We often enhance our comprehension of a topic when we have to think through solutions to problems, so to help you really understand the cash flow statement, we've put together some questions for you to answer. As you formulate your response you will be learning to think about cash flows the way an accountant does.

Much of what you learned in the practice questions above is common sense. For example, when you use cash to buy a book, you now own the book (you've increased your "assets") but you also have less money (you've decreased your cash). Based on what you learned, you can make the following general assumptions:

• When an asset (other than cash) increases, the Cash account decreases.
• When an asset (other than cash) decreases, the Cash account increases.
• When a liability increases, the Cash account increases.
• When a liability decreases, the Cash account decreases.
• When owner's equity increases, the Cash account increases.
• When owner's equity decreases, the Cash account decreases.

The statement of cash flows has four distinct sections:

1. Cash involving operating activities
2. Cash involving investing activities
3. Cash involving financing activities
4. Supplemental information.

Assuming that the cash flow statement is being prepared using the indirect method (the method used by most companies) the differences in a company's balance sheet accounts will provide much of the needed information. For example, if the statement of cash flows is for the year 2010, the balance sheet accounts at December 31, 2010 will be compared to the balance sheet accounts at December 31, 2009. The changes—or differences—in these account balances will likely be entered in one of the sections of the statement of cash flows.

Shown below is each of the four sections of the statement of cash flows, followed by a list of those balance sheet accounts which affect it.

This section of the cash flow statement reports the company's net income and then converts it from the accrual basis to the cash basis by using the changes in the balances of current asset and current liability accounts, such as:

Accounts Receivable
Inventory
Supplies
Prepaid Insurance
Other Current Assets
Notes Payable (generally due within one year)
Accounts Payable
Wages Payable
Payroll Taxes Payable
Interest Payable
Income Taxes Payable
Unearned Revenues
Other Current Liabilities

In addition to using the changes in current assets and current liabilities, the operating activities section has adjustments for depreciation expense and for the gains and losses on the sale of long-term assets.

This section of the cash flow statement reports changes in the balances of long-term asset accounts, such as:

Long-term Investments
Land
Buildings
Equipment
Furniture & Fixtures
Vehicles

In short, investing activities involve the purchase and/or sale of long-term investments and property, plant, and equipment.

This section of the cash flow statement reports changes in balances of the long-term liability and stockholders' equity accounts, such as:

Notes Payable (generally due after one year)
Bonds Payable
Deferred Income Taxes
Preferred Stock
Paid-in Capital in Excess of Par-Preferred Stock
Common Stock
Paid-in Capital in Excess of Par-Common Stock
Paid-in Capital from Treasury Stock
Retained Earnings
Treasury Stock

In short, financing activities involve the issuance and/or the repurchase of a company's own bonds or stock. Dividend payments are also reported in this section.

This section of the cash flow statement discloses the amount of interest and income taxes paid. Also reported are significant exchanges not involving cash. For example, the exchange of company stock for company bonds would be reported in this section.

Take a look at the summary below—it shows where the changes in balance sheet accounts should be entered on your statement of cash flows:

When we use the indirect method to prepare a statement of cash flows we begin with the net income figure from the company's income statement as our starting point. We then make adjustments to that figure to arrive at the cash amount.

If all of a company's revenues were cash sales (no credit sales), and if the company paid out cash for all of its expenses, then net income would equal the cash from operating activities. However, since some of the revenues and expenses on the income statement were not cash transactions, we must include depreciation, gain or losses on sales of assets, and the changes in current assets and current liabilities. These adjustments will be illustrated in the hypothetical story presented in Part 3.

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