11 Tools of the Trade, Part III
The Statement of Cash Flows:
Bringing the Focus Back to Cash
Discussion Questions
11-1. The criteria for revenue and expense recognition under accrual accounting focus on the earnings process and the expenses incurred to generate income, with no regard to the receipt or payment of cash. The obvious outcome of this approach is a lack of overt attention to cash.
11-2. NOTE TO INSTRUCTOR: Your students do not yet have the background to answer Discussion Question 11-2 according to the classification used by the accounting profession in the statement of cash flows, but this question serves to preview the standard classifications of activities presented a little later in the chapter. You can probably expect your students to have more difficulty with investing activities than with either of the other two categories. More important than the answers is the students= reasoning for why certain activities should be classified in a certain category. This would be a good question to revisit as more of the definitions are provided in the chapter.
Examples of the three activities your students should be able to identify include:
a. Operating activities. Buying and selling books, paying wages to employees, paying for janitorial services, paying building rent (unless the building is owned) and paying for advertising. These items are classified as operating activities because they are activities related to the day-to-day operations of the business.
b. Investing activities. The items your students are most likely to think of as investing activities will be buying and selling stock in other companies or loaning somebody money and then being paid back. These are legitimate examples, of course, but you may want to point out that for most companies these are peripheral or incidental activities. The bookstore is not in the business of investing in other companies.
The examples of investing activities you should focus on are the buying and selling of bookshelves, desks, chairs, cash registers, and maybe even the building in which the bookstore is located. These items are classified as investing activities because investment in these things is necessary to create the environment in which the bookstore can operate.
c. Financing activities. Borrowing from banks (or others), owner contributions, paying dividends, and repaying loans. These items are classified as financing activities because they are the means by which the investing activities and operating activities are financed.
11-3. This question can be answered in two correct ways. The first is very basic and the second is a bit more complex.
a. Look through the inflows (deposits) and outflows (checks written) recorded in the check register during the period. Consider only inflows and outflows dealing with operating activities, ignoring all inflows and outflows dealing with investing and financing activities. Once you have determined the operating inflows and operating outflows, subtract the outflows from the inflows and you will have determined the net cash flow from operations.
b. Because of the way the cash basis of accounting measures revenues (receipt of cash) and expenses (payment of cash), net cash flow from operations is disclosed in the cash basis income statement. This concept is logical, but not intuitive. If you will take the time to gently guide your students through the discussion of this question, their understanding of the presentation of the operating activities section of the statement of cash flows later in the chapter will be greatly enhanced.
11-4. This is an integrating question from material previously presented (in Chapter 6). Help your students walk through the cash vs. accrual treatment of various sales, constantly reinforcing that the trigger for the cash basis is always cash inflow or outflow and that the trigger for the accrual basis is the earnings process. This question is important because it focuses on the process of converting accrual accounting to cash accounting to arrive at net cash flow from operations.
a. Under the cash basis, the revenue would not be recognized until the cash was received from the customer (presumably 30 days after the sale).
b. Under the accrual basis, the revenue would be recognized at the time the sale was made even though the cash associated with the sale will not be collected for at least 30 days following the sale.
11-5. This will likely be a difficult question for your students to answer. The key here is for students to recognize that accrual basis income from operations is not cash flow, so certain items must be Aadjusted@ to arrive at cash flow from operations. Emphasizing the different measurement criteria used by cash accounting and accrual accounting in Discussion Question 11-4 will help your students grasp that the operating activities section of the statement of cash flows is essentially a conversion of accrual accounting to cash accounting.
Returning to the scenario presented in Discussion Question 11-4, the credit sale made to the customer was appropriately included in the income statement for the month and flowed through to net income. In determining cash flow from operations for the month, however, that sale must be removed because it did not generate cash in the current month. The same process must be repeated for any revenue or expense item that did not generate or use cash during the current month.
11-6. This question actually has two purposes. The first is to make sure your students understand that the ending balance of any item on the balance sheet is the beginning balance for the next year. In the case of Pipkin Company, the balance of accounts receivable on December 31, 2006 was $3,112,000, which is the beginning balance of accounts receivable on January 1, 2007.
The second purpose of the question is to help your students become comfortable with using information from comparative financial statements. Accounts receivable decreased by $187,000 during 2007 ($3,112,000 beginning balance - $2,925,000 ending balance).
11-7. This question actually has two purposes. The first is to make sure your students understand that the ending balance of any item on the balance sheet is the beginning balance for the next year. In the case of Pipkin Company, the balance of retained earnings on December 31, 2006 was $1,774,000, which is the beginning balance of retained earnings on January 1, 2007.
The second purpose of the question is to reinforce your students= understanding of what causes retained earnings to change. In the case of Pipkin Company, the increase in retained earnings to $2,086,000 on December 31, 2007 resulted from a combination of $449,000 net income for 2007 and paying $137,000 in dividends during 2007.
11-8. Answers to this question should focus on financing activities. Examples should include borrowing and repaying loans, investments by owners and distributions by owners. Your students may want to include buying and selling property, plant and equipment as cash flows that would not show up in net income. Remind them that the question centers on cash basis net income. Buying and selling fixed assets does not show in accrual basis net income, but does show in cash basis net income.
11-9. Using the direct method to prepare the cash flow statement requires the extensive use of the income statement to determine the cash flows from operations. The major categories required by this format include cash flows from customers, cash paid for merchandise, interest and taxes. However, the figures from the income statement represent the accrual basis measurement of the items B not necessarily the cash paid or received. All of the numbers from the income statement are used to derive the cash flow statement numbers except for the depreciation amounts. Because depreciation never involves cash flow, it is not part of the cash flow from operations prepared with the direct method. The only numbers that appear on the cash flow statement are the interest expense and the taxes amount because they are equal to the cash paid for those items.
11-10. Cash comes into the business and is used for many activities that are unrelated to net income such as investing and financing activities. For reasons discussed extensively over the last several chapters, accrual basis net income for a particular income statement period is not equal to cash. Net income is a particular income statements period=s addition to retained earnings and dividends declared (whether paid within the period or not) are deducted from retained earnings. Therefore the only possible way that retained earnings could equal cash is by sheer coincidence.
11-11. The cash flows generated from operating activities are the same regardless of the format used. The indirect method converts the income statement from the accrual basis to the cash basis while the direct method analyzes the cash inflows and cash outflows by major operating activity.
11-12. The direct method cash flow explains the operating sources and uses of cash, similar to a cash basis income statement. The indirect method explains the differences between the accrual basis income statement and the cash derived from operations. Regardless of method used to prepare the operating section of the cash flow statement, the total cash flows generated from operating activities are the same. Students will frequently select the direct method because it is the easiest to read and understand. More critical thinking students will understand the powerful analysis contained in the indirect method because it helps them to grasp the reality of the difference between income and cash flow B or the difference between the reality of performance and the reality of cash.
Review the Facts
A. The statement of cash flows as it is presented in its present state has only been in existence since 1988. There were other prior attempts to present funds statements such as working capital statements, but the current cash flow statement presents detailed information about the sources and uses of cash.
B. The main purpose of the statement of cash flows is to bring the focus to cash and to report detailed information about the sources and uses of cash.
C. The two methods used to prepare the cash flow statement are the direct method and the indirect method. The indirect method is the preferred method by companies.
D. The three major classifications of activities on the cash flow statement are operating activities, financing activities and investing activities.
E. Cash inflows from dividends and interest received and cash outflows for interest paid are usually classified as operating activities.
F. Examples of inflows from operating activities would be cash from sales or the collection of receivables, whereas outflows might be the cash paid for salaries or rent or any expenses. Cash inflows for investing activities would come from the sale for cash of fixed assets or other investments. Cash outflows for investing activities might arise from the purchase for cash of fixed assets or investments in stocks and bonds. Cash inflows from financing activities would arise from the sale of the company’s stock or the borrowing of monies. Financing activities outflows would come from the purchase of treasury stock or the payment of dividends.
G. The direct method for preparing the cash flow statement focuses on the direct effect of cash from customers and the cash paid for purchases and the expenses necessary to run the business. The indirect method focuses on the changes in the balance sheet accounts and how these changes impact the statement of cash flows.
H. The starting point for cash flows from operations using the indirect method is the accrual basis net income.
I. The items reported in the operating section of the cash flow statement are found on the income statement of the entity and in the current asset and current liability sections of the balance sheet.
J. Items included in the investing section of the cash flow statement are found in the long-term asset section of the balance sheet.
K. The items included in the financing section of the cash flow statement would be found in the long-term liability and stockholders’ equity sections of the balance sheet.
L. The section of the cash flow statement used to tell the reader how much cash was used for the purchase of depreciable assets is the investing activities section.
M. The investments made by the company would be reported in the investing section of the cash flow statement while the methods of financing used would be reported in the financing section of the cash flow statement.
Chapter 11 - Tools of the Trade, Part III, The Statement of Cash Flows:
Bringing the Focus Back to Cash F11-7
Apply What You Have Learned
11-13.
1. b Provides a reconciliation of accrual net income to the cash provided by or used by operating activities
2. e Accounting reports providing information from two or more consecutive periods at once
3. j Investments in stocks and bonds that management intends to hold for an indefinite period.
4. a Activities centered around the day-to-day business transactions of a company
5. f Current assets less current liabilities
6. h Business activities related to long-term assets
7. g Provides detail as to the individual sources and uses of cash associated with operating activities
8. c An item that reduces reported net income, but does not require the use of cash
9. d Activities such as the issuance of debt or equity and the payment of dividends
10. i Investments in stocks and bonds that management intends to hold for an indefinite period.