I feel one of the most powerful tools you can learn from this course is to understand the statement of cash flows. The statement itself is essentially a reconciliation from earnings measured on an accrual basis to the cash flows generated by the firm for the period. The statement is made up of three distinct sections: Operating, Investing and Financing. Each section tells part of a story and the statement as a whole can provide substantial insight into how well a company is doing. One concern the accounting profession had was that when the statement was introduced, some believe it might replace the Income Statement has the true indicator of profitability. Although that has not happened still the concern is not without merit, frankly, many companies monitor cash flow more closely than earnings and frequently that becomes a problem near year end because what does well for cash flow does not necessarily look good for earnings and visa versa.

The statement allows the reader to find activities that can not be found anywhere else. Examples are, how much did we spend on new capital equipment, what were the total disposals for the period, how much new debt did we issue and how much debt was retired. You know now the balance sheet shows the beginning and ending balances for these accounts but not the detail. The cash flow statement shows us activity not just the net change.

Learning how to prepare the statement may take some time and we will proceed carefully through the process to understand each step.

Let us use the following hypothetical company to illustrate statement preparation:

Dalton Enterprises just began operations last year, the beginning Balance Sheet looks like:

* The company paid a $14,000 dividend

So retained earnings that started at zero are now $20,000 at the end of year 2000.

To start the process of generating the cash flow statement for the year 2001 we need the year end balance sheet for 2001.

I have put the two years side by side so that you can see the changes in the accounts and whether they go up or down.

Here now is the Income Statement that goes between the two balance sheets.

Additional Information:

1. In 2001 the company paid $18,000 cash dividends
2. The company issue $150,000 in bonds and received cash for $150,000
3. Land, Building and Equipment were all acquired for cash.

As I mentioned there are three parts to the Cash flow statement. We will attempt to derive the Operating section of the Statement first.

What accounts effect operations.

1. Most of the Current accounts and
2. Depreciation

Therefore, we need to go through all the current accounts and ask if their change effected the operations of Dalton.

Question: The Accounts Receivable account started at $36,000 and fell to $26,000. Did the decline of Receivables cause cash to go up or down?

Answer: Holding all other accounts constant, a decline in Accounts Receivable account would cause cash to go – up. It means that we collected the cash from the previous periods’ sales, so to reconcile to operating cash flow we would add back declines in accounts receivable.

Do we therefore also subtract increases to accounts receivable account - yes. The logic is reversed. Selling on account means we have not yet collected the cash. So the earnings are higher than the cash collected from sales.

In our problem above we would add back to the $134,000 of net income the $10,000 decline in Accounts receivable.

Account 2, Prepaid Expenses:

Question: The prepaid expense account increased by $6,000, so do we add or subtract the $6,000 to net income to find the cash flow from operations?

Answer: We subtract the increase. Net income is higher than cash flow because we have not yet expensed the payment for the prepaid. I.e. we have paid the money for the insurance policy, however, the company has not yet expensed the payment so net income is higher (by $6,000) than is the cash flow.

Account 3, Accounts Payable.

Are there any other adjustments to the operating section of the Cash Flow Statement?

Yes

Depreciation expense lowers income, however, note the entry debiting depreciation expense and crediting accumulated depreciation. Since there is no cash in that entry, even though net income is lowered by the depreciation expense adjustment, no cash was expended.

The total depreciation expense according to the income statement was $21,000. Therefore we add back to net income the depreciation expense recorded for the years.

Note: The depreciation expense adjustment can be huge for some companies, literally billions of dollars are added back for GM, GE, etc. to net income to calculate cash flow from operations. Cinergy adds back over $250 million in determining their cash flow from operations.

What does the statement look like after these adjustments are made.

The next section discusses the other two major activities a company performs. Investing (buying and disposing of product assets) and financing (issue and repaying debt, raising of capital and the payment of dividends). Fortunately, the logic does not change when we account for these other transactions. Therefore, buying an asset is a use of cash and is shown as an outflow of cash resources.

Land increased from 0 to $70,000, that $70,000 increase was a use of cash therefore in the Investing section we must show an outflow of $70,000 for land.

We acquired an office building for $200,000 and Equipment for $68,000. We show these separately as outflows of cash for purchased building and purchased equipment. Now if we had borrowed the money directly we would still show the outflow for the gross amount and then later shown the inflow from borrowing. So even if we make a simultaneous transaction, we show the two parts separately.

Interestingly, we have already accounted for the depreciation expense when we looked at the income statement. If we did not have an income statement we still see that the total change in the two accumulated depreciation accounts was $21,000 that exactly equaled the adjustment we made to the operating section.

We had two financing activities, first we issued debt and second we paid dividends, the issuance of debt is a cash inflow while the payment of debt is an outflow. When we add these last two transactions the final statement looks like

----------- End Part 1 example -----------

Let us extend the illustration one more year and capture a few more transactions. If we look at the next years balance sheet we see the following transactions.

Also, here is the 2002 Income Statement

Additional Information

Calculation of the operating section:

Subtract the increase in Inventory – do not confused this adjustment with the payables adjustment. The change in inventory reflects merchandise acquired but not yet expensed through cost of good sold therefore holding all other accounts constant we spent money but have not yet expensed it.

Add a decrease in prepaids, we paid for last year and expensed it this year.

Subtract a decrease in accounts payable. We are paying this year for items bought last year.

Depreciation – look at accumulated depreciation for the Equipment account.

We know that the accumulated depreciation was reduced when we sold equipment costing $41,000 for $34,000 when it’s book value was $36,000. Therefore, accumulated depreciation was debited for $5,000 reflecting the sale. That means the depreciation expense was $23,000 for equipment and therefore, $10,000, for the building. The total of $33,000 agrees with the income statement shown above and will be added to the operating section of the cash flow statement.

When we sell an asset for a loss we know that loss is included as part of net income. We also believe the loss is not an operating activity. To fix the problem, we show the full proceeds from the sale of equipment in the investing section $36,000 and to avoid double counting we must then add back to the operating section the loss that was included in net income.

Land must have been sold for its’ book value of $25,000

Equipment was sold for $34,000 and other equipment was purchased for $166,000.

Prove to yourself this was so by setting up a T account.

Bonds Payable went down by $40,000 the bonds were redeemed and this was a financing transaction.

Common Stock increase $160,000, new stock was issued to raise funds.

Retained Earnings increase by $70,000 this is explained by $125,000 in earnings and payment of a $55,000 dividend.