Preparing a statement of cash flows involves five steps: compute the net increase or decrease in cash; compute and report the net cash provided or used by operating activities (using either the direct or indirect method; both are explained); compute and report the net cash provided or used by investing activities; compute and report the net cash provided or used by financing activities; and compute the net cash flow by combining net cash provided or used by operating, investing, and financing activities and then prove it by adding it to the beginning cash balance to show that it equals the ending cash balance.
Computing the net increase or net decrease in cash is a simple but crucial computation. It equals the current period’s cash balance minus the prior period’s cash balance. This is the bottom-line figure for the statement of cash flows and is a check on accuracy. The information we need to prepare a statement of cash flows comes from various sources including comparative balance sheets at the beginning and end of the period, and an income statement for the period. There are two alternative approaches to preparing the statement: (1) analyzing the Cash account and (2) analyzing noncash accounts.
Point: View the change in cash as a target number that we will fully explain and prove in the statement of cash flows.
Analyzing the Cash Account A company’s cash receipts and cash payments are recorded in the Cash account in its general ledger. The Cash account is therefore a natural place to look for information about cash flows from operating, investing, and financing activities. To illustrate, review the summarized Cash T-account of Genesis, Inc., in Exhibit 16.6. Individual cash transactions are summarized in this Cash account according to the major types of cash receipts and cash payments. For instance, only the total of cash receipts from all customers is listed. Individual cash transactions underlying these totals can number in the thousands. Accounting software is available to provide summarized cash accounts.
Preparing a statement of cash flows from Exhibit 16.6 requires determining whether an individual cash inflow or outflow is an operating, investing, or financing activity, and then listing each by activity. This yields the statement shown in Exhibit 16.7. However, preparing the statement of cash flows from an analysis of the summarized Cash account has two limitations. First, most companies have many individual cash receipts and payments, making it difficult to review them all. Accounting software minimizes this burden, but it is still a task requiring professional judgment for many transactions. Second, the Cash account does not usually carry an adequate description of each cash transaction, making assignment of all cash transactions according to activity difficult.
Analyzing Noncash Accounts A second approach to preparing the statement of cash flows is analyzing noncash accounts. This approach uses the fact that when a company records cash inflows and outflows with debits and credits to the Cash account (see Exhibit 16.6), it also records credits and debits in noncash accounts (reflecting double-entry accounting). Many of these noncash accounts are balance sheet accounts—for instance, from the sale of land for cash. Others are revenue and expense accounts that are closed to equity. For instance, the sale of services for cash yields a credit to Services Revenue that is closed to Retained Earnings for a corporation. In sum, all cash transactions eventually affect noncash balance sheet accounts. Thus, we can determine cash inflows and outflows by analyzing changes in noncash balance sheet accounts.
Exhibit 16.8 uses the accounting equation to show the relation between the Cash account and the noncash balance sheet accounts. This exhibit starts with the accounting equation at the top. It is then expanded in line (2) to separate cash from noncash asset accounts. Line (3) moves noncash asset accounts to the right-hand side of the equality where they are subtracted. This shows that cash equals the sum of the liability and equity accounts minus the noncash asset accounts. Line (4) points out that changes on one side of the accounting equation equal changes on the other side. It shows that we can explain changes in cash by analyzing changes in the noncash accounts consisting of liability accounts, equity accounts, and noncash asset accounts. By analyzing noncash balance sheet accounts and any related income statement accounts, we can prepare a statement of cash flows.
Information to Prepare the Statement Information to prepare the statement of cash flows usually comes from three sources: (1) comparative balance sheets, (2) the current income statement, and (3) additional information. Comparative balance sheets are used to compute changes in noncash accounts from the beginning to the end of the period. The current income statement is used to help compute cash flows from operating activities. Additional information often includes details on transactions and events that help explain both the cash flows and noncash investing and financing activities.