Preparing Cash Flow Statement [In Detail]

Cash FlowA statement of cash flows is a required part of a complete set of financial statements for business enterprises and not-for-profit organizations.  The primary purpose of the statement of cash flows is to provide information about cash receipts and cash payments of an entity during a period.  A secondary purpose is to provide information about the entity’s investing and financing activities during the period.

CON 1 states:

Financial reporting should provide information that is useful to present and potential investors, creditors, and other users for making rational investment and credit decisions.

Since the ultimate objective of investment and credit decisions is the maximization of net cash inflows, information for assessing the amounts, timing, and uncertainty of prospective cash flows is needed. How a cash flow supposed to be prepared in accordance with the standard?

This post provides a detail guideline on how to prepare a cash flow statement in accordance the accounting standard, illustrated with case example, T-accounts, its entries and calculations. Enjoy!

 

Basically, statement of cash flows includes only inflows and outflows of cash and cash equivalents.  Cash equivalents include any short-term highly liquid investments used as a temporary investment of idle cash.  The effects of investing and financing activities that do not result in receipts or payments of cash are to be reported in a separate schedule immediately following the statement or in the notes to the financial statements.  The reasoning for not including noncash items in the statement of cash flows and placing them in a separate schedule is that it preserves the statement’s primary focus on cash flows from operating, investing, and financing activities.  Thus, if a transaction is part cash and part noncash, only the cash portion is reported in the body of the statement of cash flows.

 

Classification of Cash Receipts and Disbursements

The statement of cash flows requires classification of cash receipts and cash disbursements into three categories.

  • Investing Activities – Investing activities include the acquisition and disposition of (1) long-term productive assets or (2) securities held in available-for-sale or held-to-maturity portfolios that are not considered cash equivalents.  Investing activities also include the lending of money and the collection on loans. ASC 230-10-45 requires classification to be determined with reference to the nature of, and purpose for which, the related financial assets and financial liabilities were acquired or incurred.  In other words, it is necessary to evaluate the facts and circumstances of each situation, rather than applying a mechanical prescription.
  • Financing Activities – Financing activities result from transactions with owners and lenders that provide financial resources to the reporting entity or return or repay those resources to those owners and lenders.  The financing activities of not-for-profit organizations also include receiving contributions from donors that require the resources to be used for long-term purposes, such as an endowment restricted for the purchase of long-lived assets.  
  • Operating Activities – Operating activities include all transactions that are  not classified as investing or financing activities.  Operating activities include delivering or producing goods for sale and providing services.  Most income tax-related cash flows are classified as operating activities.  Certain cash flows relating to the portion of income tax expense associated with share-based compensation are classified as financing activities.

 

Examples of Cash Inflows and Outflows Classification

The following are examples of the classification of cash inflows and outflows within the statement of cash flows:

Cash Flow Classification

Disclosure of Non-cash Investing and Financing Activities

Disclosure of the following noncash investing and financing activities may be added to the statement or reported in the accompanying notes:

  • Acquiring an asset through a capital lease or by incurring long-term debtConversion of debt to equity
  • Exchange of noncash assets or liabilities for other noncash assets or liabilities
  • Issuance of ownership shares to acquire assets
  • Obtaining an investment asset or a building by receiving a contribution

 

Preparing Cash Flow Statement [Case Example]

Under a cash and cash equivalents basis, the changes in the cash account and any cash equivalent account is the bottom line figure of the statement of cash flows.  Using the 2008 and 2009 balance sheets shown below, let’s try to construct a Cash Flow Statement both for direct and indirect method.

A Balance Sheet Example

A Balance Sheet Example Used to Prepare Cash Flow Statement

Earning and Comprehensive Income Statement Example

Earning and Comprehensive Income Statement Example

Additional Information (all relating to 2009)

  • Equipment costing $6,000 with a book value of $2,000 was sold for $5,000.
  • The company received a $3,000 dividend from its investment in XYZ, accounted for under the equity method and recorded income  from the investment of $5,000 that is included in other income.
  • The company issued 200 shares of common stock for $5,000.
  • The company signed a note payable for $9,000.
  • Equipment was purchased for $8,000.
  • The company converted $15,000 bonds payable into 500 shares of common stock.  The book value method was used to record the transaction.
  • A dividend of $12,000 was declared.
  • Equipment was leased on December 31, 2009.  The principal portion of the first payment due December 31, 2010, is $700.
  • The company sold half of their available-for-sale investments during the year for $8,000.  The fair value of the remaining available-for-sale investments was $8,500 on December 31, 2009.
  • The income tax rate is 36%.

Preparing Cash Flow Statement Using Direct Method

When preparing the statement of cash flows using the direct method, gross cash inflows from revenues and gross cash outflows to suppliers and for expenses are presented in the operating activities section.

In preparing the reconciliation of net income  to net cash flow from operating activities (indirect method), changes in all accounts (other than cash and cash equivalents) that are related to operations are additions to or deductions from net income to arrive at net cash provided by operating activities.

 

A T-account analysis may be helpful when preparing the statement of cash flows

A T-account is set up for each account, and beginning (2008) and ending (2009) balances are taken from the appropriate balance sheet.   Additionally, a T-account for cash and cash equivalents from operating activities and a master or summary T-account of cash and cash equivalents should be used.

 
The T-Accounts

T-Accounts used to Prepare Cash Flow Statement
Explanation of Entries for the T-Accounts:

(a).  Cash and Cash Equivalents—Operating activities is debited for $16,320 (net income) and the credit is to Retained Earnings.

(b).  Depreciation is not a cash flow; however, depreciation expense was deducted to arrive at net income.  Therefore, Accumulated Depreciation is credited and Cash and Cash Equivalents—Operating activities is debited.

(c).  Amortization of patents is another expense  not requiring cash; therefore, Cash and Cash Equivalents—Operating activities is debited and Patent is credited.

(d).  The sale of equipment (additional information, item 1.) resulted in a $3,000 gain.  The gain is computed by comparing the book value of $2,000 with the sales price of $5,000.  Cash proceeds of $5,000 are an inflow of cash.  Since the gain was included in net income, it must be deducted from net income to determine cash provided by operating activities.  This is necessary to avoid counting the $3,000 gain both in cash provided by operating activities and in investing activities.  The following entry would have been made on the date of sale:

[Debit]. Cash = $5,000  
[Debit]. Accumulated depreciation ($6,000 – $2,000) = $4,000  
[Credit]. Property, plant, and equipment = $6,000
[Credit]. Gain on sale of equipment ($5,000 – $2,000) = $3,000

Adjust the T-accounts as follows:  debit Summary of Cash and Cash Equivalents for $5,000, debit Accumulated Depreciation for $4,000, credit Property, Plant, and Equipment for $6,000, and credit Cash and Cash Equivalents—Operating activities for $3,000.  Note that per FAS 95, the gross gain, not the net of tax gain, is removed from operating activities.  The tax effect on this gain is left in operating activities.

(e).  The deferred income tax liability account shows an increase of $4,440.  The $3,000 increase that pertains to amounts reported in the income statement must be added to income from operations. Although the $3,000 was deducted as part of income tax expense in determining net income, it did not require an outflow of cash.  Therefore, debit Cash and Cash Equivalents—Operating activities and credit Deferred Taxes.  The other two amounts in the deferred tax liability account are covered below, under paragraph “p.”

(f).  Item 2. under the additional information indicates that the investment in XYZ is accounted for under the equity method.  The investment in XYZ had a net increase of $2,000, which is the result of the equity in the earnings of XYZ of $5,000 and the receipt of a $3,000 dividend. Dividends received (an inflow of cash) would reduce the investment in XYZ, while the equity in the income of XYZ would increase the investment without affecting cash.  The journal entries would have been:

[Debit]. Cash (dividend received) = $3,000  
[Credit]. Investment in XYZ = $3,000
And;
[Debit]. Investment in XYZ = $5,000  
[Credit]. Equity in earnings of XYZ = $5,000
 
The dividend received ($3,000) is an inflow of cash, and the equity earnings are not.  Debit Investment in XYZ for $5,000, credit Cash and Cash Equivalents—Operating activities for $5,000, debit Cash and Cash Equivalents—Operating activities for $3,000, and credit Investment in XYZ for $3,000.

(g).  The Property, Plant, and Equipment account increased because of the purchase of $8,000 (additional information, item 5.).  The purchase of assets is an outflow of cash.  Debit Property, Plant, and Equipment for $8,000 and credit Summary of Cash and Cash Equivalents.

(h).  The company sold 200 shares of common stock during the year (additional information, item 3.).  The entry for the sale of stock was:

[Debit]. Cash = $5,000  
[Credit]. Common stock (200 shares × $10) = $2,000
[Credit]. Additional paid-in capital = $3,000

This transaction resulted in an inflow of cash.  Debit Summary of Cash and Cash Equivalents $5,000, credit Common Stock $2,000, and credit Additional Paid-in Capital $3,000.

(i).  Dividends of $12,000 were declared (additional information, item 7.).  Only $9,000 was actually paid in cash, resulting in an ending balance of $5,000 in the Dividends Payable account. Therefore, the following entries were made during the year:

[Debit]. Retained earnings = $12,000  
[Credit]. Dividends payable 12,000
And;
[Debit]. Dividends payable = $9,000  
[Credit]. Cash   9,000

These transactions result in an outflow of cash.  Debit Retained Earnings $12,000 and credit Dividends Payable $12,000.  Additionally, debit Dividends Payable $9,000 and credit Summary of Cash and Cash Equivalents $9,000 to  indicate the cash dividends paid during the year.

(j).  Accounts Receivable (net) decreased by $2,000.  This is added as an adjustment to net income in the computation of cash provided by operating activities.  The decrease of $2,000 means that an additional $2,000 cash was collected on account above and beyond the sales reported in the income statement.  Debit Cash and Cash Equivalents—Operating activities and credit Accounts Receivable for $2,000.

(k). Inventories increased by $5,000.  This is subtracted as an adjustment to net income in the computation of cash provided by operating activities.  Although $5,000 additional cash was spent to increase inventories, this expenditure is not reflected in accrual-basis cost of goods sold.  Debit Inventory and credit Cash and  Cash Equivalents—Operating activities for $5,000.

(l). Prepaid Expenses decreased by $3,000.  This is added back to net income in the computation of cash provided by operating activities.  The decrease means that no cash was spent when incurring the related expense.  The cash was spent when the prepaid assets were purchased, not when they were expensed on the income statement.  Debit Cash and Cash Equivalents—Operating activities and credit Prepaid Expenses for $3,000.

(m). Accounts Payable decreased by $10,000.  This is subtracted as an adjustment to net income.  The decrease of $10,000 means that an additional $10,000 of purchases were paid for in cash; therefore, income was not affected but cash was decreased.   Debit Accounts Payable and credit Cash and Cash Equivalents—Operating activities for $10,000.

(n). Notes Payable increased by $9,000 (as listed under additional information, item 4.).  This is an inflow of cash and would be included in the financing activities.  Debit Summary of Cash and Cash Equivalents and credit Notes Payable for $9,000.

(o). Interest Payable increased by $1,000, but interest expense reported on the income statement was $2,000.  Therefore, although $2,000 was expensed, only $1,000 cash was paid ($2,000 expense – $1,000 increase in interest payable).  Debit Cash and Cash Equivalents—Operating activities for $1,000 for the noncash portion, debit Interest Payable for $1,000 for the cash portion, and credit Interest Payable for $2,000 for the expense.

(p). The following entry was made to record the incurrence of the tax liability:

[Debit]. Income tax expense = $9,180  
[Credit]. Income taxes payable = $6,180
[Credit]. Deferred tax liability  = $3,000

Therefore, $9,180 was deducted in arriving at net income.  The $3,000 credit to Deferred Income Taxes was accounted for in entry e. above.  The $6,180 credit to Taxes Payable does not, however, indicate that $6,180 cash was paid  for taxes.  Since Taxes Payable increased $1,180, only $5,000 must have been paid and $1,180 remains unpaid.  Debit Cash and Cash Equivalents—Operating activities for $1,180, debit Income Taxes Payable for $5,000, and credit Income Taxes Payable for $6,180.

(q). Item 6. under the additional information indicates that $15,000 of bonds payable were converted to common stock.  This is a noncash financing activity and should be reported in a separate schedule.  The following entry was made to record the transaction:

[Debit]. Bonds payable = $15,000  
[Credit]. Common stock (500 shares × $10 par) = $5,000
[Credit]. Additional paid-in capital = $10,000

Adjust the T-accounts with a debit to Bonds Payable, $15,000; a credit to Common Stock, $5,000; and a credit to Additional Paid-in Capital, $10,000.

(r). Item 8. under the additional information indicates that leased equipment was acquired on the last day of 2009.  This is also a noncash financing activity and should be reported in a separate schedule.  The following entry was made to record the lease transaction:

[Debit]. Leased asset = $5,000
[Credit]. Lease obligation = $5,000

(s). The company sold half of its available-for-sale investments during the year for $8,000 (additional information, item 9.).  The entry for the sale of the investments was:

[Debit]. Cash = $8,000  
[Credit]. Investment in available-for-sale securities = $7,500
[Credit]. Gain on sale of investments = $500

This transaction resulted in an inflow of cash.  Debit Summary of Cash and Cash Equivalents $8,000, credit Investment in Available-for-Sale Securities $7,500, and credit Cash and Cash Equivalents—Operating activities $500.  The following additional journal entries were made:

[Debit]. Adjustment for changes in FV = $1,500  
[Credit]. Other comprehensive income ($1,500 × 64%) = $960
[Credit]. Deferred tax liability ($1,500 × 36%) = $540

To adjust the allowance account for the sale, one-half of the amounts provided at the end of 2008 must be taken off the books when the related securities are sold.

[Debit]. Adjustment for changes in FV = $2,500  
[Credit]. Unrealized gain on available-for-sale securities ($2,500 × 64%) = $1,600
Deferred tax liability ($2,500 × 36%) = $900

The change in FV of the remaining securities at year-end (as listed under additional information, item 9.) must be adjusted.  The book value of the securities before the adjustment above is $6,000 ($7,500 – $1,500).  The fair value of the securities is $8,500.   An adjustment of $2,500 is necessary.

(t).  The cash and cash equivalents from operations ($15,000) is transferred to the Summary of Cash and Cash Equivalents.
 
All of the changes in the noncash accounts have been accounted for and the balance in the Summary of Cash and Cash Equivalents account of $25,000 is the amount of the year-to-year increase in cash and cash equivalents.  The formal statement may now be prepared using the T-account, Summary of Cash and Cash Equivalents

The alphabetic characters in the statement below refer to the entries in that T-account.  The following statement of cash flows is prepared under the direct method.  

Cash Flow Statement Example

Note: Calculations for gross receipts and gross payments needed for the direct method are shown below:

Calculation of Amounts for Operating Activities Section

Cash received from customers = Net sales + Beginning A/R – Ending A/R
$102,000 = $100,000 + $11,000 – $9,000 

Cash paid to suppliers = Cost of goods sold + Beginning A/P – Ending A/P + Ending inventory –
Beginning inventory
$75,000 = $60,000 + $12,000 – $2,000 + $14,000 – $9,000

Cash paid for operating expenses = Operating expenses + Ending prepaid expenses 
– Beginning prepaid expenses – Depreciation expense (and other noncash operating expenses)
$9,000 = $12,000 + $8,000 + $1,000 + $10,000 – $13,000 – $8,000 – $1,000 

Interest paid = Interest expense + Beginning interest payable – Ending interest payable
$1,000 = $2,000 + $2,000 – $3,000

Taxes paid = Income taxes + Beginning income taxes payable – Ending income taxes payable
 – Change in deferred income taxes—operating portion
$5,000 = $9,180 + $1,000 – $2,180 – $3,000

 

 
Preparing Cash Flow Statement Using Indirect Method

When a statement of cash flows is prepared using the direct method of reporting operating cash flows, the reconciliation of net income to operating cash flows must also be provided.  The T-account, Cash and Cash Equivalents—Operating Activities is used to prepare the reconciliation.

 
The alphabetic characters in the reconciliation below refer to the entries in the T-account
.

 

Reconciliation of Net Income to Net Cash  

 

Author: Lie Dharma Putra

Putra is a CPA. His last position, in the corporate world, was a controller for a corporation in Costa Mesa, CA. After spending 15 years as a nine-to-five employee, he decided to serve more companies, families and even individuals, as a trusted business advisor. He blogs about accounting, finance and tax, during his spare time, and helps accounting students (around the globe) to understand the subject matter easier , faster. Follow him on twitter @LieDharmaPutra or add him to your circle at Google Plus Lie+

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