16.3: Prepare the Statement of Cash Flows Using the Indirect Method (2024)

Adjust for Changes in Current Assets and Liabilities

Because the Balance Sheet and Income Statement reflect theaccrual basis of accounting, whereas the statement of cash flowsconsiders the incoming and outgoing cash transactions, there arecontinual differences between (1) cash collected and paid and (2)reported revenue and expense on these statements. Changes in thevarious current assets and liabilities can be determined fromanalysis of the company’s comparative balance sheet, which liststhe current period and previous period balances for all assets andliabilities. The following four possibilities offer explanations ofthe type of difference that might arise, and demonstrate examplesfrom Propensity Company’s statement of cash flows, which representtypical differences that arise relating to these current assets andliabilities.

Increase in Noncash Current Assets

Increases in current assets indicate a decrease in cash, becauseeither (1) cash was paid to generate another current asset, such asinventory, or (2) revenue was accrued, but not yet collected, suchas accounts receivable. In the first scenario, the use of cash toincrease the current assets is not reflected in the net incomereported on the income statement. In the second scenario, revenueis included in the net income on the income statement, but the cashhas not been received by the end of the period. In both cases,current assets increased and net income was reported on the incomestatement greater than the actual net cash impact from the relatedoperating activities. To reconcile net income to cash flow fromoperating activities, subtractincreases in current assets.

Propensity Company had two instances of increases in currentassets. One was an increase of $700 in prepaid insurance, and theother was an increase of $2,500 in inventory. In both cases, theincreases can be explained as additional cash that was spent, butwhich was not reflected in the expenses reported on the incomestatement.

Current Operating Liability Increase

Increases in current liabilities indicate an increase in cash,since these liabilities generally represent (1) expenses that havebeen accrued, but not yet paid, or (2) deferred revenues that havebeen collected, but not yet recorded as revenue. In the case ofaccrued expenses, costs have been reported as expenses on theincome statement, whereas the deferred revenues would arise whencash was collected in advance, but the revenue was not yet earned,so the payment would not be reflected on the income statement. Inboth cases, these increases in current liabilities signify cashcollections that exceed net income from related activities. Toreconcile net income to cash flow from operating activities,add increases in currentliabilities.

Propensity Company had an increase in the current operatingliability for salaries payable, in the amount of $400. The payablearises, or increases, when an expense is recorded but the balancedue is not paid at that time. An increase in salaries payabletherefore reflects the fact that salaries expenses on the incomestatement are greater than the cash outgo relating to that expense.This means that net cash flow from operating is greater than thereported net income, regarding this cost.

Current Operating Liability Decrease

Decreases in current liabilities indicate a decrease in cashrelating to (1) accrued expenses, or (2) deferred revenues. In thefirst instance, cash would have been expended to accomplish adecrease in liabilities arising from accrued expenses, yet thesecash payments would not be reflected in the net income on theincome statement. In the second instance, a decrease in deferredrevenue means that some revenue would have been reported on theincome statement that was collected in a previous period. As aresult, cash flows from operating activities must be decreased byany reduction in current liabilities, to account for (1) cashpayments to creditors that are higher than the expense amounts onthe income statement, or (2) amounts collected that are lower thanthe amounts reflected as income on the income statement. Toreconcile net income to cash flow from operating activities,subtract decreases in currentliabilities.

Propensity Company had a decrease of $1,800 in the currentoperating liability for accounts payable. The fact that the payabledecreased indicates that Propensity paid enough payments during theperiod to keep up with new charges, and also to pay down on amountspayable from previous periods. Therefore, the company had to havepaid more in cash payments than the amounts shown as expense on theIncome Statements, which means net cash flow from operatingactivities is lower than the related net income.

Analysis of Change in Cash

Although the net income reported on the income statement is animportant tool for evaluating the success of the company’s effortsfor the current period and their viability for future periods, thepractical effectiveness of management is not adequately revealed bythe net income alone. The net cash flows from operating activitiesadds this essential facet of information to the analysis, byilluminating whether the company’s operating cash sources wereadequate to cover their operating cash uses. When combined with thecash flows produced by investing and financing activities, theoperating activity cash flow indicates the feasibility ofcontinuance and advancement of company plans.

Cash Flow from Operating Activities

Assume you own a specialty bakery that makes gourmet cupcakes.Excerpts from your company’s financial statements are shown.

How much cash flow from operating activities did your companygenerate?

Solution

Explaining Changes in Cash Balance

Assume that you are the chief financial officer of a companythat provides accounting services to small businesses. You arecalled upon by the board of directors to explain why your cashbalance did not increase much from the beginning of 2018 until theend of 2018, since the company produced a reasonably strong profitfor the year, with a net income of $88,000. Further assume thatthere were no investing or financing transactions, and nodepreciation expense for 2018. What is your response? Provide thecalculations to back up your answer.

Investing Activities

Cash flows from investing activities always relate to long-termasset transactions and may involve increases or decreases in cashrelating to these transactions. The most common of these activitiesinvolve purchase or sale of property, plant, and equipment, butother activities, such as those involving investment assets andnotes receivable, also represent cash flows from investing. Changesin long-term assets for the period can be identified in theNoncurrent Assets section of the company’s comparative balancesheet, combined with any related gain or loss that is included onthe income statement.

In the Propensity Company example, the investing sectionincluded two transactions involving long-term assets, one of whichincreased cash, while the other one decreased cash, for a total netcash flow from investing of ($25,200). Analysis of PropensityCompany’s comparative balance sheet revealed changes in land andplant assets. Further investigation identified that the change inlong-term assets arose from three transactions:

1. Investing activity: A tract of land that had an original costof $10,000 was sold for $14,800.
2. Investing activity: Plant assets were purchased, for $40,000cash.
3. Noncash investing and financing activity: A new parcel of landwas acquired, in exchange for a $20,000 note payable.

Details relating to the treatment of each of these transactionsare provided in the following sections.

Investing Activities Leading to an Increase in Cash

Increases in net cash flow from investing usually arise from thesale of long-term assets. The cash impact is the cash proceedsreceived from the transaction, which is not the same amount as thegain or loss that is reported on the income statement. Gain or lossis computed by subtracting the asset’s net book value from the cashproceeds. Net book value is the asset’s original cost, less anyrelated accumulated depreciation. Propensity Company sold land,which was carried on the balance sheet at a net book value of$10,000, representing the original purchase price of the land, inexchange for a cash payment of $14,800. The data set explainedthese net book value and cash proceeds facts for PropensityCompany. However, had these facts not been stipulated in the dataset, the cash proceeds could have been determined by adding thereported $4,800 gain on the sale to the $10,000 net book value ofthe asset given up, to arrive at cash proceeds from the sale.

Investing Activities Leading to a Decrease in Cash

Decreases in net cash flow from investing normally occur whenlong-term assets are purchased using cash. For example, in thePropensity Company example, there was a decrease in cash for theperiod relating to a simple purchase of new plant assets, in theamount of $40,000.

Financing Activities

Cash flows from financing activities always relate to eitherlong-term debt or equity transactions and may involve increases ordecreases in cash relating to these transactions. Stockholders’equity transactions, like stock issuance, dividend payments, andtreasury stock buybacks are very common financing activities. Debttransactions, such as issuance of bonds payable or notes payable,and the related principal payback of them, are also frequentfinancing events. Changes in long-term liabilities and equity forthe period can be identified in the Noncurrent Liabilities sectionand the Stockholders’ Equity section of the company’s ComparativeBalance Sheet, and in the retained earnings statement.

In the Propensity Company example, the financing sectionincluded three transactions. One long-term debt transactiondecreased cash. Two transactions related to equity, one of whichincreased cash, while the other one decreased cash, for a total netcash flow from financing of $34,560. Analysis of PropensityCompany’s Comparative Balance Sheet revealed changes in notespayable and common stock, while the retained earnings statementindicated that dividends were distributed to stockholders. Furtherinvestigation identified that the change in long-term liabilitiesand equity arose from three transactions:

1. Financing activity: Principal payments of $10,000 were paid onnotes payable.
2. Financing activity: New shares of common stock were issued, inthe amount of $45,000.
3. Financing activity: Dividends of $440 were paid toshareholders.

Specifics about each of these three transactions are provided inthe following sections.

Financing Activities Leading to an Increase in Cash

Increases in net cash flow from financing usually arise when thecompany issues share of stock, bonds, or notes payable to raisecapital for cash flow. Propensity Company had one example of anincrease in cash flows, from the issuance of common stock.

Financing Activities Leading to a Decrease in Cash

Decreases in net cash flow from financing normally occur when(1) long-term liabilities, such as notes payable or bonds payableare repaid, (2) when the company reacquires some of its own stock(treasury stock), or (3) when the company pays dividends toshareholders. In the case of Propensity Company, the decreases incash resulted from notes payable principal repayments and cashdividend payments.

Noncash Investing and Financing Activities

Sometimes transactions can be very important to the company, yetnot involve any initial change to cash. Disclosure of these noncashinvesting and financing transactions can be included in the notesto the financial statements, or as a notation at the bottom of thestatement of cash flows, after the entire statement has beencompleted. These noncash activities usually involve one of thefollowing scenarios:

• exchanges of long-term assets for long-term liabilities orequity, or
• exchanges of long-term liabilities for equity.

Propensity Company had a noncash investing and financingactivity, involving the purchase of land (investing activity) inexchange for a $20,000 note payable (financing activity).

Summary of Investing and Financing Transactions on the CashFlow Statement

Investing and financing transactions are critical activities ofbusiness, and they often represent significant amounts of companyequity, either as sources or uses of cash. Common activities thatmust be reported as investing activities are purchases of land,equipment, stocks, and bonds, while financing activities normallyrelate to the company’s funding sources, namely, creditors andinvestors. These financing activities could include transactionssuch as borrowing or repaying notes payable, issuing or retiringbonds payable, or issuing stock or reacquiring treasury stock, toname a few instances.

Cash Flow from Investing Activities

Assume your specialty bakery makes gourmet cupcakes and has beenoperating out of rented facilities in the past. You owned a pieceof land that you had planned to someday use to build a salesstorefront. This year your company decided to sell the land andinstead buy a building, resulting in the followingtransactions.

What are the cash flows from investing activities relating tothese transactions?

Solution

Note: Interest earned on investments is an operatingactivity.