Accounting Theory© 2012 SAGE Publications, Inc.

Two Balancing Sections in the SCFP
1. Sources of resources
 Transaction credits
 Arise from increases in liabilities and owners’
equity and decreases in assets
2. Uses of resources
 Transaction debits
 Arise from decreases in liabilities and
owners’ equity and increases in assets

Accounting Theory© 2012 SAGE Publications, Inc.

 Standard Format of the
Statement of Changes in Financial Position
Sources of Resources Uses of Resources
1. Increases to fund 1. Decreases to the fund
balance accounts balance accounts
a. From net income a. From net losses
b. From other sources b. From other sources
2. Other sources of 2. Other uses of
resources resources
3. Decrease, if any, in 3. Increase, if any, in
the fund balance for the fund balance for
the period the period

Accounting Theory© 2012 SAGE Publications, Inc.

Motivation for a Statement of Cash Flows.
Net working capital came to be viewed as a poor
measure of liquidity for three reasons.
1. Deferred charges and credits are included in net
working capital, but have no cash flow consequences.
2. The conversion of current assets into cash can take a
year or longer for firms with a long operating cycle.
3. Items such as inventory are carried on a cost basis and
thus do not explicitly measure the cash flow potential
of the inventory.
In light of these ambiguities, cash flow reporting
appeals because of its literal interpretation—cash
is cash is cash.
Accounting Theory© 2012 SAGE Publications, Inc.
An Early FASB Discussion Memo suggested that
cash flow data are a useful supplemental disclosure
because they
1. Provide feedback on actual cash flows
2. Help to identify the relationship between
accounting income and cash flows
3. Provide information about the quality of income
4. Improve comparability of information in
financial reports
5. Aid in assessing flexibility and liquidity
6. Assist in predicting future cash flows
Accounting Theory© 2012 SAGE Publications, Inc.
 Statement of Cash Flows
Cash Flows from Operating Activities

Cash Flows from Investing Activities

Cash Flows from Financing Activities

Net Change in Cash & Cash Equivalents

Cash & Cash Equivalents at Beginning of Year

Cash & Cash Equivalents at End of Year

Accounting Theory© 2012 SAGE Publications, Inc.
Definition: Cash
Literal cash on hand or
on demand deposit
plus cash equivalents
Cash equivalents are
highly liquid assets
that are convertible to
known amounts of
cash and have short-
term maturities
Accounting Theory© 2012 SAGE Publications, Inc.
 Statement of Cash Flows
Cash Flows from Operating Activities

Cash Flows from Investing Activities

Cash Flows from Financing Activities

Net Change in Cash & Cash Equivalents

Cash & Cash Equivalents at Beginning of Year

Cash & Cash Equivalents at End of Year

Accounting Theory© 2012 SAGE Publications, Inc.
Operating Activities Section
Direct method reports literal cash flows related to
income statement classifications
 FASB appears to favor
 Cost to prepare > than with indirect method

Indirect or reconciliation method starts with

accrual income and adjusts it for the noncash
items in it
 In 1996, 98% of American firms use
 Nonarticulation problems

Accounting Theory© 2012 SAGE Publications, Inc.

Direct vs. Indirect Method

Operating activities
section is the only
section that differs
The investing and
financing activities
sections are the same
under both methods

Accounting Theory© 2012 SAGE Publications, Inc.

Indirect Method: Nonarticulation
Working capital account changes on balance sheet do not
equal working capital adjustments in the operating
activities section of SCF (75% of the time in sample)
Potential causes
 Acquisitions of subsidiaries during the year
 Transactions involving working capital accounts that do not affect
cash
 Write-up/down of working capital items
 Depreciation allocations within inventories
 Reclassifications of accounts between current and non current
categories
 occur when one accounts payable account is used for the purchase
of both working capital assets (e.g., inventories), as well as for the
purchase of non-working capital assets
Accounting Theory© 2012 SAGE Publications, Inc.
 Statement of Cash Flows
Cash Flows from Operating Activities

Cash Flows from Investing Activities

Cash Flows from Financing Activities

Net Change in Cash & Cash Equivalents

Cash & Cash Equivalents at Beginning of Year

Cash & Cash Equivalents at End of Year

Accounting Theory© 2012 SAGE Publications, Inc.
Investing Activities Section: Examples

Proceeds from sale of facility

Payment received on note for sale of
plant
Capital expenditures
Payment for purchase of company X

Accounting Theory© 2012 SAGE Publications, Inc.

 Statement of Cash Flows
Cash Flows from Operating Activities

Cash Flows from Investing Activities

Cash Flows from Financing Activities

Net Change in Cash & Cash Equivalents

Cash & Cash Equivalents at Beginning of Year

Cash & Cash Equivalents at End of Year

Accounting Theory© 2012 SAGE Publications, Inc.
Financing Activities Section: Examples

Net borrowings under line-of-credit

agreement
Principal payments under capital lease
obligation
Proceeds from issuance of long-term debt
Proceeds from issuance of common stock
Dividends paid
Accounting Theory© 2012 SAGE Publications, Inc.
SFAS No. 95 Classification Issues
Appearing in operating activities section
 Interest expense
 Interest revenue
 Dividend revenue

Related balance sheet items (bonds payable,

stock investments, and long-term notes
receivable) are either financing or investing
elements

Accounting Theory© 2012 SAGE Publications, Inc.

Ingram and Lee (1997)
1,000 firms over the period 1974-1992
Use the income statement and the cash flow
statement together
Over time growing firms will have higher
income and lower cash flows
Reverse occurs for shrinking firms

Accounting Theory© 2012 SAGE Publications, Inc.

SCF is less subject to manipulation than
income; it is not exempt from the problem.

Increase cash flows from operations by

shifting cash outflows from operating
activities to investing activities, or
Move cash inflows from investing activities
to cash inflows from operating activities

Accounting Theory© 2012 SAGE Publications, Inc.

Free Cash Flows
There are several definitions of free cash
flow used by companies and in the financial
press.
Free Cash Flows (FCF) cannot be
determined directly from the Statement of
Cash Flows.
FCF = NOPLAT – investment in operating
invested capital

Accounting Theory© 2012 SAGE Publications, Inc.

Improving Accounting Standards
Require the direct method for the Statement
of Cash Flows.
Require the associated reconciliation of net
income to operating cash flow for the
operating activities section.
Require a firm to explain the source of any
nonarticulation that occurs in the operating
section of the SCF.

Accounting Theory© 2012 SAGE Publications, Inc.

Summary
1. Statement of Changes in Financial Position.
2. Motivation for a Statement of Cash Flows.
3. The cash flow statement and the nonarticulation
problem that arises when using the indirect method.
4. Classification problems that exist in the FASB’s
trichotomy of operating, investing, and financing
activities.
5. Analytical usefulness of the cash flow statement for
different users.
6. Free cash flows, what are they?

Accounting Theory© 2012 SAGE Publications, Inc.