EXHIBIT 13-3

Net income
Calculation of cash flows
provided by operating
activities—indirect method.
• Non-cash expenses (depreciation,
amortization, depletion)
+ • Losses on investing and financing transactions
• Decreases in current asset balances
• Increases in current liability balances

• Gains on investing and financing transactions

– • Increases in current asset balances
• Decreases in current liability balances

= Cash flow from operating activities

non-cash expenses that were subtracted in calculating net income, such as bad debt
expense, depreciation, amortization, and depletion, are added back. Although these
non-cash expenses reduce income, they do not reduce the company’s cash balance.
Net income must also be adjusted for gains and losses from investing and
financing activities, such as sales of property, equipment, or investments and the
early extinguishment of debt. Let’s consider an example to see why. Suppose a
company that owns some land with a book value of $80,000 sells it for $75,000.
The sale will result in a $5,000 loss that must be recorded on the income state-
ment. Net income, then, is $5,000 lower because of the sale. Because the $5,000
doesn’t represent a cash transaction, however, it must be removed from net in-
come when calculating cash flows. In converting net income to cash flows pro-
vided by operations, then, losses should be added because they were originally
subtracted in calculating net income. Gains should be subtracted because they
were originally added in calculating net income.
Finally, net income must be adjusted for changes in the non-cash current asset
and current liability accounts.3 How do we know whether a change should be added
or subtracted? Think about how the change impacts cash. Let’s start with the cur-
rent asset Accounts Receivable. Accounts Receivable increases by the amount of
sales to customers and decreases by the amount of cash collections from customers.
Accounts Receivable, beginning balance
+ Sales
– Collections from customers
= Accounts Receivable, ending balance

If Accounts Receivable increases (that is, if the ending balance is greater than the
beginning balance), then the amount of cash collected must be less than the amount
of sales included in net income. To convert from sales to collections from customers,
then, we must reduce net income by the increase in Accounts Receivable:

Sales – increase in Accounts Receivable = Collections from customers

Using the same logic, we can adjust net income for changes in each current asset
balance. We subtract increases in the account balance (a use of cash) from net
income. We add decreases in the account balance (a source of cash) to net income.

Unit 13.2 Cash Flows Provided by Operating Activities: The Indirect Method 681
 For current liabilities, the opposite is true. Consider Accrued Liabilities,
which increases when operating expenses are incurred and decreases when op-
erating expenses are paid.

Accrued Liabilities, beginning balance

+ Operating expenses
– Payments for operating costs
= Accrued Liabilities, ending balance

If Accrued Liabilities increases (that is, if the ending balance is greater than the
beginning balance), then operating expenses were greater than payments for those
expenses. That means the amount of cash paid was less than the amount of op-
erating expense included on the income statement. To convert from operating ex-
penses to payments for operating costs, then, we must increase net income by the
increase in Accrued Liabilities. Thus, we add increases in current liabilities to net
income; we subtract decreases in current liabilities from net income.
Let’s work through an example to see how to calculate cash flows provided
by operating activities using the indirect method. To calculate the cash flows, we
will need comparative balance sheets, an income statement, and some additional
information on specific transactions. Exhibits 13-4 and 13-5 show the compara-
tive balance sheets and income statement for Prescott Company. The following
information relates to transactions that occurred during the year:
• Land costing $40,000 was purchased with cash.
• Equipment with a book value of $18,000 was sold for $20,000 cash.

EXHIBIT 13-4 PRESCOTT COMPANY

Prescott Company’s Comparative Balance Sheets
balance sheets. For the Years Ended
12/31/2014 1/1/2014 Increase/(Decrease)
Cash and cash equivalents $ 96,600 $ 11,500 $ 85,100
Accounts receivable 23,200 11,200 12,000
Inventories 323,370 326,340 (2,970)
Total current assets $443,170 $349,040 $ 94,130
Property and equipment, net 128,000 119,700 8,300
Total assets $571,170 $468,740 $102,430

Accounts payable $144,600 $162,200 $ (17,600)

Accrued liabilities 45,220 42,540 2,680
Salaries payable 1,950 1,600 350
Income taxes payable 13,200 12,000 1,200
Dividends payable 14,000 0 14,000
Total current liabilities $218,970 $218,340 $ 630
Long-term debt 128,200 143,200 (15,000)
Total liabilities $347,170 $361,540 $ (14,370)
Common stock $175,000 $ 75,000 $100,000
Retained earnings 49,000 32,200 16,800
Total stockholders’ equity $224,000 $107,200 $116,800
Total liabilities and stockholders’ equity $571,170 $468,740 $102,430

682 Chapter 13 Statement of Cash Flows

 PRESCOTT COMPANY EXHIBIT 13-5
Income Statement Prescott Company’s
For the Year Ending December 31, 2014 income statement.

Sales $1,050,000
Cost of goods sold (777,000)
Gross profit $ 273,000
Operating expenses
Salaries $92,400
Depreciation 13,700
Rent 83,000
Interest 17,000
Utilities 15,000
Other 9,900
Total operating expenses (231,000)
Operating income $ 42,000
Gain on sale of equipment 2,000
Income before taxes $ 44,000
Tax expense (30%) (13,200)
Net income $ 30,800

• No new debt was issued.

• Common stock was issued for $100,000 cash.
• Dividends of $14,000 were declared but not paid.
Exhibit 13-6 shows Prescott’s cash flows provided by operating activities us-
ing the indirect method. Notice that the exhibit begins with the net income shown
on the income statement in Exhibit 13-5. Depreciation expense of $13,700 is
added back, and the $2,000 gain on the sale of equipment is subtracted. The
final adjustments to net income are the changes in the current asset and current
liability accounts. Notice that these amounts match the changes shown in the
balance sheet accounts in Exhibit 13-4. Thus, Prescott’s cash flows provided by
operating activities equal $20,100. The indirect method may seem complicated,

Cash flows provided by operating activities EXHIBIT 13-6

Net income $30,800 Prescott Company’s cash
Adjustments to reconcile net income to flows from operations–
cash provided by operating activities indirect method.
Depreciation $13,700
Gain on sale of equipment (2,000)
Changes in operating assets and liabilities
Increase in accounts receivable (12,000)
Decrease in inventories 2,970
Decrease in accounts payable (17,600)
Increase in accrued liabilities 2,680
Increase in salaries payable 350
Increase in income taxes payable 1,200 (10,700)
Net cash provided (used) by operating activities $20,100

Unit 13.2 Cash Flows Provided by Operating Activities: The Indirect Method 683
 REALITY CHECK—Running out of cash?

In 1966 a new shoe took the courts at Wimbledon when K-Swiss introduced its “Classic”
model, the first leather tennis shoe. Since that time, the company has expanded its product
line to include other shoes, apparel, and accessories.
Entertainment/Getty Images
Valerie Macon/Getty Images

But recent times have not been kind to K-Swiss. Between 2006 and 2012, sales dropped
by approximately 50%, and the company experienced a cash drain of over $200 million.
While the company reported $42.7 million in cash and cash equivalents at the end of 2012,
this was down from $260.2 million at the end of 2006. And for each of the three years from
2010 to 2012, the company’s operations used more cash than they generated.
Some analysts think that cash flows provided by operating activities is a key indicator
of a company’s future performance. StockDiagnostics.com founder Michael Markowski is
one of them. Markowski has developed a measure called operational cash flow per share
(OPS), which he believes is a leading indicator of performance that is not as easily managed
as earnings per share.
Between 2006 and 2012, With $42.7 million in the bank, isn’t K-Swiss still in a good position to succeed even with
sales dropped by approxi- the sales and cash decline? Apparently South Korean apparel distributor E.Land World Ltd.
mately 50%, and K-Swiss thinks so. The company agreed in January 2013 to acquire K-Swiss for $170 million.

experienced a cash drain of Sources: K-Swiss 2012 10-K, K-Swiss 2009 10-K, K-Swiss 2006 10-K, http://www.kswiss.com/customer/page/about
(accessed February 27, 2013); Matt Townsend, “E.Land to Pay $170 Million for K-Swiss Shoes to Add Brands,” http://
over $200 million. www.bloomberg.com/news/2013-01-17/e-land-to-pay-170-million-for-money-losing-shoemaker-k-swiss.html (accessed
February 27, 2013).

but notice that the non-cash items can be found directly on the income state-
ment, and all the changes in the current assets and liabilities are easily calculated
using the balance sheet accounts.

THINK ABOUT IT 13.2

Look at C&C Sports’ Statement of Cash Flows in Exhibit 13-1. Compare net
income to cash flows provided by operating activities. What seems to be causing
C&C Sports’ continual cash flow problems?

UNIT 13.2 REVIEW

PR A CTI CE Q U E STION S

1. LO 2 Which of the following items would be added to 2. LO 2 Which of the following items would be subtracted
net income when using the indirect method of calculat- from net income when using the indirect method of cal-
ing cash flows provided by operating activities? culating cash flows provided by operating activities?

a. A decrease in Accounts Payable a. A gain on the sale of a piece of equipment

b. A decrease in Accounts Receivable b. A loss on the sale of a piece of equipment
c. An increase in Accounts Receivable c. Depreciation expense
d. An increase in Long-Term Debt d. A decrease in Long-Term Debt

684 Chapter 13 Statement of Cash Flows

3. LO 2 Which of the following items would not be included 4. LO 2 During the year, Messer, Inc. purchased $500,000
in the calculation of cash flows provided by operating ac- in inventory from vendors and paid vendors a total of
tivities using the indirect method? $525,000. The result was a decrease in Accounts Pay-
able that should be subtracted from net income in deter-
a. Net income mining cash flows provided by operating activities using
b. Amortization expense the indirect method. True or False?

c. An increase in Inventory 5. LO 2 During the year, Messer, Inc. paid executives

bonuses of 500 shares of stock. This non-cash payment
d. Purchase of a new delivery truck should be subtracted from net income in determining
cash flows provided by operating activities using the
indirect method. True or False?

U N I T 1 3 . 2 P RA CTICE EX ERC IS E
The following balances were gathered from Newton Company’s general ledger.

December 31, 2014 December 31, 2013

Accounts Receivable $75,581 $95,297
Inventories 213,345 117,406
Accounts Payable 60,567 75,447
Accrued Liabilities 21,885 18,113
Income Taxes Payable 2,100 3,750
Sales Revenue 7,549,515
Cost of Goods Sold 4,529,709
Operating Expenses 1,354,355
Depreciation Expense 125,547
Loss on sale of land 30,000
Income Tax Expense 452,971

Required
Using the indirect method, prepare the cash flows provided by operating activities section of Newton’s statement of cash flows
for 2014.

SE L E CTE D U N IT 1 3 . 2 AN S WERS

Think About It 13.2

Although net income and cash flows provided by operat- tors to the use of cash from operations have been the
ing activities have been increasing each year, with net increases in Accounts Receivable and Inventories and
income more than doubling, cash flows provided by op- the decreases in liabilities. Inventories in particular seem
erating activities remain negative. The biggest contribu- to be building up.

Practice Questions
1. B
2. A
3. D
4. True
5. False

Unit 13.2 Review 685

Unit 13.2 Practice Exercise
Cash flows provided by operating activities
Net Income $1,056,933a
Adjustments to reconcile net income to
cash provided by operating activities
Depreciation 125,547
Loss on sale of land 30,000
Changes in operating assets and liabilities
Decrease in Accounts Receivable 19,716
Increase in Inventories (95,939)
Decrease in Accounts Payable (14,880)
Increase in Accrued Liabilities 3,772
Decrease in Income Taxes Payable (1,650)
Net cash provided (used) by operating activities $1,123,499
a
$7,549,515 2 $4,529,709 2 $1,354,355 2 $125,547 2 $30,000 2 $452,971 5 $1,056,933

UNIT 13.3
Cash Flows Provided by Investing
and Financing Activities
GUIDED UNIT PREPARATION

Answering the following questions while you read this unit will guide your understanding
of the key concepts found in the unit. The questions are linked to the learning objectives
presented at the beginning of the chapter.

LO 3 1. In which asset accounts are investing activities recorded?

2. When an asset is sold for a gain, how do you determine the amount to
be reported in the investing section of the statement of cash flows?

LO 4 3. In which liability and equity accounts are financing activities recorded?

As we learned in Unit 13.1, operating activities are not the sole sources and uses
of a company’s cash. Although those activities are certainly more important than
others in generating an ongoing supply of cash, investing and financing activities
also provide and consume cash.

Cash Flows Provided by Investing Activities

Recall from Unit 13.1 that investing activities involve investments in assets other
than current operating assets. These activities include purchases and sales of
property and equipment, loans made and collected, and purchases and sales of
another company’s stock. The safest way to make sure that all investing activities
have been identified is to go through a company’s balance sheet line by line. To
calculate the cash flows provided by investing activities, let’s continue with the
example of the Prescott Company, introduced in Unit 13.2.

686 Chapter 13 Statement of Cash Flows

Property and Equipment
On Prescott Company’s balance sheet, the first account listed after the current
assets is Property and Equipment, net. The balance in this account is calculated
as follows:
Property and Equipment, net, beginning balance
+ Purchase price of assets acquired
– Book value of assets disposed of
– Depreciation expense
= Property and Equipment, net, ending balance

To make sure that all cash activities involving property and equipment have been
identified, we need to enumerate all the changes in this account.
In our example, Prescott paid $40,000 cash for land. This purchase is reported
as a use of cash in the cash flows provided by investing activities section of the state-
ment of cash flows. We also know that Prescott sold a piece of equipment with a
book value of $18,000. Finally, we know from the income statement that $13,700
of depreciation expense was recorded. Let’s plug these items into the equation for
this account to make sure that all transactions have been identified:
Property and Equipment, net, beginning balance $ 119,700
+ Purchase price of assets acquired 40,000
– Book value of assets disposed of (18,000)
– Depreciation expense (13,700)
= Property and Equipment, net, ending balance $ 128,000

As you can see, the depreciation expense and the purchase and sale of property
and equipment comprise all the changes in this account.
Now we need to figure out how to report these items in the investing section
of the statement of cash flows. Recall that depreciation expense was added back
to net income in the operating section of the statement of cash flows, so we don’t
need to do anything more with it. The $40,000 purchase of land is shown as a
use of cash in the investing section. The sale of equipment is a source of cash, but
it should be reported at the cash amount of the transaction, not the book value
of the equipment. Although we already know that the equipment was sold for
$20,000, let’s review the transaction to see how to use book value to determine
the amount reported in the statement of cash flows:

Book value of property sold $18,000

1 Gains or 2 Losses 12,000
Cash from sale of property $20,000
WATCH OUT!
Because the gain must be added to the property’s book value to arrive at the When an asset is sold at a gain
cash amount, we must subtract it from net income. Refer back to the operating or loss, remember to include
two amounts on the statement
section of the statement of cash flows in Exhibit 13-6 to see where the gain was
of cash flows. First, subtract
subtracted from net income. the gain or add the loss from
Exhibit 13-7 shows the cash flows provided by investing activities section of the sale from net income in the
the statement of cash flows. Note that it reports one source of cash, the sale of operating section of the state-
ment of cash flows. Second,
equipment for $20,000, and one use of cash, the purchase of land for $40,000.
report the cash amount of the
The total cash flow provided by investing activities is ($20,000). It is negative sale in the investing section.
because more cash was used than was generated.

Unit 13.3 Cash Flows Provided by Investing and Financing Activities 687
 EXHIBIT 13-7
Cash flows provided by investing activities
Prescott Company’s cash
flows used by investing Sale of equipment $ 20,000
activities. Purchase of land (40,000)
Net cash provided (used) by investing activities $(20,000)

WATCH OUT! Why not just show the ($20,000) as a net use of cash from investing activi-
New property and equipment ties? GAAP requires that companies report these cash flows at gross, not net,
is not always purchased with amounts. That is, when a company makes an investment in an asset (a use of
cash. Sometimes a company cash) and sells an asset (a source of cash), two lines are required on the statement
will issue debt for the pur- of cash flows, one for the investment and one for the sale. The company cannot
chase and pay off the balance
over time. In that case, the add purchases and sales together and report the net amount on a single line.
increase does not result from However, combining all similar investments into a single amount, and all similar
a cash activity, even though sales into another amount, is permissible.
the property and equipment
account increases by the full
purchase price. Therefore, Other Investing Assets
an asset purchased by issu- Although Prescott Company does not have any other investing assets, that is not
ing debt is not reported in
always the case. Companies may also hold notes receivable, marketable securi-
the investing section of the
statement of cash flows. (In ties or investments in other companies, and other assets. The following table
the problems, you will be summarizes the transactions that increase and decrease these additional invest-
told when assets have been ing asset accounts:
purchased by a method other
than cash.)

Marketable Securities/
Notes Receivable Investments Other Assets
Increases Loans made Investments Assets
purchased/acquired purchased/
acquired
Decreases Loans collected/ Investments Assets sold/
written off sold/disposed disposed

Increases and decreases in these accounts may or may not involve cash. For
example, a firm may own stock in a company that has declared bankruptcy
and gone out of business. Although the bankruptcy decreases the amount of the
firm’s investment in the Marketable Securities account, it is not a use of cash.
The firm’s financial statements should provide enough information for users to
determine whether changes in these accounts were sources or uses of cash.

Cash Flows Provided by Financing Activities

Financing can be obtained through either debt (loans) or equity (stock). Financ-
ing activities include issuing and repaying debt, issuing and repurchasing stock,
and paying dividends. Once again, we need to go through all the nonoperating
liability and equity accounts to identify these financing activities.

Debt Financing
Debt accounts increase when new debt is issued (that is, when money is bor-
rowed) and decrease when debt is repaid. On the balance sheet, look for accounts

688 Chapter 13 Statement of Cash Flows

such as “Short-term Notes Payable,” “Long-term Debt,” and “Bonds Payable.”
Regardless of the name, the account balances are calculated as follows:
Beginning balance
1 New debt issued
2 Debt repayments
5 Ending balance

The balance sheet shows the beginning and ending balances in the debt account.
You need only one more piece of information to make sure you have considered
all possible financing activities: the amount of new debt issued or the amount
of debt repaid. If either of these amounts involved a cash transaction, you must
include it in the financing section of the statement of cash flows.
Let’s continue with the Prescott Company example. From the information
found in Exhibits 13-4 and 13-5 we know that no new debt was issued. Therefore,
we can use the following equation to determine whether any debt was repaid:
Long-term Debt, beginning balance $143,200
1 New debt issued 0
2 Debt repayments (x)
5 Long-term Debt, ending balance $128,200

Solving for x, we find that $15,000 of debt was repaid. So we must include a
$15,000 use of cash in the financing section of the statement of cash flows.

Equity Financing
Companies obtain equity financing by issuing new shares of stock. Both com-
mon and preferred stock accounts increase with an issue of new stock and de-
crease with a retirement or repurchase of stock.4

Stock, beginning balance

1 New stock issued
2 Stock retired/repurchased
5 Stock, ending balance

The balance sheet shows the beginning and ending balances in the Stock account.
You need only one more piece of information to make sure you have considered
all possible financing activities: the amount of new stock issued or the amount
of stock retired/repurchased. If either of these amounts involves a cash transac-
tion, you must include it in the financing section of the statement of cash flows.
Continuing with the Prescott Company example, we know from the informa-
tion provided that additional common stock was issued for $100,000 cash. This
amount should be reported as a source of cash in the financing section. Let’s use our
equation to determine whether any stock was retired or repurchased:

Common Stock, beginning balance $ 75,000

1 New stock issued 100,000
2 Stock retired/repurchased (x)
5 Common Stock, ending balance $175,000

Unit 13.3 Cash Flows Provided by Investing and Financing Activities 689
 Solving for x, we find that no other activities were recorded in the Common
Stock account. So the only activity that must be reported on the statement of
cash flows is the issue of stock.
The only other equity account we will discuss is Retained Earnings. This
account increases by the amount of net income for the period and decreases by
dividends declared:

Retained Earnings, beginning balance

+ Net income
– Dividends declared
= Retained Earnings, ending balance

The balance sheet shows the beginning and ending balances in Retained Earn-
ings; the income statement shows net income. If you don’t have any information
about dividends, you can use this equation to determine whether dividends were
declared.
From the information found in Exhibit 13-4, we know that Prescott Company
declared dividends in the amount of $14,000. Let’s use our equation to make
sure that everything has been accounted for in the Retained Earnings account:

Retained Earnings, beginning balance $ 32,200

+ Net income 30,800
– Dividends declared 114,0002
= Retained Earnings, ending balance $ 49,000

Because our equation adds up correctly, we can be sure we have accounted for
all activities in this account.
Neither net income nor dividends declared is a cash flow. Thus, net income
will show up on the statement of cash flows only if the indirect method is used.
Dividends are not reported on the statement of cash flows until they have actu-
ally been paid, at which time they are reported as a use of cash in the section on
financing activities.
How can you determine whether dividends were paid? If dividends were
declared but the balance sheet shows no liability for dividends payable, you can
assume that the dividends were paid. If the balance sheet shows a Dividends
Payable account, you must analyze the account to determine whether some or
all of the declared dividends were paid. The Dividends Payable account increases
when a company declares a dividend and decreases when the dividend is paid:

Dividends Payable, beginning balance

+ Dividends declared
– Dividends paid
= Dividends Payable, ending balance

The balance sheet shows the beginning and ending balances in the Dividends
Payable account. The Retained Earnings account indicates whether a dividend
was declared. With that information, you can determine whether any dividends
were paid during the year.
Continuing with the Prescott Company example, we know that $14,000
in dividends were declared. Let’s use the equation to determine whether any
dividends were paid:

690 Chapter 13 Statement of Cash Flows