Statements of Cash Flows

Introduction to Accounting
NYUAD – Fall I – 2021

Anisa Shyti

1-1
 Recap of previous meeting

• The Accounting Cycle – background on information disclosure

• Accrual Accounting – Principles

– Revenue Recognition: earned and realized
– Matching Expenses: recognized when generating revenues or when
incurred

• Unadjusted Trial Balance and Adjusting Entries

– Deferred Expenses and Revenues
– Accrued Expenses and Revenues

• Preparing Financial Statements

• Closing Entries and starting a new accounting period

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 Objectives

• Define cash

• Classify cash flows from the following business

activities:
– Operating
– Investing
– Financing

• Direct method to prepare SCF

• Indirect method to prepare SCF

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 Understanding the Business

Positive cash flows permit a company to . . .

Pay
dividends to
owners Expand its
operations and
finance growth
Take advantage
of market
Replace needed
opportunities
assets

Wall Street analysts consider cash flow an important

indicator of a company’s financial health.
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 Classifications of the Statement of Cash Flows

Currency
Cash Equivalents

• Short-term, highly liquid investments

• Readily convertible into cash
• So near maturity that market value is unaffected by interest rate changes
(i.e., original maturities of less than 3 months)

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 Classifications of the Statement of Cash Flows

Cash inflows and outflows directly

Operating
related to earnings from normal
Activities operations

Cash inflows and outflows related to

the acquisition or sale of productive
Investing Activities facilities and investments in the
securities of other companies

Cash inflows and outflows related to

Financing external sources of financing
Activities (owners and creditors) for the
enterprise
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 Statement of Cash Flows

• Reports changes in cash due to operating, investing, and financing

activities over a period of time

• Statement of Cash Flows format:

Net cash from operating activities

+ Net cash from investing activities
+ Net cash from financing activities
= Net change in cash balance

• Non-cash transactions are disclosed at the bottom of the statement

• Cash interest paid and cash income taxes paid must also be disclosed

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 Operating Activities

Transactions related to providing goods and services to customers and

to paying expenses related to generating revenue (i.e. “income
statement” activities)

Operating cash outflows exclude these income statement items:

• Depreciation and amortization (and other noncash items)
• Gains or losses on disposal of PP&E

1-8 KNOWLEDGE FOR ACTION

 Investing Activities

Transactions related to acquisitions or disposals of long-term assets

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 Financing Activities

Transactions related to owners or creditors (except for interest

payments)

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 Statement of Cash Flows

Transactions related to owners or creditors (except for interest

payments)

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 Statement of Cash Flows

Note: Under IFRS, interest and dividends received and paid may be
classified as operating, investing, or financing
1-12 KNOWLEDGE FOR ACTION
 Disagreement over FASB Classification

• Many investors and analysts prefer to classify

• Interest payments as a financing activity
• Cash paid for interest must be disclosed
• Interest and dividends received as an investment activity

• All income tax effects are shown in the operating section,

even if the income relates to financing or investing activities
• Cash taxes must be disclosed

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 International Perspective—IFRS
Classification of Interest on the Cash Flow Statement

U.S. GAAP and IFRS differ in the cash flow statement

treatment of interest received and interest paid.

These differences are currently on the agenda of the joint

FASB/IASB financial statement presentation project.

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 SCF and Growth Stages: Illustration

What do we learn by dividing cash flow in these three buckets?

Start Up Early Growth Mature Decline

Operating Cash Flow (3) 7 15 4
Investing Cash Flow (15) (12) (8) (1)
Financing Cash Flow 18 5 (7) (3)
Net Cash Flow 0 0 0 0

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 Interpreting Cash Flows from Financing Activities

The long-term growth of a company is normally financed from

three sources:
• internally generated funds
• the issuance of stock
• and money borrowed on a long-term basis

The statement of cash flows shows how management has elected

to fund its growth.

This information is used by analysts who wish to evaluate the

capital structure and growth potential of a business

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 Direct Method vs. Indirect Method

Two Formats for Reporting Operating Activities

Direct Method Indirect Method

Reports the cash Starts with accrual

effects of each net income and
operating activity converts to cash
basis

Note that no matter which format is used, the same amount of net
cash flows from operating activities is generated.

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 Methods for Preparing SCF

Direct method
• Lists cash receipts and disbursements by source/use of funds
• Always used for investing and financing activities
• Rarely used for operating activities

Indirect method
• Only used for operating activities
• Goal is to reconcile net income with cash from operations by removing
noncash items from net income and including additional cash flows not
in net income
• Almost every company uses this method for operating activities

1-18 KNOWLEDGE FOR ACTION

 Indirect Method for Preparing SCF

• Start with Net Income

• Adjust for components of Net Income tied to noncash items or to investing

activities
• Add back expenses or subtract revenues
• Noncash items: Depreciation, amortization
• Investing activities: Gains/losses on sale of PP&E or investments

• Adjust for components of Net Income tied to assets or liabilities created

through operating activities (i.e., working capital)
• Add or subtract change in asset/liability account balance
• Use the balance sheet equation to determine whether to add or subtract:

Cash + Noncash Assets = Liabilities + Owners’ Equity

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 Direct vs. Indirect Method – Example I

$ Direct SCF $ Indirect SCF $

Sales: $100 100 Collections from 100 N.I. 40

cash customers
COGS: $60 (60) Payments to (60)
acquired suppliers
inventory
with cash
N.I. 40 Operating CF 40 Operating CF 40

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 Direct vs. Indirect Method – Example II

$ Direct SCF $ Indirect $

SCF
Sales: $100 cash 100 Collections from 100 N.I. 30
customers
COGS: (60) Payments to (60) Add Depr. 10
-$60 acquired suppliers Expense
inventory with
cash
-Depreciation: $10 (10)
N.I. 30 Operating CF 40 Operating 40
CF

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 Direct vs. Indirect Method – Example III

$ Direct SCF $ Indirect $

SCF
Sales: $80 cash, 100 Collections from 80 N.I. 30
$20 A/R customers
COGS: (60) Payments to (60) Add Depr. 10
-$60 acquired suppliers Expense
inventory with
cash Increase (20)
A/R
Depreciation: $10 (10)
N.I. 30 Operating CF 20 Operating 20
CF

Cash + Non-Cash Assets = Liabilities + Owners’ Equity

Decrease cash 20; Increase A/R 20

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 Direct vs. Indirect Method – Example IV

$ Direct SCF $ Indirect SCF $

Sales: $80 cash, 100 Collections from 80 N.I. 30

$20 A/R customers
COGS: (60) Payments to (50) Add Depr. 10
-$60, but purchased suppliers Expense
$75 of inventory,
$50 paid in cash, -Increase in (20)
and $25 A/P A/R
-Depreciation: $10 -Increase in (15)
(10) inventory
-Increase in 25
A/P
N.I. 30 Operating CF 30 Operating CF 30

Cash + Non-Cash Assets = Liabilities + Owners’ Equity

Decrease cash 15; Increase inv. 15 (75 – 60 sold)
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 Direct vs. Indirect Method – Example V

- Sell PPE worth $70 on books for $75 cash

- Gain of $5 goes on income statement
- But, all $75 of cash is considered investing

$ Direct SCF $ Indirect SCF $

Sales: $100 cash 100 Collections from 100 N.I. 35

customers
COGS: (60) Payments to (60) Add Depr. 10
-$60, all cash suppliers Expense
-Depreciation: $10 (10) Less Gain (5)
-Gain on sale of 5 _____ _____
PPE: $5 Operating CF 40 Operating 40

Proceeds from 75 Proceeds 75

Sale from Sale
N.I. 35 Investing CF 75 Investing CF 75
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 SCF Complications

• Why does the change in balance sheet numbers often not equal the
number on the SCF?

• Noncash investing and financing activities

• Supplemental disclosure below SCF

• Acquisitions and divestitures of businesses

• Investing activity that affects balances in operating asset and liability accounts

• Foreign Currency Translation Adjustments

• Changes in cash due to exchange rate movements shown separately

• Subsidiaries in different industries (e.g. real estate)

• Some transactions (e.g. buying land) are investing activities in one part of
business and operating in another

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 EBITDA, Earnings, and Cash Flow

• EBITDA (Earnings before interest, taxes, depreciation, and

amortization) is often used as a proxy for cash flow that
excludes interest and taxes
• However, EBITDA is not a faithful proxy of cash flow if there are large
changes in working capital and suffers from the same manipulation
potential as net income

• For example, “channel stuffing” would increase earnings and EBITDA,

but no cash is collected (instead, accounts receivable increase).
Subtracting the increase in AR from EBITDA would correct this problem

• Research finds that Earnings are a better predictor of future

cash flow than current Cash Flow from Operations
• But using both gives the best predictions

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 Free Cash Flow

• Operating cash flow minus cash for long-term investments

• There is no standard measure for operating cash flow. Examples for

different textbooks include:

• Cash from operations before interest expense

• NOPLAT (Net operating profits less adjusted taxes)
• (NOPLAT = EBITDA – Cash taxes on EBITDA)
• NOPAT – increase in working capital
• (NOPAT = Net Income + After-tax net interest expense)
• Net income adjusted for depreciation and other noncash items – increase
in working capital
• EBIT(1-tax rate) + Depreciation
• EBITDA

• Companies often disclose free cash flow using their own custom
definition
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 Completing the Statement and Additional Disclosures

Three Required Disclosures

1. Reconciliation of net income to cash flow from operations

2. Noncash investing and financing activities
3. Cash paid for interest and income taxes

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ement of Cash Flows

Exercise 1
XERCISES

3-1 Matching Items Reported to Cash Flow Statement Categories (Indirect Method)
LO1 Reebok International Ltd. is a global company that designs and markets sports and fitness products,
including footwear, apparel, and accessories. Some of the items included in its recent annual consoli-
bok
dated statement of cash flows presented using the indirect method are listed here.
Indicate whether each item is disclosed in the Operating Activities (O), Investing Activities (I), or
Financing Activities (F) section of the statement or (NA) if the item does not appear on the statement.
(Note: This is the exact wording used on the actual statement.)
1. Dividends paid.
2. Repayments of long-term debt.
3. Depreciation and amortization.
4. Proceeds from issuance of common stock to employees.
5. [Change in] Accounts payable and accrued expenses.
6. Cash collections from customers.
7. Net repayments of notes payable to banks.
8. Net income.
9. Payments to acquire property and equipment.
10. [Change in] Inventory.

3-2 Matching Items Reported to Cash Flow Statement Categories (Direct Method)
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LO1
 Solution Exercise 1

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 1. Present the operating activities section of the statement of cash flows for Capaz Company using the
indirect method.

Exercise 2
2. What were the major reasons that Capaz was able to report a net loss but positive cash flow from
operations? Why are the reasons for the difference between cash flow from operations and net
income important to financial analysts?

E13-8 Reporting and Interpreting Cash Flows from Operating Activities with Loss on Sale
LO2 of Equipment (Indirect Method)
New Vision Company completed its income statement and balance sheet for 2011 and provided the
following information:

Service revenue $66,000

Expenses:
Salaries $42,000
Depreciation 7,300
Utilities 7,000
Loss on sale of equipment 1,700 58,000
Net income $ 8,000

Partial Balance Sheet 2011 2010

Accounts receivable $12,000 $24,000
Salaries payable 19,000 10,000
Other accrued liabilities 5,000 9,000
Land 52,000 57,000

Required:
Present the operating activities section of the statement of cash flows for New Vision Company using the
indirect method.
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