Needles Finman Irm Ch14

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CHAPTER 14
The Statement of Cash Flows
PLANNING MATRIX
Enhancing Your
Building Your Basic Knowledge and Knowledge, Skills,
Learning Objective Skills and Critical Thinking
1. Describe the principal SE 1, 8 E 1, 3 P 1, 2, 6 C1
purposes and uses of the C6
statement of cash flows, and C9
identify its components.
2. Analyze the statement of SE 2, 3 E 1, 4
P 2, 3, 4,5, 7, C 2
cash flows. 8, 9, 10 C3
C4
C6
C7
C8
C9
3. Use the indirect method to SE 4, 5, 8 E 2, 5, 6, 7, P 3, 4, 5, 7, C 1
determine cash flows from 11 8, 9, 10 C4
operating activities. C6
4. Determine cash flows from SE 6, 8 E 2, 8, 9, 11 P 3, 4, 5, 7, C 4
investing activities. 8, 9, 10 C6
5. Determine cash flows from SE 7, 8 E 2, 10, 11 P 3, 4, 5, 7, C 4
financing activities. 8, 9, 10 C6
MEMORANDA:
SE: Short Exercises
E: Exercises
P: Problems (Each problem has a User Insight question.)
All questions are in the text with related Learning Objectives (Stop, Think, and Apply).
SUGGESTED INSTRUCTIONAL STRATEGY

Output Skills Developed:
Technical, Communication
Related Learning Objective:

2
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
190 Chapter 14: The Statement of Cash Flows
Instructional Strategy
Learning activity: Group work, case study analysis, discussion
Learning environment: Active, in-class
Learning tool: Textbook assignment Case 2
Steps to Implement
1. Ask students to compute the cash flow measures called for in Interpreting Financial Reports Case
2 as homework.
2. Then, in class, form small groups and have groups complete the required analysis by assessing
Enron’s cash-generating efficiency and evaluating its free cash flow in light of its financing
activities.
3. Ask the groups to discuss the usefulness of the concept of free cash flow. Remind students that in
evaluating any measure, it is important to look in detail at all components.
4. Summarize on the board (or use an overhead transparency) the ratios for the two years. First
discuss the numbers themselves; then identify the differences between the two years.
5. Lead a discussion of the groups’ results by calling on a spokesperson from each group to present
the salient points of its analysis, and, on the board, list all causes of the decline in cash flow
performance.
Assessment
Technical skills: Include a related problem on the next examination.
Communication skills: On the examination, include an essay question that includes the tasks students
need to perform to interpret the results of the related problem.
RESOURCE MATERIALS AND OUTLINE

OBJECTIVE 1: Describe the principal purposes and uses of the statement of cash flows,
and identify its components.
Summary Statement
The statement of cash flows is considered a major financial statement, along with the income statement,
balance sheet, and statement of stockholders’ equity. The statement of cash flows, however, provides
much information and answers certain questions that the other three statements do not. It has replaced
the statement of changes in financial position, and its presentation is required whenever an income
statement is prepared.
The statement of cash flows shows the effect on cash and cash equivalents of the operating, investing,
and financing activities of a company for an accounting period. Cash equivalents are short-term, highly
liquid investments such as money market accounts, commercial paper (short-term notes), and U.S.
Treasury bills. Short-term investments (marketable securities) are not considered cash equivalents.
The principal purpose of the statement of cash flows is to provide information about a company’s cash
receipts and cash payments during an accounting period. The secondary purpose of the statement of
cash flows is to provide information about a company’s operating, investing, and financing activities
during the period.
Chapter 14: The Statement of Cash Flows 191
Investors and creditors may use the statement of cash flows to assess such conditions as the company’s
ability to generate positive future cash flows, its ability to pay its liabilities, its ability to pay dividends,
and its need for additional financing. Management uses the statement of cash flows (among other
sources) to assess the business’s debt-paying ability, determine its dividend policy, and plan its
investing and financing needs.
The statement of cash flows categorizes cash receipts and cash payments as operating, investing, and
financing activities.
1. Operating activities include receiving cash from customers for the sale of goods and services;
receiving interest and dividends on loans and investments; receiving cash from the sale of trading
securities; and making cash payments for wages, goods and services purchased, interest, taxes,
and purchases of trading securities.
2. Investing activities include purchasing and selling long-term assets and marketable securities
(other than trading securities or cash equivalents) as well as making and collecting on loans to
other entities.
3. Financing activities include issuing and buying back capital stock as well as borrowing and
repaying loans on a short- or long-term basis (issuing bonds and notes). Dividends paid are also
included in this category, but the repayment of accounts payable or accrued liabilities is not.
The statement of cash flows should be accompanied by a schedule of noncash investing and financing
transactions, involving only long-term assets, long-term liabilities, or stockholders’ equity.
Transactions such as the issuance of stock for land and the conversion of bonds into stock represent
simultaneous investing and financing activities that do not, however, result in an inflow or outflow of
cash. On the formal statement of cash flows, individual cash inflows and outflows from investing and
financing activities are shown separately in their respective categories.
Because cash flows from operations are a widely used measure of performance, companies have been
known to overstate cash flows through questionable accounting practices. While these practices may
not be illegal, they are considered unethical because they misrepresent actual performance.
New Concepts and Terminology

statement of cash flows; cash; cash equivalents; operating activities; investing activities; financing
activities; noncash investing and financing transactions
Related Text Illustrations

Figure 1: Classification of Cash Inflows and Cash Outflows
Exhibit 1: Consolidated Statement of Cash Flows
Focus on Business Practice: How Universal Is the Statement of Cash Flows?
Lecture Outline
I. The statement of cash flows is a major financial statement.
II. Purposes of the statement of cash flows
A. The statement of cash flows provides information that is not provided by the other three
statements.
B. The statement of cash flows shows the effects on cash and cash equivalents of operating,
investing, and financing activities.
1. Cash equivalents are short-term, highly liquid investments.
2. Marketable securities are not cash equivalents.
C. The statement of cash flows provides information about a company’s cash receipts and cash
payments.
III. Uses of the statement of cash flows
A. The statement of cash flows also provides information about a company’s investing and
financing activities.
B. Investors, creditors, and management use the statement of cash flows for many reasons:
1. To assess a company’s ability to generate positive future cash flows
2. To assess a company’s ability to pay debts
3. To assess a company’s ability to pay dividends
4. To assess a company’s need for additional financing
5. To plan for investing idle cash
IV. Classification of cash flows
A. Operating activities include cash received from customers; interest and dividends received;
sales of trading securities; and cash paid for wages, goods, services, interest, taxes, and
purchases of trading securities.
B. Investing activities involve long-term asset and marketable-security transactions and loans
made and collected.
C. Financing activities involve stock, bond, and note transactions, as well as dividends paid.
V. A schedule of noncash investing and financing transactions should accompany the statement of
cash flows.
VI. In the statement of cash flows, individual cash inflows and outflows are shown separately in their
respective categories.
VII. Unethical means of falsely enhancing cash flows range from failing to fully disclose financial
transactions to misclassifying payments and expenses.
Teaching Strategy
Use part 1 of the answer to the review problem as an illustration of a statement of cash flows while
delivering the lecture on this objective. Distinguish between cash equivalents and short-term
investments/marketable securities.
List the primary and secondary purposes of the statement of cash flows. Make a list or allow students to
suggest a list of management uses (such as determining the need for short-term financing, determining
available cash for dividends, and planning for long-term investing and financing). Do the same for
investors’ and creditors’ uses (determining the ability to repay loans, pay dividends, and so on).
Operating Activities
Explain to students that transactions involving cash and current assets (except for marketable securities
and notes receivable) and transactions involving cash and current liabilities (except for notes payable
and dividends payable) are classified as operating activities.
Investing Activities
Explain that transactions involving cash and noncurrent assets, current marketable securities, and
current notes receivable are classified as investing activities.
Financing Activities
Explain that transactions involving cash and the rest of the balance sheet accounts are classified as
financing activities. These accounts are the noncurrent liabilities, current notes payable, current
dividends payable, and the equity accounts (except that net income’s effect on retained earnings is part
of operating activities).
Noncash Investing and Financing

Transactions involving any of the accounts listed as investing or financing activities that do not involve
cash are classified as noncash investing or financing.
Refer students to Figure 1 for examples of operating, investing, and financing activities. Work Short
Exercise 1 and Exercise 3 for reinforcement. Case 7 pertains to ethics and cash flow classifications.
Case 1 deals with the real-world use of EBITDA.
Remind students that earnings management is unethical and can be criminal. Companies should adhere
to high standards of financial reporting, and reviewers of financial reports should be both armed with
knowledge of types of accounting trickery and alert for manipulation.
OBJECTIVE 2: Analyze the statement of cash flows.

Summary Statement
The components of the statement of cash flows show how management is spending cash. Interpreting
the statement of cash flows includes examining fundamental relationships such as cash-generating
efficiency and free cash flow. Cash-generating efficiency, which focuses on net cash flows from
operating activities, is the ability of a company to generate cash from operations. Three measures of
cash-generating efficiency are cash flow yield, cash flows to sales, and cash flows to assets.
1. Cash flow yield is the ratio of net cash flows from operating activities to net income.
2. Cash flows to sales is the ratio of net cash flows from operating activities to net sales.
3. Cash flows to assets is the ratio of net cash flows from operating activities to average total assets.
Free cash flow is the cash remaining after the company has met current operating commitments, such as
those for operations, interest, income taxes, dividends, and net capital expenditures. A positive free cash
flow means that the company has met its cash commitments and has cash remaining to reduce debt or
expand further. A negative free cash flow means that the company will have to sell investments, borrow
money, or issue stock in order to continue at its planned levels.
As is true with all financial statement ratios, it is necessary to consider trends in order to obtain an
accurate picture. The trends in the cash-generating efficiency and free cash flow over several years
should be examined to analyze a company’s cash flows.

cash-generating efficiency; cash flow yield; cash flows to sales; cash flows to assets; free cash flow

Focus on Business Practice: Cash Flows Tell All
Focus on Business Practice: What Do You Mean, “Free Cash Flow”?
Lecture Outline
I. Many companies put their cash to good use, but sometimes shareholders suffer when management
is too conservative and keeps cash in low-yielding assets.
II. Cash-generating efficiency is the ability of a company to generate cash from operations.
A. Cash flow yield is the quotient of net cash flows from operating activities divided by net
income.
B. Cash flows to sales is the quotient of net cash flows from operating activities divided by net
sales.
C. Cash flows to assets is the quotient of net cash flows from operating activities divided by
average total assets.
III. To interpret a statement of cash flows, it is important to know the right questions to ask.
A. Why did cash flow from operating activities differ from net income?
B. What investing activities are important other than capital expenditures?
C. How did the company manage it’s financing activities during the fiscal year?
IV. Free cash flow is net cash flows from operating activities less dividends and investments in plant
assets plus proceeds from the sale of plant assets.
Teaching Strategy
This objective is best taught by illustration. Use Short Exercise 2 and Exercise 4 or 5 for classroom
illustration. Case 7 considers ethics and cash flow classification; Case 2 on Enron’s statement of cash
flows is always of high interest to students.
OBJECTIVE 3: Use the indirect method to determine cash flows from operating activities.
Summary Statement
To determine cash flows from operating activities, it is necessary to convert the figures on the income
statement from an accrual basis to a cash basis using either the direct method or the more common
indirect method. Under the direct method, each item in the income statement is adjusted from the
accrual basis to the cash basis. Under the indirect method, (net) cash flows from operating activities are
determined by taking net income and adding or deducting items that do not affect cash flow from
operations. Items to add include depreciation expense, amortization expense, depletion expense, losses,
decreases in certain current assets (accounts receivable, inventory, and prepaid expenses), and increases
in certain current liabilities (accounts payable, accrued liabilities, and income taxes payable). Items to
deduct include gains, increases in certain current assets, and decreases in certain current liabilities. The
direct and indirect methods produce the same results, and both are considered GAAP. The indirect
method is used more often, however, and is the focus of this objective. It has the advantage of being
easier and less expensive to prepare than the direct method.

direct method; indirect method

Exhibit 2: Income Statement
Exhibit 3: Comparative Balance Sheets Showing Changes in Accounts
Figure 2: Indirect Method of Determining Net Cash Flows from Operating Activities
Focus on Business Practice: The Direct Method May Become More Important
Exhibit 4: Schedule of Cash Flows from Operating Activities: Indirect Method
Focus on Business Practice: What Is EBITDA, and Is It Any Good?
Lecture Outline
I. Under the indirect method, cash flows from operating activities equal net income adjusted by
items that increase or decrease cash flow from operations.
A. Discuss the items to be added back to net income:
1. Depreciation expense, amortization expense, and depletion expense
2. Losses
3. Decreases in accounts receivable, inventory, and prepaid expenses

4. Increases in accounts payable, accrued liabilities, and income taxes payable
B. Discuss the items to be deducted from net income:
1. Gains
2. Increases in accounts receivable, inventory, and prepaid expenses
3. Decreases in accounts payable, accrued liabilities, and income taxes payable
II. The direct and indirect methods produce the same results, and both are GAAP.
Teaching Strategy
Point out that both the direct and indirect methods attempt to convert from the accrual basis to the cash
basis. Under the indirect method, however, net income is the starting point. Students have difficulty
understanding why items such as depreciation expense are “added back,” whereas items such as “gain
on sale” are deducted to arrive at cash flows from operations. For the sale of plant assets, point out that
it is the proceeds of the sale that produce the cash flow, not the amount of the gain or loss (which must,
in effect, be eliminated).
Work Short Exercise 4 or 5 and Exercise 6 or 7 for practice.
OBJECTIVE 4: Determine cash flows from investing activities.

Summary Statement
To determine cash flows from investing activities, it is necessary to examine each account involving
cash receipts and cash payments from investing activities. The objective is to explain the change in the
appropriate account balances from one year to the next. As previously stated, investing activities
concern the purchase and sale of long-term assets and short-term investments. Under the indirect
approach, gains and losses from the sale of these assets should, respectively, be deducted from and
added back to net income to arrive at net cash flows from operating activities. Then, the full cash
proceeds are entered into the cash flows from investing activities section of the statement of cash flows.
Investing activities center on long-term assets shown on the balance sheet. They also include
transactions affecting short-term investments from the current assets section of the balance sheet and
investment gains and losses from the income statement.
Lecture Outline
I. Investing activities include the following:
A. Purchase and sale of long-term assets
B. Purchase and sale of short-term investments
II. Discuss the treatment of gains and losses under the indirect approach.
III. Upon a sale, the full cash proceeds are entered into the statement of cash flows.
IV. Upon a purchase, the full cash outflows are entered into the statement of cash flows.
Teaching Strategy
As each transaction is journalized, mark the cash as investing or set up a cash T account for each
transaction and post to the accounts just as other accounts are posted.
Point out that all of the items pertaining to financing activities relate to the right-hand side of the
balance sheet (stocks, bonds, etc.) and that they appear in the financing activities section whether they
produce an inflow or an outflow of cash. Dividends declared is included because it relates to retained
earnings.
Short Exercise 6 and Exercises 8 and 9 apply to this learning objective.
OBJECTIVE 5: Determine cash flows from financing activities.

Summary Statement
Financing activities focus on certain liability and stockholders’ equity accounts. They include short-
and long-term borrowing (notes and bonds) and repayment, issuance and repurchase of capital stock,
and payment of dividends. Changes in the Retained Earnings account are explained on the statement of
cash flows, for the most part, through analyses of net income and dividends declared.
Exhibit 5 illustrates a completed statement of cash flows using the indirect method. The essence of the
indirect approach is the conversion of net income to net cash flows from operating activities.

Focus on Business Practice: How Much Cash Does a Company Need?
Exhibit 5: Statement of Cash Flows: Indirect Method
Lecture Outline
I. Financing activities include the following:
A. Short- and long-term borrowing (notes and bonds) and repayment
B. Issuance and repurchase of capital stock
II. Changes in retained earnings are explained through analyses of net income and dividends
declared.
III. The direct and indirect methods differ only in the cash flows from operating activities section of
the statement of cash flows.
IV. Discuss Exhibit 5, a completed indirect method statement of cash flows.
Teaching Strategy
As each transaction is journalized, mark the cash as financing or set up a cash T account for each
transaction and post to the accounts just as other accounts are posted.
Point out that all of the items pertaining to financing activities relate to the right-hand side of the
balance sheet (stock, bonds, etc.) and that they appear in the financing activities section whether they
produce an inflow or an outflow of cash. Dividends declared is included because it relates to retained
earnings.
Short Exercise 7 and Exercise 10 apply to this learning objective.
REVIEW QUIZ
True-False
1. T F Cash flow yield measures net cash flows from operating activities in relation to net
income.
2. T F A firm’s sale of its own common or preferred stock is a cash inflow that will appear in
the investing activities category.
3. T F Cash equivalents are highly liquid investments with an original maturity of less than
one year.
4. T F The indirect method of determining cash flows begins with net income and lists all
noncash effects to adjust net income to a cash flow basis.
5. T F Interest and dividends received are considered financing activities.
6. T F Purchases and sales of investments are disclosed separately on the statement of cash
flows.
7. T F Interest paid appears in the operating activities section, whereas dividends paid appears
in the financing activities section.
Multiple Choice
8. Cash receipts from sales equals sales minus a(n)
a. decrease in accounts payable.
b. decrease in accounts receivable.
c. increase in accounts receivable.
d. increase in accounts payable.
9. All of the following are components of free cash flow except

a. dividends paid.
b. cash flows from operating activities.
c. net income.
d. net capital expenditures.
10. The settlement of a debt by issuing stock is considered a(n)

a. financing activity.
b. investing activity.
c. operating activity.
d. noncash transaction.
11. During 20xx, cost of goods sold totaled $75,000, inventory increased by $18,000, and accounts
payable decreased by $9,000. Cash payments for purchases totaled
a. $48,000.
b. $66,000.
c. $84,000.
d. $102,000.
12. Which of the following is deducted from net income in converting net income to net cash flows
from operating activities?
a. Depreciation expense
b. Gains
c. Decrease in accounts receivable
d. Losses
13. Analysis of the investing activities section of the statement of cash flows will show
a. any sales or repurchases of stock.
b. whether the company is shrinking or growing.
c. how corporate growth is being funded.
d. to what extent day-to-day operations are affecting cash flow.
14. Which of the following transactions produces a cash outflow?

a. Issuance of debt
b. Receipt of interest and/or dividends from loans and investments
c. Reacquisition of common or preferred stock
d. Issuance of preferred or common stock for cash
15. Operating activities do not include

a. cash payments for dividends.
b. cash payments to the government for taxes.
c. cash payments for inventory.
d. cash inflows from the sale of goods or services.
16. Which of the following is not characteristic of the operating activities section of the statement of
cash flows?
a. Begins with net income, followed by a list of adjustments
b. Adjusts income statement items from an accrual basis to a cash basis
c. Shows free cash flow
d. Adjusts for items of expense that do not require cash outflows
17. Investors and creditors would be least likely to use the statement of cash flows to assess a
company’s
a. ability to generate positive future cash flows.
b. ability to pay interest and dividends.
c. need for additional financing.
d. profitability during the period reported upon.
ANSWERS TO REVIEW QUIZ
True-False Multiple Choice

1. T 8. c
2. F 9. c
3. F 10. d
4. T 11. d
5. F 12. b
6. T 13. b
7. T 14. c
15. a
16. c
17. d

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ً ‫ صفحة الباحث العلوي هجانا‬Alaa.aliasrei@gmail.

com ‫@ عالء هحسن شحن‬Aliasrei ‫تلكرام‬

SUGGESTED INSTRUCTIONAL STRATEGY

Related Learning Objective:

RESOURCE MATERIALS AND OUTLINE

New Concepts and Terminology

Related Text Illustrations

Noncash Investing and Financing

OBJECTIVE 2: Analyze the statement of cash flows.

New Concepts and Terminology

Related Text Illustrations

New Concepts and Terminology

Related Text Illustrations

3. Decreases in accounts receivable, inventory, and prepaid expenses

OBJECTIVE 4: Determine cash flows from investing activities.

OBJECTIVE 5: Determine cash flows from financing activities.

Related Text Illustrations

9. All of the following are components of free cash flow except

10. The settlement of a debt by issuing stock is considered a(n)

14. Which of the following transactions produces a cash outflow?

15. Operating activities do not include

ANSWERS TO REVIEW QUIZ

True-False Multiple Choice

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