chapter 12 • The Statement of cash flows 12-1
CHAPTER 12
The Statement of Cash Flows
OVERVIEW OF EXERCISES, PROBLEMS, AND CASES
Estimated
Time in
Learning OutcomesExercisesMinutesLevel
1.Explain the purpose of a statement of cash flows. 15* 60 Diff
2.Explain what cash equivalents are and how they are treated on 1 5 Easy
the statement of cash flows. 12* 10 Easy
3.Describe operating, investing, and financing activities, and give 2 10 Easy
examples of each. 3 10 Mod
12* 10 Easy
13* 10 Easy
14* 25 Diff
4.Describe the difference between the direct and the indirect
methods of computing cash flow from operating activities.
5.Prepare a statement of cash flows, using the 4 5 Mod
direct method to determine cash flow from operating activities. 5 10 Mod
6 20 Mod
7 20 Mod
8 10 Mod
13* 10 Easy
15* 60 Diff
6.Prepare a statement of cash flows, using 9 10 Easy
the indirect method to determine cash flow from operating 10 15Mod
activities. 14* 25 Diff
7.Use cash flow information to help analyze a company. 11 15Mod
8.Use a work sheet to prepare a statement of cash flows, using
the indirect method to determine cash flow from operating
activities (Appendix).
*Exercise, problem, or case covers two or more learning outcomes
Level = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)
ProblemsEstimated
andTime in
Learning OutcomesAlternatesMinutesLevel
1.Explain the purpose of a statement of cash flows.
2.Explain what cash equivalents are and how they are treated on 13*30Diff
the statement of cash flows.
3.Describe operating, investing, and financing activities, and give
examples of each.
4.Describe the difference between the direct and the indirect 11* 30Mod
methods of computing cash flow from operating activities. 12* 30Mod
5.Prepare a statement of cash flows, using the 3 45 Mod
direct method to determine cash flow from operating activities. 6 30 Mod
11* 30 Mod
13* 30 Diff
6.Prepare a statement of cash flows, using 1 30 Mod
the indirect method to determine cash flow from operating 4 45Mod
activities. 7 30 Mod
9 45 Diff
12* 30 Mod
7.Use cash flow information to help analyze a company.
8.Use a work sheet to prepare a statement of cash flows, using 2 60 Mod
the indirect method to determine cash flow from operating 5 60Mod
activities (Appendix). 8 60 Mod
10 60 Diff
*Exercise, problem, or case covers two or more learning outcomes
Level = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)
Estimated
Time in
Learning OutcomesCasesMinutesLevel
1.Explain the purpose of a statement of cash flows. 3* 60 Diff
4* 25 Mod
5* 25 Mod
2.Explain what cash equivalents are and how they are treated on 6*20Mod
the statement of cash flows.
3.Describe operating, investing, and financing activities, and give 1*30Mod examples of each. 6* 20 Mod
4.Describe the difference between the direct and the indirect 1* 30Mod methods of computing cash flow from operating activities.
5.Prepare a statement of cash flows, using the 3* 60 Diff
direct method to determine cash flow from operating activities.
6.Prepare a statement of cash flows, using 4* 25 Mod
the indirect method to determine cash flow from operating 5* 25Mod
activities.
7.Use cash flow information to help analyze a company. 2 20Mod
8.Use a work sheet to prepare a statement of cash flows, using
the indirect method to determine cash flow from operating
activities (Appendix).
*Exercise, problem, or case covers two or more learning outcomes
Level = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)
questions
1.The purpose of the statement of cash flows is to summarize an entity’s cash flows from operating, investing, and financing activities during a period.Because it is concerned with activity for a specific period of time, the statement is similar to the
income statement.However, they differ in two important respects.First, with a few exceptions, the income statement deals only with operating activities.Second, the income statement is on an accrual basis, while the statement of cash flows reports operating activities on a cash basis.
2.A cash equivalent is an item that is readily convertible to a known amount of cash and has an original maturity of three months or less.These items, such as Treasury bills and money market funds, present very little risk to the holder, and therefore they are included with cash for the purpose of preparing the statement of cash flows.That is, purchases and sales of cash equivalents are not considered significant activities to be separately reported on the statement.
3.The down payment of $20,000 is a cash outflow that would be reported in the investing activities section of the statement of cash flows.The issuance of the promissory note for $60,000 would appear in a supplemental schedule of noncash investing and financing activities.
4.A 60-day Treasury bill would be classified as a cash equivalent and combined with cash on the balance sheet.Therefore, the purchase of the treasury bill would not be reported as an investing activity.However, the purchase of Motorola stock would appear as a cash outflow in the investing activities section of the statement of cash flows.
5.Companies cannot continue in business if they do not generate positive cash flows from operating activities.Also, over a period of years, a company cannot continue to borrow more than it repays, nor can it issue capital stock indefinitely.Thus, you would not expect a net cash outflow from financing activities over a sustained period of time.However, many companies regularly experience a net cash outflow from investing activities.A company must at a minimum replace existing assets and in many cases acquire additional plant and equipment to remain competitive.At the same time, disposals of long-term assets may be fairly common, but usually they will not generate significant amounts of cash inflow.
6.The student is correct in that it is simple enough to find the net inflow or outflow of cash during the period.But this is only the starting point in preparing the statement of cash flows.First, all of the balance sheet accounts must be analyzed to find the explanations for the increases and decreases in cash during the period.Second, each of these inflows and outflows must be classified as either operating, investing, or financing activities.
7.The only accurate part of this statement is that depreciation is often one of the largest items in the Operating Activities section of the statement.However, this is merely a result of using the indirect method to prepare this section. In computing net income, depreciation is deducted.Therefore, under the indirect method it must be added back to net income because it is a noncash expense.Depreciation does not in any way generate cash.
8.There is considerable debate over which method is most useful.Many accountants, as well as users of the statements, believe that the direct method, with its emphasis on cash receipts and cash payments, provides the most information.Others believe that the indirect method is better because it focuses attention on the differences between net income and net cash provided by operations.Accounting standards allow the use of either method, but companies are strongly encouraged to use the direct method.
9.Under the indirect method, net income is reported at the top of the Operating Activities section, and adjustments are made to convert income to a cash basis.Sales revenue is included in net income.However, on a cash basis we are interested in cash collections from sales, not the sales on an accrual basis.A decrease in accounts receivable indicates that cash collections exceeded sales revenue.Therefore, the excess is added back to the net income of the period.
10.Inventory is analyzed to determine the purchases of the period.Cost of goods sold decreases the Inventory account, and purchases increase it.After the purchases of the period are found, they are added to the beginning balance in the Accounts Payable account.The difference between the addition of these amounts and the ending balance in Accounts Payable is the amount of cash payments.
11.A profitable year does not guarantee a large cash balance at the end of the year.A large share of the profits may be returned to the stockholders in the form of cash dividends.Investments in new plant and equipment require significant amounts of cash, as does the repayment of various forms of borrowing.
12.Yes, it is possible to report a net loss and still experience a net increase incash.First, a company could report large noncash charges against net income, such as depreciation and various types of losses.Thus, it is possible that net cash provided by operating activities is positive even though a net loss is reported.Second, the net loss deals only with operating activities. It is possible that a net cash inflow was provided by either investing or financing activities, or both.
13.Regardless of which method is used, a decrease in income taxes payablemeans that cash paid to the government during the period exceeded income tax expense on the income statement.Under the direct method, the amount of cash paid is reported as a cash outflow in the Operating Activities section of the statement.If the indirect method is used, the decrease in taxes payable is deducted from net income to arrive at net cash flow from operations.
14.The requirement to separately disclose income taxes paid and interest paid when the indirect method is used is a compromise.Accounting standards strongly encourage companies to use the direct method because each major operating cash receipt and payment is reported in the Operating Activities section of the statement. However, if a company chooses to use the indirect approach, they are still required to report separately how much cash was actually paid to the government in taxes and to creditors in interest.
15.An argument can be made that it is inconsistent to report interest paid in the operating section and dividends paid in the financing section.Both represent returns to providers of capital:interest to creditors and dividends to stockholders.Furthermore, the cash raised from each of these sources—the amounts borrowed from creditors and the amounts contributed by stockholders—is classified as an inflow in the financing section of the statement.The rationale normally given for this treatment is that interest enters into the determination of net income, and thus the cash expended in interest should appear in the operating section.Many believe that this is illogical and that both interest paid and dividends paid belong in the financing section.
16.An analysis of the Prepaid Rent account can be used to find the amount of cash paid for rent:
Beginning Prepaid Rent$9,600
+ Cash paymentsX
– Rent Expense45,900
= Ending Prepaid Rent$7,300
$9,600 + X – $45,900 = $7,300
X = $43,600
17.The purchase of 2,000 shares of treasury stock at $20 per share would be reflected on the statement of cash flows as a cash outflow of $40,000 in the financing activities section of the statement.
18.The effect on the accounting equation of the sale of the truck is as follows:
Balance Sheetincome Statement
Assets=Liabilities+Stockholders’ Equity+ Revenues – Expenses
Cash 9,000
Loss on Sale
of Asset (2,000)*
Accumulated
Depreciation 14,000**
Delivery Truck (25,000)
*$11,000 – $9,000 = $2,000
**$25,000 – $11,000 = $14,000
Two items would be reported on a statement of cash flows using the indirect method.First, the loss of $2,000 would be added back to net income in the operating activities section.Second, the cash received of $9,000 would be reported as a cash inflow in the investing activities section.
19.Since the company neither bought nor sold any patents during the year, the decrease in the balance in the account of $4,000 represents the amortization of the patent for the year.Amortization is a noncash expense, as is depreciation, and is added back to net income under the indirect method.
20.A stock dividend does not involve the inflow or outflow of cash and therefore is not reported on a statement of cash flows. It is questionable whether it is even a significant noncash activity that should be reported in the supplemental schedule.It could be argued that the issuance of stock in connection with a stock dividend is a financing activity and that it should be included on the schedule.If a 10% stock dividend is included on the schedule, it would be reported at the market value of the shares issued.
21.The information needed to determine a company’s cash flow adequacy comes from two sources.The numbers in the numerator of the ratio, net cash provided by operating activities and capital expenditures, appear on the statement of cash flows.The amount of average annual debt maturing over the next five years in the denominator can be found in a note to the financial statements.
exercises
LO2 / EXERCISE 12-1 CASH EQUIVALENTSInvestments made during December 2007 that qualify as cash equivalents at December 31, 2007:
Certificate of deposit, due January 31, 2008$35,000
Money Market fund105,000
90-day Treasury bills75,000
Cash equivalents at December 31, 2007$215,000
LO 3 / EXERCISE 12-2 CLASSIFICATION OF ACTIVITIES1.F8.F
2.S9.S
3.F10.I
4.F11.I or O*
5.O12.O
6.O13.O
7.O
*Investing activity if stock is classified as an available-for-sale security; operating activity if it is classified as a trading security.
LO 3 / EXERCISE 12-3 RETIREMENT OF BONDS PAYABLE ON THE STATEMENT OF CASH FLOWS—INDIRECT METHOD1.The effect on the accounting equation of the December 31, 2007, bond retirement is as follows:
Balance Sheetincome Statement
Assets=Liabilities+Stockholders’ Equity+ Revenues – Expenses
Cash (510,000) Bonds Payable (500,000) Loss on Retire-
Discount on ment of Bonds (50,000)*
Bonds Payable 40,000
*$510,000 – $460,000 = $50,000
2.The $510,000 in cash paid to retire the bonds would be reported as a cash outflow in the financing activities section.Assuming the company uses the indirect method, the loss of $50,000 would be added back in the operating activities section.
LO 5 / EXERCISE 12-4 CASH COLLECTIONS—DIRECT METHODCash collections to be reported in the operating activities section of Stanley’s 2007 statement of cash flows (direct method):
Accounts receivable, December 31, 2006$ 80,800
Plus sales during 2007 1,450,000
Less cash collections during 2007(X)
Accounts receivable, December 31, 2007$ 101,100
$80,800 + $1,450,000 – X = $101,100
X = $1,429,700
LO 5 / EXERCISE 12-5 CASH PAYMENTS—DIRECT METHODCash payments for inventory to be reported in the operating activities section of Lester Enterprise’s 2007 statement of cash flows (direct method):
Inventory, December 31, 2006$ 90,200
Plus purchases during 2007 X
Less cost of goods sold during 2007 (770,900)
Inventory, December 31, 2007$ 70,600
$90,200 + X – $770,900 = $70,600
X = $751,300
Accounts payable, December 31, 2006$ 57,700
Plus purchases during 2007 751,300
Less cash payments during 2007 (X)
Accounts payable, December 31, 2007$ 39,200
$57,700 + $751,300 – X = $39,200
X=$769,800
LO 5 / EXERCISE 12-6 OPERATING ACTIVITIES SECTION—DIRECT METHOD1.Operating activities section of the statement of cash flows:
LABRADOR COMPANY
PARTIAL STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2007
Cash Flows from Operating Activities
Cash collected from customers $ 102,0001
Cash payments for:
Inventory$ (79,000)2
General and administrative (6,000)3
Interest (3,500)4
Taxes (3,500)5
Total cash payments$ (92,000)
Net cash provided by operating activities$ 10,000
Footnotes:
1Cash collections from customers:
Sales revenue$ 100,000
Add: Decrease in accounts receivable 2,000
Cash collections$ 102,000
2Payments for inventory:
Cost of goods sold$ 75,000
Add: Increase in inventory 7,000
Less: Increase in accounts payable (3,000)
Cash payments$ 79,000
3For general and administrative expenses:
General and administrative expense$ 8,000
Less: Decrease in office supplies (3,000)
Add: Decrease in salaries and wages payable 1,000
Cash payments$ 6,000
4For interest:
Interest expense$ 3,000
Add: Decrease in interest payable 500
Cash payments$ 3,500
5For taxes:
Income tax expense$ 5,000
Less: Increase in income taxes payable (1,500)
Cash payments$ 3,500
EXERCISE 12–6 (Concluded)
2.The use of the direct method reveals the amounts collected from customers and the amounts paid for inventory, interest, taxes, and other operating purposes.The indirect method simply reconciles the net income of the period to the net cash flow from operations.The direct method shows the reader of the statement the specific amounts collected and paid for operating purposes.
LO 5 / EXERCISE 12-7 DETERMINATION OF MISSING AMOUNTS—CASH FLOW FROM OPERATING ACTIVITIESCase 1:
Beginning accounts receivable$ 150,000
+Credit sales revenue 175,000
–Write-offs (35,000)
–Cash collections(X)
=Ending accounts receivable$ 100,000
$150,000 + $175,000 – $35,000 – X = $100,000
X = $190,000 credit sales
$190,000 + $60,000 (cash sales) = $250,000
Case 2:
Beginning inventory$ 80,000
+Purchases X
–Cost of goods sold (175,000)
=Ending inventory$ 55,000
$80,000 + X – $175,000 = $55,000
X = $150,000
Beginning accounts payable$ 25,000
+Purchases 150,000
–Cash payments(X)
=Ending accounts payable$ 15,000
$25,000 + $150,000 – X = $15,000
X = $160,000
Case 3:
Beginning prepaid insurance$ 17,000
+Cash payments X
–Insurance expense (15,000)
=Ending prepaid insurance$ 20,000
$17,000 + X – $15,000 = $20,000
X = $18,000
EXERCISE 12-7 (Concluded)
Case 4:
Beginning income taxes payable$ 95,000
+Income tax expense 300,000
–Cash payments (X)
=Ending income taxes payable$ 115,000
$95,000 + $300,000 – X = $115,000
X = $280,000
LO 5 / EXERCISE 12-8 DIVIDENDS ON THE STATEMENT OF CASH FLOWS1.First, determine the amount of dividends declared:
Beginning retained earnings$ 250,000
+Net income 285,000
–Stock dividends (50,000)
–Dividends declared(X)
=Ending retained earnings$ 375,000
$250,000 + $285,000 – $50,000 – X = $375,000
X = $110,000
Then, solve for the amount of dividends paid:
Beginning dividends payable$ 20,000
+Dividends declared 110,000
–Cash dividends paid(X)
=Ending dividends payable$ 30,000
$20,000 + $110,000 – X = $30,000
X = $100,000
2.Because a stock dividend does not involve cash, it is not reported on the statement of cash flows.It is questionable whether or not a stock dividend is a significant noncash activity that should be reported on a supplemental schedule.
LO 6 / EXERCISE 12-9 ADJUSTMENTS TO NET INCOME WITH THE INDIRECT METHOD1.A6.A
2.D7.D
3.A8.A
4.A9.NR
5.NR10.A
LO 6 / EXERCISE 12-10 OPERATING ACTIVITIES SECTION—INDIRECT METHOD1.Operating activities section of the statement of cash flows:
SUFFOLK COMPANY
PARTIAL STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2007
Cash Provided by Operating Activities
Net income $40,000
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation expense 20,000
Increase in accounts receivable (8,000)
Decrease in inventory 10,000
Increase in prepaid rent (2,000)
Increase in accounts payable 7,000
Decrease in income taxes payable (4,000)
Increase in interest payable 3,000
Net cash inflow from operating activities $66,000
2.The primary reason that net cash inflow from operating activities of $66,000 is more than net income of $40,000 is depreciation of $20,000.It is deducted on the income statement but it does not require the use of cash.Other reasons for the higher amount of net cash inflow from operating activities are the decrease in inventory (the company is not buying as much inventory) and the increase in accounts payable (the company is slowing down payments to its creditors).
LO 7 / EXERCISE 12-11 CASH FLOW ADEQUACY1.Cash flow adequacy ratio:
(Net cash provided by operations – Capital expenditures)/Average annual debt
maturing over next five years
=($12,000,000 – $2,000,000)/($20,000,000/5)
=$10,000,000/$4,000,000
=2.5
2.The cash flow adequacy ratio gives the user an indication of whether or not the company is generating sufficient cash from its operations to repay its debts, after taking into consideration the need to make necessary expenditures on new plant and equipment.It would appear that a ratio of 2.5 is reasonable;however, other factors should be considered, including how the ratio compares with prior years as well as with competitors.
MULTI-CONCEPT exercises