Preparing the Statement of Cash Flows
This section illustrates a procedure for preparing an implied statement of cash flows using information from the balance sheet and income statement. The implied statement of cash flows assumes that all of the changes in non-cash assets, liabilities, and
implies borrowing, while a decrease implies payment. Due to the four factors discussed earlier in the chapter for why changes rarely match the actual cash flow adjustments, the implied statement of cash flows that you prepare merely approximates the amounts the statement of cash flows would report if the analyst had full access to a firm’s accounting records. For example, you can assume that all changes in operating working capital accounts are operating transactions even though some of these changes might arise from a corporate acquisition or divestiture, which are investing activities. As a second example, consider a firm that acquires another firm by payingcash and assuming its liabilities .
This section illustrates a procedure for preparing an implied statement of cash flows using information from the balance sheet and income statement. The implied statement of cash flows assumes that all of the changes in non-cash assets, liabilities, and
implies borrowing, while a decrease implies payment. Due to the four factors discussed earlier in the chapter for why changes rarely match the actual cash flow adjustments, the implied statement of cash flows that you prepare merely approximates the amounts the statement of cash flows would report if the analyst had full access to a firm’s accounting records. For example, you can assume that all changes in operating working capital accounts are operating transactions even though some of these changes might arise from a corporate acquisition or divestiture, which are investing activities. As a second example, consider a firm that acquires another firm by payingcash and assuming its liabilities .
Only the cash outflow appears in the investing section of the statement of cash flows. Acquiring assets by assuming liabilities is a non-cash acquisition of assets, and these do not appear in the statement of cash flows (because they do not affect cash). However, firms must report them either below the statement of cash flows or in a supplemental note to the financial statements. Absent information about non-cash exchanges, the preparation procedure described in this section assumes that all of the change in each account involves a cash flow that relates to one of the three activities reported in the statement of cash flows. Despite these concerns, the estimated amounts should approximate the actual amounts closely enough for the analyst to make meaningful interpretations.
We further emphasize the above caveat by noting that cash flow statements provided by managers are not a calculation of cash flows, per se. For example, because the statement of cash flows frequently shows an addback for depreciation expense, students sometimes mistakenly infer that if a firm changes depreciation assumptions that, say, increase depreciation expense, then cash flows from operations would increase. To the contrary, cash flows from operations are what they are regardless of a firm’s depreciation policies. A change in depreciation policy for financial reporting is always cash flow neutral.
To illustrate, suppose that after preparing financial statements, a firm receives new information that requires it to shorten the depreciable life of its assets, beginning with the most recently completed year. Consequently, it will need to redo those financial statements. The shortened depreciable life would trigger an increase in depreciation expense. The higher depreciation expense would trigger lower net income. This lower net income would be the revised starting point of the statement of cash flows. The depreciation addback in the operating section would be the new, higher depreciation expense. These changes would cancel each other out, and the resulting cash flows from operations would be identical to those initially reported in the financial statements.
We further emphasize the above caveat by noting that cash flow statements provided by managers are not a calculation of cash flows, per se. For example, because the statement of cash flows frequently shows an addback for depreciation expense, students sometimes mistakenly infer that if a firm changes depreciation assumptions that, say, increase depreciation expense, then cash flows from operations would increase. To the contrary, cash flows from operations are what they are regardless of a firm’s depreciation policies. A change in depreciation policy for financial reporting is always cash flow neutral.
To illustrate, suppose that after preparing financial statements, a firm receives new information that requires it to shorten the depreciable life of its assets, beginning with the most recently completed year. Consequently, it will need to redo those financial statements. The shortened depreciable life would trigger an increase in depreciation expense. The higher depreciation expense would trigger lower net income. This lower net income would be the revised starting point of the statement of cash flows. The depreciation addback in the operating section would be the new, higher depreciation expense. These changes would cancel each other out, and the resulting cash flows from operations would be identical to those initially reported in the financial statements.
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