Prerequisite Reading 17:

Cash Flow Statements

CASH FLOW STATEMENTS
This reading introduces the third important required financial statement: the statement of cash flows.
Since the income statement is based on the accrual method, net income may not represent cash
generated from operations. A company may be generating positive and growing net income but may
be headed for insolvency because insufficient cash is being generated from operating activities.
Constructing a statement of cash flows, by either the direct or indirect method, is therefore very
important in an analysis of a firm’s activities and prospects. This is a notoriously tricky area for
candidates, and so this prerequisite is crucial. The main readings, Analyzing Statements of Cash
Flow I and II, build on the information covered below with little recap, so take your time to really
ensure you have understood this prerequisite. LOS 17.d itself is repeated in the first of the main
readings, however the content is more detailed there so must be studied in both places.

MODULE 17.1: CASH FLOW INTRODUCTION

The cash flow statement provides information beyond that available from the income statement,
which is based on accrual, rather than cash, accounting. The cash flow statement provides the
following:

 Information about a company’s cash receipts and cash payments during an accounting
period.

 Information about a company’s operating, investing, and financing activities.

 An understanding of the impact of accrual accounting events on cash flows.

The cash flow statement provides information to assess the firm’s liquidity, solvency, and financial
flexibility. An analyst can use the statement of cash flows to determine whether:

 Regular operations generate enough cash to sustain the business.

 Enough cash is generated to pay off existing debts as they mature.

 The firm is likely to need additional financing.

 Unexpected obligations can be met.

 The firm can take advantage of new business opportunities as they arise.

LOS 17.a: Compare cash flows from operating, investing, and financing activities and classify
cash flow items as relating to one of those three categories given a description of the items.
Items on the cash flow statement come from two sources: (1) income statement items and (2)
changes in balance sheet accounts. A firm’s cash receipts and payments are classified on the cash
flow statement as either operating, investing, or financing activities.

Cash flow from operating activities (CFO), sometimes referred to as “cash flow from operations”
or “operating cash flow,” consists of the inflows and outflows of cash resulting from transactions
that affect a firm’s net income.

Cash flow from investing activities (CFI) consists of the inflows and outflows of cash resulting
from the acquisition or disposal of long-term assets and certain investments.

Cash flow from financing activities (CFF) consists of the inflows and outflows of cash resulting
from transactions affecting a firm’s capital structure.

Examples of each cash flow classification, in accordance with U.S. GAAP, are presented in Figure
17.1.

Note that the acquisition of debt and equity investments (other than trading securities) and loans
made to others are reported as investing activities; however, the income from these investments
(interest and dividends received) is reported as an operating activity. Also, note that principal
amounts borrowed from others are reported as financing activities; however, the interest paid is
reported as an operating activity. Finally, note that dividends paid to the firm’s shareholders are
financing activities.

PROFESSOR’S NOTE
Don’t confuse dividends received and dividends paid. Under U.S. GAAP, dividends
received are operating cash flows and dividends paid are financing cash flows.
Figure 17.1: U.S. GAAP Cash Flow Classifications

Operating Activities
Inflows Outflows
Cash collected from customers Cash paid to employees and suppliers
Interest and dividends received Cash paid for other expenses
Sale proceeds from trading securities Acquisition of trading securities
Interest paid on debt or leases
Taxes paid
Investing Activities
Inflows Outflows
Sale proceeds from fixed assets Acquisition of fixed assets
Sale proceeds from debt and equity investments Acquisition of debt and equity investments
Principal received from loans made to others Loans made to others
Financing Activities
Inflows Outflows
Principal amounts of debt issued Principal paid on debt or leases
Proceeds from issuing stock Payments to reacquire stock
Dividends paid to shareholders

LOS 17.b: Describe how non-cash investing and financing activities are reported.

Non-cash investing and financing activities are not reported in the cash flow statement since they
do not result in inflows or outflows of cash.

For example, if a firm acquires real estate with financing provided by the seller, the firm has made
an investing and financing decision. This transaction is the equivalent of borrowing the purchase
price. However, since no cash is involved in the transaction, it is not reported as an investing and
financing activity in the cash flow statement.

Another example of a noncash transaction is an exchange of debt for equity. Such an exchange
results in a reduction of debt and an increase in equity. However, since no cash is involved in the
transaction, it is not reported as a financing activity in the cash flow statement.

Noncash transactions must be disclosed in either a footnote or supplemental schedule to the cash
flow statement. Analysts should be aware of the firm’s noncash transactions, incorporate them into
analysis of past and current performance, and include their effects in estimating future cash flows.
LOS 17.d: Contrast cash flow statements prepared under International Financial Reporting
Standards (IFRS) and US generally accepted accounting principles (US GAAP).

Recall from Figure 17.1 that under U.S. GAAP, dividends paid to the firm’s shareholders are
reported as financing activities while interest paid is reported in operating activities. Interest received
and dividends received from investments are also reported as operating activities.

International Financial Reporting Standards (IFRS) allow more flexibility in the classification of
cash flows. Under IFRS, interest and dividends received may be classified as either operating or
investing activities. Dividends paid to the company’s shareholders and interest paid on the
company’s debt may be classified as either operating or financing activities.

LOS 17.c: Compare and contrast the direct and indirect methods of presenting cash from
operating activities and describe arguments in favor of each method.

There are two methods of presenting the cash flow statement: the direct method and the indirect
method. Both methods are permitted under U.S. GAAP and IFRS. The use of the direct method,
however, is encouraged by both standard setters. Regrettably, most firms use the indirect method.
The difference between the two methods relates to the presentation of cash flow from operating
activities. The presentation of cash flows from investing activities and financing activities is exactly
the same under both methods.

PROFESSOR’S NOTE
You will become very familiar with how to calculate and produce cash from
operating activities under these two methods in the main readings. Focus on
understanding the concept of the direct and indirect methods here.

Direct Method
Under the direct method, each line item of the accrual-based income statement is converted into
cash receipts or cash payments. Recall that under the accrual method of accounting, the timing of
revenue and expense recognition may differ from the timing of the related cash flows. Under cash-
basis accounting, revenue and expense recognition occur when cash is received or paid. Simply
stated, the direct method converts an accrual-basis income statement into a cash-basis income
statement.

Figure 17.2 contains an example of a presentation of operating cash flow for Seagraves Supply
Company using the direct method.
Figure 17.2: Direct Method of Presenting Operating Cash Flow

Seagraves Supply Company Operating Cash Flow – Direct Method For the year ended December
31, 20X7
Cash collections from customers $429,980
Cash paid to suppliers (265,866)
Cash paid for operating expenses (124,784)
Cash paid for interest (4,326)
Cash paid for taxes (14,956)
Operating cash flow $20,048

Notice the similarities of the direct method cash flow presentation and an income statement. The
direct method begins with cash inflows from customers and then deducts cash outflows for
purchases, operating expenses, interest, and taxes.

Indirect Method
Under the indirect method, net income is converted to operating cash flow by making adjustments
for transactions that affect net income but are not cash transactions. These adjustments include
eliminating noncash expenses (e.g., depreciation and amortization), nonoperating items (e.g., gains
and losses), and changes in balance sheet accounts resulting from accrual accounting events.

Figure 17.3 contains an example of a presentation of operating cash flow for Seagraves Supply
Company under the indirect method.

Figure 17.3: Indirect Method of Presenting Operating Cash Flow

Seagraves Supply Company Operating Cash Flow – Indirect Method For the year ended December
31, 20X7
Net income $18,788
Adjustments to reconcile net income to cash flow provided by operating
activities:
Depreciation and amortization 7,996
Deferred income taxes 416
Increase in accounts receivable (1,220)
Increase in inventory (20,544)
Decrease in prepaid expenses 494
Increase in accounts payable 13,406
Increase in accrued liabilities 712
Operating cash flow $20,048

Notice that under the indirect method, the starting point is net income, the “bottom line” of the
income statement. Under the direct method, the starting point is the top of the income statement,
revenues, adjusted to show cash received from customers. Total cash flow from operating activities
is exactly the same under both methods, only the presentation methods differ.

Arguments in Favor of Each Method

The primary advantage of the direct method is that it presents the firm’s operating cash receipts and
payments, while the indirect method only presents the net result of these receipts and payments.
Therefore, the direct method provides more information than the indirect method. This knowledge
of past receipts and payments is useful in estimating future operating cash flows.

The main advantage of the indirect method is that it focuses on the difference between net income
and operating cash flow. This provides a useful link to the income statement when forecasting future
operating cash flow. Analysts forecast net income and then derive operating cash flow by adjusting
net income for the differences between accrual accounting and the cash basis of accounting.

Disclosure Requirements
Under U.S. GAAP, a direct method presentation must also disclose the adjustments necessary to
reconcile net income to cash flow from operating activities. This disclosure is the same information
that is presented in an indirect method cash flow statement. This reconciliation is not required under
IFRS.

Under IFRS, payments for interest and taxes must be disclosed separately in the cash flow statement
under either method (direct or indirect). Under U.S. GAAP, payments for interest and taxes can be
reported in the cash flow statement or disclosed in the footnotes.
 MODULE QUIZ 17.1

1. Which of the following items is least likely considered a cash flow from financing
activity under U.S. GAAP?
A. Receipt of cash from the sale of bonds.
B. Payment of cash for dividends.
C. Payment of interest on debt.

2. Which of the following would be least likely to cause a change in investing cash
flow?
A. The sale of a division of the company.
B. The purchase of new machinery.
C. An increase in depreciation expense.

3. Which of the following is least likely a change in cash flow from operations under
U.S. GAAP?
A. A decrease in notes payable.
B. An increase in interest expense.
C. An increase in accounts payable.

4. Sales of inventory would be classified as:

A. operating cash flow.
B. investing cash flow.
C. financing cash flow.

5. Issuing bonds would be classified as:

A. investing cash flow.
B. financing cash flow.
C. no cash flow impact.

6. Sale of land would be classified as:

A. operating cash flow.
B. investing cash flow.
C. financing cash flow.

7. The write-off of obsolete equipment would be classified as:

A. operating cash flow.
B. investing cash flow.
C. no cash flow impact.

8. Under IFRS, interest expense would be classified as:

A. either operating cash flow or financing cash flow.
B. operating cash flow only.
C. financing cash flow only.
9. Under U.S. GAAP, dividends received from investments would be classified as:
A. operating cash flow.
B. investing cash flow.
C. financing cash flow.

10. Torval, Inc., retires debt securities by issuing equity securities. This is considered
a:
A. cash flow from investing.
B. cash flow from financing.
C. noncash transaction.

11. Where are dividends paid to shareholders reported in the cash flow statement
under U.S. GAAP and IFRS?
U.S. GAAP IFRS
A. Operating or financing activities Operating or financing activities
B. Financing activities Operating or financing activities
C. Operating activities Financing activities

12. From an analyst’s perspective, an advantage of the indirect method for presenting
operating cash flow is that the indirect method:
A. shows operating cash received and paid.
B. provides more information than the direct method.
C. shows the difference between net income and operating cash flow.
Key Concepts
LOS 17.a

Cash flow from operating activities (CFO) consists of the inflows and outflows of cash resulting
from transactions that affect a firm’s net income.

Cash flow from investing activities (CFI) consists of the inflows and outflows of cash resulting from
the acquisition or disposal of long-term assets and certain investments.

Cash flow from financing activities (CFF) consists of the inflows and outflows of cash resulting from
transactions affecting a firm’s capital structure, such as issuing or repaying debt and issuing or
repurchasing stock.

LOS 17.b

Noncash investing and financing activities, such as taking on debt to the seller of a purchased asset,
are not reported in the cash flow statement but must be disclosed in the footnotes or a supplemental
schedule.

LOS 17.c

Under the direct method of presenting CFO, each line item of the accrual-based income statement is
adjusted to get cash receipts or cash payments. The main advantage of the direct method is that it
presents clearly the firm’s operating cash receipts and payments.

Under the indirect method of presenting CFO, net income is adjusted for transactions that affect net
income but do not affect operating cash flow, such as depreciation and gains or losses on asset sales,
and for changes in balance sheet items. The main advantage of the indirect method is that it focuses
on the differences between net income and operating cash flow. This provides a useful link to the
income statement when forecasting future operating cash flow.

LOS 17.d

Under U.S. GAAP, dividends paid are financing cash flows. Interest paid, interest received, and
dividends received are operating cash flows.

Under IFRS, dividends paid and interest paid can be reported as either operating or financing cash
flows. Interest received and dividends received can be reported as either operating or investing cash
flows.
Module Quiz Answers
Module Quiz 17.1
1. c The payment of interest on debt is an operating cash flow under U.S. GAAP.

(Module 17.1, LOS 17.a)

2. c Depreciation does not represent a cash flow. To the extent that it affects the firm’s taxes, an
increase in depreciation changes operating cash flows, but not investing cash flows.

(Module 17.1, LOS 17.a)

3. a A change in notes payable is a financing cash flow. (Module 17.1, LOS 17.a)

4. a Sales of inventory would be classified as operating cash flow. (Module 17.1, LOS 17.a)

5. b Issuing bonds would be classified as financing cash flow. (Module 17.1, LOS 17.a)

6. b Sale of land would be classified as investing cash flow. (Module 17.1, LOS 17.a)

7. c Write-off of obsolete equipment has no cash flow impact. (Module 17.1, LOS 17.a)

8. a Under IFRS, interest expense can be classified as either an operating cash flow or financing cash
flow. (Module 17.1, LOS 17.a)

9. a Dividends received from investments would be classified as operating cash flow under U.S.
GAAP. (Module 17.1, LOS 17.a)

10. c The exchange of debt securities for equity securities is a noncash transaction.

(Module 17.1, LOS 17.b)

11. b Under U.S. GAAP, dividends paid are reported as financing activities. Under IFRS, dividends paid
can be reported as either operating or financing activities. (Module 17.1, LOS 17.d)

12. c The indirect method reconciles the difference between net income and CFO. The direct method
shows operating cash received and paid and, therefore, provides more information on its face than
the indirect method. (Module 17.1, LOS 17.c)