Chapter 22

Statement of Cash
Flows—Indirect
Method

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College Accounting
10th Edition
McQuaig Bille Nobles

PowerPoint presented by Douglas Cloud

McQuaig Professor Emeritus of Accounting, Pepperdine University
Bille © 2011 Cengage Learning 22–1
 Accounting Language
 The income statement shows the results of operations.
 The statement of retained earnings shows additional
investments by owners and payments to owners.
 The balance sheet portrays a company’s financial
condition.
 The statement of cash flows was developed to explain
the reasons for the inflows and outflows of cash.

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 Definitions
 The statement of cash flows is a financial statement
that explains in detail how the balance of cash and cash
equivalents has changed between the beginning and
the end of the fiscal period.
 On the statement of cash flows, cash is defined to
include both cash, as you think of it, and cash
equivalents.
 Cash equivalents are short-term, highly liquid
investments, including money market accounts.

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 Purpose
 The main purpose of the statement of cash flows is to
provide a summary of information concerning a
company’s cash receipts and payments during a fiscal
period.
 A secondary purpose is to provide information about a
firm’s operating, investing, and financing activities
during a fiscal period.
 The statement of cash flows also serves to reconcile the
beginning and ending cash balance for the period.

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 Uses of the Statement of Cash Flows
 Management uses the statement of cash flows to
determine the liquidity of the business, to determine
dividend policy, and to evaluate possible investments
and means of financing.
 Liquidity is generating enough cash to enable the
company to pay the bills.
 Dividend policy is to be sure enough cash is being
generated to establish a regular cash dividend
policy.
 Investment and financing to determine if the firm
has a sound strategy so that if it borrows to buy an
asset, there is enough cash being generated to
make the payments.
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 Operating Activities

 Operating activities is the first category on the

statement of cash flows, and this category lists and
classifies cash inflows and outflows from a variety of
sources.
 Cash inflows include cash receipts from customers for
the sale of merchandise and services and cash receipts
in the form of interest and dividend income.
 Cash outflows include cash payments for merchandise
purchases and operating expenses.

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 Investing Activities
 Investing activities is the second category on the
statement of cash flows.
 Investing activities include:
1. Buying and selling property and equipment
2. Acquiring and selling investments other than cash
equivalents
3. Making and collecting loans
 Cash inflows include the cash received from selling
investments, and from collecting loans.
 Cash outflows include cash paid to purchase property
and equipment, cash invested in another corporation’s
stocks or bonds, and cash loaned to borrowers.
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 Financing Activities
 Financing activities, the last category listed on the
statement of cash flows, includes:
1. Cash transactions that involve borrowing from or
repaying creditors
2. Additional cash investments from owners
3. Transactions that reduce owners’ investments
 Cash inflows include proceeds received from short- or
long-term borrowing and those from issuing stock for
cash.
 Cash outflows include repayments of loans (issuing
notes or bonds) and payments to owners, including
personal withdrawals and cash dividends.
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 Developing the Statement
of Cash Flows
STEP 1. Determine the change in cash.
STEP 2. Determine the net cash flows from
operating activities.
STEP 3. Determine the net cash flows from
investing activities.
STEP 4. Determine the net cash flows from
financing activities.

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 Illustration 1
Jenny’s Paintings, a one-owner merchandising
business operates on the accrual basis.
Illustration 1

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Illustration 1

(concluded) 22–13
 Illustration 1

STEP 1. Determine the change in cash.

Jenny’s Paintings had a $3,600 ($31,400 ‒ $35,000)
decrease in cash for the year. This change in cash will be
verified on the statement of cash flows at the bottom of
the statement.

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 Illustration 1
STEP 2. Determine the net cash flows from operating
activities.
The net income for Jenny’s Paintings is $146,000 as
found on the income statement. This amount is listed
first in the Operating Activities.

Next, we will add or subtract noncash operating income

and expense items. We need to convert net income to a
cash-only basis.
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 Illustration 1
 Depreciation Expense. Jenny’s Paintings had $22,000
recorded as Depreciation Expense, Equipment on the
income statement for the current year. Depreciation
decreases net income but represents a noncash amount
that was deducted from net income. So, we need to add
it back.

To convert net income from an accrual basis to a cash basis, we

will adjust net income for the change in current assets (other than
Cash) and current liabilities that are found on the balance sheet.
 Illustration 1
Increase in Accounts Receivable. Accounts
Receivable increased by $12,600 ($45,600 – $33,000).
The $12,600 increase in accounts receivable,
representing noncash sales, will need to be subtracted
from net income.

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 Illustration 1
 Increase in Merchandise Inventory. In order to
analyze Merchandise Inventory, it will help if we
review of the T accounts related to cost of Goods sold—
Cash, Merchandise Inventory, Accounts Payable,
and Cost of Goods Sold.
 As you analyze the T accounts and the journal entries,
notice that cash payments for inventory sold during the
year are $8,500 ($518,500 – $510,000) higher than
what is represented by Cost of Goods Sold on the
income statement.

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Illustration 1

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Illustration 1

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 Illustration 1
 The difference in Cost of Goods Sold is comprised of
two parts: the change in inventory, $4,000 ($130,000 –
$126,000), and the change in Accounts Payable,
$(4,500) ($51,500 – $56,000).
 The increase in inventory of $4,000 will need to be
subtracted from net income to eliminate the noncash
portion of cost of goods sold.
 Illustration 1
Increase in Prepaid Insurance. The Prepaid Insurance
account for Jenny’s Paintings increased by $900 during the
year. This means that $900 more in cash than the $400
listed as Insurance Expense on the income statement was
paid out. Below is a summary journal entry:

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Illustration 1

(continued)
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 Illustration 1
 Decrease in Accounts Payable. Jenny’s Paintings Accounts
Payable decreased by $4,500. The reduction in Accounts
Payable means that the company paid cash of $4,500 to
suppliers that was not reflected in the cost of goods sold
shown on the income statement.
 The additional cash outflow of $4,500 needs to be subtracted
from net income to reflect operating activities on a cash basis.
 Illustration 1
Increase in Salaries Payable. The Salaries Payable
account increased by $400 during the year. As depicted in
the following summary journal entry, Jenny’s Paintings’
Salary Expense.

Salary Expense

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Illustration 1

(continued)
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 Illustration 1
Let’s total the Operating Activities.

(continued)
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Converting from Accrual to Cash Basis

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 Illustration 1
STEP 3. Determine the net cash flows from investing
activities.
 Investing activities are concerned with changes in
property and equipment (long-term assets). There were
no changes in the Equipment account balance.
 Accumulated Depreciation, Equipment increased
from $40,000 to $62,000. This $22,000 change is
accounted for by reporting $22,000 as Depreciation
Expense.
 Because there are no other changes in long-term
assets, we can say that there have been no cash
transactions involving investing activities.
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 Illustration 1
STEP 4. Determine the net cash flows from financing
activities.
Financing activities include additions to or reductions in
owner’s equity. On the statement of owner’s equity, we
note $150,000 in personal withdrawals. We record
$150,000 as an outflow of cash in the Financing Activities
section.

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 Illustration 1
Putting these cash conversions all together, we have the
complete statement of cash flows for Jenny’s Paintings.
 Illustration 2
Bryan Corporation is a merchandising business operating on an
accrual basis. In this example, you will learn how to handle sale
of equipment, issuance on note payable, and issuance of stock.
Illustration 2

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Illustration 2

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Illustration 2

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 Illustration 2

STEP 1. Determine the change in cash.

Bryan Corporation had a $14,400 ($47,800 – $33,400)
increase in cash for the year. This change in cash will be
verified on the statement of cash flows at the bottom of the
following statement:

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 Illustration 2
STEP 2. Determine the net cash flows from operating
activities.
Bryan Corporation had net income of $2,500 during the
year. This is listed first in the Operating Activities section of
the statement of cash flows.

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 Illustration 2
Depreciation Expense. Depreciation Expense is
treated as an addition to cash flows. Depreciation
Expense is a noncash expense that we need to add
back to determine net income on a cash basis. Bryan
Corporation had $24,000 recorded as Depreciation
Expense on the income statement for the current year.
The adjustment is added to net income.

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 Illustration 2
Gain (or Loss) on Disposal of Property and Equipment.
Gain (or Loss) on Disposal of Property and Equipment is a
noncash net income item. The cash received when disposing of
the equipment is reported in the Investing Activities section.
Bryan Corporation’s income statement shows a $5,000 gain on
sale of property and equipment. An adjustment is necessary to
remove the gain from Cash Flows from Operating Activities.
 Illustration 2

Loss on Disposal of Property and Equipment is treated in the

opposite manner. A loss is an addition to cash flows and is
added to net income in the Operating activities section.

As we did in Illustration 1, we need to convert net

income from an accrual basis to a cash basis.
We must adjust net income for the changes in
current assets (other than Cash) and current
liabilities that are found n the balance sheet.

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 Illustration 2
Decrease in Accounts Receivable. Bryan Corporation
experienced a decrease of $2,600 ($66,400 – $69,000) it
its Accounts Receivable account. This means less was
recorded as revenue than was received in cash.
Therefore, $2,600 needs to added to net income.

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 Illustration 2
Increase in Merchandise Inventory. Let’s look at the T
accounts related to cost of goods.

(c) Cash payments

(b) Purchases of (a) The cost of goods
for inventory for
inventory for year that were sold
the year

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 Illustration 2
Increase in Prepaid Insurance. If a prepaid expense
increases, cash payments for the item(s) are more than
the amount listed as an expense and will need to be
subtracted from net income. Because Bryan Corporation’s
Prepaid Insurance increased by $1,100 during the year,
net income will need to be reduced by that amount.
 Illustration 2
Decrease in Accounts Payable. Bryan Corporation’s
Accounts Payable account decreased by $11,100. This
means that the company paid cash of $11,100 to suppliers
that was not reflected in the Cost of Goods Sold shown on
the income statement. Therefore, the $11,100 should be
subtracted from net income.
 Illustration 2
Decrease in Wages Payable. Bryan Corporation’s
Wages Payable account decreased by $300 during
the year. When Wages Payable decreases, more
wages were paid than were actually recorded in net
income, so we to decrease net income.
 Illustration 2

Increase in Property Tax Payable and Interest

Payable. Bryan Corporation’s Property Tax Payable
account increased by $200 during the year, while
Interest Payable increased by $600. Less property
taxes and interest was paid for than actually used or
expired, so we increase net income for Bryan
Corporation by $200 and $600, respectively.

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Illustration 2

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 Illustration 2
Now, the complete Operating Activities.

Note that there are

no adjustments for
the change in Notes
Payable and
Dividends Payable.
These are reported
in the Financing
Activities section.
 Illustration 2

STEP 3. Determine the net cash flows from investing

activities.
Record Cash Receipts from the Sale of Equip-ment.
 Investing activities include changes in property and
equipment (long-term assets).
 During 2011, Equipment decreased from $143,000 to
$114,000.
 Gain on Disposal of Property and Equipment of
$5,000 is listed as Other Income.

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 Illustration 2
 Accumulated Depreciation increased only $12,000
even though there was $24,000 reported in Depreciation
Expense on the income statement.

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Illustration 2

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 Illustration 2

Notice that there is no adjustment for

Depreciation Expense because this
adjustment was already made in the
Operating Activities section.

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 Illustration 2
STEP 4. Determine the net cash flows from financing activities.
Convert Notes Payable to Cash Receipts from the Issuance of
a Note. Notes Payable increased from $0 to $24,000.
 Illustration 2
Convert Common Stock to Cash Receipts from the Issuance
of Common Stock. During 2011, Common Stock increased
from $297,500 to $306,500.
 Illustration 2
Convert Dividends to Cash Payments of Dividends. On
the statement of retained earnings, we note $16,000 listed
as cash dividends. Dividends Payable decreased from
$3,000 to $2,000.

Cash Dividends Declared $16,000

+ Beginning Dividends Payable 3,000
= Total $19,000
– Ending Dividends Payable 2,000
= Cash Payments of Dividends $17,000

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Illustration 2

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 Noncash Investing and
Financing Transactions
 A significant transaction sometimes does not affect
cash directly. For example, issuing a long-term
mortgage for the purchase of land, or issuing common
stock for the land and building.
 The Financial Accounting Standards Board determined
that these noncash transactions should be presented
in a separate schedule at the bottom of the statement
of cash flows.

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 Benefits to Users

 Anyone who uses financial statements can gather a

great deal of information from the statement of cash
flows.
 Managers, investors, and creditors use the statement
of cash flows to judge how a company is doing.

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