Final Paper Accounting 206
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chapter 1
The Statement of Cash Flows
Learning Objectives
• Understand the purpose of a statement of cash flows.
• Distinguish between operating, investing, and financing activities.
• Know how to calculate operating cash flows using direct and indirect approaches.
• Be able to prepare a statement of cash flows by general reference to a balance sheet, income statement, and other supplemental information.
• Be able to prepare an organized worksheet facilitating preparation of a statement of cash flows.
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CHAPTER 1Chapter Outline
Chapter Outline
1.1 How Is Cash Flow to Be Monitored? Operating Activities Investing Activities Financing Activities Noncash Investing and Financing Activities Example Statement
1.2 A Deeper Focus on Operating Cash Flows Cash Received From Customers Cash Paid for Inventory Cash Paid for Operating Expenses Noncash Expenses and Gains/Losses
1.3 Alternative View of Operating Activities Investing Activities Financing Activities Net Change in Cash Noncash Investing/Financing Activities
1.4 Using a Worksheet to Prepare the Statement
1.5 Comprehensive Example
In the previous course, you learned that financial accounting is based on accrual concepts. Income measurement is geared to report revenues as earned and expenses as incurred. Indeed, you were taught that accounting measurements tied to a cash basis sometimes result in very misleading signals about operating success or failure. For example, a busi- ness may continue to function by putting off bill payments, but only for a short while. If accounting was only based on activity reflected in the checkbook, one could easily be fooled! This observation underscores why accounting is primarily focused on the accrual basis of measurement.
Although accrual information is arguably the best indicator of long-term business results, a company’s cash flow data cannot be ignored. Cash flow relates to actual money coming in and out of a business. Cash flow can differ from accrual basis measures for a variety of reasons. The actual cash inflow from sales on account is usually delayed by several days or months following the accounting recognition of the sale. The opposite is true for many expenses. For instance, you pay your electric bill after you have consumed the service. Thus, the expense occurs (accrues) well in advance of its corresponding cash outflow.
Cash is necessary to meet payroll and other business costs. It is needed for capital invest- ment and debt retirement. Even a profitable business can experience cash flow difficulties. Sales on account may require some time to collect. Adding inventory can consume cash. Buying plant assets can also be a drain on cash. Thus, it is important also to monitor cash flow; just observing accrual-based income can mask business-limiting cash flow prob- lems. This issue is important to both external users, such as investors and creditors, and internal management responsible for maintenance of a sustainable business model.
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CHAPTER 1Section 1.1 How Is Cash Flow to Be Monitored?
1.1 How Is Cash Flow to Be Monitored?
Beyond just looking at cash on the balance sheet, how is one to assess a company’s cash, cash flow, and cash flow prospects? For many years, the accounting profession only required presentation of the balance sheet, income statement, and a statement of retained earnings (or stockholders’ equity). In the 1960s, following several prominent and seemingly sudden business failures due to poor cash flow, the profession determined to require a fourth financial statement reporting on funds flow. The specific content and format evolved. In the 1990s, the profession began to require the current format for a state- ment of cash flows. This statement has become a well-established component of required reporting for corporate entities. The objective of the statement is to provide information that is helpful in assessing the amounts, timing, and uncertainty of an organization’s cash inflows and outflows. Accordingly, the statement of cash flows divides cash flow information into key categories related to operating activities, investing activities, and financing activities. The statement also provides information about other investing and financing activities that do not directly entail the generation or consumption of cash. Thus, the statement also provides a key source of insight about a company’s overall investing and financing actions.
Operating Activities
In a sweeping generalization, think of the operating activities of a business as the routine transactions and events that enter into the determination of ongoing income. Thus, the operating activities section of the statement of cash flows is a bit like a cash basis income statement. But, as you will soon see from the following details, this generalization should be used as a frame of reference only. Specifically, cash inflows from operating activities consist of receipts from customers for providing goods and services, the cash amount of interest earnings, and cash dividends received. Cash outflows relate to payments for inventory purchases, salaries, wages, taxes, interest, and other such business expenses. However, another way to view “operating” cash flows is to include anything that is not an “investing” or “financing” cash flow. This means that any cash flows that do not clearly fall into the categories of investing activities or financing activities are regarded as related to operations. Because this view casts the operating activities section as a “default” group- ing, it is also necessary to understand the specifics of each of the next two categories.
Investing Activities
Investing activities relate to acquiring and disposing of longer term investments in stocks and debt issued by others, as well as buying and selling items of property, plant, and equipment. Investing cash inflows result when a company receives the proceeds from selling the stock and debt of others (unless such investment was initially acquired for “trading” rather than longer term investment purposes) and when proceeds from the sale of plant assets are received. Similarly, if longer term loans have been made to others, an investing cash inflow occurs when the principal amount of debt is repaid. As noted in the discussion of operating activities, it is important to note that interest earned on loans is regarded as an operating cash inflow. Only the principal collections are reported as investing inflows. Conversely, cash outflows from investing activities result on payment to acquire land, buildings, and equipment, as well as the acquisition of long-term invest- ments in other firms, loans to others, and similar items.
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CHAPTER 1Section 1.1 How Is Cash Flow to Be Monitored?
Financing Activities
Financing activities relate to obtaining and repaying capital funding needs. Cash inflows result by interactions with investors and lenders via the issuance of stock and bonds as well as borrowing from specific lenders. Conversely, repaying the principal amounts bor- rowed is a financing activity that results in a cash outflow. One must be very careful to differentiate between repayments of principal on debt versus the interest cost. Interest is treated as an expense in income and is also treated as an operating cash flow in the cash flow statement. One generally thinks of obtaining capital from shareholders as a cash inflow; however, a company may occasionally buy back treasury shares, and these transactions are reported as a cash outflow in the financing activities section. Likewise, dividends paid to shareholders are similarly classified as a cash outflow.
The classification of dividends and interest is potentially confusing and bears clarifica- tion. Accounting rules require that dividends paid be reported as a financing cash out- flow. Dividends received, interest received, and interest paid are all reported as operating cash flows. Because the classification of these amounts is subject to conceptual debate, the accounting rules have explicitly adopted this specific classification model.
The preceding discussion was intended to build your general understanding of the clas- sification scheme for various cash flow items. At times, accounting can become somewhat detailed, and Table 1.1 dives deeper into this subject by providing a more detailed listing of appropriate schemes to use for classifying most cash flow items.
Table 1.1: Summary table of investing/financing/operating activities
Inflows Outflows
Investing activities
Receipts from collections or sales of loans made by the enterprise and of other entities’ debt instruments
Disbursements for loans made by the enterprise and payments to acquire debt instruments of other entities
Receipts from sales of equity instruments of other enterprises and from returns on investment in those instruments
Payments to acquire equity instruments of other enterprises
Receipts from sales of property, plant, and equipment and other productive assets
Payments at the time of purchase or soon before or after purchase to acquire property, plant, and equipment and other productive assets (continued)
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CHAPTER 1Section 1.1 How Is Cash Flow to Be Monitored?
Table 1.1: Summary table of investing/financing/operating activities (continued)
Inflows Outflows
Financing activities
Proceeds from issuing equity instruments Payments of dividends or other distributions to owners, including outlays to reacquire the enterprise’s equity instruments
Proceeds from issuing bonds, mortgages, and notes and from other short- or long-term borrowing
Repayments of amounts borrowed
Receipts from contributions and investment income that by donor stipulation are restricted for the purposes of acquiring, constructing, or improving property, plant, equipment, or other long-lived assets
Other principal payments to creditors who have extended long-term credit
Proceeds received from derivative instruments that include financing elements at inception
Distributions to counterparties of derivative instruments that include financing elements at inception
Cash retained as a result of the tax deductibility of increases in the value of certain equity instruments issued under share-based payment arrangements
Operating activities
Cash receipts from sales of goods or services, including receipts from collection or sale of accounts and both short- and long-term notes receivable from customers arising from those sales
Cash payments to acquire materials for manufacture or goods for resale, including principal payments on accounts and both short- and long-term notes payable to suppliers for those materials or goods
Cash receipts from returns on loans, other debt instruments of other entities, and equity securities—interest and dividends
Cash payments to other suppliers and employees for other goods or services
All other cash receipts that do not stem from transactions defined as investing or financing activities, such as amounts received to settle lawsuits; proceeds of insurance settlements except for those that are directly related to investing or financing activities, such as from destruction of a building; and refunds from suppliers
Cash payments to governments for taxes, duties, fines, and other fees or penalties and the cash that would have been paid for income taxes if increases in the value of certain equity instruments issued under share-based payment arrangements
Cash payments to lenders and other creditors for interest
All other cash payments that do not stem from transactions defined as investing or financing activities, such as payments to settle lawsuits, cash contributions to charities, and cash refunds to customers
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CHAPTER 1Section 1.1 How Is Cash Flow to Be Monitored?
Table 1.1 was adapted from the scheme set forth by the Financial Accounting Standards Board (Statement of Financial Accounting Standard No. 95, Statement of Cash Flows, FASB, 1997) and provides a useful decision table for most transactions that are apt to arise in the ordinary course of business. As you can see, the classification scheme can become rather detailed; at this point in your studies, you should not be overly concerned about under- standing the nuances of unfamiliar-sounding transactions.
Noncash Investing and Financing Activities
The statement of cash flows represents a compilation of all operating, investing, and financ- ing activities that cause a change in cash. The net change represents the increase or decrease to cash during a period and should serve to reconcile the change from the beginning- of-period to end-of-period cash balances. This reconciliation within the statement of cash flows could be viewed as complete fulfillment of the objectives for a cash flow state- ment. However, the statement has an enhanced purpose. It is expanded to reveal other noncash investing and financing activities. For example, a company may exchange common stock for land. Such transactions do not trigger a direct inflow or outflow of cash, but they are nonetheless highly significant investing/financing events. Other examples include acquiring a building for a note payable, retiring debt with stock, and so forth. The statement of cash flows includes a separate section reporting noncash investing and financing activities.
Example Statement
The following example presents a statement of cash flows. For now, do not be too con- cerned with details. Instead, just take note of the overall structure. Notice that this is an operating statement covering a defined period of time, much like the income statement and statement of retained earnings. Thus, the date calls attention to the period of time cov- ered by the report. The statement contains a major section for each category of cash flow activities and culminates with a reconciliation of the change in cash balance over the span of the period. Finally, it concludes with details on the noncash investing/financing actions.
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CHAPTER 1Section 1.2 A Deeper Focus on Operating Cash Flows
Exhibit 1.1
Exhibit 1.1 prepared the operating activities section under a direct approach. That is, each cash flow component was directly presented (e.g., cash received from customers). An alternative indirect approach is also permitted. Later sections of this chapter make this distinction much clearer, and you will be exposed to both techniques by chapter’s end.
1.2 A Deeper Focus on Operating Cash Flows
It is now time to focus on the details within the operating activities section of the state-ment of cash flows for Example Corporation. Therein, it is revealed that $167,000 of cash was generated from operations. This is noted by the total for the operating activities sec- tion. The first line within the operating activities section shows that customers paid the company $1,500,000. But much of that cash flow was spent on inventory, salaries, rent, interest, other operating expenses, and taxes. These data are relatively easy to identify by looking at the operating activities section of the cash flow statement. Also, they tend to be self-explanatory as to their meaning. But, how are the data derived? Some companies have very strong information systems that allow accountants to mine their databases for
Cash flows from operating activities:
Cash received from customers
Less cash paid for:
Inventory
Salaries
Rent
Interest
Other operating expenses
Income taxes
Net cash provided by operating activities
Cash flows from investing activities:
Sale of land
Purchase of equipment
Net cash used by investing activities
Cash flows from financing activities:
Proceeds from issuing stock
Dividends on common
Net cash provided by financing activities
Net increase in cash
Cash balance at January 1, 20X3
Cash balance at December 31, 20X3
------------------
Noncash investing/financing activities
Issued note payable for land
$ 800,000
275,000
60,000
3,000
25,000
170,000
$ 1,500,000
(1,333,000)
$ 167,000
175,000
$ 421,000
251,000
$ 672,000
$ 70,000
79,000
$ 175,000
(96,000)
$ 200,000
(25,000)
EXAMPLE CORPORATION Statement of Cash Flows
For the year ending December 31, 20X3
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CHAPTER 1Section 1.2 A Deeper Focus on Operating Cash Flows
specific cash payments. At other times, a company must use analytical procedures and assumptions to estimate the specific cash flow amounts. Let’s think about how this would occur, beginning with the calculation of cash received from customers.
Cash Received From Customers
The operating activities section revealed cash collections from customers of $1,500,000. If all sales were for cash, then this amount would correspond to total sales in the income statement. However, companies typically make some sales on account. Thus, cash col- lected is not exactly the same as total sales. The difference between cash collections and total sales is reflected as an increase or decrease in accounts receivable. In other words, increasing accounts receivable balances signal that more sales occurred on account than were collections on account. The opposite is of course true. Thus, one can adjust total sales found on an accrual basis income statement by the change in accounts receivable to estimate cash collections from customers. This assumes uncollectible accounts are not material; if they were, additional adjustments would be necessary.
Students generally understand this concept, but an additional example may prove help- ful. Suppose you started a new business. During your first year of operations, total sales were $100,000. If you ended the year with $20,000 in accounts receivable, how much of the sales did you collect? Hopefully, it is apparent that the answer to this question is $80,000. In other words, cash collected from customers was $80,000. If you discontinued the busi- ness and made no additional sales in the second year, but did collect the $20,000 owed to you from the prior year sales, then your cash collections would be $20,000. In the first year, accounts receivable increased (and you subtracted that from sales to find cash col- lections); in the second year, accounts receivable decreased (and you added that to sales to find cash collections). This gives rise to the general model that you can use to calculate cash collected from customers:
Total Sales Minus the Increase in Receivables (or, plus a decrease in receivables)
Next, let’s apply this model to Example Corporation. Assume total sales were $1,750,000, and accounts receivable increased from $300,000 to $550,000. The $250,000 increase in receivables (i.e., uncollected sales) would be subtracted from total sales to arrive at cash collections of $1,500,000. Applying the standard formula produces the correct calculation, as shown:
$1,750,000 2 ($550,000 2 $300,000) 5 $1,500,000
Cash Paid for Inventory
The operating activities section revealed that $800,000 in cash was paid for the purchase of inventory. This calculation is a bit trickier because it must take into consideration both changes in inventory and changes in accounts payable related to the purchase of inven- tory. The starting point to calculate cash paid for inventory is to determine total purchases of inventory. If inventory levels were unchanged during the period, then cost of goods sold would equal total purchases. However, if inventory on the balance sheet increased, then total purchases would exceed cost of goods sold (and vice versa). The following
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CHAPTER 1Section 1.2 A Deeper Focus on Operating Cash Flows
formula shows the general frame of reference for converting cost of goods sold to total purchases:
Cost of Goods Sold Plus the Increase in Inventory (or, minus a decrease in inventory)
Once total purchases are determined, it is next necessary to assess how much of the pur- chases were for cash. In other words, total inventory purchased must be adjusted for the portion that was purchased on credit. This is similar logic to that which was used for cal- culating cash collected on sales. The following formula shows the general frame of refer- ence for converting purchases of inventory to cash paid for inventory:
Inventory Purchased Minus the Increase in Payables (or, plus a decrease in payables)
To be clear, the preceding formula only takes into consideration payables related to the purchase of inventory. Payables related to utilities, rent, and other operating expenses should not be commingled with this particular calculation.
Assume that Example Corporation had $750,000 in cost of goods sold during the period. Furthermore, inventory on the balance sheet increased by $100,000, and accounts payable related to inventory increased by $50,000. Logically, total purchases were $850,000, but the increase in payables means that only $800,000 of total purchases were funded.
Cash Paid for Operating Expenses
Example Corporation incurred operating expenses for salaries, rent, interest, other costs, and taxes. Any or all of these could have been paid in cash, in which case the reported amount of expense and cash flow effects would be identical. However, to the extent there were/remain unpaid obligations, an adjustment would be needed. Assume that the com- pany reported salaries expense of $250,000. The beginning balance sheet included $35,000 of salaries payable and the ending balance sheet included $10,000 of salaries payable. The $275,000 cash paid for salaries would reflect the total expense plus the additional $25,000 paid to bring about a reduction in the payable balance. Similar considerations would be needed for each expense category, as reflected by the following formulation:
Expense Plus the Decrease in Related Payable (or, minus an increase in related payable)
For Example Corporation, assume that all other expenses were equal to their respective cash payment amounts.
Noncash Expenses and Gains/Losses
Some expenses do not impact operating cash flows. One of the most prominent examples is depreciation. Consider the journal entry that is used to record depreciation:
12-31-X3 Depreciation Expense 80,000
Accumulated Depreciation 80,000
To record annual depreciation expense
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CHAPTER 1Section 1.3 Alternative View of Operating Activities
Notice that this expense is not accompanied by a credit to cash. There is no impact on cash from this entry, even though an expense is recorded. Thus, it is not reported as an operat- ing cash flow item, despite its negative impact on income. You can extend the logic appli- cable to depreciation to other noncash expenses. They should not be reported within cash flows from operating activities. Of course, it may occur to you that cash was expended to buy the depreciable asset. Thus, there is a cash flow effect at the time the asset is pur- chased for cash. As will be demonstrated subsequently, the cash paid to purchase a depre- ciable item is shown as an investing activity at the time the asset is acquired.
Another element that you might find in an income statement is a gain or loss on the sale of an item of property, plant, and equipment. Here, it is important to note that the full proceeds from the asset sale are reported as a cash inflow within the investing activities section of the cash flow statement. This is true, whether the asset sale is at a gain or loss. Thus, nothing additional needs to be reported in the operating activities section. In other words, the gain or loss you will observe in the income statement does not have a corollary impact on the operating activities section of the cash flow statement.
1.3 Alternative View of Operating Activities
Previously, it was mentioned that the operating activities section of the cash flow state-ment was akin to a cash basis income statement. The illustrated approach was the direct approach to presenting the operating activities of the business. In other words, each line item shows the direct amount of cash flow attributable to the described object. How- ever, current accounting rules permit an alternative format called the indirect approach. The indirect approach starts with a company’s reported income number and reconciles that number to the amount of cash provided by operating activities. Thus, the method is a roundabout, or “indirect,” technique to come up with operating cash flows. Importantly, the amount of cash provided by operating activities is the same under both approaches. They are simply alternative ways to demonstrate how cash from operations is reported: (a) by measuring each direct contribution to a company’s cash or (b) by starting with reported income and reconciling for differences between income and operating cash flow.
It is interesting that most companies opt for the indirect approach, although accounting standard setters have long suggested that the direct approach is preferable. One reason is that compiling direct cash flow data can be more problematic than the simpler indirect approach. Companies often do not have a sufficiently robust information system to sort all cash receipts and payments in a way that enables a precise assessment of each category of direct cash flows. Actual business environments are more complex than the illustration provided within. With that having been said, let’s look closer at the indirect approach. In the next few paragraphs, the logic of each amount included within the indirect approach will be explained. First, however, is a comparative view of the presentation of operating activities under each of the two methods (Exhibit 1.2). In particular, (a) take note that the indirect approach begins with net income and reconciles to operating cash flows, and (b) operating cash flows are the same under both approaches. This is just a road map to what you are about to learn. Don’t allow yourself to be overwhelmed by this initial view.
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CHAPTER 1Section 1.3 Alternative View of Operating Activities
Exhibit 1.2
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12
CHAPTER 1Section 1.3 Alternative View of Operating Activities
To begin to understand the indirect approach better, start by examining the income state- ment for Example Corporation in Exhibit 1.3.
Exhibit 1.3
The net income of $457,000 is not equivalent to the operating cash flows or change in cash. It is the accrual basis measure of the results of operations. Some of the data points within the income statement may look familiar from the preceding narrative. For example, take notice that total sales are $1,750,000, which equals the amount noted previously in the discussion about cash collected from sales.
The indirect approach begins with the company’s income and provides a listing of various adjustments that are needed to convert the results to a measure of operating cash flows. Exhibit 1.4 is the cash flow statement for Example Corporation, this time prepared under the indirect approach. This statement is identical to the one presented previously, except that the operating activities section has been significantly revised to reflect the indirect approach.
Revenues
Cost of goods sold
Gross profit
Operating expenses
Salaries
Rent
Depreciation
Interest expense
Other operating expenses
Gain on sale of land
Income before income taxes
Less: income taxes
Net income
$ 250,000
60,000
80,000
3,000
25,000
(45,000)
$1,750,000
750,000
$1,000,000
373,000
$ 627,000
170,000
$ 457,000
EXAMPLE CORPORATION Income Statement
For the year ending December 31, 20X3
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CHAPTER 1Section 1.3 Alternative View of Operating Activities
Exhibit 1.4
Perhaps additional explanation will help you follow the construction of the indirect pre- sentation of operating cash flows. Table 1.2 provides an added explanation for each adjust- ment for each of Example Corporation components within the operating activities section.
Cash flows from operating activities:
Net income
Add (deduct) noncash effects on operating income
Depreciation expense
Increase in accounts receivable
Increase in inventory
Increase in accounts payable
Decrease in salaries payable
Gain on sale of land
Net cash provided by operating activities
Cash flows from investing activities:
Sale of land
Purchase of equipment
Net cash used by investing activities
Cash flows from financing activities:
Proceeds from issuing stock
Dividends on common
Net cash provided by financing activities
Net increase in cash
Cash balance at January 1, 20X3
Cash balance at December 31, 20X3
------------------
Noncash investing/financing activities
Issued note payable for land
$ 80,000
(250,000)
(100,000)
50,000
(25,000)
(45,000)
$ 457,000
(290,000)
$ 167,000
175,000
$ 421,000
251,000
$ 672,000
$ 70,000
79,000
$ 175,000
(96,000)
$ 200,000
(25,000)
EXAMPLE CORPORATION Statement of Cash Flows
For the year ending December 31, 20X3
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CHAPTER 1Section 1.3 Alternative View of Operating Activities
Table 1.2: Explanation for each adjustment for each of Example Corporation components within the operating activities section
Depreciation expense Added back to net income because it is a noncash expense
Increase in accounts receivable Subtracted because it represents uncollected sales
Increase in inventory Subtracted because it corresponds to purchases of inventory in excess of cost of goods sold
Increase in accounts payable Added because it represents costs not yet funded
Decrease in salaries payable Subtracted because it represents payments in excess of the amount expensed
Gain on sale of equipment Subtracted because (a) it is not related to operating activities, and (b) the full proceeds from the land sale are shown in the investing activities section
In a full business setting, the logic evident in the preceding table would potentially be extended to a countless variety of other revenue and expense items. Table 1.3 is at times helpful in classifying the needed adjustments within the operating activities section.
Table 1.3: Needed adjustments within operating activities
Current assets Current liabilities
Those that increased are subtracted
Examples include increases in accounts receivable, inventory, prepaid expenses
Those that decreased are subtracted
Examples include decreases in accounts payable, salaries payable, interest payable
Those that decreased are added
Examples include decreases in accounts receivable, inventory, prepaid expenses
Those that increased are added
Examples include increases in accounts payable, salaries payable, interest payable
Indeed, a following section in this chapter will show how a worksheet can be used to pinpoint the change in each balance sheet. Eventually, the change in all accounts on the balance sheet must be considered in preparing a statement of cash flows. Logical analy- sis and reasoning is necessary to tackle this challenge, and in some respects the ability to translate accrual basis income to operating cash flows can be viewed as a litmus test of your understanding of accounting. For Example Corporation, the conversion process distills itself to an amount equal to the $167,000 net cash provided by operating activities. This is an identical result to the direct approach. Either approach is an accepted manner of presentation. However, for companies opting to report under the direct approach, a supplemental table is required to reconcile net income to operating cash flows. Thus, as a practical matter, companies opting for the direct approach also present the indirect infor- mation. Conversely, companies opting for the indirect approach must also report supple- ment data about the amount of cash paid for interest and taxes.
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CHAPTER 1Section 1.3 Alternative View of Operating Activities
As you have already noted, following the operating activities section you will find the investing and financing activities. These are presented in the same manner, regardless of the method used to report operating activities.
Investing Activities
The next section of the cash flow statement relates to investing activities and is much sim- pler. Both inflows and outflows related to investment-related transactions are reported within this category. During the year, Example Corporation had the following unique investing transactions:
1. Sold land costing $130,000 for a total of $175,000 (producing a $45,000 gain) 2. Purchased equipment for $96,000 3. Acquired $70,000 of land in exchange for a note payable
Reviewing the statement, you should notice that Example Corporation reported a cash inflow from the sale of land and a cash outflow for the purchase of equipment. The $70,000 note-for-land transaction is a noncash transaction and is reported in the separate section reserved for such activities.
Recall that the sale of land produced a gain of $45,000, as reflected in the income statement (and operating activities section of the cash flow statement using the indirect approach). Regardless of whether a gain or loss resulted on the sale of land, what is reported in the investing activities section is the gross sales proceeds of $175,000. Because the gain was either (a) not reported under the direct approach or (b) subtracted from income under the indirect approach, the result is that the operating activities section is void of any effect from this transaction. Thus, the investing activity section need only report an addition for the sales price. Conversely, the cash paid to purchase equipment is subtracted. Non- cash acquisitions are not reported in this section but are instead reserved for the noncash investing/financing activities section.
Financing Activities
The next major section of the cash flow statement relates to financing activities. This sec- tion reveals the inflows and outflows related to securing and repayment of corporate funding. You will notice that Example Corporation issued stock for a total consideration of $200,000. Assume that the par value of the newly issued shares was $100,000, thus the balance sheet will include an increase to Common Stock for $100,000 and an increase to Paid-in-Capital in Excess of Par for $100,000. Nevertheless, the only line item in the cash flow statement pertains to the gross cash received upon issuance of the shares. Dividends paid on common stock are shown as a cash outflow within this section. As long as the amounts declared and paid were identical, the dividends from the statement of retained earnings would equal the amount on the cash flow statement.
Had the company borrowed cash or repaid amounts borrowed, the financing activities section would also show these amounts. Recall, however, that interest paid on debt is instead shown in the operating activities section.
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16
CHAPTER 1Section 1.4 Using a Worksheet to Prepare the Statement
Net Change in Cash
The net amount of cash generated or consumed by the operating, investing, and financ- ing sections should equal the change in cash for the period. Usually, a company will show the change in cash and reconcile it to the beginning and end cash positions on the bal- ance sheet, as was done for Example Corporation. Example Corporation had a $421,000 increase in cash; when added to the beginning cash amount of $251,000, the ending bal- ance of $672,000 results.
Noncash Investing/Financing Activities
As previously noted, the noncash investing and financing section reports on investing and financing actions that do not directly entail the use of cash. It is quite common for a company to purchase property, plant, and equipment in exchange for a promissory note. Likewise, a company may exchange stock for assets or even issue stock to retire debt. There are many such transactions and events where assets/debt/equity increase/ decrease without triggering cash flow. Example Corporation’s event related to the acquisi- tion of land in exchange for a note payable. It is assumed that this is the only debt incurred by the company; the interest during the period of $3,000 was paid in cash and is reported in the operating activities section.
1.4 Using a Worksheet to Prepare the Statement
You may be wondering how to go about preparing a statement of cash flows. One approach is to set up the shell structure for the statement and gradually fill in known information about specific cash flow events. This is like solving a puzzle. You know the change in cash by reference to the balance sheet. Once you have assembled all the known information so that it fully explains the change in cash, you probably will have success- fully completed the task. But, this approach can prove very frustrating, as there may be elusive components that escape your attention. A far better approach is to employ a sys- tematic worksheet.
The worksheet forces one to compare the change in every balance sheet account during the period and squeeze out the corresponding cash flow consequences. Following is the beginning- and end-of-period balance sheets for Example Corporation. To the right of the balance sheet is an additional table showing the change in each balance sheet account. This will prove helpful in visually connecting the worksheet in Exhibit 1.5.
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17
CHAPTER 1Section 1.4 Using a Worksheet to Prepare the Statement
Exhibit 1.5
This balance sheet information is incorporated into the leftmost and rightmost numerical data columns of Exhibit 1.6.
$ 672,000
550,000
525,000
4,000
190,000
771,000
(320,000)
$ 2,392,000
$ 130,000
10,000
70,000
550,000
700,000
932,000
$ 2,392,000
EXAMPLE CORPORATION Balance Sheet
December 31, 20X2 and 20X3
Assets
Cash
Accounts receivable
Inventories
Prepaid expenses
Land
Building and equipment
Less: Accumulated depreciation
Total assets
Liabilities
Accounts payable
Salaries payable
Note payable
Stockholders’ Equity
Common stock
Paid in capital in excess of par
Retained earnings
Total liabilities and equity
20X3 20X2
$ 251,000
300,000
425,000
4,000
250,000
675,000
(240,000)
$ 1,665,000
$ 80,000
35,000
–
450,000
600,000
500,000
$ 1,665,000
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18
CHAPTER 1Section 1.4 Using a Worksheet to Prepare the Statement
Exhibit 1.6
The middle two columns of the top half of the worksheet capture the change for each row (i.e., balance sheet accounts). For instance, Example Corporation’s beginning accounts receivable was $300,000, and the ending balance was $550,000. This is a net debit to accounts receivable, as shown in the middle column. Importantly, one is not actually deb- iting or crediting these accounts at this time. The worksheet is merely used to demonstrate the net change for each account. The change for every row of the balance sheet must be explained. On occasion (such as with the Land account in the example), there can be both increases and decreases that must be taken into consideration as part of the full explana- tion of all balance changes.
20X4 Debit Credit 20X5
Debits
Cash
Accounts receivable
Inventory
Prepaid expenses
Land
Building and equipment
Credits
Accumulated depreciation
Accounts payable
Salaries payable
Long-term note payable
Common stock ($1 par)
Paid-in capital in excess of par
Retained earnings
Cash flows from operating activities:
Net income
Depreciation expense
Gain on sale of land
Increase in accounts receivable
Increase in inventory
Increase in accounts payable
Decrease in salaries payable
Cash flows from investing activities:
Sale of land
Purchase of equipment
Cash flows from financing activities:
Proceeds from issuing stock
Dividends on common
Noncash investing/financing activities:
Issued note payable for land
Increase in cash
$ 251,000
300,000
425,000
4,000
250,000
675,000
$ 1,905,000
$ 240,000
80,000
35,000
–
450,000
600,000
500,000
$ 1,905,000
$ 421,000
250,000
100,000
70,000
96,000
25,000
25,000
457,000
80,000
50,000
175,000
200,000
70,000
–
$ 2,019,000
(a)
(b)
(c)
(d)
(f)
(i)
(k)
(l)
(g)
(h)
(e)
(j)
(d)
130,000
80,000
50,000
70,000
100,000
100,000
457,000
45,000
250,000
100,000
25,000
96,000
25,000
70,000
421,000
$ 2,019,000
(e)
(g)
(h)
(d)
(i)
(j)
(l)
(e)
(b)
(c)
(i)
(f)
(k)
(d)
(a)
$ 672,000
550,000
525,000
4,000
190,000
771,000
$ 2,712,000
$ 320,000
130,000
10,000
70,000
550,000
700,000
932,000
$ 2,712,000
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19
CHAPTER 1Section 1.4 Using a Worksheet to Prepare the Statement
For each element of change to a balance sheet account, the lower half of the worksheet shows the corresponding (offsetting debit or credit) effect of the change on a company’s cash flow. For example, the increase in accounts receivable (debit) is subtracted from net income as part of the calculation of operating cash flow. In other words, cash was not generated for uncollected sales, and this is shown in the credit column in the lower por- tion of the worksheet. Similar effects are noted for each item, and the small letters key the changes in the top half of the worksheet to the bottom half of the worksheet. Table 1.4 provides a fuller explanation of each keyed item for Example Corporation.
Table 1.4: Example Corporation
Upper portion Lower portion Comment
(a) Increase to Cash via Debit Remaining Net Positive Cash Flow as Credit
This is the net change in cash
(b) Increase to Accounts Receivable via Debit
Negative Cash Flow Effect via Credit
Reflects uncollected sales
(c) Increase to Inventory via Debit Negative Cash Flow Effect via Credit
Reflects buying inventory in excess of what was sold
(d) Increase to Land via Debit and Increase to Note Payable via Credit
Debit and Credit as Noncash Investing/Financing
Reflects increase in land from purchase (via note)
(e) Decrease to Land via Credit Positive Cash Flow Effect via Debit for Sales Proceeds, and Offsetting Credit for Gain Portion to be Excluded From Operating Activities
Reflects decrease to land from sale and inflows from investing activity
(f) Increase to Buildings and Equipment via Debit
Negative Cash Flow Effect via Credit
This is the purchase price of new equipment bought for cash
(g) Increase to Accumulated Depreciation via Credit
Offsetting Debit for Expense Portion to be Excluded From Operating Activities
Reflects the amount of depreciation expense
(h) Increase to Accounts Payable via Credit
Positive Cash Flow Effect via Debit
Reflects unpaid inventory purchases
(i) Decrease to Salaries Payable via Debit
Negative Cash Flow Effect via Credit
Reflects payments for salaries previously expensed
(j) Increase to Common Stock and Paid-in Capital in Excess of Par via Credit
Positive Cash Flow Effect via Debit
Reflects issuance of stock for cash
(k) Decrease to Retained Earnings for Dividends via Debit
Negative Cash Flow Effect via Credit
Reflects cash paid for dividends
(l) Increase to Retained Earnings for Net Income via Credit
Positive Cash Flow Effect (before considering all other operating adjustments as per above) via Debit
The amount of net income during the period (starting point for calculating cash flows from operations under the indirect approach)
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20
CHAPTER 1Section 1.5 Comprehensive Example
Finally, you should take time to compare the lower portion of the worksheet to the indi- rect statement of cash flows presented previously. It is important for you to note how the information from the worksheet is transferred to a cash flow statement. Although the worksheet can at first appear daunting, it is actually a simplifying procedural tool that will ease the frustration that can accompany the process of preparing a cash flow state- ment. Without this thoughtful approach of taking into consideration all the accounts on the balance sheet, one can easily overlook a few data points that are needed to complete a correct statement of cash flows.
1.5 Comprehensive Example
Many accounting educators agree that the statement of cash flows is the most chal-lenging topic for new accounting students. It is often seen as a capstone topic for financial accounting and a litmus test for your depth of accounting knowledge. To assist you in gaining comprehension, this chapter closes with an additional comprehensive example of a statement of cash flows prepared under the indirect approach. The follow- ing example does not introduce new knowledge. Instead, it is designed to reinforce the concepts of this chapter and provide a framework for garnering a deeper appreciation of the approach you can use to master your ability to prepare a statement of cash flows. Take sufficient time to review the facts and exhibits carefully, and try to reconcile each number reported in the statement of cash flows.
Corporation presented the comparative balance sheet shown in Exhibit 1.7.
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21
CHAPTER 1Section 1.5 Comprehensive Example
Exhibit 1.7
Additional information about transactions and events occurring in 20X9 follows:
• Net income was $160,000, and dividends of $10,000 were declared and paid. • Accounts payable and accounts receivable relate only to purchases and sales of
inventory. • The decrease in land resulted from the sale of a parcel of land that cost $100,000
but was sold for $125,000, producing a $25,000 gain. • A building valued at $50,000 was acquired in exchange for 10,000 shares of $1 par
value stock. • A new piece of equipment was acquired in exchange for cash of $25,000.
$ 512,000
460,000
625,000
75,000
$ 1,672,000
450,000
650,000
200,000
$ 1,300,000
(450,000)
$ 850,000
$ 2,522,000
$ 140,000
25,000
$ 165,000
277,000
$ 442,000
$ 230,000
750,000
1,100,000
$ 2,080,000
$ 2,522,000
ASSETS
Current assets
Cash
Accounts receivable
Inventories
Prepaid rent
Total current assets
Property, plant, & equipment
Land
Building
Equipment
Less: Accumulated depreciation
Total property, plant, & equipment
Total assets
LIABILITIES
Current liabilities
Accounts payable
Interest payable
Total current liabilities
Long-term liabilities
Long-term note payable
Total liabilites
STOCKHOLDERS’ EQUITY
Common stock ($1 par)
Paid-in capital in excess of par
Retained earnings
Total stockholders’ equity
Total liabilities and equity
20X9 20X8
$ 337,000
385,000
500,000
64,000
$ 1,286,000
550,000
600,000
175,000
$ 1,325,000
(410,000)
$ 915,000
$ 2,201,000
$ 119,000
–
$ 119,000
202,000
$ 321,000
$ 220,000
710,000
950,000
$ 1,880,000
$ 2,201,000
GRAHAM CORPORATION Comparative Balance Sheet
December 31, 20X9 and 20X8
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22
CHAPTER 1Section 1.5 Comprehensive Example
• $75,000 cash was borrowed via issuing an additional note payable. • Total interest expense was $100,000, of which $75,000 was paid in cash. • Total taxes were $46,000, all paid in cash.
Exhibit 1.8 shows the worksheet for Graham Corporation. Be sure to observe how the beginning and ending balances for each balance sheet account are compared and the differences noted. Each difference identifies a cash flow statement impact, as further explained in Table 1.5.
Exhibit 1.8
20X8 Debit Credit 20X9
Debits
Cash
Accounts receivable
Inventory
Prepaid rent
Land
Building
Equipment
Credits
Accumulated depreciation
Accounts payable
Interest payable
Long-term note payable
Common stock ($1 par)
Paid-in capital in excess of par
Retained earnings
Cash flows from operating activities:
Net income
Depreciation expense
Gain on sale of land
Increase in accounts receivable
Increase in inventory
Increase in prepaid rent
Increase in accounts payable
Increase in interest payable
Cash flows from investing activities:
Purchase of equiipment
Proceeds from sale of land
Cash flows from financing activities:
Proceeds from issuing note
Dividends on common
Noncash investing/financing activities:
Issued stock for building
Increase in cash
$ 337,000
385,000
500,000
64,000
550,000
600,000
175,000
$ 2,611,000
$ 410,000
119,000
–
202,000
220,000
710,000
950,000
$ 2,611,000
$ 175,000
75,000
125,000
11,000
50,000
25,000
10,000
160,000
40,000
21,000
25,000
125,000
75,000
50,000
–
$ 967,000
(a)
(b)
(c)
(d)
(f)
(g)
(k)
(l)
(h)
(i)
(j)
(e)
(j)
(f)
100,000
40,000
21,000
25,000
75,000
10,000
40,000
160,000
25,000
75,000
125,000
11,000
25,000
10,000
50,000
175,000
$ 967,000
(e)
(h)
(i)
(j)
(f)
(f)
(l)
(e)
(b)
(c)
(d)
(g)
(k)
(f)
(a)
$ 512,000
460,000
625,000
75,000
450,000
650,000
200,000
$ 2,972,000
$ 450,000
140,000
25,000
277,000
230,000
750,000
1,100,000
$ 2,972,000
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23
CHAPTER 1Section 1.5 Comprehensive Example
Table 1.5: Cash flow statement impact
Upper portion Lower portion Comment
(a) Increase to Cash via Debit Remaining Net Positive Cash Flow as Credit
This is the net change in cash
(b) Increase to Accounts Receivable via Debit
Negative Cash Flow Effect via Credit
Reflects uncollected sales
(c) Increase to Inventory via Debit
Negative Cash Flow Effect via Credit
Reflects buying inventory in excess of what was sold
(d) Increase to Prepaid Rent via Debit
Negative Cash Flow Effect via Credit
Reflects paying rent in advance
(e) Decrease to Land via Credit Positive Cash Flow Effect via Debit for Sales Proceeds, and Offsetting Credit for Gain Portion to be Excluded From Operating Activities
Reflects decrease to land from sale and inflow from investing activity
(f) Increase to Building via Debit and Increase to Common Stock and Paid-in Capital via Credit
Debit and Credit as Noncash Investing/Financing
Reflects increase in building from purchase (via stock)
(g) Increase to Equipment via Debit
Negative Cash Flow Effect via Credit
This is the purchase price of new equipment bought for cash
(h) Increase to Accumulated Depreciation via Credit
Offsetting Debit for Expense Portion to be Excluded From Operating Activities
Reflects the amount of depreciation expense
(i) Increase to Accounts Payable via Credit
Positive Cash Flow Effect via Debit
Reflects unpaid inventory purchases
(j) Increase to Interest Payable via Credit
Positive Cash Flow Effect via Debit
Reflects unpaid interest
(k) Decrease to Retained Earnings for Dividends via Debit
Negative Cash Flow Effect via Credit
Reflects cash paid for dividends
(l) Increase to Retained Earnings for Net Income via Credit
Positive Cash Flow Effect (before considering all other operating adjustments as per above) via Debit
The amount of net income during the period (starting point for calculating cash flows from operations under the indirect approach)
The lower portion of the worksheet is readily assembled into the following proper format for presentation of the statement of cash flows in Exhibit 1.9.
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24
CHAPTER 1Section 1.5 Comprehensive Example
Exhibit 1.9
In summary review of the statement, it appears that the bulk of Graham’s $175,000 increase in cash was due to the sale of assets and loans. Although the company is prof- itable, the operating cash flow was slight. The simple explanation, as revealed by the operating activities section, is that most of the profits were needed to support growth in receivables and inventory. This is a common problem for successful growing businesses, and it underscores the need to look beyond the income statement to determine the abil- ity of a business to grow and prosper. The cash flow statement is an often overlooked but highly important financial statement!
Cash flows from operating activities:
Net income
Add (deduct) noncash effects on operating income
Depreciation expense
Gain on sale of land
Increase in accounts receivable
Increase in inventory
Increase in prepaid rent
Increase in accounts payable
Increase in interest payable
Net cash provided by operating activities
Cash flows from investing activities:
Purchase of equipment
Sale of land
Net cash provided by investing activities
Cash flows from financing activities:
Proceeds from long-term note
Dividends on common
Net cash provided by financing activities:
Net increase in cash
Cash balance at January 1, 20X9
Cash balance at December 31, 20X9
------------------
Noncash investing/financing activities
Issued common stock for building
------------------
Supplemental information:
Cash paid for interest
Cash paid for taxes
$ 40,000
(25,000)
(75,000)
(125,000)
(11,000)
21,000
25,000
$ 160,000
(150,000)
$ 10,000
100,000
65,000
$ 175,000
337,000
$ 512,000
$ 50,000
$ 75,000
46,000
$ (25,000)
125,000
$ 75,000
(10,000)
GRAHAM CORPORATION Statement of Cash Flows
For the year ending December 31, 20X9
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25
CHAPTER 1Concept Check
Concept Check
The five questions that follow relate to several issues raised in the chapter. Test your knowledge of the issues by selecting the best answer. (The correct answers can be found at the end of your text.)
1. Which of the following is a financing activity? a. Purchase of office equipment b. Payment of dividends c. Receipt of dividends d. Sale of merchandise on account
2. When preparing a statement of cash flows, the direct method is often used in calcu- lating the cash flows from
a. operating, investing, and financing activities. b. investing and financing activities. c. operating and investing activities. d. operating activities only.
3. When converting accrual-based net income to the cash basis with the indirect meth- od, which of the following items is added in the operating activities section of the cash flow statement?
a. Dividends paid b. Cash dividends received c. Loss on the sale of land d. Gain on the sale of land
4. Phillips Corporation’s net cash flow provided by investing activities totaled $100,000 for the year. Dividends paid amounted to $5,000, payments to retire outstanding loans were $40,000, depreciation expense on buildings was $15,000, and new equipment acquired cost $30,000. If the company sold land for cash, the proceeds from the sale must have been
a. $10,000 b. $25,000 c. $100,000 d. $130,000
5. The balance of Ebony’s Machinery account increased by $50,000 during the year. Machinery that cost $80,000 was discarded at a local landfill; additional equip- ment of $130,000 was purchased via the issuance of common stock. In view of these transactions, an examination of the company’s cash flows from investing activities will show
a. a $130,000 outflow for the machinery purchase. b. a $130,000 outflow for the machinery purchase and an $80,000 inflow from disposal. c. a $130,000 outflow for the machinery purchase and an $80,00 loss. d. nothing.
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26
CHAPTER 1Exercises
Key Terms
direct approach An approach to statement construction whereby individual income statement items are converted from the accrual basis to cash basis of accounting.
financing activities Transactions related to obtaining and repaying capital funding needs.
indirect approach An approach to state- ment construction whereby cash flow from operations is derived by making certain adjustments to accrual-basis net income.
investing activities Transactions related to acquiring and disposing of longer-term investments in stocks and debt issued by others, as well as buying and selling items of property, plant, and equipment.
noncash investing and financing activi- ties Transactions that do not trigger a direct inflow or outflow of cash but are nonetheless highly significant investing/ financing events.
operating activities The routine transac- tions of a business and events that enter into the determination of ongoing income.
Critical Thinking Questions
1. What information does the statement of cash flows disclose? Give several examples. 2. Describe the nature of operating activities, including specific examples of operating
cash inflows and outflows. 3. Define investing activities, citing several examples of typical investing inflows and
outflows. 4. List five examples of financing activities. Which of these cause cash inflows and
which cause cash outflows? 5. Why are noncash transactions, such as the exchange of common stock for a building,
included on a statement of cash flows? How are these noncash transactions disclosed? 6. Differentiate between the direct and indirect methods of preparing the statement of
cash flows.
Exercises
1. Classification of activities Classify each of the following transactions as arising from an operating (O), investing (I), financing (F), or noncash investing/financing (N) activity:
________ a. Received $80,000 from the sale of land ________ b. Received $3,200 from cash sales ________ c. Paid a $5,000 dividend ________ d. Purchased $8,800 of merchandise for cash ________ e. Received $100,000 from the issuance of common stock ________ f. Paid $1,200 of interest on a note payable ________ g. Acquired a new laser printer by paying $650 ________ h. Acquired a $400,000 building by signing a $400,000 mortgage note
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27
CHAPTER 1Exercises
2. Indirect calculation of operating cash flows Video Corporation’s balance sheet revealed the following account balance information:
Account Dec. 31, 20X6 Dec. 31, 20X5
Accounts receivable $52,000 $57,000
Merchandise inventory 75,000 68,000
Accounts payable 21,000 19,500
The accrual-basis net income was $107,000. In computing net income, the company recorded $12,600 of depreciation expense; there were no gains or losses from invest- ing and financing activities.
On the basis of the preceding information, calculate Video’s cash flows from operat- ing activities by using the indirect method.
3. Indirect calculation of operating cash flows Specialty Services Inc. reported a net income of $110,000 for the year just ended, which includes an $18,000 gain on the sale of long-term investments. The following data were obtained from comparative balance sheets:
Oct. 31, 20X2 Oct. 31, 20X1
Trade accounts receivable $245,000 $203,000
Merchandise inventory 230,000 308,000
Accumulated depreciation: equipment
120,000 65,000
Accounts payable 190,000 124,000
Accrued liabilities 38,000 73,000
There were no purchases or disposals of equipment during the year. The long-term investment had a carrying (book) value of $77,000 and was sold for cash on June 15.
On the basis of the preceding information, determine the cash provided by operat- ing activities from November 1, 20X1 through October 31, 20X2. The firm uses the indirect method of statement preparation.
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28
CHAPTER 1Exercises
4. Overview of direct and indirect methods Evaluate the comments that follow as being true or false. If the comment is false, briefly explain why.
a. Both the direct method and the indirect method will produce the same cash flow from operating activities.
b. Depreciation expense is added back to net income when the indirect method is used.
c. One of the advantages of using the direct method rather than the indirect method is that larger cash flows from financing activities will be reported.
d. The cash paid to suppliers is normally disclosed on the statement of cash flows when the indirect method of statement preparation is employed.
e. The dollar change in the Merchandise Inventory account appears on the statement of cash flows only when the direct method of statement preparation is used.
5. Statement preparation: Direct method The comparative balance sheets of Village Company follow:
VILLAGE COMPANY Comparative Balance Sheets December 31, 20X2 and 20X1
Dec. 31, 20X2 Dec. 31, 20X1
Cash $ 5,000 $ 7,000
Accounts receivable (net) 12,000 18,000
Merchandise inventory 35,000 28,000
Property, plant, & equipment 40,000 30,000
Less: Accumulated depreciation (17,000) (10,000)
Total assets $ 75,000 $ 73,000
Accounts payable* $ 25,000 $ 21,000
Income taxes payable 4,000 1,000
Common stock 24,000 24,000
Retained earnings 22,000 27,000
Total liabilities & stock, equity $ 75,000 $ 73,000
*Relate to purchases of merchandise
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29
CHAPTER 1Exercises
The firm’s accrual-basis income statement revealed the following data: sales, $120,000; cost of goods sold, $80,000; selling and administrative expenses, $25,000; deprecia- tion expense, $7,000; and income taxes, $3,000. (There was no interest expense.) Div- idends declared and paid during 20X2 totaled $10,000. Finally, Village purchased $10,000 of equipment for cash on August 14.
a. Determine the increase or decrease in cash during 20X2. b. Prepare a statement of cash flows by using the direct method.
6. Equipment transaction and cash flow reporting The property, plant, and equipment section of ProComp Inc.’s comparative balance sheet follows:
Dec. 31, 20X4 Dec. 31, 20X3
Property, plant, & equipment
Land $ 94,000 $ 94,000
Equipment 652,000 527,000
Less: Accumulated depreciation (316,000) (341,000)
New equipment purchased during 20X4 totaled $280,000. The 20X4 income state- ment disclosed equipment depreciation expense of $41,000 and a $9,000 loss on the sale of equipment.
a. Determine the cost and accumulated depreciation of the equipment sold during 20X4.
b. Determine the selling price of the equipment sold. c. Show how the sale of equipment would appear on a statement of cash flows pre-
pared by using the indirect method.
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CHAPTER 1Exercises
7. Evaluation of cash flows The following statement of cash flows was prepared for Yellowstone Company:
YELLOWSTONE COMPANY Statement of Cash Flows
for the Year Ended December 31, 20X2
Cash flows from operating activities
Cash received from customers $240,000
Less cash payments for:
Purchases of merchandise $180,000
Selling & administrative expenses 75,000
Interest 20,000 275,000
Net cash used by operating activities $ (35,000)
Cash flows from investing activities
Sale of equipment $ 20,000
Sale of vehicles 10,000
Sale of long-term investments 40,000
Net cash provided by investing act 70,000
Cash flows from financing activities
Retirement of long-term debt (50,000)
Net increase (decrease) in cash $ (15,000)
Cash balance, January 1, 20X2 54,000
Cash balance, December 31, 20X2 $ 39,000
Evaluate the nature of the decrease in cash. Does your analysis indicate any potential problems for Yellowstone?
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CHAPTER 1Problems
Problems
1. Transaction analysis: Operating, investing, and financing activities The management of Maui Corporation desires to know the nature of each of the following transactions and events:
1. Collected cash from customers for cash sales. 2. Purchased a short-term investment for cash. 3. Secured a mortgage note to finance the acquisition of a building. 4. Issued 10-year bonds for cash. 5. Paid a short-term nonoperating note. 6. Sold equipment having a book value of $30,000 for $30,000 cash. 7. Sold a parcel of land at cost; received a long-term note. 8. Received dividends on a long-term stock investment. 9. Paid income taxes.
10. Issued preferred stock in exchange for a valuable patent. 11. Reacquired treasury stock for cash. 12. Paid previously declared cash dividends.
Instructions a. Briefly explain the difference between investing and financing activities and non-
cash investing/financing activities. b. Design a table with the following columnar headings: operating activity, invest-
ing activity, financing activity, and noncash investing/financing activity. Classify the 12 transactions listed by using these headings. For all classifications except noncash investing/financing, indicate whether the transaction causes a cash inflow (1) or a cash outflow (2).
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CHAPTER 1Problems
2. Operating activities: Direct and indirect methods The 20X5 income statement of Office Products Inc. follows:
OFFICE PRODUCTS INC. Income Statement
for the Year Ended December 31, 20X5
Net sales $980,000
Cost of goods sold
Beginning inventory $235,000
Net purchases 720,000
Goods available for sale $955,000
Less: Ending inventory 260,000
Cost of goods sold 695,000
Gross profit $285,000
Expenses
Selling & administrative $149,000
Depreciation 54,000 203,000
$ 82,000
Other revenue (expense)
Interest expense $ (18,000)
Gain on sale of equipment 26,000 8,000
Income before income taxes $ 90,000
Income taxes 27,000
Net income $ 63,000
The following additional information was obtained from the general ledger and management personnel:
1. Accounts payable related to the purchases of merchandise decreased during 20X5 by $32,800. In contrast, accounts receivable increased by $23,700.
2. Prepaid expenses and wages payable increased throughout 20X5 by $2,400 and $5,600, respectively.
3. The balance in the income taxes payable account on January 1 was $4,900; the December 31 balance was $4,100.
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CHAPTER 1Problems
4. The company financed a $78,000 equipment purchase by signing a note payable that is due in 20X8.
Instructions a. Prepare the operating activities section of the statement of cash flows by using
the direct method. b. Prepare the operating activities section of the statement of cash flows by using
the indirect method. 3. Cash flow information: Direct and indirect methods
The comparative year-end balance sheets of Sign Graphics Inc. revealed the follow- ing activity in the company’s current accounts:
20X5 20X4 Increase
(decrease)
Current assets
Cash $ 55,400 $ 35,200 $ 20,200
Accounts receivable (net)
83,800 88,000 (4,200)
Inventory 243,400 233,800 9,600
Prepaid expenses 25,400 24,200 1,200
Current liabilities
Accounts payable $ 123,600 $140,600 $(17,000)
Taxes payable 43,600 49,200 (5,600)
Interest payable 9,000 6,400 2,600
Accrued liabilities 38,800 60,400 (21,600)
Note payable 44,000 — 44,000
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CHAPTER 1Problems
The accounts payable were for the purchase of merchandise. Prepaid expenses and accrued liabilities relate to the firm’s selling and administrative expenses. The com- pany’s condensed income statement follows:
SIGN GRAPHICS INC. Income Statement
for the Year Ended December 31, 20X5
Sales $713,800
Less: Cost of goods sold 323,000
Gross profit $390,800
Less: Selling & administrative expenses $ 186,000
Depreciation expense 17,000
Interest expense 27,000 230,000
Add: Gain on sale of land $160,800
21,800
Income before taxes $182,600
Income taxes 36,800
Net income $145,800
Other data:
1. Long-term investments were purchased for cash at a cost of $74,600. 2. Cash proceeds from the sale of land totaled $76,200. 3. Store equipment of $44,000 was purchased by signing a short-term note pay-
able. Also, a $150,000 telecommunications system was acquired by issuing 3,000 shares of preferred stock.
4. A long-term note of $49,400 was repaid. 5. Twenty thousand shares of common stock were issued at $5.19 per share. 6. The company paid cash dividends amounting to $128,600.
Instructions a. Prepare the operating activities section of the company’s statement of cash flows,
assuming use of 1) the direct method. 2) the indirect method.
b. Prepare the investing and financing activities sections of the statement of cash flows.
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