Cash Flow Statement Preparation Flashcards

Question 1

What is the purpose of the statement of cash flows?

Accepted Answer

The statement of cash flows reports the cash received and paid by a business during a period. It shows why cash changed, grouping activity into operating, investing, and financing categories. Unlike the income statement, it excludes accrual-based revenue and expense timing, so it reveals liquidity and the ability to fund operations.

Question 2

What is the difference between cash and cash equivalents?

Accepted Answer

Cash includes currency on hand and deposits available for immediate withdrawal. Cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash and close enough to maturity that value changes from interest rates are insignificant. Common examples include Treasury bills with original maturities of three months or less.

Question 3

What are the three categories of activities on the cash flow statement?

Accepted Answer

The three categories are operating, investing, and financing activities. Operating activities cover cash from core revenue-producing operations such as sales and payments to suppliers. Investing activities cover buying and selling long-term assets and certain securities. Financing activities cover borrowing, repaying debt, issuing stock, and paying dividends to owners.

Question 4

Why does the total of the three activity categories equal the change in cash?

Accepted Answer

Every cash transaction appears in exactly one of the three categories, so adding the category totals captures all cash movement. Adding the net change from operating, investing, and financing gives the overall increase or decrease in cash for the period. Foreign currency effects on cash are reported as a separate line when they apply.

Question 5

Why must changes in balance sheet accounts be analyzed when preparing the statement?

Accepted Answer

Balance sheet accounts record the cumulative effect of past transactions, so their period-to-period changes reveal the cash effect of activity. An increase in an asset usually uses cash, while an increase in a liability or equity account usually provides cash. Analysts compare opening and closing balances to identify these cash effects for each line.

Question 6

What does a negative number on the cash flow statement indicate?

Accepted Answer

A negative number in a cash flow line shows a net cash outflow, meaning cash left the business in that category. Parentheses are the usual format for negative amounts. Persistent negative operating cash flow can signal that core operations are not generating enough cash.

Question 7

Why is net income not the same as cash generated by operations?

Accepted Answer

Net income is calculated on the accrual basis, recognizing revenue when earned and expenses when incurred, regardless of when cash moves. Operating cash flow therefore differs because of non-cash expenses like depreciation and changes in receivables, inventory, and payables. Adjustments convert accrual income into cash generated by operations.

Question 8

What is the difference between the direct and indirect methods?

Accepted Answer

The direct method reports operating cash receipts and payments by category, such as cash collected from customers and cash paid to suppliers. The indirect method starts with net income and adjusts for non-cash items and working capital changes. Both give the same operating cash flow total, but the indirect method is more common.

Question 9

What is the first step in preparing operating cash flow by the indirect method?

Accepted Answer

The first step is to start with net income from the income statement for the period. This figure is on an accrual basis, so it becomes the starting point for adjustments. Each subsequent adjustment converts an accrual item into its cash equivalent, moving the total toward actual cash generated by operations.

Question 10

Why is depreciation added back when using the indirect method?

Accepted Answer

Depreciation reduces net income as a non-cash expense, since no cash leaves the business when the allocation is recorded. Adding it back reverses that deduction. The cash outflow for the asset occurred earlier, when it was purchased, and that outflow appears in investing activities instead.

Question 11

How are gains and losses on asset sales treated in operating activities?

Accepted Answer

A gain on the sale of an asset is subtracted from net income, and a loss is added back. The full sale proceeds are reported in investing activities, so removing the gain or loss from operating avoids counting the same amount twice. The gain or loss is a non-cash component of net income.

Question 12

How do increases in accounts receivable affect operating cash flow?

Accepted Answer

An increase in accounts receivable means revenue was recorded but cash has not yet been collected, so the adjustment is a deduction from net income. A decrease means customers paid more than the period's credit sales, so the change is added back. Credit sales are a common source of this difference.

Question 13

How do changes in inventory affect operating cash flow?

Accepted Answer

An increase in inventory means the business spent cash to acquire goods not yet sold, so the change is subtracted from net income. A decrease in inventory means goods sold were partly from existing stock, so the reduction is added back. Inventory relates to the core sales cycle.

Question 14

How do increases in accounts payable affect operating cash flow?

Accepted Answer

An increase in accounts payable means expenses were recorded but cash has not yet been paid, so the change is added back to net income. A decrease in accounts payable means the business paid down earlier obligations, so the reduction is subtracted. Delaying payments to suppliers therefore temporarily increases operating cash flow.

Question 15

How are accrued liabilities and prepaid expenses adjusted in the indirect method?

Accepted Answer

An increase in an accrued liability is added back, because the expense was recognized without cash being paid. An increase in a prepaid expense is subtracted, because cash was paid before the expense was recognized. Reverse these signs when the balances decrease, since the cash effect then runs in the opposite direction.

Question 16

How do you verify that the operating subtotal is correct?

Accepted Answer

Confirm that every balance sheet change appears exactly once with the correct sign. Check that the operating adjustments plus net income equal operating cash flow, and that non-operating changes are captured in other sections. A missing account is a frequent cause of mismatch.

Question 17

Which common transactions are classified as investing activities?

Accepted Answer

Investing activities generally include purchasing and selling property, plant, and equipment, buying and selling investments in other companies' debt or equity securities, and making or collecting loans to others. Cash paid for capital expenditures is the most common investing outflow for most businesses.

Question 18

Which common transactions are classified as financing activities?

Accepted Answer

Financing activities include issuing or repurchasing the company's own stock, borrowing money and repaying principal on loans or bonds, and paying cash dividends to shareholders. Payments of principal on debt are financing, while interest paid is generally reported in operating activities under US GAAP.

Question 19

How is the purchase of equipment with cash shown on the statement?

Accepted Answer

The purchase appears as a negative amount in investing activities, labeled something like purchase of equipment, because cash left the business to acquire a long-term asset. It does not reduce net income directly. Depreciation on that equipment is later added back in operating activities.

Question 20

How are proceeds from issuing new common stock reported?

Accepted Answer

Cash received from issuing new common stock is reported as a positive inflow in financing activities. The amount is typically the cash received net of issuance costs. The stock issuance does not appear in operating activities, even though it affects equity on the balance sheet.

Question 21

How are dividends paid to shareholders presented in the cash flow statement?

Accepted Answer

Cash dividends paid to shareholders are shown as a negative amount in financing activities. They are not an expense on the income statement, so they do not reduce net income and are not part of operating cash flow. Dividends declared but not yet paid are not reported as cash outflows until payment occurs.

Question 22

Why are noncash investing and financing transactions excluded from the cash sections?

Accepted Answer

Noncash transactions, such as acquiring equipment by issuing a note payable or converting debt into stock, do not change cash during the period. Because the statement reports only cash movements, these transactions are disclosed separately in a supplementary schedule or footnote. Including them would misstate the cash flows.

Question 23

How are loans made to other parties and collections of those loans classified?

Accepted Answer

Cash lent to other parties is an investing outflow, and cash collected from principal repayments is an investing inflow. Loans made by a financial institution as its ordinary business are often treated as operating activities instead. The classification depends on the nature of the business and applicable reporting rules.

Question 24

What does a net cash outflow from financing activities usually indicate?

Accepted Answer

A net financing outflow usually means the company repaid more debt, bought back stock, or paid more dividends than it raised from new borrowing or equity. This is not necessarily negative, since mature firms often return cash to owners. Investing and operating results help judge whether such payments are sustainable.

Question 25

What are the main cash receipts under the direct method?

Accepted Answer

The main operating receipts under the direct method are cash collected from customers and interest and dividends received. Cash from customers is computed as sales revenue adjusted for the change in accounts receivable and, where relevant, unearned revenue. Receipts are reported as gross amounts, not as adjustments to net income.

Question 26

How is cash paid to suppliers computed under the direct method?

Accepted Answer

Cash paid to suppliers equals cost of goods sold adjusted for the change in inventory and the change in accounts payable. Purchases equal cost of goods sold plus the increase in inventory, then cash paid equals purchases minus the increase in accounts payable. Balance sheet changes convert accrual figures to cash. Decreases reverse these adjustments, and the same logic applies to other operating expenses.

Question 27

How are cash payments for operating expenses and income taxes calculated?

Accepted Answer

Cash paid for operating expenses equals the expense on the income statement adjusted for changes in related prepaid and accrued accounts, excluding depreciation. Cash paid for income taxes equals tax expense adjusted for changes in taxes payable. Each figure converts an accrual amount to cash.

Question 28

What is the purpose of the reconciliation schedule that accompanies the direct method?

Accepted Answer

The reconciliation schedule reports net income and adjusts it to operating cash flow, showing the same result as the indirect method. Companies using the direct method must disclose this reconciliation of net income to net cash from operating activities. It lets readers see how accrual income relates to cash generated.

Question 29

Why do direct and indirect methods produce the same total operating cash flow?

Accepted Answer

Both methods measure the same underlying cash receipts and payments from operations, just presented differently. The indirect method reaches the total by starting from net income and adjusting for noncash items, while the direct method sums the cash transactions themselves. Because the cash amounts do not change, the operating total is identical.

Question 30

How do you check a direct method schedule against the balance sheet?

Accepted Answer

Compare the total operating cash flow from the direct schedule with the total from an indirect calculation built from the same data. Then confirm that investing and financing totals, combined with operating cash flow, equal the change in cash on the balance sheet. Any gap points to a misclassified or omitted transaction.

Question 31

What is the role of the beginning and ending balances in direct method calculations?

Accepted Answer

Beginning and ending balances of receivables, inventory, payables, and similar accounts drive each direct-method line. The change between them shows how much of the period's accrual amount was collected or paid in cash. Receipts and payments are computed by applying these changes to the income statement amounts for the period.

Question 32

How are cash receipts from interest income determined when interest receivable exists?

Accepted Answer

Cash receipts from interest equal interest income adjusted for the change in interest receivable. An increase in interest receivable means income was earned but not yet collected, so the amount collected is smaller than income. A decrease means prior accruals were collected, so receipts exceed income.

Question 33

What are the steps for preparing a statement of cash flows from comparative balance sheets?

Accepted Answer

Start by computing the change in each balance sheet account between periods. Next, use the income statement and those changes to build operating cash flow, then analyze investing and financing accounts for cash effects. Finally, total the three sections, confirm the sum equals the change in cash, and prepare any noncash disclosures.

Question 34

What is the T-account approach used to prepare the cash flow statement?

Accepted Answer

The T-account approach places each balance sheet change in a working T-account and records the related cash flow entries until the cash account reconciles. Each noncash account, such as equipment or long-term debt, is analyzed for its cash effects. This method provides a systematic check that no account is omitted from the statement.

Question 35

How do you compute a company's free cash flow from its statement?

Accepted Answer

A common measure is operating cash flow minus capital expenditures, which is the purchase of property, plant, and equipment shown in investing activities. Some analysts also subtract other recurring investments. Definitions vary, so the formula used should always be stated when comparing companies.

Question 36

Why might a profitable company still report negative operating cash flow?

Accepted Answer

Rapid sales growth can tie up cash in receivables and inventory, so net income rises while cash lags behind. Paying suppliers or employees faster than customers pay can also drain cash. Profit is an accrual measure, and timing differences in collections and payments can make operating cash flow negative even when income is positive.

Question 37

How can a company's cash flow pattern reveal its life cycle stage?

Accepted Answer

A young company often shows negative operating and investing cash flows, funded by positive financing inflows from borrowing or stock sales. A mature company usually generates positive operating cash flow, invests moderately, and returns cash through debt repayment and dividends. A declining company may show shrinking operating cash flow, offset by asset sales.

Question 38

What does the ratio of operating cash flow to net income reveal?

Accepted Answer

The ratio shows how much of reported earnings is backed by actual operating cash. A ratio near or above one suggests earnings quality is strong, while a persistently low ratio can signal aggressive revenue recognition or rising receivables. Analysts look at this ratio over several periods rather than relying on a single period's result.

Question 39

How does a cash flow statement help evaluate a company's liquidity?

Accepted Answer

The statement shows whether operations generate enough cash to cover debt payments, capital needs, and dividends without new borrowing. Liquidity depends on the timing and amount of cash inflows and outflows, which the balance sheet alone cannot show. Reviewing trends across the three categories reveals whether the company depends on external financing.

Question 40

What does a sudden drop in cash from operations combined with rising debt suggest?

Accepted Answer

The combination suggests the business may be relying on borrowing to fund its core activities or to cover shortfalls. Analysts would examine whether the drop reflects temporary working capital swings, such as inventory buildup, or a lasting decline in earnings quality. Such a pattern deserves closer review of the notes and future obligations.

Cash Flow Statement Preparation Flashcards

1Foundations of the Cash Flow Statement

2Indirect Method Operating Adjustments

3Investing and Financing Activities

4Direct Method and Reconciliation

5Applied Preparation and Analysis

Learning Resources