Preparing the Statement of Cash Flows: A Comprehensive Guide

16.5 Preparing the Statement of Cash Flows

The statement of cash flows is a crucial financial statement that provides insights into a company’s cash inflows and outflows over a specific period. It is essential for assessing a company’s liquidity, financial flexibility, and overall financial health. In this section, we will focus on preparing the statement of cash flows using the indirect method, which is widely used in practice and is a key topic in Canadian accounting exams.

Understanding the Statement of Cash Flows

Before diving into the preparation process, it’s important to understand the structure and purpose of the statement of cash flows. This financial statement is divided into three main sections:

1. Operating Activities: This section reflects the cash generated or used by the company’s core business operations. It includes adjustments for non-cash items and changes in working capital.

2. Investing Activities: This section reports cash flows related to the acquisition and disposal of long-term assets, such as property, plant, equipment, and investments.

3. Financing Activities: This section includes cash flows from transactions with the company’s owners and creditors, such as issuing or repurchasing shares and borrowing or repaying debt.

The Indirect Method

The indirect method is a popular approach for preparing the operating activities section of the statement of cash flows. It starts with net income from the income statement and adjusts for non-cash items and changes in working capital to arrive at cash flows from operating activities. This method is favored because it provides a clear reconciliation between net income and cash flows from operations.

Steps in Preparing the Statement of Cash Flows Using the Indirect Method

Step 1: Gather Necessary Information

To prepare the statement of cash flows, you will need the following financial statements and information:

• Income Statement: To obtain net income and identify non-cash expenses such as depreciation and amortization.

• Balance Sheet: To determine changes in assets, liabilities, and equity accounts between the beginning and end of the period.

• Additional Information: Details about non-cash transactions, such as stock dividends, and any other relevant information not captured in the financial statements.

Step 2: Calculate Cash Flows from Operating Activities

1. Start with Net Income: Begin with the net income figure from the income statement.

2. Adjust for Non-Cash Items: Add back non-cash expenses such as depreciation, amortization, and any impairment losses. Subtract non-cash gains, such as gains on the sale of assets.

3. Adjust for Changes in Working Capital: Analyze the changes in current assets and current liabilities to determine their impact on cash flows. Common adjustments include:

   • Accounts Receivable: A decrease in accounts receivable indicates cash collection, while an increase suggests cash is still owed.
   • Inventory: An increase in inventory represents cash outflow for purchases, whereas a decrease indicates cash inflow from sales.
   • Accounts Payable: An increase in accounts payable suggests cash is retained, while a decrease indicates cash payments to suppliers.
   • Accrued Liabilities: Similar to accounts payable, changes in accrued liabilities reflect cash payments or retentions.

Step 3: Calculate Cash Flows from Investing Activities

1. Identify Cash Flows from Asset Purchases and Sales: Review the balance sheet for changes in long-term asset accounts. Cash outflows occur when assets are purchased, and inflows occur when assets are sold.

2. Consider Non-Cash Transactions: Adjust for any non-cash transactions involving long-term assets, such as exchanges or donations.

Step 4: Calculate Cash Flows from Financing Activities

1. Identify Cash Flows from Debt and Equity Transactions: Examine changes in long-term liabilities and equity accounts. Cash inflows occur from issuing debt or equity, while outflows occur from repaying debt or repurchasing shares.

2. Include Dividend Payments: Cash outflows for dividend payments should be included in this section.

Step 5: Compile the Statement of Cash Flows

1. Summarize Cash Flows: Combine the cash flows from operating, investing, and financing activities to determine the net increase or decrease in cash for the period.

2. Reconcile with Cash Balances: Ensure that the net change in cash reconciles with the beginning and ending cash balances on the balance sheet.

Step 6: Review and Analyze

1. Verify Accuracy: Double-check calculations and ensure all necessary adjustments have been made.

2. Analyze Cash Flow Trends: Evaluate the cash flow statement to understand the company’s liquidity and financial health. Consider the implications of cash flow trends for future operations and strategic decisions.

Practical Example

Let’s consider a practical example to illustrate the preparation of a statement of cash flows using the indirect method.

Example Company: ABC Manufacturing Ltd.

Income Statement for the Year Ended December 31, 2023:

• Net Income: $150,000
• Depreciation Expense: $30,000
• Gain on Sale of Equipment: $10,000

Balance Sheet as of December 31, 2023, and 2022:

Additional Information:

• Equipment with a book value of $20,000 was sold for $30,000.
• Dividends of $50,000 were paid during the year.

Preparation of the Statement of Cash Flows:

Cash Flows from Operating Activities:

• Net Income: $150,000
• Adjustments for Non-Cash Items:
  • Depreciation: +$30,000
  • Gain on Sale of Equipment: -$10,000
• Changes in Working Capital:
  • Increase in Accounts Receivable: -$10,000 ($50,000 - $40,000)
  • Increase in Inventory: -$10,000 ($70,000 - $60,000)
  • Increase in Accounts Payable: +$5,000 ($30,000 - $25,000)

Net Cash Provided by Operating Activities: $155,000

Cash Flows from Investing Activities:

• Sale of Equipment: +$30,000
• Purchase of Equipment: -$10,000 (calculated from net decrease in equipment)

Net Cash Provided by Investing Activities: $20,000

Cash Flows from Financing Activities:

• Repayment of Long-term Debt: -$20,000 ($120,000 - $100,000)
• Payment of Dividends: -$50,000

Net Cash Used in Financing Activities: -$70,000

Net Increase in Cash: $105,000

Reconciliation with Cash Balances:

• Beginning Cash Balance: $10,000
• Ending Cash Balance: $20,000

The net increase in cash of $105,000 reconciles with the change in cash balances from $10,000 to $20,000.

Real-World Applications and Regulatory Considerations

In Canada, companies must prepare financial statements in accordance with International Financial Reporting Standards (IFRS) or Accounting Standards for Private Enterprises (ASPE), depending on their classification. The statement of cash flows is a mandatory component of financial reporting under these standards.

IFRS Considerations:

• Under IFRS, the statement of cash flows is prepared in accordance with IAS 7, which outlines the requirements for presenting cash flows from operating, investing, and financing activities.

• Companies have the option to use either the direct or indirect method for reporting cash flows from operating activities, although the indirect method is more commonly used.

ASPE Considerations:

• ASPE Section 1540 provides guidance on the preparation of the statement of cash flows for private enterprises in Canada.

• Similar to IFRS, ASPE allows for the use of either the direct or indirect method, with the indirect method being more prevalent.

Best Practices and Common Pitfalls

Best Practices:

• Thoroughly Review Financial Statements: Ensure all relevant information is captured from the income statement and balance sheet.

• Double-Check Calculations: Accuracy is crucial in preparing the statement of cash flows. Verify all adjustments and reconciliations.

• Understand Non-Cash Transactions: Be aware of non-cash transactions that may impact cash flow reporting, such as stock dividends or asset exchanges.

Common Pitfalls:

• Overlooking Changes in Working Capital: Failing to account for changes in current assets and liabilities can lead to inaccurate cash flow calculations.

• Misclassifying Cash Flows: Ensure cash flows are correctly categorized into operating, investing, and financing activities.

• Ignoring Non-Cash Adjustments: Non-cash items such as depreciation and gains or losses on asset sales must be properly adjusted to reflect cash flows accurately.

Conclusion

Preparing the statement of cash flows using the indirect method is a vital skill for accounting professionals and is a key component of Canadian accounting exams. By understanding the structure and steps involved, you can effectively analyze a company’s cash flows and assess its financial health. Practice preparing cash flow statements using real-world scenarios to reinforce your understanding and build confidence for the exam.

Ready to Test Your Knowledge?