Question: Recall from your financial accounting course that the accrual basis of accounting recognizes revenue when earned and expenses when incurred, regardless of when cash is exchanged. Conversely, the cash basis of accounting recognizes revenue when cash is received and expenses when cash is paid, regardless of when goods or services are exchanged. The income statement, balance sheet, and statement of owners’ equity are all created using the accrual basis of accounting. However, the statement of cash flows is based on cash flows only, and thus adjustments must be made to convert accrual basis information to a cash basis. What information is necessary to make these adjustments?
Answer: Several pieces of information are required to make these adjustments in preparing the statement of cash flows:
Question: With this information in hand, four steps are required to prepare the statement of cash flows. What are these four steps?
Answer: The four steps required to prepare the statement of cash flows are described as follows:
Step 1. Prepare the operating activities section by converting net income from an accrual basis to a cash basis.
This step can be done using one of two methods—the direct method or the indirect method. Because more than 98 percent of companies surveyed use the indirect method (see Note 12.15 "Business in Action 12.3"), we will use the indirect method throughout this chapter. The appendix describes the direct method.
The indirect methodA statement of cash flows method that begins with net income from the income statement and makes several adjustments related to changes in current assets, current liabilities, and other items to arrive at cash provided by (used by) operating activities. begins with net income from the income statement and makes several adjustments related to changes in current assets, current liabilities, and other items to arrive at cash provided by operating activities (or used by operating activities if the result is a cash outflow). Cash provided by operating activities represents net income on a cash basis. It tells the reader how much cash was received from the daily operations of the business.
Step 2. Prepare the investing activities section by presenting cash activity for noncurrent assets.
This step focuses on the effect changes in noncurrent assets have on cash. Noncurrent asset balances found on the balance sheet, coupled with other information (e.g., cash proceeds from sale of equipment) are used to perform this step.
Step 3. Prepare the financing activities section by presenting cash activity for noncurrent liabilities and owners’ equity.
This step focuses on the effect changes in noncurrent liabilities and owners’ equity have on cash. Noncurrent liabilities and owners’ equity balances found on the balance sheet, coupled with other information (e.g., cash dividends paid) are used to perform this step.
Step 4. Reconcile the change in cash.
Each section of the statement of cash flows described in steps 1, 2, and 3, will show the total cash provided by (increase) or used by (decrease) the activity. Step 4 simply confirms that the net of these changes equates to the change in cash on the balance sheet.
For example, assume the balance sheet shows cash totaled $100 at the end of last year and $140 at the end of the current year. Thus cash increased $40 over the course of the current year. Step 4 reconciles this change with the changes shown in the three sections of the statement of cash flows. Suppose operating activities provided cash of $170, investing activities used cash of $160, and financing activities provided cash of $30. These 3 amounts netted together reconcile to the $40 increase in cash shown on the balance sheet (= $170 − $160 + $30).
Indirect Method Is Most Popular
Most companies prefer to use the indirect method to prepare the operating activities section of the statement of cash flows. A survey taken in 2001 showed more than 98 percent of the 600 companies surveyed used the indirect method. Reasons for this preference vary, but several possibilities are as follows:
Source: American Institute of Certified Accountants, Accounting Trends and Techniques (Washington, D.C.: American Institute of Certified Public Accountants, 2001).
The four steps required to prepare the statement of cash flows are described as follows:
Step 1. Prepare the operating activities section by converting net income from an accrual basis to a cash basis.
Step 2. Prepare the investing activities section by presenting cash activities for noncurrent assets.
Step 3. Prepare the financing activities section by presenting cash activities for noncurrent liabilities and owners’ equity.
Step 4. Reconcile the change in cash from the beginning of the period to the end of the period.
Describe the four steps necessary to prepare the statement of cash flows.
Solution to Review Problem 12.3
The four steps required to prepare the statement of cash flows are as follows:
Step 1. Prepare the operating activities section by converting net income from an accrual basis to a cash basis.
This step starts with net income on an accrual basis (from the income statement) and makes adjustments related to changes in current assets, current liabilities, and other items to find net income on a cash basis. The resulting cash basis net income is called cash provided by operating activities.
Step 2. Prepare the investing activities section by presenting cash activity for noncurrent assets.
This step focuses on the effect changes in noncurrent assets have on cash.
Step 3. Prepare the financing activities section by presenting cash activity for noncurrent liabilities and owners’ equity.
This step focuses on the effect changes in noncurrent liabilities and owners’ equity have on cash.
Step 4. Reconcile the change in cash.
Each section of the statement of cash flows described in steps 1, 2, and 3 will show the total cash provided by or used by each activity. Step 4 confirms that the net of these changes equates to the change in cash derived from the balance sheet.
