Chapter 10

The Statement of Cash Flows

1
 Chapter 10’s Learning Objectives

1. Explain the uses of the statement of cash flows

2. Explain and classify cash flows from operating, investing,
and financing activities
3. Prepare a statement of cash flows using the indirect method
of determining cash flows from operating activities

• .

2
Learning Objective One

Explain the uses of the statement of cash

flows

3
 Definition of Cash

• On the statement of cash flows,, the definition of cash includes:

1. Cash, and
2. Cash equivalents – short term highly liquid investments (e.g.,
treasury bills, money market funds, and etc.)
• Readily convertible to known amounts of cash, and
• Usually matures in 3 months or less (thus generally
unaffected by fluctuations in interest rate).

4
 Why should we care about cash?

Without cash, a company cannot:

• Expand operations
• Replace/acquired needed assets
• Pay salaries and bills
• Repay debt
• Pay dividends to owners
 Without sufficient cash flows, businesses can’t continue to
operate. Therefore, how a company generates/uses cash is
important.
 Company needs both net income and strong cash flow to
succeed.
5
 Uses of the Statement of Cash Flows

• The balance sheet reports the financial position of the company at

a point in time, and comparison of the balance sheets from two
periods show whether cash increased or decreased. But that
doesn’t tell why the cash balance changed.

• The income statement reports the company’s operational

performance and offers clues about cash, but it doesn’t tell how the
operations affected cash because the income statement is
prepared using accrual accounting rules that ignore the timing of
receipt or payment of cash. (Net income ≠ cash flow)

• Hence, we need another financial statement – statement of cash

flows.

6
Canadian Tire Statement of Cash Flows (p.482-483)

Net income ≠ cash generated from operating activities

Net income ≠ Cash generated in the year

7
 Uses of the Statement of Cash Flows

• The statement of cash flows reports details about a company’s cash

receipts and cash disbursements from operating, investing, and
financing activities.
• It permits a user to determine exactly what caused the company’s
cash balance to increase or decrease during the period.
(Exhibit.1-6, p.12)

Increase in
cash =
$18.9M

• The statement covers a span of time and therefore is dated “Year

Ended” (e.g., December 31, 2017) or “Month Ended” (E.g., June 30,
2017) as opposed to “As At”.

8
 Cash Flow Statement - Format

ABC Inc.
Pay attention Consolidated Statement of Cash Flows
to the heading For the Year Ended June 30, 2017
(Thousands of Canadian dollars)

Cash flows from operating activities $xxx

Cash flows from investing activities xxx
Cash flows from financing activities xxx
Elements

Net increase (decrease) in cash xxx

Cash, beginning of year xxx
$xxx
Cash, end of year
This ending cash balance should agree with the
cash account balance on the Balance Sheet. 9
Timing of the Financial Statements

10
 Purposes of Cash Flow Statements

This statement helps managers, investors, and creditors to:

1. Predict future cash flows
2. Evaluate management decisions
3. Determine ability to pay dividends and interest
4. Asses the relationship between net income and cash flows
5. Compare the operating performance of different companies
(i.e., using “Cash” income as opposed to “Accrual” income).

11
Learning Objective Two

Explain and classify cash flows from

operating, investing, and financing
activities

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 Cash Flows Categories

Statement of cash flows reports cash flows for the 3 types of

business activities:

1. Operating Activities

2. Investing Activities

3. Financing Activities
 Operating Activities

 Operating activities include the main revenue-producing

activities of a business
 Companies need to generate sufficient cash from their operating
activities to fund capital expenditures, pay dividends and their
day-to-day operations. Companies that do not regularly generate
sufficient cash flow from operations will eventually suffer liquidity
and solvency problems.

• Example:
– cash receipts from a company’s sales of its primary
goods/services, and
– cash payments to suppliers and employees for goods/services
they provide the company to generate revenue.

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 Investing Activities

• Investing activities include transactions that results in cash flows

related to resources used to generate future income and cash
flows.
• Example:
– cash flows from purchase and sale of tangible and intangible
long-lived assets,
– cash flows from purchase and sale of equity and debt
instruments of other companies (e.g., Facebook invests in
Tesla’s shares)
– cash flows related to advances and loans made to other entities
(Facebook lends money to ABC Inc.).

• Note: cash flow from purchase and sale of Inventory is an

operating activity.

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 Financing Activities

• Financing activities include transactions that result in changes in

the size and composition of a company’s contributed equity and
borrowings:
• Example:
– issuance and acquisition of a company’s own shares,
– payment of cash dividends,
– cash proceeds from loans, bonds, and notes, and
– payment on the loan principal.

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Classifying Interest and Dividends – IFRS vs. ASPE

ASPE
• Interest paid, and interest and
dividends received are operating
activities.
• Dividends paid are financing
activities.
IFRS
• Interest and dividends paid may
be classified as either operating
or financing activities.
• Interest and dividends received
may be classified as either
operating or investing cash
flows.
• Whichever classification the
company chooses, it must use the
classification consistently.

In this introductory course, however, we classify:

– Interest paid, and interest and dividends received as Operating
activities, and
– Dividends paid as a Financing activity.
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 Relationship to Balance Sheet
General rule for identifying the activity a transaction pertains to:

Assets = Liabilities + Shareholders’

equity

Current + Non-current = Current + Non-current + Shareholders’

assets assets liabilities liabilities equity

NOT net
income*

Operating Investing Operating Financing

*Note: Net income, although it affects retained earnings which

is part of SHE, is part operating activities as net income mostly
comprises of the core operating activities of the firm.
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 Cash Flow Categories – Example 1

1 Purchase of long-term I 8 Depreciation and O

investments amortization
2 Net earnings O 9 Issuance of shares F
3 Changes in trade receivables O 10 Cash received from bank F
borrowing
4 Changes in prepayments and O 11 Cash paid for interest O
other current assets
5 Changes in inventories O 12 Cash paid for taxes O
6 Changes in trade payables O 13 Cash paid for dividends F
7 Additions to PP&E I

Note: Cash received/paid for loan principle is (F), while cash paid for loan
interest is (O).
 Cash Flows from Operating Activities
There are two methods of determining cash flows from operating
activities:
1. Direct Method:
 Subtracts operating cash disbursements (outflows) from cash
collections (inflows).
2. Indirect Method:
 Adjusts the previously calculated accrual net income from the
income statement to compute cash net income.
 Note, these methods only apply to the operating activities section.
The investing and financing activities sections are identical under
the two methods.
 We will focus on the indirect method as this is the most
commonly used method in companies.
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 Direct Method vs. Indirect Method

• Regardless of which method is used, the total net cash flow from
operating activities will ALWAYS be the same. It is only the
presentation of the data that differs.
• The direct method provides more details about cash from operating
activities.
• The IFRS prefers the direct method but almost all companies use the
indirect method. Why? (see next slide)

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 Direct Method vs. Indirect Method (cont’d)

Most companies prefer the indirect method because it:

1. It is easier and cheaper to prepare,

2. It focuses on the differences between net earnings and net

cash flow from operating activities, and

3. It reveals less company information to competitors.

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Learning Objective Three
Prepare a statement of cash flows using
the indirect method of determining cash
flows from operating activities

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 Indirect Method - Concept

• Why does accrual net income differ from cash-basis net income
(CFO)?

 Because Income Statement is prepared using the accrual

principles.

• Indirect method: the operating section of the statement of cash

flows begins with net income (accrual income) taken from the
income statement (exhibit 10-5 on page 491) and makes
adjustments to it for deferrals and accruals and non-operating
elements (e.g., gain/loss on sale of PPE) to convert accrual income
to cash-basis operating income (net cash flow from operating
activities) (Exhibit 10-6 on page 492).

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 Indirect Method – General Rules
To reconcile accrual income (net income) to cash-basis income (net
cash flow from operating activities):
1. Add Depreciation/Amortization expense (non-cash expense).
2. Add losses and subtract gains on the sale of long-term assets (non-
operating activities)
3. Add/subtract changes in non-cash operating working capital
i. For Current Assets (other than cash):
• Subtract increases.
Change Change in Adjustment to
• Add decreases. in Assets Liabilities Operating CF
ii. For Current Liabilities: - + Add
• Add increases. + - Subtract
• Subtract decreases.

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 Indirect Method – Change in Account Receivable

Increase in accounts receivable:

 AR increases when a company makes a sale on credit.

 ↑ Revenue → ↑ Net income, but not cash!
 Back out this non-cash revenue by deducting the increase in AR.

Decrease in accounts receivable:

 AR decreases when a customer pays down their account.
 ↑ Cash, but no impact on net income! (Affected net income when the
revenue was earned, which is before cash collection)
 Record this cash inflow by adding the decrease in AR.

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 Indirect Method – Change in Inventory

Increase in inventory:

 Inventory increases when a company purchases inventory.

 ↓ Cash, but no impact on net income! (will affect net income via cost of
goods sold (COGS) when the inventory is sold later)
 Record this cash outflow by deducting the increase in inventory.

Decrease in inventory:
 Inventory decreases when the inventory is sold.
 ↑ COGS → ↓ Net income, but cash is not affected!
 Back out this non-cash expense by adding the decrease in inventory.

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 Indirect Method – Change in Prepaid Expense

Increase in prepaid expense:

 Prepaid expense increases when a company prepays an expense.

 ↓ Cash, but no impact on net income! (will affect net income when the
expense is incurred)
 Record this cash outflow by deducting the increase in prepaid expense.

Decrease in prepaid expense :

 Prepaid expense decreases when the expense is incurred.
 ↑ expense → ↓ Net income, but cash is not affected!
 Back out this non-cash expense by adding the decrease in prepaid
expense.

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 Indirect Method – Change in Accounts Payable and
Accrued Liabilities

Increase in accounts payable and accrued liabilities:

 Accounts payable and accrued liabilities increase when a company incurs

an expense but does not pay for it in cash until later.
 ↑ Expense → ↓ Net income, but cash is not affected!
 Back out this non-cash expense by adding the increase in accounts
payable and accrued liabilities.

Decrease in accounts payable and accrued liabilities:

 Accounts payable and accrued liabilities decrease when the company
pays the debt
 ↓ Cash, but no impact on net income!
 Record this cash outflow by deducting the decrease in accounts payable
and accrued liabilities.
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 Indirect Method – Change in Unearned Revenue

Increase in unearned revenue:

 Unearned revenue increases when a customer pays the company before

the goods/services are delivered.
 ↑ Cash, but no impact on net income! (will affect net income when the
revenue is earned later)
 Record this cash inflow by adding the increase in unearned revenue

Decrease in unearned revenue :

 Unearned revenue decreases when the company delivers the
goods/services (i.e., earns the revenue)
 ↑ Revenue → ↑ Net income, but cash is not affected!
 Back out this non-cash revenue by deducting the decrease in unearned
revenue.
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 Indirect Method – General Rules Illustration
Indirect method starts with net income and then removes the non-cash and
non-operating elements to compute the net cash flow from operating activities.
Cash flows from operating activities:

Net income
Adjustments to reconcile net income to net cash provided by operating
activities:
+ Depreciation
+ Loss on sale of long-term assets
- Gain on sale of long-term assets
- Increases in current assets (other than cash)
+ Decreases in current assets (other than cash)
+ Increases in current liabilities
- Decreases in current liabilities
= Net cash provided by operating activities

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 Sources for preparing the Operating Activities
Section – Indirect Method
1. Comparative balance sheets (current and prior period):
– Increase or decrease in each current asset account (other
than cash)
– Increase or decrease in each current liability account
2. Current income statement
– Net income
– Depreciation and amortization expense
– Gains and losses on sales of long-term assets

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 Income Statement
Bradshaw Corporation
For the Year Ended December 31, 2017
(in thousands)
Revenues and gains:
Sales revenue $284
Interest revenue 12
Dividend revenue 9
Gain on sale of prop, plant & equip 8 Subtract
Total revenues and gains $313
Expenses:
Cost of goods sold $150
Salary and wages expense 56
Amortization expense 18 Add
Other operating expense 17
Interest expense 16
Total expenses 272
Net income Starting
$ 41
point

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 Bradshaw Corporation – December 31
(in thousands) 2017 2016 Increase
(Decrease)
Comparative Balance Sheets
Assets
Current:
Changes Cash $ 22 $ 42 $ (20)
in Accounts receivable 93 80 13 O-
current
Interest receivable 3 1 2 O-
assets
except Inventory 135 138 (3) O+
cash Prepaid expenses 8 7 1 O-
Long-term receivable 11 – 11
Prop, plant & equip, net 353 219 134
Total $625 $487 $138
Liabilities

Changes Current:
in Accounts payable $ 91 $ 57 $ 34 O+
current Salary & wages payable 4 6 (2) O-
liabilities
Accrued liabilities 1 3 (2) O-
Long-term debt 160 77 83
Shareholders’ equity
Common shares 259 258 1
Retained earnings 110 86 24
Total $625 $487 $138

• Note: line items in red are operating activities.

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Statement of Cash Flows: Operating Activities
CFO activities section of Exhibit 10-8 on page 495

35
 Mid-Chapter Summary Problem

• Carefully study the Mid-chapter summary problem on page 495.

• Then, try to solve it on your own without looking at the solution.

36
 Cash Flows from Investing Activities

Cash effects related to purchase and sales of long-term assets

or investments (other than those which qualify as cash
equivalents).
Inflows
• Sales of long-lived assets (e.g.,
PPE, intangible assets)
• Sales of investments other than
cash equivalents
• Interest and dividends received
if classified as operating activity
• Collecting loans and advances
made to others (i.e., decrease
loans/notes receivable)
Outflows
• Purchase of long-lived assets
(e.g, PPE, intangible assets)
• Purchase of investments other
than cash equivalents.
• Making loans and advances to
others (i.e., loans/notes
receivable)

37
Sources for preparing the Investing Activities Section

1. The comparative balance sheets (current and prior period):

• Increase or decrease in each non-current asset account
2. The income statement (if sale of equipment or investments)

• Gain/loss on sale

3. Additional information. For example:

– Purchase of PP&E for $xxx
– Sale of PP&E for $xxx
– Purchase of land by issuing common shares
– Etc.

38
 Investing Activities

Three main groups of investing activities:

1. Acquisitions and sales of long-term assets (e.g., PPE)
• Purchase of long-term asset – purchase price
• Sale of equipment – sale proceeds
2. Acquisitions and sales of investments (other than cash equivalents)
• Purchase of investment – purchase price
• Sale of investment – sale proceeds
3. Making and collecting loans and advances to other (e.g., loans /
advances receivable)
• Loan made to others
• Collection of loan

39
 Acquisitions and Sales of PP&E – Investing Activity

• Bradshaw had capital assets, net of depreciation, of $219,000 at

the beginning of 2017 and $353,000 at year end.
• The acquisition of capital assets amounted to $206,000 during the
year  additional info given on page 497.
• The income statement shows depreciation of $18,000 and an
$8,000 gain on sale of PP&E.
How much are the proceeds from the sale of capital assets?
 We first need to figure out the carrying amount (book value) of the
assets sold. Recall from Chapter 3, that the carrying amount is
(cost – accumulated depreciation).

PP&E beginning balance + Acquisitions – Depreciation

– Carrying amount of assets sold = PP&E ending balance

40
Acquisitions and Sales of PP&E – Investing Activity
(cont’d)

PP&E beginning balance + Acquisitions – Depreciation

– Carrying amount of assets sold = PP&E ending balance

 $219,000 + $206,000 – $18,000 – X = $353,000

X = $219,000 + $206,000 – $18,000 – $353,000

X = $54,000 (Carrying Amount)

Capital Assets (Net)

Beginning balance 219,000 Depreciation 18,000
(2017)
Acquisitions 206,000 Carrying amount ?
of assets sold
Ending balance (2017) 353,000

41
 Acquisitions and Sales of PP&E – Investing Activity
(cont’d)

How much are the proceeds from the sale of capital assets?
Gain (Loss) = Sale proceeds – Carrying amount
Sale proceeds = Carrying amount + gain (or – loss)
Check line 19 of
Sale proceeds = $54,000 + $8,000 = $62,000 Exhibit 10-8 on
page 495
 So, remember these two formulas:

PP&E beginning balance + Acquisitions – Depreciation – Carrying amount of

assets sold = PP&E ending balance

Sale proceeds = Carrying Amount + Gain (or – Loss)

Note: There is a typo in the textbook. Exhibit 10-8 (p.495), line 16 should read “
Cash flows from investing activities”, not “Cash flow from financing activities”.
42
 Acquisitions and Sales of Investments - Investing
Activity
• The cash amounts of investment transactions can be computed in the
manner illustrated for PP&E - however, computations for Investments are
easier because there is no depreciation.

• Just as with plant assets, the amount to be reported on the cash flow
statement is the proceeds from sale, which is the book value of
investments sold plus any gain or minus any loss. Refer to example on
page 498.

Beginning balance + Purchases – Carrying amount of investment sold

= Ending balance
no depreciation

Sale proceeds = Carrying Amount + Gain – Loss

43
 Computing Cash from Making and Collecting Loans
and Advances to others – Investing Activity
• In general, the notes receivable account is increased by new loans made
and decreased by collections.
• Bradshaw has a long-term note receivable of $11,000 at the end of 2017;
this balance was zero at the end of 2016 (Refer to line 10 of Exhibit 10-4
on page 491) (additional info provided on pages 498-499):

Beginning balance + New loans made – Collections = Ending balance

$0 + $X – 0 = $11,000  X = $11,000 Check line 18 of

Exhibit 10-8 on
page 495

Note: We know collections are zero because there was no note

receivable to be collected at the beginning of the year and question
provides no further information.

44
 Cash Flows from Financing Activities

Cash effects related to cash obtained from owners and creditors

(i.e., sale or repurchase of company’s own shares, the issuance
or repayment of debt securities, and the payment of cash
dividends.)

Inflows
• Borrowing money (e.g.,
loans, bonds and notes
payable)
• Issuance of equity
Outflows
• Repaying debts (e.g., loans,
bonds and notes payable)
• Payment of interest and
dividends (if classified as
financing activities)
• Repurchase of equity

45
Sources for preparing the Financing Activities Section

1. The comparative balance sheets (current and prior period):

• Increase or decrease in each non-current liabilities account
• Increase or decrease in each shareholders’ equity account
2. The income statement (dividends)
• Net income
3. Additional information. For example:
– Borrowings of new debt $xxx
– Repurchase of shares $xxx
– Purchase of land by issuing common shares
– Etc.

46
 Financing Activities

Three main groups of financing activities:

1. Borrowing money and repaying debts (long-term liabilities)
• Proceeds from issuance of long-term debt
• Repayment of long-term debt
2. Issuance or repurchase of equity (shareholders’ equity)
• Proceeds from issuance of common shares
• Repurchase of common shares
3. Payment of dividends

47
 Issuances and Payments of Long-Term Debt –
Financing Activity

• The balance of Long-term debt at the beginning of 2017 is $77,000.

• The balance of Long-term debt at the end of 2017 is $160,000.
• New debt amounting to $94,000 was borrowed during the year
(additional info provided on page 499)
 What was the amount of debt repayments during the year?

Beginning balance + Borrowing of new debt – Repayments of debt

= Ending balance
$77,000 +$94,000 – X = $160,000  X = $11,000 Check line 24
of Exhibit 10-8
on page 495
Long-Term Debt
Beginning balance 77,000
Payments ? Issuance of new debt 94,000
Ending balance 160,000

48
 Issuances of Shares: Repurchases of Shares –
Financing Activity
• The balance of Share capital at the beginning of 2017 is
$258,000.
• The balance of Share capital at the end of 2017 is $259,000.
• How much cash was received by issuing new shares?

Beg. balance + Issuance of new shares – Repurchase of shares

= Ending balance

Check line 22
$258,000 + X – $0 = $259,000  X = $1,000 of Exhibit 10-8
on page 495

49
 Dividend Payments – Financing Activity

• The balance of Retained earnings at the beginning of 2017 is

$86,000.
• The balance of Retained earnings at the end of 2017 is
$110,000.
• How much cash was paid for dividends?

Retained earnings beginning balance + Net income – Dividends declared

= Ending balance

Check line 25
$86,000 + $41,000 – X = $110,000  X = $17,000 of Exhibit 10-8
on page 495

Note: if the company has a balance in either the opening or closing

dividends payable accounts, we need to make further adjustments to
determine the payment of dividends. (see next slide)
50
 Bradshaw Corporation – December 31
(in thousands) 2017 2016 Increase
(Decrease)

Comparative Balance Sheets Assets

Current:
Cash $ 22 $ 42 $ (20)
Accounts receivable 93 80 13 O-
Interest receivable 3 1 2 O-
Inventory 135 138 (3) O+
Prepaid expenses 8 7 1 O-
Long-term receivable 11 – 11 I-
Prop, plant & equip, net 353 219 134 I-
Total $625 $487 $138
Liabilities
Current:
Accounts payable $ 91 $ 57 $ 34 O+
Salary & wages payable 4 6 (2) O-
Accrued liabilities 1 3 (2) O-
Long-term debt 160 77 83 F+
Shareholders’ equity
Common shares 259 258 1 F+
Retained earnings 110 86 24 F+
Total $625 $487 $138

• Note: line items in red are Investing and Financing activities. 51

Statement of Cash Flows: Investing and Financing Activities

Includes
impact of cash
flows from
operating
activities (see
slide 32 or
exhibit 10-8).

52
Cash Flow Statement Template
Indirect
method
applied to
the cash
flow from
operating
activities

Similar
to
Exhibit
10-2
(p.489)

53
 Noncash Investing and Financing Activities
• Companies can engage in investing or financing activities that do
NOT require cash.
• These non-cash investing and financing activities must be reported
in a separate schedule under the statement of cash flows. Both
IFRS and ASPE require disclosure of non-cash investing and
financing activities.

54
 Noncash Investing and Financing Activities (cont’d)

• Example: Bradshaw Corporation issued common shares (F) valued at $320,000 to

acquire a warehouse (I).

• If a transaction involves an exchange of part cash and part something else, such as
shares, a note, etc…, the cash portion is reported in the statement of cash flows and
the non-cash portion is reported here.
• Exhibit 10-9: Sample Disclosure on Non-cash Investing and Financing Activities

55
 Measuring Cash Adequacy: Free Cash Flow

• Free cash flow is the amount of cash available from operations after
paying for PP&E.

Free cash flow = Net Cash flow provided – Capital expenditures

by operating activities on PP&E

• A company with significant free cash flow is better able to respond to

new opportunities.
• Does a negative free cash flow necessarily mean a bad thing?
Why?

• It is a bad thing, or because they just made a large investment, in

which can support the company for next few years.--require a large
56
 Cash Flow Categories – Example 2
Identify each of the transactions as operating (O), investing (I), financing (F), non-cash
investing and financing (NIF), or a transaction that is not reported on the statement of cash
flows (N). Indicate whether each item increases (+) or decreases (–) cash*. The indirect
method is used for operating activities.

A Sale of long-term investment Investment activities I+

B Issuance of long-term note payable to borrow cash F+
C Increase in prepaid expenses O−
D Payment of cash dividend O−
E Loss on sale of equipment O+
F Decrease in merchandise inventory-debiting expense O+
G Acquisition of equipment by issuance of a note payable NIF
H Increase in accounts payable--borrow cash/debiting expense O+
I Amortization of intangible assets-debit appreciation expense O+
J Net income O+

*For adjustments to net income (e.g., depreciation, gain/loss on sale of long-lived assets),
indicate whether each item is added (+) or subtracted (-) from net income. 57
 Financing and Investing Activities – Example 3
ABC Inc. raises $1M by selling stock and invests it as follows:
 Invest $400K in marketable securities (cash equivalent)
 Uses $600K to purchase equipment
What is the net cash flow effect from the above activities?

Answer:
• Raises $1mil by issuing stocks (F+)
• Uses $600K to purchase equip (I–)---PPE Investing
• Invests $400K in marketable securities (cash equiv-expect to convert in
cash in 3 months.)
 Not an investing activity since it is a cash equivalent
 Simply turning one type of cash into another type of cash, thus no
cash effect!
There is a net increase in cash of $400K
58
 End-of-Chapter Summary Problem

• Carefully study the End-of-chapter summary problem on page 505.

• Then, try to solve it on your own without looking at the solution.

59