Ch12 ACCT1101 S1 2223 MOODLE

ACCT1101
Dr. Olivia Leung chapter 12 Statement of Cash Flows
ACCT1101
Dr. Olivia Leung
Financial Accounting
10e
Libby • Libby • Hodge
Learning Objectives After studying this chapter,
you should be able to:
12-1 Classify cash flow statement items as part of net cash flows from operating,
investing, and financing activities. (E12-5)
12-2 Report and interpret cash flows from operating activities using the indirect
method.
Chapter Supplement B: Adjustment for Gains/Losses on Sale of L-T Assets
(indirect method) (pg 654-655 in textbook)
12-4 Analyze and interpret cash flows from investing activities.
12-6 Report and interpret cash flows from financing activities.
12-7 Understand the format of the cash flow statement and additional cash flow
disclosures.
LECTURE EXERCISES: E12-8, AP12-5, E12-13; E12-14
12-3 Quality of income Ratios

12-5 Capital acquisitions ratio, Free cash flow
Cash coverage ratio (pg708 in textbook)
Copyright ©2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-2
Learning Objective 12-1
12-1 Classify cash flow statement items as part of net cash flows from
operating, investing, and financing activities.
Copyright ©2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
12-3
Understanding the Business
Positive cash flows permit a company to . . .
Pay
dividends to Expand its
owners. operations.
Take
advantage of Replace
investment worn assets.
opportunities.
Some Wall Street analysts consider it important to

understand the various sources and uses of cash that are
associated with business activity.
12-4
What is cash? (Refer to Ch 6)
The definition of cash includes cash and cash

equivalents.
Cash equivalents are short-term, highly liquid

investments that are both
§ Readily convertible into known amounts
of cash and
§ So near to maturity there is little risk that
their value will change if interest rates
change.
Generally, only investments with original
maturities of three months or less qualify as
cash equivalents
12-5
Classifications of the Statement of Cash Flows
Cash inflows and outflows directly related

Operating Activities
to earnings from normal operations.
Cash inflows and outflows related to the

acquisition or sale of productive facilities
Investing Activities and investments in the securities of other
companies.
Cash inflows and outflows related to

Financing Activities external sources of financing (owners and
creditors) for the enterprise.
12-6
Exhibit 12.1
Consolidated
Statement of
Cash Flows
The ending cash

balance should
agree with the
balance sheet.
© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
12-7
Cash Flows from Operating Activities
Inflows
Cash received from:
l Customers
l Dividends and interest on
investments + Inflows
Cash Flows
from Operating
Outflows
Activities
Cash paid for:
l Purchase of services
(electricity, etc.) and
goods for resale
_ Outflows
l Salaries and wages
l Income taxes
l Interest on liabilities
12-8
Cash Flows from Investing Activities
Inflows
Cash received from:
l Sale or disposal of property,
plant, and equipment
l Sale or maturity of investments
in securities + Inflows
Cash Flows from
Investing
Outflows Activities
Cash paid for:
l Purchase of property, plant, and
equipment
_ Outflows
l Purchase of investments in
securities
12-9
Cash Flows from Financing Activities
Inflows
Cash received from:
l Borrowings on notes, mortgages,
bonds, etc., from creditors
l Issuing stock to owners
+ Inflows
Cash Flows from
Financing
Activities
Outflows
Cash paid for:
l Repayment of principal to creditors
(excluding interest, which is an
_ Outflows
operating activity)
l Repurchasing stock from owners
l Dividends to owners
12-10
Net Increase (Decrease) in Cash
The combination of the net cash flows from operating, investing, and
financing activities must equal the net increase or decrease in cash.
12-11
Exhibit 12.2
Selected Cash Transactions and Their Effects on Other Balance Sheet Accounts
EXERCISE 12-5
12-2 Report and interpret cash flows from operating activities using
the indirect method.
Chapter Supplement B: (TEXTBOOK Pg 642-643)
Adjustment for Gains and Losses on Sale of Long-Term Assets
—Indirect Method
12-4 Analyze and interpret cash flows from investing activities.

12-7 Understand the format of the cash flow statement

and additional cash flow disclosures.
12-14
Exhibit 12.1
Consolidated
Statement of
Cash Flows
The ending cash

balance should
agree with the
balance sheet.
12-15
Direct Method vs. Indirect Method (1 of 2)
Two Formats for Reporting Cash Flow from Operating Activities
99
%
com of l
p arg
Direct Method Indirect Method a
use nie e
ind the s
me irect
tho
d
Reports the cash effects of Starts with accrual net
each operating activity income and converts to
cash flow from operating
activities
The cash flows from operating activities are always the same,
regardless of whether the direct or indirect method is used.
12-16
Relationships to the Balance Sheet and Income Statement
Information needed to prepare a statement of cash flows:
l Comparative balance sheets

l A complete income statement
l Additional details concerning selected accounts
12-17
Exhibit 12.3 Comparative Balance Sheet
12-18
Exhibit 12.3 Current Income Statement
Under the indirect method, the statement of cash flows

begins with net income from the income statement.
12-19
Reporting and Interpreting Cash Flows from Operating
Activities
The indirect method adjusts net income by

eliminating noncash items.
STEP 2
+ Losses and – Gains
Cash Flows
Net from
Income Operating
STEP 1 STEP 3 Activities
+ Noncash +/− Changes in
expenses such as current assets and
depreciation and current liabilities.
amortization.
12-20
Exhibit 12.4 (1 of 3)
Schedule for Net Cash Flow from Operating Activities, Indirect Method
12-21
Step 1
Adjust net income for depreciation and amortization
expense and gains and losses on sale of investing assets.
12-22
STEP 2: Adjustment for Gains and Losses
Cash received from the sale or disposal of long-term assets is classified as

investing cash inflow. Gains/losses on the income statement, if any, are
subtracted from/added to net income in order to compute cash flow from
operating activities.
Gains must be subtracted from net

Gains income to avoid double counting the gain.
Losses must be added to net income to

Losses
avoid double counting the loss.
12-23
Chapter Supplement B: Adjustment for Gains and Losses on
Sale of Long-Term Assets—Indirect Method
The Operating Activities section of the cash flow statement prepared using
the indirect method may include an adjustment for gains and losses on the
sale of long-term assets reported on the income statement.
If property, plant, and equipment with an original cost of $10,000 and

accumulated depreciation of $4,000 is sold for $8,000 cash, the following
entry is made.
12-24
Step 3
Adjust net income for
changes in
current assets and current
liabilities.
12-25
Summary
We can summarize the typical additions and subtractions that are
required to reconcile net income with cash flow from operating
activities as follows:
12-26
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.
12-27
Interpreting Cash Flows from Operating Activities
A common rule of thumb followed by financial and credit analysts is to

avoid firms with rising net income but falling cash flow from operations.
In the long run, operations are the only source of cash!
Investors will not invest in a company if they do not believe that cash
generated from operations will be available to pay them dividends or
expand the company.
Creditors will not lend money if they do not believe that cash
generated from operations will be available to pay back the loan.
12-28
12-4 Report and interpret cash flows from investing activities.
12-29
Reporting and Interpreting Cash Flows from Investing
Activities
Preparing this section of the cash flow statement requires an analysis of
the accounts related to property, plant, and equipment; intangible
assets; and investments in the securities of other companies.
Remember that:
• Only purchases paid for with cash or cash equivalents are included.
• The amount of cash that is received from the sale of assets is included,
regardless of whether the assets are sold at a gain or loss.
12-30
Exhibit 12.5 Schedule for Net Cash Flow from Investing Activities
We must report
individually the Although short-term investments is a current asset,
cash used to it is reported in the investing section on the
purchase statement of cash flows. The company purchased
equipment and short-term investments for $1,252. They company
the cash proceeds also sold short-term investments for $3,685.
received from the
sale of equipment.
12-31
related to creditor & shareholders on B/S under equity
any interest on the borrowing is OA!!!! --- repayment of loan principal
12-32
Reporting Cash Flows from Financing Activities
Remember that:
• Cash repayments of principal are cash flows from financing activities.
• Interest payments are cash flows from operating activities.
• Dividend payments are cash flows from financing activities.
• If debt or stock is issued for other than cash, it is not included in this section.
12-33
Exhibit 12.6
Retained Earnings Analysis

Cash received from Cash received from
issuance of long- issuing common Beginning balance $ 312,425
term debt. stock. Add net income 140,853
Less dividends (141,391)
Ending balance $ 311,887
12-34
Interpreting Cash Flows from Financing Activities
The long-term growth of a company is normally financed from

three sources:
1. Internally generated funds (cash from operating activities)
2. The issuance of stock
3. 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.
12-35
12-7 Understand the format of the cash flow statement and additional
cash flow disclosures.
12-36
Completing the Statement and Additional Disclosures
Supplemental Cash Flow Information
Two additional required cash flow disclosures are normally

listed at the bottom of the statement or in the notes.
1. Noncash investing and financing activities, such as the
purchase of a building with a mortgage given by the
former owner.
2. Cash paid for interest and cash paid for income taxes
(for companies that use the indirect method)
LECTURE EXERCISES
E12-8, AP12-5,
E12-13, E12-14
12-39
FORMAT & RULES:
12-40
12-41
Exhibit 12.1
Consolidated
Statement of
Cash Flows
The ending cash

balance should
agree with the
balance sheet.
12-42
E12-8
12-43
12-44
12-45
12-46
AP12-5 AP12-5
12-47
12-48
12-49
12-50
12-51
E12-13
12-52
12-53
12-54
E12-14
12-55
12-56
12-57
12-58
OPERATING ACTIVITIES :
In-depth Explanations about

the CFS Adjustments
resulting from Changes in A/R,
Prepaid, Accrued Expenses,
Inventory, and A/P
12-59
Exhibit 12.3 Comparative Balance Sheet
12-60
Exhibit 12.3 Current Income Statement
Under the indirect method, the statement of cash flows

begins with net income from the income statement.
12-61
Step 3
Adjust net income for
changes in
current assets and current
liabilities.
12-62
12-63
Summary
Change in Account Balance During Year

Increase Decrease
Noncash
Current Subtract from profit Add to profit
Assets
Current Add to profit Subtract from profit
Liabilities
12-64
Change in Accounts Receivable
• Sales on account increase the balance in accounts receivable, and

collections from customers decrease the balance.
• The balance sheet indicates an increase in accounts receivable of
$481 for the period, which means that cash collected from customers
is lower than revenue.
• To convert to cash flows from operating activities, the amount of the
increase (the amount of sales over and above collections) must be
subtracted from net income. (A decrease is added.)
12-65
Change in Prepaid Expenses
• The balance sheet indicates a $5,676 decrease in prepaid expenses,

which means that new cash prepayments are less than the amount
of expenses.
• The decrease (the extra prepayments) must be added to net
income. (An increase is subtracted.)
12-66
Change in Inventory
• The balance sheet indicates that inventory increased by $9,782,

which means that the amount of purchases is more than the amount
of merchandise sold.
• The increase (the extra goods purchased) must be subtracted from
net income to convert to cash flow from operating activities. (A
decrease is added.)
12-67
Change in Accounts Payable
• The balance sheet indicates accounts payable decreased by

$8,651, which means that cash payments were more than
purchases on account.
• This decrease (the extra purchases on account) must be
subtracted from net income. (An increase is added.)
12-68
Change in Accrued Expenses
• The balance sheet indicates accrued expenses increased by

$1,018, which indicates that cash paid for the expenses is less
than accrual basis expenses.
• The increase (the lower cash paid) must be added to net
income. (A decrease is subtracted.)
12-69
Learning Objective 12-3, 12-5
12-3 Quality of income ratio.
12-5 Capital acquisitions ratio, Free cash flow,

Cash coverage ratio (pg 694 in textbook)
12-70
12-71
Quality of Income Ratio
This ratio measures the portion of income that was generated in

cash. All other things equal, a higher quality of income ratio
indicates greater ability to finance operating and other cash
needs from operating cash inflows.
= $142,077 / $140,853
= 1.09
12-72
Capital Acquisitions Ratio
This ratio reflects the portion of purchases of property, plant, and

equipment financed from operating activities. A high ratio indicates
less need for outside financing for current and future expansions.
A high ratio benefits the company because:

• it provides the company opportunities for strategic acquisitions
• it avoids the cost of additional debt
• it reduces the risk of bankruptcy that comes with additional leverage
12-73
Free Cash Flow
Managers and analysts often calculate free cash flow as a measure of

a firm’s ability to pursue long-term investment opportunities.
• Any positive free cash flow is available for additional capital

expenditures, investments in other companies, and mergers and
acquisitions without the need for external financing or reductions
in dividends to shareholders.
• Sometimes managers use free cash flow to pursue unprofitable
investments just for the sake of growth or to obtain perquisites.
12-74
Cash Coverage Ratio
This ratio compares the cash from operations to the cash needed to
make required interest payments.
The Home Depot’s cash coverage ratio shows that the

company generated $15.18 in cash for every $1.00 of interest
paid, which is strong coverage.
© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 12-75
Exhibit 13.1 The Home Depot Financial Statements (1 of 2)
(2 of 3)
Exhibit 13.1 The Home Depot Financial Statements (2 of 2)
(3 of 3)
Exhibit 13.2
Component Percentages for The Home Depot

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ACCT1101

Dr. Olivia Leung chapter 12 Statement of Cash Flows

LECTURE EXERCISES: E12-8, AP12-5, E12-13; E12-14

12-3 Quality of income Ratios

Positive cash flows permit a company to . . .

Some Wall Street analysts consider it important to

The definition of cash includes cash and cash

Cash equivalents are short-term, highly liquid

Cash inflows and outflows directly related

Cash inflows and outflows related to the

Cash inflows and outflows related to

The ending cash

12-4 Analyze and interpret cash flows from investing activities.

12-7 Understand the format of the cash flow statement

The ending cash

Two Formats for Reporting Cash Flow from Operating Activities

Information needed to prepare a statement of cash flows:

l Comparative balance sheets

l Additional details concerning selected accounts

Under the indirect method, the statement of cash flows

The indirect method adjusts net income by

Cash received from the sale or disposal of long-term assets is classified as

Gains must be subtracted from net

Losses must be added to net income to

If property, plant, and equipment with an original cost of $10,000 and

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

A common rule of thumb followed by financial and credit analysts is to

In the long run, operations are the only source of cash!

related to creditor & shareholders on B/S under equity

any interest on the borrowing is OA!!!! --- repayment of loan principal

Retained Earnings Analysis

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

The statement of cash flows shows how management has

Two additional required cash flow disclosures are normally

The ending cash

In-depth Explanations about

Under the indirect method, the statement of cash flows

Change in Account Balance During Year

• Sales on account increase the balance in accounts receivable, and

• The balance sheet indicates a $5,676 decrease in prepaid expenses,

• The balance sheet indicates that inventory increased by $9,782,

• The balance sheet indicates accounts payable decreased by

• The balance sheet indicates accrued expenses increased by

12-5 Capital acquisitions ratio, Free cash flow,

This ratio measures the portion of income that was generated in

This ratio reflects the portion of purchases of property, plant, and

A high ratio benefits the company because:

Managers and analysts often calculate free cash flow as a measure of

• Any positive free cash flow is available for additional capital

The Home Depot’s cash coverage ratio shows that the

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