Details about the amount of cash received and paid out during an accounting period are not shown on the balance sheet, income statement, or statement of changes in equity. This information is disclosed on the statement of cash flows (SCF). This chapter discusses the purpose of the statement of cash flows, the steps in preparing the SCF, as well as how to interpret various sections of the statement of cash flows.

11.1 Financial Statement Reporting

Cash flow is an important factor in determining the success or failure of a corporation. It is quite possible for a profitable business to be short of cash. As discussed in Chapter 7, a company can have liquidity issues because of large amounts of cash tied up in inventory and accounts receivable, for instance. Conversely, an unprofitable business might have sufficient cash to pay its bills if it has access to enough financing from loans or by issuing share capital.

We know that the financial activities of a corporation are reported through four financial statements: a balance sheet, an income statement, a statement of changes in equity, and a statement of cash flows (SCF). Statement of cash flowsThis chapter discusses the statement of cash flows in detail.

The SCF identifies the sources (inflows) and uses (outflows) of cash during the accounting period. It explains why the cash balance at the end of the accounting period is different from that at the beginning of the period by describing the enterprise’s financing, investing, and operating activities.

Cash flow information is useful to management when making decisions such as purchasing equipment, plant expansion, retiring long-term debt, or declaring dividends. The SCF is useful to external users when evaluating a corporation’s financial performance.

The SCF, together with the income statement, provides a somewhat limited means of assessing future cash flows because these statements are based on historical, not prospective data. Nevertheless, the ability to generate cash from past operations is often an important indication of whether the enterprise will be able to meet obligations as they become due, pay dividends, pay for recurring operating costs, or survive adverse economic conditions.

For SCF purposes, cash includes cash and cash equivalents — assets that can be quickly converted into a known amount of cash, such as short-term investments that are not subject to significant risk of changes in value. For our purposes, an investment will be considered a cash equivalent when it has a maturity of three months or less from the date of acquisition.

Because of differences in the nature of each entity and industry, management judgment is required to determine what assets constitute cash and cash equivalents for a particular firm. This decision needs to be disclosed on the SCF or in a note to the financial statements as shown in the following example:

For simplicity, examples throughout this chapter involving cash and cash equivalents will include only cash.

Cash flows result from a wide variety of a corporation’s activities as cash is received and disbursed over a period of time. Because the income statement is based on accrual accounting that matches expenses with revenues, net income most often does not reflect cash receipts and disbursements during the time period they were made. As we will see, the statement of cash flows converts accrual net income to a cash basis net income.

11.2 Preparing the Statement of Cash Flows

The general format for a SCF is shown in Figure 11.1. The SCF details the cash inflows and outflows that caused the beginning of the period cash account balance to change to its end of period balance.

Notice that the cash flows in Figure 11.1 are separated into three groups: cash flows from operating, investing, and financing activities. Grouping or classifying cash flows is a key component of preparing a SCF.

Classifying Cash Flows—Operating Activities

Cash flow from operating activities represents cash flows generated from the principal activities that produce revenue for a corporation, such as selling products, and the related expenses reported on the income statement. Because of accrual accounting, the net income reported on the income statement includes noncash transactions. For example, revenue earned on account is included in accrual net income but it does not involve cash (debit accounts receivable and credit revenue). Therefore, the operating activities section of the SCF must convert accrual net income to a cash basis net income. There are two generally accepted methods for preparing the operating activities section of the SCF, namely the direct method and the indirect method. This chapter illustrates the indirect method because it is more commonly used in Canada. The direct method is addressed in a different textbook. Both methods result in the same cash flows from operating activities — it is the way in which the number is calculated that differs. The method used has an impact on only the operating activities section and not on the investing or financing activities sections.

In using the indirect method for preparing the operating activities section, the accrual net income is adjusted for changes in current assets (except cash), current liabilities (except dividends payable), depreciation expense, and gains/losses on the disposition of non-current assets. Figure 11.2 illustrates the effect of these items on the SCF.

Decreases in current assets are added back as an adjustment to net income because, for example, a decrease in accounts receivable indicates that cash was collected from credit customers (debit cash and credit accounts receivable) yet it is not part of accrual net income, so the cash collected must be added. An increase in accounts receivable indicates that sales on account were recorded (debit accounts receivable and credit sales) so it is part of accrual net income. However, since no cash was collected, this must be subtracted from accrual net income to adjust it to a cash basis.

Increases in current liabilities are added back as an adjustment to net income because, for example, an increase in accounts payable indicates that a purchase/expense was made on account (debit expense and credit accounts payable) so it was subtracted in calculating accrual net income. However, since no cash was paid, this must be added back to accrual net income to adjust it to a cash basis. A decrease in accounts payable indicates that a payment was made to a creditor (debit accounts payable and credit cash) yet it is not part of accrual net income so the cash paid must be subtracted.

Depreciation expense is subtracted in calculating accrual net income. However, an analysis of the journal entry shows that no cash was involved (debit depreciation expense and credit accumulated depreciation), so it must be added back to adjust the accrual net income to a cash basis.

A loss on the disposal of a non-current asset is added back as an adjustment to net income because, in analyzing the journal entry when losses occur (e.g., debit cash, debit loss, credit land), the loss represents the difference between the cash proceeds and the book value of the non-current asset. Since a loss is subtracted on the income statement and does not represent a cash outflow, it is added back to adjust the accrual net income to a cash basis. The same logic applies for a gain on the disposal of a non-current asset.

Classifying Cash Flows—Investing Activities

Cash flows from investing activities involve increases and decreases in long-term asset accounts. These include outlays for the acquisition of property, plant, and equipment, as well as proceeds from their disposal. Figure 11.3 illustrates the effect of these items on the SCF.

Classifying Cash Flows—Financing Activities

Cash flows from financing activities result when the composition of the debt and equity capital structure of the entity changes. This category is generally limited to increases and decreases in long-term liability accounts and share capital accounts such as common and preferred shares. These include cash flows from the issue and repayment of debt, and the issue and repurchase of share capital. Dividend payments are generally considered to be financing activities, since these represent a return to shareholders on the original capital they invested. Figure 11.4 illustrates the effect of these items on the SCF.

Classifying Cash Flows—Noncash Investing and Noncash Financing Activities

There are some transactions that involve the direct exchange of non-current balance sheet items so that cash is not affected. For example, noncash investing and noncash financing activities would include the purchase of a non-current asset by issuing debt or share capital, the declaration and issuance of a share dividend, retirement of debt by issuing shares, or the exchange of noncash assets for other noncash assets. Although noncash investing and noncash financing activities do not appear on the SCF, the full disclosure principle requires that they be disclosed either in a note to the financial statements or in a schedule on the SCF.

Now, let us demonstrate the preparation of a SCF using the balance sheet, income statement, and statement of changes in equity of Example Corporation shown below.

The SCF can be prepared from an analysis of transactions recorded in the Cash account. Accountants summarize and classify these cash flows on the SCF for the three major activities noted earlier, namely operating, investing, and financing. To aid our analysis, the following list of additional information from the records of Example Corporation will be used.

1. A building was purchased for $720 cash.
2. Machinery was purchased for $350 cash.
3. Machinery costing $140 with accumulated depreciation of $100 was sold for $30 cash.
4. Total depreciation expense of $260 was recorded during the year; $150 on the building and $110 on the machinery.
5. Example Corporation received $500 cash from issuing a long-term loan with the bank.
6. Shares were issued for $410 cash.
7. $58 of dividends were declared during the year.

Analysis of Cash Flows

There are different ways to analyze cash flows and then prepare the SCF; only one of those techniques will be illustrated here using the following steps.

1. Set up a cash flow table.
2. Calculate the changes in each balance sheet account.
3. Calculate and analyze the changes in retained earnings and dividends payable (if there is a Dividends Payable account).
4. Calculate and analyze the changes in the noncash current assets and current liabilities (excluding Dividends Payable account).
5. Calculate and analyze changes in non-current asset accounts
6. Calculate and analyze changes in Long-term Liability and Share Capital accounts.
7. Reconcile the analysis.
8. Prepare a statement of cash flows.

Step 1: Set up a cash flow table

Set up a table as shown below with a row for each account shown on the balance sheet. Enter amounts for each account for 2015 and 2016. Show credit balances in parentheses. Total both columns and ensure they equal zero. The table should appear as follows after this step has been completed:

Step 2: Calculate the change in cash

Add two columns to the cash flow table. Calculate the net debit or net credit change in cash and insert this change in the appropriate column. This step is shown below:

Step 3: Calculate and analyze the changes in retained earnings and dividends payable (if there is a Dividends Payable account)

When we calculate the changes for each of retained earnings and dividends payable, the net difference may not always reflect the causes for change in these accounts. For example, the net difference between the beginning and ending balances in retained earnings is an increase of $22 thousand. However, two things occurred to cause this net change: a net income of $80 thousand (a debit to income summary and a credit to retained earnings) and dividends of $58 thousand that were declared during the year per the additional information (a debit to retained earnings of $58k and a credit to dividends payable of $58k). The net income of $80 thousand is the starting position in the operating activities section of the SCF (see Figure 11.5).

The change in the dividends payable balance was also caused by two transactions — the dividend declaration of $58 thousand (a debit to retained earnings and a credit to dividends payable) and a $63 thousand payment of dividends (a debit to dividends payable and a credit to cash). The $63 thousand cash payment is subtracted in the financing activities section of the SCF (see Figure 11.5). Dividends payable can change because of two transactions, as in this example, or because of one transaction, which could be either a dividend declaration with no payment of cash, or a payment of the dividend payable and no dividend declaration. Step 3 as it applies to Example Corporation is detailed below:

Step 4: Calculate and analyze the changes in the noncash current assets and current liabilities (excluding Dividends Payable account)

Calculate the net debit or net credit changes for each current asset and current liability account on the balance sheet and insert these changes in the appropriate column. Step 4 as it applies to Example Corporation is detailed below. The $75 thousand decrease in accounts receivable is added in the operating activities section of the SCF, the $450 thousand increase in merchandise inventory is subtracted, the $10 thousand increase in prepaid expenses is subtracted, the $90 thousand increase in accounts payable is added, and the $15 thousand increase in income taxes payable is added (see Figure 11.5):

Step 5: Calculate and analyze changes in non-current asset accounts

Changes in non-current assets are classified as investing activities. There was no change in the Land account. We know from the additional information provided that buildings and machinery were purchased and that machinery was sold.

Buildings were purchased for $720 thousand (a debit to buildings and a credit to cash). The cash payment of $720 thousand is shown in the investing activities section (see Figure 11.5).

Accumulated depreciation–buildings is a non-current asset account and it increased by $150 thousand. This change was caused by a debit to depreciation expense and a credit to accumulated depreciation–building. We know from an earlier discussion that depreciation expense is an adjustment in the operating activities section of the SCF therefore the $150 thousand is added in the operating activities section (see Figure 11.5).

Two transactions caused machinery to change. First, the purchase of $350 thousand of machinery (debit machinery and credit cash); the $350 thousand cash payment is shown in the investing activities section (see Figure 11.5). Second, machinery costing $140 thousand with accumulated depreciation of $100 thousand was sold for cash of $30 thousand resulting in a loss of $10 thousand. The cash proceeds of $30 thousand is shown in the investing activities section of the SCF and the $10 thousand loss is added in the operating activities section (see Figure 11.5).

Accumulated depreciation–machinery not only decreased $100 thousand because of the sale of machinery but it increased by $110 thousand because of depreciation (debit depreciation expense and credit accumulated depreciation–machinery). The $110 thousand of depreciation expense is added in the operating activities section of the SCF (see Figure 11.5):

Step 6: Calculate and analyze changes in Long-term Liability and Share Capital accounts

Changes in Long-term Liability and Share Capital accounts result from financing activities. We know from the additional information provided earlier that Example Corporation received cash of $500k from a bank loan (debit cash and credit long-term loan payable) and issued shares for $410k cash (debit cash and credit share capital). The $500 thousand cash proceeds from the bank loan and $410 thousand cash proceeds from the issuance of shares are listed in the financing section of the SCF (see Figure 11.5):

Step 7: Reconcile the analysis

The analysis is now complete. Add the debit and credit changes, excluding the change in cash. The total debits of $1,693 less the total credits of $1,570 equal a difference of $123 which reconciles to the decrease in cash calculated in Step 2:

The information in the completed analysis can be used to prepare the statement of cash flows shown in Figure 11.5.

11.3 Interpreting the Statement of Cash Flows

Readers of financial statements need to know how cash has been used by the enterprise. The SCF provides external decision makers such as creditors and investors with this information. The statement of cash flows provides information about an enterprise’s financial management policies and practices. It also may aid in predicting future cash flows, which is an important piece of information for investors and creditors.

The quality of earnings as reported on the income statement can also be assessed with the information provided by the SCF. The measurement of net income depends on a number of accruals and allocations that may not provide clear information about the cash-generating power of a company. Users will be more confident in a company with a high correlation between cash provided by operations and net income measured under the accrual basis. Recall, for instance, that although Example Corporation has net income of $80,000 during 2016, its net cash inflow from operations is only $70,000, chiefly due to the large increase in inventory levels. Although net cash flow from operations is still positive, this discrepancy between net income and cash flow from operations may indicate looming cash flow problems, particularly if the trend continues over time.

Example Corporation’s SCF also reveals that significant net additions to plant and equipment assets occurred during the year ($1,070,000), financed in part by cash flow from operating activities but primarily by financing activities. These activities included the assumption of loans and issue of shares that amounted to $847,000, net of dividend payments ($500,000 from issuing a long-term loan plus $410,000 from issuing shares less $63,000 for payment of dividends).

It appears that a significant plant and equipment asset acquisition program may be underway, which may affect future financial performance positively. This expansion has been financed mainly by increases in long-term debt and the issuance of common shares. However, the magnitude of the plant and equipment asset purchases, coupled with the payment of the dividends to shareholders, has more than offset cash inflows from operating and financing activities, resulting in a net overall decrease in cash of $123,000. Though the current cash expenditure on long-term productive assets may be a prudent business decision, it has resulted in (hopefully temporary) adverse effects on overall cash flow.

The SCF is not a substitute for an income statement prepared on the accrual basis. Both statements should be used to evaluate a company’s financial performance. Together, the SCF and income statement provide a better basis for determining the enterprise’s ability to generate funds from operations and thereby meet current obligations when they fall due (liquidity), pay dividends, meet recurring operating costs, survive adverse economic conditions, or expand operations with internally-generated cash.

The SCF highlights the amount of cash available to a corporation, which is important. Excess cash on hand is unproductive. Conversely, inadequate cash decreases liquidity. Cash is the most liquid asset, and its efficient use is one of the most important tasks of management. Cash flow information, interpreted in conjunction with other financial statement analyses, is useful in assessing the effectiveness of the enterprise’s cash management policies.

Readers who wish to evaluate the financial position and results of an enterprise’s operations also require information on cash flows produced by investing and financing activities. The SCF is the only statement that explicitly provides this information. By examining the relationship among the various sources and uses of cash during the year, readers can also focus on the effectiveness of management’s investing and financing decisions and how these may affect future financial performance.

11.4 Appendix A: Putting It All Together: Corporate Financial Statements

The core financial statements connect to complete an overall picture of the company’s operations and its current financial state. It is important to understand how these reports connect; therefore, a review of some simplified financial statements for Wellbourn Services Ltd. is presented below:

As can be seen from the flow of the numbers above, the net income from the statement of income is closed to retained earnings.

The statement of changes in equity total column flows to the equity section of the balance sheet. Finally, the statement of cash flows (SCF) ending cash balance must be equal to the cash ending balance reported in the balance sheet, which completes the loop of interconnecting accounts and amounts.

Statement of Income with Discontinued Operations

Single-step and Multiple-step Statement of Income

Companies can choose whichever format best suits their reporting needs. Smaller companies tend to use the simpler single-step format, while larger companies tend to use the multiple-step format.

The Wellbourn Services Ltd. statement of income, shown earlier, is an example of a typical single-step income statement. For this type of statement, revenue and expenses are each reported in the two sections for continuing operations. Discontinued operations are separately reported below the continuing operations. The separate disclosure and format for the discontinued operations section is a reporting requirement and is discussed and illustrated below. The single-step format makes the statement simple to complete and keeps sensitive information out of the hands of competitive companies, but provides little in the way of analytical detail.

The multiple-step income statement format provides much more detail. Below is an example of a multiple-step statement of income for Toulon Ltd. for the year ended December 31, 2015:

The multiple-step format with its section subtotals makes performance analysis and ratio calculations such as gross profit margins easier to complete and makes it easier to assess the company’s future earnings potential. The multiple-step format also enables investors and creditors to evaluate company performance results from continuing and ongoing operations having a high predictive value separately, compared to non-operating or unusual items having little predictive value.

Operating Expenses

As discussed in an earlier chapter, expenses from operations can be reported by their nature and, optionally, by function. Expenses by nature relate to the type of expense or the source of expense such as salaries, insurance, advertising, travel and entertainment, supplies expense, depreciation and amortization, and utilities expense, to name a few. The statement for Toulon Ltd. is an example of reporting expenses by nature.

Expenses by function relate to how various expenses are incurred within the various departments and activities of a company such as selling and administrative expenses.

The sum of all the revenues, expenses, gains, and losses to this point represents the income or loss from continuing operations. This is a key component used in performance analysis.

Income Tax Allocations

This is the process of allocating income tax expense to various categories within the statement of income such as income from continuing operations before taxes and discontinued operations. The purpose of these allocations is to make the information within the statements more informative and complete. For example, Toulon’s statement of income for the year ending December 31, 2015, allocates tax at a rate of 30% to the following:

• Income from continuing operations of $850,000 ()
• Loss from disposal of discontinued operations of $63,000

Discontinued operations

Sometimes companies will sell or shut down certain business operations because the operating segment is no longer profitable, or they may wish to focus their resources on other business operations. Examples are a major business line or geographical area. If the discontinued operation has not yet been sold, then there must be a formal plan in place to dispose of the component within one year and to report it as a discontinued operation.

The items reported in this section of the statement of income are to be reported net of tax, with the tax amount disclosed.

Earnings per Share

Basic earnings per share represent the amount of income attributable to each outstanding common share, as shown in the calculation below:

The earnings per share amounts are not required for private companies. This is because ownership of privately owned companies is often held by only a few investors, compared to publicly-traded companies where shares are held by many investors.

Basic earnings per share are to be reported on the face of the statement of income as follows:

• Basic EPS from continuing operations
• Basic EPS from discontinued operations, if any

If the outstanding common shares for Toulon was 121,500, the EPS from continuing operations would be $16.32 () and $(1.21) from discontinued operations (), as reported in their statement above. There is also a requirement to report diluted EPS but this is beyond the scope of this course.

11.5 Appendix B: Statement of Cash Flows – Direct Method

The Importance of Cash Flow – For Better, For Worse, For Richer, For Poorer…

A business is a lot like a marriage. It takes work to make it succeed. One of the keys to business success is managing and maintaining adequate cash flows. In the field of financial management, there is an old saying that revenue is vanity, profits are sanity, but cash is king. In other words, a firm’s revenues and profits may look spectacular, but this does not guarantee there will be cash in the bank. Without cash, a business cannot pay its bills and it will ultimately not survive.

Let’s take a look at the distinctions between revenue and profits, and cash, using a numeric example for a new business:

* Sales of $400,000 were paid in cash
** Purchases of $300,000 were paid in cash
*** Operating expenses of $90,000 were cash paid

Revenue is reported in the income statement as $1 million which is a sizeable amount, but only $400,000 was cash paid by customers. (The rest is reported as accounts receivable.) Gross profit is reported in the income statement as $500,000. This is also a respectable number, but only $100,000 translates into a positive cash flow, because only some of the inventory purchases were paid in cash. (The rest of the inventory is reported as accounts payable.) The company must still pay some of its operating expenses, leaving only $10,000 cash in the bank.

When investors and creditors review the income statement, they will see $1 million in revenue with gross profits of one-half million or 50%, and a respectable net income of $300,000 or 30% of revenue. They could conclude that this looks pretty good for the first year of operations and incorrectly assume that the company now has $300,000 available to spend.

However, lurking deeper in the financial statements is the cash position of the company–the amount of cash left over from this operating cycle. Sadly, there is only $10,000 cash in the bank, so the company cannot even pay its remaining accounts payable in the short term. So, how can management keep track of its cash?

The statement of cash flows is the definitive financial statement to bridge the gaps between revenues and profits, and cash. Therefore, it is vital to understand the statement of cash flows.

As cash is generally viewed by many as the most critical asset to success, this appendix will focus on how to correctly prepare and interpret the statement of cash flows using the direct method.

For example, below is the statement of cash flows using the direct method for the year ended December 31, 2015 for Wellbourn Services Ltd. at December 31, 2015:

Note how Wellbourn’s ending cash balance of $135,500, from the statement of cash flows for the year ended December 31, matches the ending cash balance in the balance sheet on that date. This is a critical relationship between these two financial statements. The balance sheet provides information about a company’s resources (assets) at a specific point in time, and whether these resources are financed mainly by debt (current and long-term liabilities) or equity (shareholders’ equity). The statement of cash flows identifies how the company utilized its cash inflows and outflows over the reporting period and, ultimately, ends with its current cash and cash equivalents balance at the balance sheet date. As well, since the statement of cash flows is prepared on a cash basis, it excludes non-cash accruals like depreciation and interest, making the statement of cash flows harder to manipulate than the other financial statements.

Two methods are used to prepare a statement of cash flows, namely the indirect method and the direct method. The indirect method was discussed earlier in this chapter. Both methods organize the reported cash flows into three activities: operating, investing, and financing. The only difference when applying the direct method is in the operating activities section; the investing and financing sections are prepared exactly the same way for both methods.

For the direct method categories are based on the nature of the cash flows. With the indirect method the cash flows are based on the income statement and changes in each current asset and liability account, except cash. Below is a comparison of the two methods:

The direct method is straightforward due to the grouping of information by nature. This also makes interpretation of the statement easier for stakeholders. However, companies record thousands of transactions every year and many of them do not involve cash. Since the accounting records are kept on an accrual basis, it can be a time-consuming and expensive task to separate and collect the cash-only data required for the direct method categories by nature. Also, reporting on sensitive information, such as cash receipts from customers and cash payments to suppliers, may not be in the best interest of the company in light of competitor companies using the information to their advantage. For these reasons, many companies prefer not to use the direct method, even though IFRS standards prefer its use over the indirect method. Also, the indirect method may be easier to prepare because it collects much of its data directly from the existing income statement and balance sheet. However, it is more difficult to understand because it uses the accounts-based categories as shown above.

11.5.1. Preparing a Statement of Cash Flows: Direct Method

As with the indirect method, preparing a statement of cash flows using the direct method is made much easier if specific steps are followed in sequence. Below is a summary of those steps to complete the operating section of the statement of cash flows using the direct method for Watson Ltd:

Direct Method Steps:

Step 1: Record headings, categories, and three additional columns into an Operating Activities worksheet as shown below:

Step 2: Record each income statement amount into the corresponding direct method category of the Operating Activities worksheet shown below (recall that non-cash items such as depreciation and gains or losses are excluded from a statement of cash flows so they are will be recorded as memo items only):

Step 3: Calculate the net change amount for each current asset (except cash), and each current liability from the balance sheet below. Record each change amount in the second column of the Operating Activities worksheet:

Note how items 13 and 17 on the operating activities statement cancel each other out. This is because the interest income was accrued and not actually received in cash. Also note that the current portion of long-term notes was excluded from the operating activities section. Recall from the earlier chapter material on the indirect method that this account is combined with its corresponding long-term note payable account in the financing section of the statement of cash flows.

Step 4: Calculate the net cash flow total for each category and the net cashflow total for the operating activities section. Transfer the amounts to the statement of cash flows, operating activities section:

The completed portion of the statement of cash flows, operating section is shown below: