Manajemen | Fakultas Ekonomi Universitas Maritim Raja Ali Haji joeb.80.1.41-46
Journal of Education for Business
ISSN: 0883-2323 (Print) 1940-3356 (Online) Journal homepage: http://www.tandfonline.com/loi/vjeb20
Teaching the Indirect Method of the Statement of
Cash Flows in Introductory Financial Accounting: A
Comprehensive, Problem-Based Approach
Daniel R. Brickner & Gary B. Mccombs
To cite this article: Daniel R. Brickner & Gary B. Mccombs (2004) Teaching the Indirect Method
of the Statement of Cash Flows in Introductory Financial Accounting: A Comprehensive,
Problem-Based Approach, Journal of Education for Business, 80:1, 41-46, DOI: 10.3200/
JOEB.80.1.41-46
To link to this article: http://dx.doi.org/10.3200/JOEB.80.1.41-46
Published online: 07 Aug 2010.
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Teaching the Indirect Method of the
Statement of Cash Flows in
Introductory Financial Accounting:
A Comprehensive,
Problem-Based Approach
DANIEL R. BRICKNER
GARY B. McCOMBS
Eastern Michigan University
Ypsilanti, Michigan
W
hen teaching the indirect method
of the statement of cash flows
(SCF) in an introductory financial
accounting course, instructors usually
focus students’ understanding of (a) how
the SCF is constructed and (b) why reconciling items are recorded in the operating activities section. Certainly, the
SCF is an integral financial statement for
financial reporting purposes and an
essential one for any business major to
understand and interpret. Because of the
relative importance of the SCF, we
believe that a need exists in the literature
for alternative instructional aids related
to teaching it, especially in introductory
financial accounting courses.
Alternative methods do exist for teaching and explaining the SCF. However,
there is a relatively scant amount of literature related to instructional resource
materials for the SCF. Before the recent
article by Rai (2003), the only other SCF
instructional materials that we identified
were by Donelan (1993) and Vent and
Cocco (1996). In this article, we present
a unique approach as an alternative to the
strategies illustrated in several commonly
used financial accounting textbooks.
Our instructional materials relate to
preparing the SCF under the indirect
method. Because enrollment in an intro-
ABSTRACT. In this article, the
authors provide an instructional
resource for presenting the indirect
method of the statement of cash flows
(SCF) in an introductory financial
accounting course. The authors focus
primarily on presenting a comprehensive example that illustrates the “why”
of SCF preparation and show how
journal entries and T-accounts can be
used in the analysis of the impact on
net income and/or cash for each transaction in their example. This approach
can be viewed as an alternative to the
methods illustrated in the accounting
education literature and commonly
used financial accounting textbooks.
ductory financial accounting course frequently includes a large number of
nonaccounting majors, our school, like
many others, adopted a balanced orientation between both users and preparers
of financial accounting information.
Consequently, because a financial statement user would need to know how to
read and interpret the financial statements, emphasizing the indirect method
of preparing the SCF in an introductory
financial accounting course appears
appropriate because most firms employ
that approach in practice.
In teaching the indirect method of the
SCF in an introductory financial account-
ing course, we first establish the criteria
regarding where certain transactions or
account changes are reported in the three
sections of the statement. Once we have
established these criteria, we then present
an application of the financial statement
by creating and completing a comprehensive, in-class example. This example
illustrates how the SCF is prepared and
enforces the reasons behind the adjustments made in the operating activities
section under the indirect method.
Our example employs significant
account analysis through journal entries
or T-accounts for evaluating the impact of
transactions on net income or cash. Alternatively, instructors who de-emphasize or
completely avoid the use of journal
entries in introductory financial accounting courses can modify the example by
employing the accounting equation for
account analysis instead of using journal
entries. Our example primarily emphasizes content from the operating activities
section of the SCF. Specifically, our
approach entails asking the following
two questions to analyze how the transaction should be treated in that section:
(a) What was the transaction’s impact on
cash? and (b) What was the transaction’s
impact on net income? By correctly
answering these two questions, students
September/October 2004
41
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should be able to decipher the nature (i.e.,
positive or negative) and the amount of
the adjustment necessary in the reconciliation of net income to cash flows in the
operating activities section.
In this article, we explain our pedagogical approach related to teaching the
SCF in an introductory financial accounting course and identify how it differs
from approaches found in commonly
used financial accounting textbooks. We
then provide our comprehensive example, including both the related analysis
and solution.
PEDAGOGICAL APPROACH
COMPARED WITH FINANCIAL
ACCOUNTING TEXTBOOKS
Our teaching approach begins by
establishing the purpose and the objectives of the SCF. We follow this by
clearly indicating in which of the SCF’s
three sections those transactions or
account changes are reported. After
establishing these “prerequisites,” we
present a comprehensive example that
employs a great deal of account analysis, to explain and illustrate both the
preparation and the format of the SCF.
Although this approach might appear
to be a traditional one for teaching the
SCF, we found that the textbooks that we
have used over the past several years did
not provide a comprehensive problem
that effectively illustrated and explained
how to prepare the SCF. Subsequently,
we examined several other textbooks
commonly used for introductory financial accounting courses to determine
whether a comprehensive illustration was
prevalent. To our surprise, we found that
all of the textbooks examined were deficient in providing a comprehensive
example that employed commonly used
analysis techniques such as journal
entries and T-account analysis. In Table
1, we present a summary of our findings
for the 10 textbooks we reviewed.
As shown in Table 1, each of the textbooks that we reviewed employed journal entries in some capacity. However,
although many of the texts could be
classified as either “preparer oriented”
or oriented to both the preparer’s and
user’s perspectives, only one of the texts
(Needles, 2004) employed journal
entries in explaining the preparation of
the SCF. However, that text did not
employ journal entries comprehensively
in its illustration. This finding was surprising, because we believe that journal
entries provide an effective analysis tool
for explaining the SCF.
We also believe that T-account analysis is effective in explaining the adjustments in the operating activities section
of the SCF. However, only half of the
textbooks that we reviewed employed
T-account analysis in explaining the
preparation of the SCF, and none
among this subset used T-accounts
comprehensively. Specifically, none of
the textbooks that we examined
employed T-account analysis to explain
the adjustment for either the change in
inventory or the treatment of gains and
losses in the operating activities section
of the SCF. We view these adjustments
to be conceptually important.
Therefore, we have created an example that (a) provides analysis and
explains the rationale behind common
adjustments in the operating activities
section of the SCF and (b) illustrates
how to prepare this financial statement
in its entirety. This illustration comprehensively employs journal entries and
T-accounts as analysis tools to aid student understanding of the SCF.
COMPREHENSIVE EXAMPLE
WITH ANALYSIS OF THE SCF
UNDER THE INDIRECT METHOD
In Table 2, we present the income
statement and additional data related to
our comprehensive example.
Analysis of Individual Items in
Completing the Example
Purchase of Equipment and Recording
Depreciation Expense
General concept. As a long-term asset,
TABLE 1. Introductory Textbook Use of Journal Entries and T-Accounts to Explain the Statement of Cash Flows
(SCF) (Indirect Method)
Textbook
(Lead author and
edition are listed)
Edmonds (4th)
Harrison (5th)
Ingram (5th)
Kimmel (3rd)
Libby (4th)
Needles (2004)
Porter (4th)
Werner (3rd)
Weygandt (4th)
Williams (11th)
Does the
textbook
use
journal
entries?
Are journal
entries used
to explain
the SCF?
Are T-accounts used
use to explain the
SCF?
Are journal entries and/or
T-accounts employed to
illustrate comprehensively
the operating activities
section of the SCF?a
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
No
No
No
No
No
Yes
No
No
No
No
No
Yes
No
Yes
Yes
Yes
No
No
Yes
No
N/A
No
N/A
No
No
No
N/A
N/A
No
N/A
a
We define comprehensive illustration of the preparation of the SCF as including the following common components found in a company’s operating activities section of the SCF: changes in accounts receivable, changes in inventory, changes in accounts payable, depreciation, and gains and/or losses.
42
Journal of Education for Business
TABLE 2. Income Statement and Additional Data for the Comprehensive
Example
Sales revenues
Gain on the sale of equipment
Total revenues and gain:
Expenses:
Cost of goods sold
Depreciation expense
Other operating expenses
Income taxes expense
Total expenses:
$500,000
3,000
503,000
300,000
10,000
112,000
21,000
443,000
Net income
60,000
Sale of Equipment for Cash, Resulting
in a Gain
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Additional Data
The company purchased equipment at the beginning of the year for $55,000. The equipment was sold at the end of the year for $48,000, resulting in a $3,000 gain.
All of the company’s purchases of inventory and sales to customers are on account. The
only transactions affecting accounts payable during the year were for purchases of
inventory and payments related to those purchases.
Accounts receivable increased during the year by $10,000.
(The beginning balance of accounts receivable was $40,000.)
Inventory decreased during the year by $50,000.
(The beginning balance of inventory was $75,000.)
Accounts payable decreased during the year by $15,000.
(The beginning balance of accounts payable was $35,000.)
There were no other changes in noncash current assets and current liabilities.
The company issued common stock at par value for $70,000 during the year.
A cash dividend of $5,000 was paid to shareholders during the year.
the purchase of equipment for cash is
recorded in the investing activities section of the statement of cash flows.
Depreciation is included in total expenses to derive net income; however,
because it is a noncash expense, the
accountant adds it back to net income to
compute net cash flows from operating
activities.
Example A. At the beginning of the
year, equipment was purchased for
$55,000 cash. The equipment had an
estimated useful life of 5 years and an
estimated residual value of $5,000.
(1) The journal entry to record the
equipment purchase would be:
Equipment
Cash
income is reduced by the $10,000 of
depreciation expense but there was no
cash outflow related to recording the
expense, one would have to add $10,000
back to net income to derive net cash
flows in the Operating Activities section. (Note: Without this adjustment for
depreciation, the statement of cash
flows would report a $65,000 total cash
outflow related to the equipment for the
year, as opposed to the correct amount
of the $55,000 purchase price.)
55,000
55,000
(2) The journal entry to record annual
depreciation expense for the equipment would be:
Depreciation expense
10,000
Accumulated depreciation 10,000
[Calculated: (55,000 – 5,000)/5 years
= $10,000]
Class discussion question. What was the
impact on both cash flows and net
income from the above journal entries?
Answer. The impact on cash was an outflow of $55,000 from Transaction 1 and
a $10,000 decrease in net income from
Transaction 2.
Analysis. Because the $55,000 cash outflow in Transaction 1 relates to a purchase of a long-term asset, it is reported
in the Investing Activities section. However, in Journal Entry 2, because net
General concept. Cash proceeds from
the sale of equipment, a long-term
asset, should be reported in the investing activities section of the statement
of cash flows. A gain from selling a
long-term asset is included in total revenues (generally treated as “Other
Revenue” on the income statement in
deriving net income). Therefore, to
prevent “double counting” the gain,
the accountant must deduct it from net
income to remove it from the operating
activities section of the statement of
cash flows.
Example B. Assume the equipment
referred to above was sold at the end of
the first year for $48,000 (i.e., after
$10,000 of depreciation had been recorded, resulting in a book value of $45,000
and a gain of $3,000 on the disposal).
The journal entry to record the sale of
the equipment would be:
Cash
48,000
Accumulated depreciation
10,000
Equipment
55,000
Gain on sale of equipment
3,000
Class discussion question. What was
the impact on both cash flows and net
income from the above journal entry?
Answer. The impact on cash was an
inflow of $48,000. Net income increased
by the $3,000 gain.
Analysis. Because the $48,000 cash
inflow relates to the sale of a long-term
asset, it is reported in the “Investing
Activities” section. However, because
September/October 2004
43
net income was increased by the $3,000
gain, it should be subtracted from net
income in the Operating Activities section in order to prevent “doublecounting” it. (Note: Without this adjustment
for the gain, the statement of cash flows
would report a $51,000 total cash inflow
related to the sale of the equipment for
the year, as opposed to the correct
amount of $48,000.)
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Increase in Accounts Receivable
General concept. When accounts
receivable increases during a period,
credit sales (which increase total revenues, and thus net income) exceed
cash collections on account. The
accountant deducts the increase in
accounts receivable from net income to
derive net cash flows from operating
activities.
Example C. At the beginning of the
year, the company had a balance of
$40,000 for accounts receivable. During
the year, they had sales on account for
$500,000. Also, they made cash collections on account in the amount of
$490,000 during the year.
(1) The summary journal entry for credit sales for the year would be:
Accounts receivable
Sales
500,000
500,000
(2) The summary journal entry for cash
collections for the year would be:
Cash
Accounts receivable
490,000
490,000
Class discussion question. What was
the impact on both cash flows and net
income from the above journal entries?
Answer. The impact on cash was an
inflow of $490,000. Net income
increased by the $500,000 increase in
sales revenues (ignoring the cost of
inventory sold, which is discussed in the
next example).
ignoring the cost of inventory sold).
Hence, in order to reconcile net income
to net cash flows from operating activities, $10,000 should be subtracted from
net income. (Note: Without making this
adjustment, the statement of cash flows
would report a $500,000 cash inflow as
opposed to the correct amount of
$490,000.)
Student tip. Notice that the $10,000 negative adjustment to net income (i.e., it is
negative because it is being subtracted
from net income) is exactly equal to the
increase in accounts receivable during
the year, as illustrated in the accounts
receivable T-account shown in Figure 1.
Decreases in Both Inventory and
Accounts Payable
General concept. The decreases for
these accounts imply that purchases of
inventory on account are less than both
the cost of inventory sold and cash payments on accounts payable during the
year (based on our example’s assumption that accounts payable is only affected by purchases of inventory on account
and payments on those purchases).
Because the cost of goods sold is more
than the cost of inventory purchases during the year, the decrease in inventory is
added to net income in order to derive
net cash flows from operating activities.
Also, because the cash payments on
account for inventory exceed the inventory purchases on account, the decrease
in accounts payable is deducted from
net income in deriving net cash flows
from operating activities.
Example D. At the beginning of the
year, the company had a $75,000 balance for inventory and a $35,000 balance for accounts payable. During the
year, inventory in the amount of
$250,000 was purchased on account,
inventory that cost $300,000 was sold,
and payments on account amounted to
$265,000 during the year.
(1) The summary journal entry for
inventory purchases would be:
Inventory
250,000
Accounts payable
250,000
(2) The summary journal entry for
recording the cost of inventory sold
would be:
Cost of goods sold
300,000
Inventory
300,000
(3) The summary journal entry for
payments on account would be:
Accounts payable
Cash
265,000
265,000
Class discussion question. What was
the impact on both cash flows and net
income from the above journal entries?
Answer. The impact on cash was an outflow of $265,000. Net income decreased
by the $300,000 increase in cost of
goods sold (ignoring the effect of sales
revenue, which was discussed in the previous example).
Analysis. The $265,000 cash outflow
relates to expense transactions; therefore,
it is reported in the Operating Activities
section. However, the above transactions
increased expenses (and thus reduced net
income) by the $300,000 of cost of goods
sold (again, ignoring sales revenues).
Hence, to reconcile net income to net
cash flows from operating activities, the
accountant should add the difference of
$35,000 to net income.
Student tips. Notice that the net positive
adjustment of $35,000 to net income is
exactly equal to the net change in the
inventory and the accounts payable
accounts combined. Specifically, inventory decreased by $50,000 during the
AC C O U N T S R E C E I VA B L E
Analysis. The $490,000 cash inflow
relates to revenue transactions; therefore, it is reported in the Operating
Activities section. However, the above
transactions increased revenues (and
thus net income) by $500,000 (again,
44
Journal of Education for Business
Beginning Balance
$10,000
Increase
(1) Sales on Account
Ending Balance
40,000
500,000
490,000
(2) Cash Collections
50,000
FIGURE 1. Accounts receivable T-account related to Example C.
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year, and accounts payable decreased by
$15,000 during the year, as illustrated in
the T-accounts presented in Figure 2.
An alternative way to remember the
sign of the adjustment for changes in
current assets or current liabilities in
the operating activities’ reconciliation
would be to examine what the change
in the account balance implies. For
example, if inventory decreases during
the period, presumably inventory must
have been sold. One would expect that
when inventory is sold, cash would be
received. Therefore, because there
would be a positive effect on cash
when inventory decreases, the sign of
the adjustment in the reconciliation
related to the decrease in inventory is
positive.
Similarly, when accounts payable
decreases, the presumption is that
account balances have been paid, thus
resulting in a decrease in cash. Because
there would be a negative effect on cash
when accounts payable decreases, the
sign of the adjustment in the reconciliation related to the decrease in accounts
payable is negative.
Beginning Balance
300,000
(2) Cost of Inventory Sold
25,000
A C C O U N T S PAYA B L E
35,000
(3) Payments on account
265,000
Example E. During the year, the company sold common stock at par value
for $70,000.
The journal entry for the issuance of
stock would be:
70,000
70,000
75,000
(1) Inventory Purchases 250,000
Ending Balance
General concept. The issuance of
stock is a source of financing for a corporation. Therefore, if cash is received
in exchange for the stock, the cash
proceeds from the sale are reported as
a cash inflow in the financing activities section of the statement of cash
flows.
Cash
Common stock
INVENTORY
$50,000
Decrease
Issuance of Stock for Cash
Beginning Balance
250,000 (1) Inventory Purchases
20,000
$15,000
Decrease
Ending Balance
FIGURE 2. T-accounts related to Example D.
Cash flows from operating activities:
$ 60,000
Depreciation
10,000
Gain on sale of equipment
(3,000)
Increase in accounts receivable
Decrease in inventory
Decrease in accounts payable
Retained earnings
Cash
(10,000)
50,000
(15,000)
Net cash provided by operating activities
General concept. A cash dividend represents a form of return for shareholders. Just as a shareholder’s investment
(in the form of the purchase of stock) is
reported in the financing activities section of the statement of cash flows, a
return on that investment in the form of
a cash dividend also is reported in the
financing activities section; however,
the cash dividend represents a cash outflow to the firm.
Example F. During the year, the company paid a cash dividend of $5,000.
The journal entry for the cash dividend
would be:
TABLE 3. Solution for the SCF Comprehensive Example
Net income
Payment of a Cash Dividend
92,000
5,000
5,000
Upon completing the analysis for
each item affecting the SCF in the comprehensive example, the SCF can be
prepared in its entirety. The SCF solution for our example is provided in
Table 3.
Cash flows from investing activities:
Purchase of equipment
Sales of equipment
(55,000)
Conclusion
48,000
Net cash used in investing activities
(7,000)
Cash flows from financing activities:
Issuance of stock
70,000
Payment of cash dividends
(5,000)
Net cash provided by financing activities
Net increase in cash and cash equivalents
65,000
150,000
In this article, we presented our
classroom approach to teaching the
statement of cash flows (SCF) in the
introductory financial accounting
course. The primary component of our
approach is a problem-based, comprehensive example that employs journal
entries and T-accounts as analysis tools
to demonstrate how to prepare the SCF
September/October 2004
45
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in its entirety under the indirect
method. Our example emphasizes
explaining why adjustments are made
in the operating activities section by
analyzing the effect of transactions on
net income or cash. The approach that
we have presented can be viewed as an
alternative to methods illustrated in
both commonly used financial accounting textbooks and the accounting education literature. Because of the importance of a company’s SCF for financial
reporting purposes, we hope that other
accounting faculty members will find
this instructional resource useful for
both themselves and their students.
REFERENCES
Donelan, J. G. (1993). An integrated approach to
teaching the statement of cash flows. Journal of
Education for Business, 68(4), 234–236.
Edmonds, T. P., McNair, F. M., Milam, E. E., &
Olds, P. R. (2003). Fundamental financial
accounting concepts. New York: McGraw-Hill.
Harrison, W. T., Jr., & Horngren, C. T. (2004).
Financial accounting. Upper Saddle River, NJ:
Pearson Education.
Ingram, R. W., Albright, T. L., & Baldwin, B. A.
(2004). Financial accounting: A bridge to decision making. Mason, OH: South-Western.
Kimmel, P. D., Weygandt, J. J., & Kieso, D. E.
(2004). Financial accounting: Tools for business decision making. New York: Wiley.
Libby, R., Libby, P. A., & Short, D. G. (2004).
Financial accounting. New York: McGraw-Hill.
Needles, B. E., Jr., & Power, M. (2004). Financial
accounting. Boston, MA: Houghton Mifflin.
Porter, G. A., & Norton, C. L. (2004). Financial
accounting: The impact on decision makers.
Mason, OH: South-Western.
Rai, A. (2003). Reconciliation of net income to
cash flow from operations: An accounting
equation approach. Journal of Accounting Education, 21(1), 17–24.
Vent, G. A., & Cocco, A. F. (1996). Teaching the
cash flows from operations section of the statement of cash flows under the indirect method:
A conceptual framework. Journal of Education
for Business, 71(6), 344–347.
Werner, M. J., & Jones, K. H. (2004). Introduction
to financial accounting: A user perspective.
Upper Saddle River, NJ: Pearson Education.
Weygandt, J. J., Kieso, D. E., & Kimmel, P. D.
(2003). Financial accounting. New York:
Wiley.
Williams, J. R., Haka, S. F., Bettner, M. S., &
Meigs, R. F. (2003). Financial accounting. New
York: McGraw-Hill.
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ISSN: 0883-2323 (Print) 1940-3356 (Online) Journal homepage: http://www.tandfonline.com/loi/vjeb20
Teaching the Indirect Method of the Statement of
Cash Flows in Introductory Financial Accounting: A
Comprehensive, Problem-Based Approach
Daniel R. Brickner & Gary B. Mccombs
To cite this article: Daniel R. Brickner & Gary B. Mccombs (2004) Teaching the Indirect Method
of the Statement of Cash Flows in Introductory Financial Accounting: A Comprehensive,
Problem-Based Approach, Journal of Education for Business, 80:1, 41-46, DOI: 10.3200/
JOEB.80.1.41-46
To link to this article: http://dx.doi.org/10.3200/JOEB.80.1.41-46
Published online: 07 Aug 2010.
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Teaching the Indirect Method of the
Statement of Cash Flows in
Introductory Financial Accounting:
A Comprehensive,
Problem-Based Approach
DANIEL R. BRICKNER
GARY B. McCOMBS
Eastern Michigan University
Ypsilanti, Michigan
W
hen teaching the indirect method
of the statement of cash flows
(SCF) in an introductory financial
accounting course, instructors usually
focus students’ understanding of (a) how
the SCF is constructed and (b) why reconciling items are recorded in the operating activities section. Certainly, the
SCF is an integral financial statement for
financial reporting purposes and an
essential one for any business major to
understand and interpret. Because of the
relative importance of the SCF, we
believe that a need exists in the literature
for alternative instructional aids related
to teaching it, especially in introductory
financial accounting courses.
Alternative methods do exist for teaching and explaining the SCF. However,
there is a relatively scant amount of literature related to instructional resource
materials for the SCF. Before the recent
article by Rai (2003), the only other SCF
instructional materials that we identified
were by Donelan (1993) and Vent and
Cocco (1996). In this article, we present
a unique approach as an alternative to the
strategies illustrated in several commonly
used financial accounting textbooks.
Our instructional materials relate to
preparing the SCF under the indirect
method. Because enrollment in an intro-
ABSTRACT. In this article, the
authors provide an instructional
resource for presenting the indirect
method of the statement of cash flows
(SCF) in an introductory financial
accounting course. The authors focus
primarily on presenting a comprehensive example that illustrates the “why”
of SCF preparation and show how
journal entries and T-accounts can be
used in the analysis of the impact on
net income and/or cash for each transaction in their example. This approach
can be viewed as an alternative to the
methods illustrated in the accounting
education literature and commonly
used financial accounting textbooks.
ductory financial accounting course frequently includes a large number of
nonaccounting majors, our school, like
many others, adopted a balanced orientation between both users and preparers
of financial accounting information.
Consequently, because a financial statement user would need to know how to
read and interpret the financial statements, emphasizing the indirect method
of preparing the SCF in an introductory
financial accounting course appears
appropriate because most firms employ
that approach in practice.
In teaching the indirect method of the
SCF in an introductory financial account-
ing course, we first establish the criteria
regarding where certain transactions or
account changes are reported in the three
sections of the statement. Once we have
established these criteria, we then present
an application of the financial statement
by creating and completing a comprehensive, in-class example. This example
illustrates how the SCF is prepared and
enforces the reasons behind the adjustments made in the operating activities
section under the indirect method.
Our example employs significant
account analysis through journal entries
or T-accounts for evaluating the impact of
transactions on net income or cash. Alternatively, instructors who de-emphasize or
completely avoid the use of journal
entries in introductory financial accounting courses can modify the example by
employing the accounting equation for
account analysis instead of using journal
entries. Our example primarily emphasizes content from the operating activities
section of the SCF. Specifically, our
approach entails asking the following
two questions to analyze how the transaction should be treated in that section:
(a) What was the transaction’s impact on
cash? and (b) What was the transaction’s
impact on net income? By correctly
answering these two questions, students
September/October 2004
41
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should be able to decipher the nature (i.e.,
positive or negative) and the amount of
the adjustment necessary in the reconciliation of net income to cash flows in the
operating activities section.
In this article, we explain our pedagogical approach related to teaching the
SCF in an introductory financial accounting course and identify how it differs
from approaches found in commonly
used financial accounting textbooks. We
then provide our comprehensive example, including both the related analysis
and solution.
PEDAGOGICAL APPROACH
COMPARED WITH FINANCIAL
ACCOUNTING TEXTBOOKS
Our teaching approach begins by
establishing the purpose and the objectives of the SCF. We follow this by
clearly indicating in which of the SCF’s
three sections those transactions or
account changes are reported. After
establishing these “prerequisites,” we
present a comprehensive example that
employs a great deal of account analysis, to explain and illustrate both the
preparation and the format of the SCF.
Although this approach might appear
to be a traditional one for teaching the
SCF, we found that the textbooks that we
have used over the past several years did
not provide a comprehensive problem
that effectively illustrated and explained
how to prepare the SCF. Subsequently,
we examined several other textbooks
commonly used for introductory financial accounting courses to determine
whether a comprehensive illustration was
prevalent. To our surprise, we found that
all of the textbooks examined were deficient in providing a comprehensive
example that employed commonly used
analysis techniques such as journal
entries and T-account analysis. In Table
1, we present a summary of our findings
for the 10 textbooks we reviewed.
As shown in Table 1, each of the textbooks that we reviewed employed journal entries in some capacity. However,
although many of the texts could be
classified as either “preparer oriented”
or oriented to both the preparer’s and
user’s perspectives, only one of the texts
(Needles, 2004) employed journal
entries in explaining the preparation of
the SCF. However, that text did not
employ journal entries comprehensively
in its illustration. This finding was surprising, because we believe that journal
entries provide an effective analysis tool
for explaining the SCF.
We also believe that T-account analysis is effective in explaining the adjustments in the operating activities section
of the SCF. However, only half of the
textbooks that we reviewed employed
T-account analysis in explaining the
preparation of the SCF, and none
among this subset used T-accounts
comprehensively. Specifically, none of
the textbooks that we examined
employed T-account analysis to explain
the adjustment for either the change in
inventory or the treatment of gains and
losses in the operating activities section
of the SCF. We view these adjustments
to be conceptually important.
Therefore, we have created an example that (a) provides analysis and
explains the rationale behind common
adjustments in the operating activities
section of the SCF and (b) illustrates
how to prepare this financial statement
in its entirety. This illustration comprehensively employs journal entries and
T-accounts as analysis tools to aid student understanding of the SCF.
COMPREHENSIVE EXAMPLE
WITH ANALYSIS OF THE SCF
UNDER THE INDIRECT METHOD
In Table 2, we present the income
statement and additional data related to
our comprehensive example.
Analysis of Individual Items in
Completing the Example
Purchase of Equipment and Recording
Depreciation Expense
General concept. As a long-term asset,
TABLE 1. Introductory Textbook Use of Journal Entries and T-Accounts to Explain the Statement of Cash Flows
(SCF) (Indirect Method)
Textbook
(Lead author and
edition are listed)
Edmonds (4th)
Harrison (5th)
Ingram (5th)
Kimmel (3rd)
Libby (4th)
Needles (2004)
Porter (4th)
Werner (3rd)
Weygandt (4th)
Williams (11th)
Does the
textbook
use
journal
entries?
Are journal
entries used
to explain
the SCF?
Are T-accounts used
use to explain the
SCF?
Are journal entries and/or
T-accounts employed to
illustrate comprehensively
the operating activities
section of the SCF?a
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
No
No
No
No
No
Yes
No
No
No
No
No
Yes
No
Yes
Yes
Yes
No
No
Yes
No
N/A
No
N/A
No
No
No
N/A
N/A
No
N/A
a
We define comprehensive illustration of the preparation of the SCF as including the following common components found in a company’s operating activities section of the SCF: changes in accounts receivable, changes in inventory, changes in accounts payable, depreciation, and gains and/or losses.
42
Journal of Education for Business
TABLE 2. Income Statement and Additional Data for the Comprehensive
Example
Sales revenues
Gain on the sale of equipment
Total revenues and gain:
Expenses:
Cost of goods sold
Depreciation expense
Other operating expenses
Income taxes expense
Total expenses:
$500,000
3,000
503,000
300,000
10,000
112,000
21,000
443,000
Net income
60,000
Sale of Equipment for Cash, Resulting
in a Gain
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Additional Data
The company purchased equipment at the beginning of the year for $55,000. The equipment was sold at the end of the year for $48,000, resulting in a $3,000 gain.
All of the company’s purchases of inventory and sales to customers are on account. The
only transactions affecting accounts payable during the year were for purchases of
inventory and payments related to those purchases.
Accounts receivable increased during the year by $10,000.
(The beginning balance of accounts receivable was $40,000.)
Inventory decreased during the year by $50,000.
(The beginning balance of inventory was $75,000.)
Accounts payable decreased during the year by $15,000.
(The beginning balance of accounts payable was $35,000.)
There were no other changes in noncash current assets and current liabilities.
The company issued common stock at par value for $70,000 during the year.
A cash dividend of $5,000 was paid to shareholders during the year.
the purchase of equipment for cash is
recorded in the investing activities section of the statement of cash flows.
Depreciation is included in total expenses to derive net income; however,
because it is a noncash expense, the
accountant adds it back to net income to
compute net cash flows from operating
activities.
Example A. At the beginning of the
year, equipment was purchased for
$55,000 cash. The equipment had an
estimated useful life of 5 years and an
estimated residual value of $5,000.
(1) The journal entry to record the
equipment purchase would be:
Equipment
Cash
income is reduced by the $10,000 of
depreciation expense but there was no
cash outflow related to recording the
expense, one would have to add $10,000
back to net income to derive net cash
flows in the Operating Activities section. (Note: Without this adjustment for
depreciation, the statement of cash
flows would report a $65,000 total cash
outflow related to the equipment for the
year, as opposed to the correct amount
of the $55,000 purchase price.)
55,000
55,000
(2) The journal entry to record annual
depreciation expense for the equipment would be:
Depreciation expense
10,000
Accumulated depreciation 10,000
[Calculated: (55,000 – 5,000)/5 years
= $10,000]
Class discussion question. What was the
impact on both cash flows and net
income from the above journal entries?
Answer. The impact on cash was an outflow of $55,000 from Transaction 1 and
a $10,000 decrease in net income from
Transaction 2.
Analysis. Because the $55,000 cash outflow in Transaction 1 relates to a purchase of a long-term asset, it is reported
in the Investing Activities section. However, in Journal Entry 2, because net
General concept. Cash proceeds from
the sale of equipment, a long-term
asset, should be reported in the investing activities section of the statement
of cash flows. A gain from selling a
long-term asset is included in total revenues (generally treated as “Other
Revenue” on the income statement in
deriving net income). Therefore, to
prevent “double counting” the gain,
the accountant must deduct it from net
income to remove it from the operating
activities section of the statement of
cash flows.
Example B. Assume the equipment
referred to above was sold at the end of
the first year for $48,000 (i.e., after
$10,000 of depreciation had been recorded, resulting in a book value of $45,000
and a gain of $3,000 on the disposal).
The journal entry to record the sale of
the equipment would be:
Cash
48,000
Accumulated depreciation
10,000
Equipment
55,000
Gain on sale of equipment
3,000
Class discussion question. What was
the impact on both cash flows and net
income from the above journal entry?
Answer. The impact on cash was an
inflow of $48,000. Net income increased
by the $3,000 gain.
Analysis. Because the $48,000 cash
inflow relates to the sale of a long-term
asset, it is reported in the “Investing
Activities” section. However, because
September/October 2004
43
net income was increased by the $3,000
gain, it should be subtracted from net
income in the Operating Activities section in order to prevent “doublecounting” it. (Note: Without this adjustment
for the gain, the statement of cash flows
would report a $51,000 total cash inflow
related to the sale of the equipment for
the year, as opposed to the correct
amount of $48,000.)
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Increase in Accounts Receivable
General concept. When accounts
receivable increases during a period,
credit sales (which increase total revenues, and thus net income) exceed
cash collections on account. The
accountant deducts the increase in
accounts receivable from net income to
derive net cash flows from operating
activities.
Example C. At the beginning of the
year, the company had a balance of
$40,000 for accounts receivable. During
the year, they had sales on account for
$500,000. Also, they made cash collections on account in the amount of
$490,000 during the year.
(1) The summary journal entry for credit sales for the year would be:
Accounts receivable
Sales
500,000
500,000
(2) The summary journal entry for cash
collections for the year would be:
Cash
Accounts receivable
490,000
490,000
Class discussion question. What was
the impact on both cash flows and net
income from the above journal entries?
Answer. The impact on cash was an
inflow of $490,000. Net income
increased by the $500,000 increase in
sales revenues (ignoring the cost of
inventory sold, which is discussed in the
next example).
ignoring the cost of inventory sold).
Hence, in order to reconcile net income
to net cash flows from operating activities, $10,000 should be subtracted from
net income. (Note: Without making this
adjustment, the statement of cash flows
would report a $500,000 cash inflow as
opposed to the correct amount of
$490,000.)
Student tip. Notice that the $10,000 negative adjustment to net income (i.e., it is
negative because it is being subtracted
from net income) is exactly equal to the
increase in accounts receivable during
the year, as illustrated in the accounts
receivable T-account shown in Figure 1.
Decreases in Both Inventory and
Accounts Payable
General concept. The decreases for
these accounts imply that purchases of
inventory on account are less than both
the cost of inventory sold and cash payments on accounts payable during the
year (based on our example’s assumption that accounts payable is only affected by purchases of inventory on account
and payments on those purchases).
Because the cost of goods sold is more
than the cost of inventory purchases during the year, the decrease in inventory is
added to net income in order to derive
net cash flows from operating activities.
Also, because the cash payments on
account for inventory exceed the inventory purchases on account, the decrease
in accounts payable is deducted from
net income in deriving net cash flows
from operating activities.
Example D. At the beginning of the
year, the company had a $75,000 balance for inventory and a $35,000 balance for accounts payable. During the
year, inventory in the amount of
$250,000 was purchased on account,
inventory that cost $300,000 was sold,
and payments on account amounted to
$265,000 during the year.
(1) The summary journal entry for
inventory purchases would be:
Inventory
250,000
Accounts payable
250,000
(2) The summary journal entry for
recording the cost of inventory sold
would be:
Cost of goods sold
300,000
Inventory
300,000
(3) The summary journal entry for
payments on account would be:
Accounts payable
Cash
265,000
265,000
Class discussion question. What was
the impact on both cash flows and net
income from the above journal entries?
Answer. The impact on cash was an outflow of $265,000. Net income decreased
by the $300,000 increase in cost of
goods sold (ignoring the effect of sales
revenue, which was discussed in the previous example).
Analysis. The $265,000 cash outflow
relates to expense transactions; therefore,
it is reported in the Operating Activities
section. However, the above transactions
increased expenses (and thus reduced net
income) by the $300,000 of cost of goods
sold (again, ignoring sales revenues).
Hence, to reconcile net income to net
cash flows from operating activities, the
accountant should add the difference of
$35,000 to net income.
Student tips. Notice that the net positive
adjustment of $35,000 to net income is
exactly equal to the net change in the
inventory and the accounts payable
accounts combined. Specifically, inventory decreased by $50,000 during the
AC C O U N T S R E C E I VA B L E
Analysis. The $490,000 cash inflow
relates to revenue transactions; therefore, it is reported in the Operating
Activities section. However, the above
transactions increased revenues (and
thus net income) by $500,000 (again,
44
Journal of Education for Business
Beginning Balance
$10,000
Increase
(1) Sales on Account
Ending Balance
40,000
500,000
490,000
(2) Cash Collections
50,000
FIGURE 1. Accounts receivable T-account related to Example C.
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year, and accounts payable decreased by
$15,000 during the year, as illustrated in
the T-accounts presented in Figure 2.
An alternative way to remember the
sign of the adjustment for changes in
current assets or current liabilities in
the operating activities’ reconciliation
would be to examine what the change
in the account balance implies. For
example, if inventory decreases during
the period, presumably inventory must
have been sold. One would expect that
when inventory is sold, cash would be
received. Therefore, because there
would be a positive effect on cash
when inventory decreases, the sign of
the adjustment in the reconciliation
related to the decrease in inventory is
positive.
Similarly, when accounts payable
decreases, the presumption is that
account balances have been paid, thus
resulting in a decrease in cash. Because
there would be a negative effect on cash
when accounts payable decreases, the
sign of the adjustment in the reconciliation related to the decrease in accounts
payable is negative.
Beginning Balance
300,000
(2) Cost of Inventory Sold
25,000
A C C O U N T S PAYA B L E
35,000
(3) Payments on account
265,000
Example E. During the year, the company sold common stock at par value
for $70,000.
The journal entry for the issuance of
stock would be:
70,000
70,000
75,000
(1) Inventory Purchases 250,000
Ending Balance
General concept. The issuance of
stock is a source of financing for a corporation. Therefore, if cash is received
in exchange for the stock, the cash
proceeds from the sale are reported as
a cash inflow in the financing activities section of the statement of cash
flows.
Cash
Common stock
INVENTORY
$50,000
Decrease
Issuance of Stock for Cash
Beginning Balance
250,000 (1) Inventory Purchases
20,000
$15,000
Decrease
Ending Balance
FIGURE 2. T-accounts related to Example D.
Cash flows from operating activities:
$ 60,000
Depreciation
10,000
Gain on sale of equipment
(3,000)
Increase in accounts receivable
Decrease in inventory
Decrease in accounts payable
Retained earnings
Cash
(10,000)
50,000
(15,000)
Net cash provided by operating activities
General concept. A cash dividend represents a form of return for shareholders. Just as a shareholder’s investment
(in the form of the purchase of stock) is
reported in the financing activities section of the statement of cash flows, a
return on that investment in the form of
a cash dividend also is reported in the
financing activities section; however,
the cash dividend represents a cash outflow to the firm.
Example F. During the year, the company paid a cash dividend of $5,000.
The journal entry for the cash dividend
would be:
TABLE 3. Solution for the SCF Comprehensive Example
Net income
Payment of a Cash Dividend
92,000
5,000
5,000
Upon completing the analysis for
each item affecting the SCF in the comprehensive example, the SCF can be
prepared in its entirety. The SCF solution for our example is provided in
Table 3.
Cash flows from investing activities:
Purchase of equipment
Sales of equipment
(55,000)
Conclusion
48,000
Net cash used in investing activities
(7,000)
Cash flows from financing activities:
Issuance of stock
70,000
Payment of cash dividends
(5,000)
Net cash provided by financing activities
Net increase in cash and cash equivalents
65,000
150,000
In this article, we presented our
classroom approach to teaching the
statement of cash flows (SCF) in the
introductory financial accounting
course. The primary component of our
approach is a problem-based, comprehensive example that employs journal
entries and T-accounts as analysis tools
to demonstrate how to prepare the SCF
September/October 2004
45
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in its entirety under the indirect
method. Our example emphasizes
explaining why adjustments are made
in the operating activities section by
analyzing the effect of transactions on
net income or cash. The approach that
we have presented can be viewed as an
alternative to methods illustrated in
both commonly used financial accounting textbooks and the accounting education literature. Because of the importance of a company’s SCF for financial
reporting purposes, we hope that other
accounting faculty members will find
this instructional resource useful for
both themselves and their students.
REFERENCES
Donelan, J. G. (1993). An integrated approach to
teaching the statement of cash flows. Journal of
Education for Business, 68(4), 234–236.
Edmonds, T. P., McNair, F. M., Milam, E. E., &
Olds, P. R. (2003). Fundamental financial
accounting concepts. New York: McGraw-Hill.
Harrison, W. T., Jr., & Horngren, C. T. (2004).
Financial accounting. Upper Saddle River, NJ:
Pearson Education.
Ingram, R. W., Albright, T. L., & Baldwin, B. A.
(2004). Financial accounting: A bridge to decision making. Mason, OH: South-Western.
Kimmel, P. D., Weygandt, J. J., & Kieso, D. E.
(2004). Financial accounting: Tools for business decision making. New York: Wiley.
Libby, R., Libby, P. A., & Short, D. G. (2004).
Financial accounting. New York: McGraw-Hill.
Needles, B. E., Jr., & Power, M. (2004). Financial
accounting. Boston, MA: Houghton Mifflin.
Porter, G. A., & Norton, C. L. (2004). Financial
accounting: The impact on decision makers.
Mason, OH: South-Western.
Rai, A. (2003). Reconciliation of net income to
cash flow from operations: An accounting
equation approach. Journal of Accounting Education, 21(1), 17–24.
Vent, G. A., & Cocco, A. F. (1996). Teaching the
cash flows from operations section of the statement of cash flows under the indirect method:
A conceptual framework. Journal of Education
for Business, 71(6), 344–347.
Werner, M. J., & Jones, K. H. (2004). Introduction
to financial accounting: A user perspective.
Upper Saddle River, NJ: Pearson Education.
Weygandt, J. J., Kieso, D. E., & Kimmel, P. D.
(2003). Financial accounting. New York:
Wiley.
Williams, J. R., Haka, S. F., Bettner, M. S., &
Meigs, R. F. (2003). Financial accounting. New
York: McGraw-Hill.
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Distribution
by Mail
(Samples,
compliment
ary, and
other free)
Helen Dwight Reid Educational Foundation
1319 Eighteenth Street NW, Washington DC 20036-1802
Editor (Name and complete mailing address)
f.
Managing Editor (Name and complete mailing address)
g.
Isabella Owen Perelman
1319 Eighteenth Street NW, Washington DC 20036-1802
h.
587
0
0
67
65
0
0
728
652
32
0
0
(3) Other Classes Mailed Through the USPS
0
0
2
2
34
34
Total Distribution (Sum of 15c. and 15f)
762
686
Copies not Distributed
231
311
Total (Sum of 15g. and h.)
993
997
96
95
Total Free Distribution (Sum of 15d. and 15e.)
i.
Full Name
j. Percent Paid and/or Requested Circulation
(15c. divided by 15g. times 100)
1319 Eighteenth Street NW, Washington DC 20036-1802
997
661
32
10. Owner (Do not leave blank. If the publication is owned by a corporation, give the name and address of the corporation immediately followed by the
names and addresses of all stockholders owning or holding 1 percent or more of the total amount of stock. If not owned by a corporation, give the
names and addresses of the individual owners. If owned by a partnership or other unincorporated firm, give its name and address as well as those of
each individual owner. If the publication is published by a nonprofit organization, give its name and address.)
Complete Mailing Address
No. Copies of Single Issue
Published Nearest to Filing Date
993
(2) In-County as Stated on Form 3541
(1) Outside-County as Stated on Form 3541
e. Free Distribution Outside the Mail
(Carriers or other means)
Board of Executive Editors
1319 Eighteenth Street NW, Washington DC 20036-1802
Helen Dwight Reid Educational Foundation
July/August 2004
Average No. Copies Each Issue
During Preceding 12 Months
Extent and Nature of Circulation
16. Publication of Statement of Ownership
XX Publication required. Will be printed in the ________________________
issue of this publication.
Sept/Oct 2004
Publication not required.
Date
17. Signature and Title of Editor, Publisher, Business Manager, or Owner
September 29, 2004
Executive Director
I certify that all information furnished on this form is true and complete. I understand that anyone who furnishes false or misleading information on this form
or who omits material or information requested on the form may be subject to criminal sanctions (including fines and imprisonme nt) and/or civil sanctions
(including civil penalties).
Instructions to Publishers
11. Known Bondholders, Mortgagees, and Other Security Holders Owning or
Holding 1 Percent or More of Total Amount of Bonds, Mortgages, or
Other Securities. If none, check box
Full Name
XXNone
Complete Mailing Address
12. Tax Status (For completion by nonprofit organizations authorized to mail at nonprofit rates) (Check one)
The purpose, function, and nonprofit status of this organization and the exempt status for federal income tax purposes:
XX Has Not Changed During Preceding 12 Months
Has Changed During Preceding 12 Months (Publisher must submit explanation of change with this statement)
PS Form 3526, October 1999
46
(See Instructions on Reverse)
Journal of Education for Business
1.
Complete and file one copy of this form with your postmaster annually on or before October 1. Keep a copy of the completed form
for your records.
2.
In cases where the stockholder or security holder is a trustee, include in items 10 and 11 the name of the person or corporation for
whom the trustee is acting. Also include the names and addresses of individuals who are stockholders who own or hold 1 percent
or more of the total amount of bonds, mortgages, or other securities of the publishing corporation. In item 11, if none, check the
box. Use blank sheets if more space is required.
3.
Be sure to furnish all circulation information called for in item 15. Free circulation must be shown in items 15d, e, and f.
4.
Item 15h., Copies not Distributed, must include (1) newsstand copies originally stated on Form 3541, and returned to the publisher,
(2) estimated returns from news agents, and (3), copies for office use, leftovers, spoiled, and all other copies not distributed.
5.
If the publication had Periodicals authorization as a general or requester publication, this Statement of Ownership, Management,
and Circulation must be published; it must be printed in any issue in October or, if the publication is not published during October,
the first issue printed after October.
6.
7.
In item 16, indicate the date of the issue in which this Statement of Ownership will be published.
Item 17 must be signed.
Failure to file or publish a statement of ownership may lead to suspension of Periodicals authorization.
PS Form 3526, October 1999 (Reverse)