Page 629 - Accounting Principles (A Business Perspective)

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16. Analysis using the

statement of cash flows

Learning objectives
After studying this chapter, you should be able to:
• Explain the purposes and uses of the statement of cash flows.
• Describe the content of the statement of cash flows and where certain items would appear on the statement.
• Describe how to calculate cash flows from operating activities under both the direct and indirect methods.
• Prepare a statement of cash flows, under both the direct and indirect methods, showing cash flows from

operating activities, investing activities, and financing activities.
• Analyze a statement of cash flows of a real company.
• Analyze and use the financial results–cash flow per share of common stock, cash flow margin, and cash flow
liquidity ratios.
• Use working paper to prepare a statement of cash flows (appendix).

A career in external auditing
In 1929 the Dow Jones Industrial Average fell 40 per cent over the period from September 3rd to October 29th.
The Dow bottomed out in July 1932, after losing 89 per cent of its value. Some blamed accounting for the run-up in
prices and the subsequent crash. Stocks may have been overpriced because companies engaged in "window
dressing" to enhance their reported income. At the time, accounting practices and reporting procedures were not
well-established. As investors began to understand this, confidence fell. Investors panicked and sold stocks in a

frenzy. This action contributed to the Great Depression of the 1930s. The Dow did not reach pre-crash levels again
until 1954.
In response to the financial crisis, the Securities and Exchange Commission (SEC) was established in 1934 to
regulate the filing requirements of firms listed on US stock exchanges. The SEC requires all listed firms in each year
to prepare financial statements in accordance with generally accepted accounting principles (GAAP) and to have
those financial statements audited by an independent party. This independent verification was meant to restore
investor confidence and provide ongoing integrity in the capital market system. If a company fails to follow GAAP,

it can be delisted from the stock exchange.
For many reasons, managers have incentives to manipulate income to enhance reported performance. It is the
job of auditors to use their understanding of accounting principles and business practices to provide reasonable
assurance that financial statements are free from such manipulation. One possible indication of income
manipulation occurs when accrual earnings are high relative to cash flows from operating activities, sometimes
referred to as "cash earnings". Accrual earnings are typically easier to manipulate because they employ estimates,
whereas cash earnings are tied to actual cash receipts and payments from operations. Accrual earnings can be

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