Mensur Boydaş, Vahdi Boydaş: Accounting Principles: Ch23

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C H A P T E R 23

STATEMENT OF CASH FLOWS

LEARNING OBJECTIVESAfter studying this chapter, you should be able to:

Describe the purpose of the statement of cash flows.

Identify the major classifications of cash flows.

Differentiate between net income and net cash flows from operating activities.

Contrast the direct and indirect methods of calculating net cash flow from operating activities.

Determine net cash flows from investing and financing activities.

Prepare a statement of cash flows.

Identify sources of information for a statement of cash flows.

Discuss special problems in preparing a statement of cash flows.

Explain the use of a worksheet in preparing a statement of cash flows.•9

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Investors usually look to net income as a keyindicator of a company’s financial health andfuture prospects. The following graph shows

the net income of one company over a seven-year period.

Don’t Take Cash Flow for Granted

1Year

Mill

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of D

olla

rs

40

50

30

0

−30

−60

2 3 4 5 6 7

Income

Cash Flowfrom Operations

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The company showed a pattern of consistent profitability and even some periods of income growth. Betweenyears 1 and 4, net income for this company grew by 32 percent, from $31 million to $41 million. Would you expect itsprofitability to continue? The company had consistently paid dividends and interest. Would you expect it to continueto do so? Investors answered “yes” to these questions, by buying the company’s stock. Eighteen months later, thiscompany—W. T. Grant—filed for bankruptcy, in what was then the largest bankruptcy filing in the United States.

How could this happen? As indicated by the second line in the graph, the company had experienced several yearsof negative cash flow from its operations, even though it reported profits. How can a company have negative cashflows while reporting profits? The answer lay partly in the fact that W. T. Grant was having trouble collecting the receiv-ables from its credit sales, causing cash flow to be less than the net income. Investors who analyzed the cash flowswould have been likely to find an early warning signal of W. T. Grant’s operating problems.

Source: Adapted from James A. Largay III and Clyde P. Stickney, “Cash Flows, Ratio Analysis, and the W. T. GrantCompany Bankruptcy,” Financial Analysts Journal (July–August 1980), p. 51.

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P R E V I E W O F C H A P T E R 2 3

As the opening story indicates, examination of W. T. Grant’s cash flows from opera-tions would have shown the financial inflexibility that eventually caused the company’sbankruptcy. This chapter explains the main components of a statement of cash flowsand the types of information it provides. The content and organization of the chapterare as follows.

PREPARAT ION OF THE STATEMENT

SPEC IAL PROBLEMS IN STATEMENT PREPARAT ION USE OF A WORKSHEET

• Usefulness

• Classification of cashflows

• Format of statement

• Steps in preparation

• Examples

• Sources of information

• Indirect vs. direct method

• Adjustments similar todepreciation

• Accounts receivable (net)

• Other working capital changes

• Net losses

• Gains

• Stock options

• Postretirement benefit costs

• Extraordinary items

• Significant noncashtransactions

• Preparation of worksheet

• Analysis of transactions

• Preparation of final statement




1244 · Chapter 23 Statement of Cash Flows

The primary purpose of the statement of cash flows is to provide informationabout a company’s cash receipts and cash payments during a period. A second-ary objective is to provide cash-basis information about the company’s operating,investing, and financing activities. The statement of cash flows therefore reportscash receipts, cash payments, and net change in cash resulting from a company’s

operating, investing, and financing activities during a period. Its format reconciles thebeginning and ending cash balances for the period.

USEFULNESS OF THE STATEMENT OF CASH FLOWSThe statement of cash flows provides information to help investors, creditors, and othersassess the following [1]:

1. The entity’s ability to generate future cash flows. A primary objective of financialreporting is to provide information with which to predict the amounts, timing, anduncertainty of future cash flows. By examining relationships between items such assales and net cash flow from operating activities, or net cash flow from operatingactivities and increases or decreases in cash, it is possible to better predict the futurecash flows than is possible using accrual-basis data alone.

2. The entity’s ability to pay dividends and meet obligations. Simply put, cash is es-sential. Without adequate cash, a company cannot pay employees, settle debts, payout dividends, or acquire equipment. A statement of cash flows indicates where thecompany’s cash comes from and how the company uses its cash. Employees, credi-tors, stockholders, and customers should be particularly interested in this statement,because it alone shows the flows of cash in a business.

3. The reasons for the difference between net income and net cash flow from operat-ing activities. The net income number is important: It provides information on theperformance of a company from one period to another. But some people are criti-cal of accrual-basis net income because companies must make estimates to arrive atit. Such is not the case with cash. Thus, as the opening story showed, financial state-ment readers can benefit from knowing why a company’s net income and net cashflow from operating activities differ, and can assess for themselves the reliability ofthe income number.

4. The cash and noncash investing and financing transactions during the period. Besidesoperating activities, companies undertake investing and financing transactions. Invest-ing activities include the purchase and sale of assets other than a company’s productsor services. Financing activities include borrowings and repayments of borrowings, in-vestments by owners, and distributions to owners. By examining a company’s invest-ing and financing activities, a financial statement reader can better understand whyassets and liabilities increased or decreased during the period. For example, by read-ing the statement of cash flows, the reader might find answers to following questions:

Why did cash decrease for Toys R Us when it reported net income for the period?How much did Southwest Airlines spend on property, plant, and equipment lastyear?Did dividends paid by Campbell’s Soup increase?How much money did Coca-Cola borrow last year?How much cash did Hewlett-Packard use to repurchase its common stock?

SECTION 1 • PREPARATION OF TH E STATEMENTOF CASH FLOWS

Objective•1Describe the purpose of thestatement of cash flows.

See the FASBCodification section(page 1285).



Classification of Cash Flows · 1245

CLASSIFICATION OF CASH FLOWSThe statement of cash flows classifies cash receipts and cash payments by oper-ating, investing, and financing activities.1 Transactions and other events charac-teristic of each kind of activity is as follows.

1. Operating activities involve the cash effects of transactions that enter into thedetermination of net income, such as cash receipts from sales of goods andservices, and cash payments to suppliers and employees for acquisitions ofinventory and expenses.

2. Investing activities generally involve long-term assets and include (a) making andcollecting loans, and (b) acquiring and disposing of investments and productivelong-lived assets.

3. Financing activities involve liability and stockholders’ equity items and include(a) obtaining cash from creditors and repaying the amounts borrowed, and (b) obtain-ing capital from owners and providing them with a return on, and a return of, theirinvestment.

Illustration 23-1 classifies the typical cash receipts and payments of a company ac-cording to operating, investing, and financing activities. The operating activities cate-gory is the most important. It shows the cash provided by company operations. Thissource of cash is generally considered to be the best measure of a company’s ability togenerate enough cash to continue as a going concern.

1The basis recommended by the FASB for the statement of cash flows is actually “cash andcash equivalents.” Cash equivalents are short-term, highly liquid investments that are both:(a) readily convertible to known amounts of cash, and (b) so near their maturity that theypresent insignificant risk of changes in interest rates. Generally, only investments withoriginal maturities of three months or less qualify under this definition. Examples of cashequivalents are Treasury bills, commercial paper, and money market funds purchased withcash that is in excess of immediate needs.

Although we use the term “cash” throughout our discussion and illustrations, we mean cashand cash equivalents when reporting the cash flows and the net increase or decrease in cash.

Objective•2Identify the major classifications ofcash flows.

ILLUSTRATION 23-1Classification of TypicalCash Inflows andOutflows

OperatingCash inflows

From sales of goods or services.From returns on loans (interest) and on equity

securities (dividends). IncomeCash outflows Statement

To suppliers for inventory. ItemsTo employees for services.To government for taxes.To lenders for interest.To others for expenses.

InvestingCash inflows

From sale of property, plant, and equipment.From sale of debt or equity securities of other entities. GenerallyFrom collection of principal on loans to other entities. Long-Term

Cash outflows Asset ItemsTo purchase property, plant, and equipment.To purchase debt or equity securities of other entities.To make loans to other entities.

FinancingCash inflows Generally

From sale of equity securities. Long-TermFrom issuance of debt (bonds and notes). Liability

Cash outflows and EquityTo stockholders as dividends. ItemsTo redeem long-term debt or reacquire capital stock.

⎫⎪⎪⎪⎪⎬⎪⎪⎪⎪⎭⎫⎪⎪⎪⎪⎬⎪⎪⎪⎪⎭⎫⎪⎪⎪⎬⎪⎪⎪⎭

According to International Accounting Standards, companies candefine “cash and cash equivalents” as“net monetary assets”—that is, as“cash and demand deposits and highlyliquid investments less short-termborrowings.”

INTERNATIONALINSIGHT




Note the following general guidelines about the classification of cash flows.

1. Operating activities involve income statement items.2. Investing activities involve cash flows resulting from changes in investments and

long-term asset items.3. Financing activities involve cash flows resulting from changes in long-term liability

and stockholders’ equity items.

Companies classify some cash flows relating to investing or financing activities asoperating activities.2 For example, companies classify receipts of investment income(interest and dividends) and payments of interest to lenders as operating activities.Why are these considered operating activities? Companies report these items in the in-come statement, where the results of operations are shown.

Conversely, companies classify some cash flows relating to operating activities asinvesting or financing activities. For example, a company classifies the cash receivedfrom the sale of property, plant, and equipment at a gain, although reported in the in-come statement, as an investing activity. It excludes the effects of the related gain innet cash flow from operating activities. Likewise, a gain or loss on the payment (extin-guishment) of debt is generally part of the cash outflow related to the repayment ofthe amount borrowed. It therefore is a financing activity.

2Banks and brokers must classify cash flows from purchases and sales of loans and securitiesspecifically for resale and carried at market value as operating activities. This requirementrecognizes that for these firms these assets are similar to inventory in other businesses. [2]

What do thenumbers mean?

To evaluate overall cash flow, it is useful to understand where in the product life cycle a companyis. Generally, companies move through several stages of development, which have implications forcash flow. As the graph below shows, the pattern of cash flows from operating, financing, andinvesting activities will vary depending on the stage of the product life cycle.

In the introductory phase, the product is likely not generating much revenue (operating cashflow is negative). Because the company is making heavy investments to get a product off the ground,cash flow from investment is negative, and financing cash flows are positive.

HOW’S MY CASH FLOW?

Introductory Growth

Neg

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Maturity

Phase

Cash

Flo

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Decline

Financing

Operating

Investing



Steps in Preparation · 1247

FORMAT OF THE STATEMENT OF CASH FLOWSThe three activities we discussed above constitute the general format of the statementof cash flows. The operating activities section always appears first. It is followed by theinvesting activities section and then the financing activities section.

A company reports the individual inflows and outflows from investing and financ-ing activities separately. That is, a company reports them gross, not netted against oneanother. Thus, a cash outflow from the purchase of property is reported separately fromthe cash inflow from the sale of property. Similarly, a cash inflow from the issuance ofdebt is reported separately from the cash outflow from its retirement.

The net increase or decrease in cash reported during the period should reconcilethe beginning and ending cash balances as reported in the comparative balance sheets.The general format of the statement of cash flows presents the results of the three ac-tivities discussed previously–operating, investing, and financing. Illustration 23-2shows a widely used form of the statement of cash flows.


(continued)

As the product moves to the growth and maturity phases, these cash flow relationships reverse.The product generates more cash flow from operations, which can be used to cover investmentsneeded to support the product, and less cash is needed from financing. So is a negative operatingcash flow bad? Not always. It depends on the product life cycle.

Source: Adapted from Paul D. Kimmel, Jerry J. Weygandt, and Donald E. Kieso, Financial Accounting: Tools forBusiness Decision Making, 5th ed. (New York: John Wiley & Sons, 2009), p. 606.

STEPS IN PREPARATIONCompanies prepare the statement of cash flows differently from the three other basicfinancial statements. For one thing, it is not prepared from an adjusted trial balance.The cash flow statement requires detailed information concerning the changes in ac-count balances that occurred between two points in time. An adjusted trial balance willnot provide the necessary data. Second, the statement of cash flows deals with cash

ILLUSTRATION 23-2Format of the Statementof Cash Flows

COMPANY NAMESTATEMENT OF CASH FLOWS

PERIOD COVERED

Cash flows from operating activitiesNet income XXXAdjustments to reconcile net income to net

cash provided (used) by operating activities:(List of individual items) XX XX

Net cash provided (used) by operating activities XXXCash flows from investing activities

(List of individual inflows and outflows) XX

Net cash provided (used) by investing activities XXXCash flows from financing activities

(List of individual inflows and outflows) XX

Net cash provided (used) by financing activities XXX

Net increase (decrease) in cash XXXCash at beginning of period XXX

Cash at end of period XXX

Both iGAAP and U.S. GAAP specify that companies must classifycash flows as operating, investing, orfinancing.





receipts and payments. As a result, the company must adjust the effects of the use ofaccrual accounting to determine cash flows. The information to prepare this statementusually comes from three sources:

1. Comparative balance sheets provide the amount of the changes in assets, liabili-ties, and equities from the beginning to the end of the period.

2. Current income statement data help determine the amount of cash provided by orused by operations during the period.

3. Selected transaction data from the general ledger provide additional detailed in-formation needed to determine how the company provided or used cash during theperiod.

Preparing the statement of cash flows from the data sources above involves threemajor steps:

Step 1. Determine the change in cash. This procedure is straightforward. A companycan easily compute the difference between the beginning and the ending cash bal-ance from examining its comparative balance sheets.Step 2. Determine the net cash flow from operating activities. This procedure iscomplex. It involves analyzing not only the current year’s income statement but alsocomparative balance sheets as well as selected transaction data.Step 3. Determine net cash flows from investing and financing activities. A com-pany must analyze all other changes in the balance sheet accounts to determine theireffects on cash.

On the following pages we work through these three steps in the process of prepar-ing the statement of cash flows for Tax Consultants Inc. over several years.

FIRST EXAMPLE—2009To illustrate a statement of cash flows, we use the first year of operations for Tax Con-sultants Inc. The company started on January 1, 2009, when it issued 60,000 shares of$1 par value common stock for $60,000 cash. The company rented its office space, fur-niture, and equipment, and performed tax consulting services throughout the first year.The comparative balance sheets at the beginning and end of the year 2009 appear inIllustration 23-3.

TAX CONSULTANTS INC.COMPARATIVE BALANCE SHEETS

ChangeAssets Dec. 31, 2009 Jan. 1, 2009 Increase/Decrease

Cash $49,000 $–0– $49,000 IncreaseAccounts receivable 36,000 –0– 36,000 Increase

Total $85,000 $–0–

Liabilities andStockholders’ Equity

Accounts payable $ 5,000 $–0– $ 5,000 IncreaseCommon stock ($1 par) 60,000 –0– 60,000 IncreaseRetained earnings 20,000 –0– 20,000 Increase

Total $85,000 $–0–

ILLUSTRATION 23-3Comparative BalanceSheets, Tax ConsultantsInc., Year 1

Illustration 23-4 (on page 1249) shows the income statement and additional infor-mation for Tax Consultants.



First Example—2009 · 1249

Step 1: Determine the Change in CashTo prepare a statement of cash flows, the first step is to determine the change in cash.This is a simple computation. Tax Consultants had no cash on hand at the beginningof the year 2009. It had $49,000 on hand at the end of 2009. Thus, cash changed (increased)in 2009 by $49,000.

Step 2: Determine Net Cash Flow from Operating ActivitiesTo determine net cash flow from operating activities,3 companies adjust net in-come in numerous ways. A useful starting point is to understand why net incomemust be converted to net cash provided by operating activities.

Under generally accepted accounting principles, most companies use the ac-crual basis of accounting. As you have learned, this basis requires that companiesrecord revenue when earned and record expenses when incurred. Earned rev-enues may include credit sales for which the company has not yet collected cash. Ex-penses incurred may include some items that the company has not yet paid in cash.Thus, under the accrual basis of accounting, net income is not the same as net cashflow from operating activities.

To arrive at net cash flow from operating activities, a company must determine rev-enues and expenses on a cash basis. It does this by eliminating the effects of incomestatement transactions that do not result in an increase or decrease in cash. Illustra-tion 23-5 shows the relationship between net income and net cash flow from operatingactivities.

TAX CONSULTANTS INC.INCOME STATEMENT

FOR THE YEAR ENDED DECEMBER 31, 2009

Revenues $125,000Operating expenses 85,000

Income before income taxes 40,000Income tax expense 6,000

Net income $ 34,000

Additional InformationExamination of selected data indicates that a dividend of $14,000 was declared and paid during the year.

ILLUSTRATION 23-4Income Statement, TaxConsultants Inc., Year 1

3“Net cash flow from operating activities” is a generic phrase, replaced in the statement ofcash flows with either “Net cash provided by operating activities” if operations increasecash, or “Net cash used by operating activities” if operations decrease cash.

Objective•3Differentiate between net incomeand net cash flows from operatingactivities.

Earnedrevenues

Incurredexpenses

Net income

Net cash flow fromoperating activities

Eliminate noncash revenues

Eliminate noncash expenses

ILLUSTRATION 23-5Net Income versus NetCash Flow fromOperating Activities




In this chapter, we use the term net income to refer to accrual-based net income.A company may convert net income to net cash flow from operating activities througheither a direct method or an indirect method. We explain both methods in the follow-ing sections. The advantages and disadvantages of these two methods are discussedlater in the chapter.

Direct MethodThe direct method (also called the income statement method) reports cash re-ceipts and cash disbursements from operating activities. The difference betweenthese two amounts is the net cash flow from operating activities. In other words,the direct method deducts operating cash disbursements from operating cash re-ceipts. The direct method results in the presentation of a condensed cash receiptsand cash disbursements statement.

As indicated from the accrual-based income statement, Tax Consultants reportedrevenues of $125,000. However, because the company’s accounts receivable increasedduring 2009 by $36,000, the company collected only $89,000 ($125,000 � $36,000) in cashfrom these revenues. Similarly, Tax Consultants reported operating expenses of $85,000.However, accounts payable increased during the period by $5,000. Assuming that thesepayables relate to operating expenses, cash operating expenses were $80,000 ($85,000 �$5,000). Because no taxes payable exist at the end of the year, the company must havepaid $6,000 income tax expense for 2009 in cash during the year. Tax Consultants com-putes net cash flow from operating activities as shown in Illustration 23-6.

Cash collected from revenues $89,000Cash payments for expenses 80,000

Income before income taxes 9,000Cash payments for income taxes 6,000

Net cash provided by operating activities $ 3,000

ILLUSTRATION 23-6Computation of Net CashFlow from OperatingActivities, Year 1—DirectMethod

Accounts Receivable

1/1/09 Balance –0– Receipts from customer 89,000Revenues 125,000

12/31/09 Balance 36,000

ILLUSTRATION 23-7Analysis of AccountsReceivable

“Net cash provided by operating activities” is the equivalent of cash basis net in-come. (“Net cash used by operating activities” is equivalent to cash basis net loss.)

Indirect MethodThe indirect method (or reconciliation method) starts with net income and convertsit to net cash flow from operating activities. In other words, the indirect method ad-justs net income for items that affected reported net income but did not affect cash.To compute net cash flow from operating activities, a company adds back noncashcharges in the income statement to net income and deducts noncash credits. We ex-plain the two adjustments to net income for Tax Consultants, namely, the increases inaccounts receivable and accounts payable, as follows.

Increase in Accounts Receivable—Indirect Method. Tax Consultant’s accounts receiv-able increased by $36,000 (from $0 to $36,000) during the year. For Tax Consultants,this means that cash receipts were $36,000 lower than revenues. The Accounts Receiv-able account in Illustration 23-7 shows that Tax Consultants had $125,000 in revenues(as reported on the income statement), but it collected only $89,000 in cash.

Objective•4Contrast the direct and indirectmethods of calculating net cashflow from operating activities.



First Example—2009 · 1251

As shown in Illustration 23-8, to adjust net income to net cash provided by oper-ating activities, Tax Consultants must deduct the increase of $36,000 in accounts receiv-able from net income. When the Accounts Receivable balance decreases, cash receiptsare higher than revenue earned under the accrual basis. Therefore, the company addsto net income the amount of the decrease in accounts receivable to arrive at net cashprovided by operating activities.

Increase in Accounts Payable—Indirect Method. When accounts payable increase dur-ing the year, expenses on an accrual basis exceed those on a cash basis. Why? BecauseTax Consultants incurred expenses, but some of the expenses are not yet paid. To con-vert net income to net cash flow from operating activities, Tax Consultants must addback the increase of $5,000 in accounts payable to net income.

As a result of the accounts receivable and accounts payable adjustments, Tax Con-sultants determines net cash provided by operating activities is $3,000 for the year 2009.Illustration 23-8 shows this computation.

Net income $34,000Adjustments to reconcile net income to net

cash provided by operating activities:Increase in accounts receivable $(36,000)Increase in accounts payable 5,000 (31,000)


ILLUSTRATION 23-8Computation of Net CashFlow from OperatingActivities, Year 1—IndirectMethod

Note that net cash provided by operating activities is the same whether usingthe direct (Illustration 23-6) or the indirect method (Illustration 23-8).


Due to recent concerns about a decline in the quality of earnings, some investors have been focus-ing on cash flow. Management has an incentive to make operating cash flow look good becauseWall Street has paid a premium for companies that generate a lot of cash from operations, ratherthan through borrowings. However, similar to earnings, companies have ways to pump up cashflow from operations.

One way that companies can boost their operating cash flow is by “securitizing” receivables.That is, companies can speed up cash collections by selling their receivables. For example, FederatedDepartment Stores reported a $2.2 billion increase in cash flow from operations. This seems im-pressive until you read the fine print, which indicates that a big part of the increase was due to thesale of receivables. As discussed in this section, decreases in accounts receivable increase cash flowfrom operations. So while it appeared that Federated’s core operations had improved, the companyreally did little more than accelerate collections of its receivables. In fact, the cash flow from the se-curitizations represented more than half of Federated’s operating cash flow. Thus, just like earn-ings, cash flow can be of high or low quality.

Source: Adapted from Ann Tergesen, “Cash Flow Hocus Pocus,” Business Week (July 16, 2002), pp. 130–131. Seealso Bear Stearns Equity Research, Accounting Issues: Cash Flow Metrics (June 2006).

PUMPING UP CASH

Step 3: Determine Net Cash Flows from Investing and Financing ActivitiesAfter Tax Consultants has computed the net cash provided by operating activities,the next step is to determine whether any other changes in balance sheet accountscaused an increase or decrease in cash.

For example, an examination of the remaining balance sheet accounts for TaxConsultants shows increases in both common stock and retained earnings. The

Objective•5Determine net cash flows frominvesting and financing activities.




common stock increase of $60,000 resulted from the issuance of common stock for cash.The issuance of common stock is reported in the statement of cash flows as a receiptof cash from a financing activity.

Two items caused the retained earnings increase of $20,000:

1. Net income of $34,000 increased retained earnings.2. Declaration of $14,000 of dividends decreased retained earnings.

Tax Consultants has converted net income into net cash flow from operating activi-ties, as explained earlier. The additional data indicate that it paid the dividend. Thus, thecompany reports the dividend payment as a cash outflow, classified as a financing activity.

Statement of Cash Flows—2009We are now ready to prepare the statement of cash flows. The statement startswith the operating activities section. Tax Consultants may use either the direct orindirect method to report net cash flow from operating activities.

The FASB encourages the use of the direct method over the indirect method.If a company uses the direct method of reporting net cash flow from operating activi-ties, the FASB requires that the company provide in a separate schedule a reconcilia-tion of net income to net cash flow from operating activities. If a company uses the in-direct method, it can either report the reconciliation within the statement of cash flowsor can provide it in a separate schedule, with the statement of cash flows reportingonly the net cash flow from operating activities. [3] Throughout this chapter we usethe indirect method, which is also used more extensively in practice.4 In doing home-work assignments, you should follow instructions for use of either the direct or indirect method.

Illustration 23-9 shows the statement of cash flows for Tax Consultants Inc., foryear 1 (2009).

Objective•6Prepare a statement of cash flows.

4Accounting Trends and Techniques—2007 reports that out of its 600 surveyed companies, 594(approximately 99 percent) used the indirect method, and only 6 used the direct method.

TAX CONSULTANTS INC.STATEMENT OF CASH FLOWS

FOR THE YEAR ENDED DECEMBER 31, 2009INCREASE (DECREASE) IN CASH

Cash flows from operating activitiesNet income $34,000Adjustments to reconcile net income to net

cash provided by operating activities:Increase in accounts receivable $(36,000)Increase in accounts payable 5,000 (31,000)

Net cash provided by operating activities 3,000Cash flows from financing activities

Issuance of common stock 60,000Payment of cash dividends (14,000)

Net cash provided by financing activities 46,000

Net increase in cash 49,000Cash, January 1, 2009 –0–

Cash, December 31, 2009 $49,000

ILLUSTRATION 23-9Statement of Cash Flows,Tax Consultants Inc., Year 1

As indicated, the $60,000 increase in common stock results in a financing-activitycash inflow. The payment of $14,000 in cash dividends is a financing-activity outflowof cash. The $49,000 increase in cash reported in the statement of cash flows agrees withthe increase of $49,000 shown in the comparative balance sheets as the change in thecash account.



Second Example—2010 · 1253

SECOND EXAMPLE—2010Tax Consultants Inc. continued to grow and prosper in its second year of operations.The company purchased land, building, and equipment, and revenues and net incomeincreased substantially over the first year. Illustrations 23-10 and 23-11 present infor-mation related to the second year of operations for Tax Consultants Inc.


AS OF DECEMBER 31

ChangeAssets 2010 2009 Increase/Decrease

Cash $ 37,000 $49,000 $ 12,000 DecreaseAccounts receivable 26,000 36,000 10,000 DecreasePrepaid expenses 6,000 –0– 6,000 IncreaseLand 70,000 –0– 70,000 IncreaseBuilding 200,000 –0– 200,000 IncreaseAccumulated depreciation—building (11,000) –0– 11,000 IncreaseEquipment 68,000 –0– 68,000 IncreaseAccumulated depreciation—equipment (10,000) –0– 10,000 Increase

Total $386,000 $85,000

Liabilities and Stockholders’ Equity

Accounts payable $ 40,000 $ 5,000 $ 35,000 IncreaseBonds payable 150,000 –0– 150,000 IncreaseCommon stock ($1 par) 60,000 60,000 –0–Retained earnings 136,000 20,000 116,000 Increase

Total $386,000 $85,000


Step 1: Determine the Change in CashTo prepare a statement of cash flows from the available information, the first step isto determine the change in cash. As indicated from the information presented, cashdecreased $12,000 ($49,000 � $37,000).

Step 2: Determine Net Cash Flow from Operating Activities—Indirect MethodUsing the indirect method, we adjust net income of $134,000 on an accrual basis toarrive at net cash flow from operating activities. Explanations for the adjustments tonet income follow.



Revenues $492,000Operating expenses (excluding depreciation) $269,000Depreciation expense 21,000 290,000

Income from operations 202,000Income tax expense 68,000

Net income $134,000

Additional Information(a) The company declared and paid an $18,000 cash dividend.(b) The company obtained $150,000 cash through the issuance of long-term bonds.(c) Land, building, and equipment were acquired for cash.





Decrease in Accounts Receivable. Accounts receivable decreased during the period,because cash receipts (cash-basis revenues) are higher than revenues reported on anaccrual basis. To convert net income to net cash flow from operating activities, thedecrease of $10,000 in accounts receivable must be added to net income.

Increase in Prepaid Expenses. When prepaid expenses (assets) increase during a pe-riod, expenses on an accrual-basis income statement are lower than they are on a cash-basis income statement. The reason: Tax Consultants has made cash payments in thecurrent period, but expenses (as charges to the income statement) have been deferredto future periods. To convert net income to net cash flow from operating activities, thecompany must deduct from net income the increase of $6,000 in prepaid expenses. Anincrease in prepaid expenses results in a decrease in cash during the period.

Increase in Accounts Payable. Like the increase in 2009, Tax Consultants must add the2010 increase of $35,000 in accounts payable to net income, to convert to net cash flowfrom operating activities. The company incurred a greater amount of expense than theamount of cash it disbursed.

Depreciation Expense (Increase in Accumulated Depreciation). The purchase of depre-ciable assets is a use of cash, shown in the investing section in the year of acquisition.Tax Consultant’s depreciation expense of $21,000 (also represented by the increase inaccumulated depreciation) is a noncash charge; the company adds it back to net in-come, to arrive at net cash flow from operating activities. The $21,000 is the sum of the$11,000 depreciation on the building plus the $10,000 depreciation on the equipment.

Certain other periodic charges to expense do not require the use of cash. Examplesare the amortization of intangible assets and depletion expense. Such charges are treatedin the same manner as depreciation. Companies frequently list depreciation and simi-lar noncash charges as the first adjustments to net income in the statement of cash flows.

As a result of the foregoing items, net cash provided by operating activities is$194,000 as shown in Illustration 23-12.

Net income $134,000Adjustments to reconcile net income to

net cash provided by operating activities:Depreciation expense $21,000Decrease in accounts receivable 10,000Increase in prepaid expenses (6,000)Increase in accounts payable 35,000 60,000

Net cash provided by operating activities $194,000

ILLUSTRATION 23-12Computation of Net CashFlow from OperatingActivities, Year 2—IndirectMethod

Step 3: Determine Net Cash Flows from Investing and Financing ActivitiesAfter you have determined the items affecting net cash provided by operating activi-ties, the next step involves analyzing the remaining changes in balance sheet accounts.Tax Consultants Inc. analyzed the following accounts.

Increase in Land. As indicated from the change in the land account, the company pur-chased land of $70,000 during the period. This transaction is an investing activity,reported as a use of cash.

Increase in Building and Related Accumulated Depreciation. As indicated in the addi-tional data, and from the change in the building account, Tax Consultants acquired anoffice building using $200,000 cash. This transaction is a cash outflow, reported in theinvesting section. The $11,000 increase in accumulated depreciation results from record-ing depreciation expense on the building. As indicated earlier, the reported deprecia-tion expense has no effect on the amount of cash.



Third Example—2011 · 1255

Increase in Equipment and Related Accumulated Depreciation. An increase in equip-ment of $68,000 resulted because the company used cash to purchase equipment. Thistransaction is an outflow of cash from an investing activity. The depreciation expenseentry for the period explains the increase in Accumulated Depreciation—Equipment.

Increase in Bonds Payable. The bonds payable account increased $150,000. Cash receivedfrom the issuance of these bonds represents an inflow of cash from a financing activity.

Increase in Retained Earnings. Retained earnings increased $116,000 during the year.Two factors explain this increase: (1) Net income of $134,000 increased retained earn-ings, and (2) dividends of $18,000 decreased retained earnings. As indicated earlier, thecompany adjusts net income to net cash provided by operating activities in the oper-ating activities section. Payment of the dividends is a financing activity that involvesa cash outflow.

Statement of Cash Flows—2010Combining the foregoing items, we get a statement of cash flows for 2010 for Tax Consul-tants Inc., using the indirect method to compute net cash flow from operating activities.

THIRD EXAMPLE—2011Our third example, covering the 2011 operations of Tax Consultants Inc., is more com-plex. It again uses the indirect method to compute and present net cash flow fromoperating activities.

Tax Consultants Inc. experienced continued success in 2011 and expanded its op-erations to include the sale of computer software used in tax-return preparation andtax planning. Thus, inventory is a new asset appearing in the company’s December 31,2011, balance sheet. Illustrations 23-14 and 23-15 (on page 1256) show the comparativebalance sheets, income statements, and selected data for 2011.



Cash flows from operating activitiesNet income $134,000Adjustments to reconcile net income to

net cash provided by operating activities:Depreciation expense $ 21,000Decrease in accounts receivable 10,000Increase in prepaid expenses (6,000)Increase in accounts payable 35,000 60,000

Net cash provided by operating activities 194,000

Cash flows from investing activitiesPurchase of land (70,000)Purchase of building (200,000)Purchase of equipment (68,000)

Net cash used by investing activities (338,000)

Cash flows from financing activitiesIssuance of bonds 150,000Payment of cash dividends (18,000)


Net decrease in cash (12,000)Cash, January 1, 2010 49,000

Cash, December 31, 2010 $ 37,000





Step 1: Determine the Change in CashThe first step in the preparation of the statement of cash flows is to determine thechange in cash. As the comparative balance sheets show, cash increased $17,000 in 2011.

Step 2: Determine Net Cash Flow from Operating Activities—Indirect MethodWe explain the adjustments to net income of $125,000 as follows.

Increase in Accounts Receivable. The increase in accounts receivable of $42,000 representsrecorded accrual-basis revenues in excess of cash collections in 2011. The company deductsthis increase from net income to convert from the accrual basis to the cash basis.

Increase in Inventories. The $54,000 increase in inventories represents an operatinguse of cash, not an expense. Tax Consultants therefore deducts this amount from net


AS OF DECEMBER 31

ChangeAssets 2011 2010 Increase/Decrease

Cash $ 54,000 $ 37,000 $ 17,000 IncreaseAccounts receivable 68,000 26,000 42,000 IncreaseInventories 54,000 –0– 54,000 IncreasePrepaid expenses 4,000 6,000 2,000 DecreaseLand 45,000 70,000 25,000 DecreaseBuildings 200,000 200,000 –0–Accumulated depreciation—buildings (21,000) (11,000) 10,000 IncreaseEquipment 193,000 68,000 125,000 IncreaseAccumulated depreciation—equipment (28,000) (10,000) 18,000 Increase

Totals $569,000 $386,000

Liabilities and Stockholders’ Equity

Accounts payable $ 33,000 $ 40,000 $ 7,000 DecreaseBonds payable 110,000 150,000 40,000 DecreaseCommon stock ($1 par) 220,000 60,000 160,000 IncreaseRetained earnings 206,000 136,000 70,000 Increase

Totals $569,000 $386,000




Revenues $890,000Cost of goods sold $465,000Operating expenses 221,000Interest expense 12,000Loss on sale of equipment 2,000 700,000

Income from operations 190,000Income tax expense 65,000

Net income $125,000

Additional Information(a) Operating expenses include depreciation expense of $33,000 and expiration of prepaid expenses of

$2,000.(b) Land was sold at its book value for cash.(c) Cash dividends of $55,000 were declared and paid.(d) Interest expense of $12,000 was paid in cash.(e) Equipment with a cost of $166,000 was purchased for cash. Equipment with a cost of $41,000 and

a book value of $36,000 was sold for $34,000 cash.(f) Bonds were redeemed at their book value for cash.(g) Common stock ($1 par) was issued for cash.




Third Example—2011 · 1257

income, to arrive at net cash flow from operations. In other words, when inventorypurchased exceeds inventory sold during a period, cost of goods sold on an accrual ba-sis is lower than on a cash basis.

Decrease in Prepaid Expenses. The $2,000 decrease in prepaid expenses represents acharge to the income statement for which Tax Consultants made no cash payment inthe current period. The company adds back the decrease to net income, to arrive at netcash flow from operating activities.

Decrease in Accounts Payable. When accounts payable decrease during the year, costof goods sold and expenses on a cash basis are higher than they are on an accrual ba-sis. To convert net income to net cash flow from operating activities, the company mustdeduct the $7,000 in accounts payable from net income.

Depreciation Expense (Increase in Accumulated Depreciation). Accumulated Depreci-ation—Buildings increased $10,000 ($21,000 � $11,000). The Buildings account did notchange during the period, which means that Tax Consultants recorded depreciationexpense of $10,000 in 2011.

Accumulated Depreciation—Equipment increased by $18,000 ($28,000 � $10,000)during the year. But Accumulated Depreciation—Equipment decreased by $5,000 asa result of the sale during the year. Thus, depreciation for the year was $23,000. Thecompany reconciled Accumulated Depreciation—Equipment as follows.

Beginning balance $10,000Add: Depreciation for 2011 23,000

33,000Deduct: Sale of equipment 5,000

Ending balance $28,000

The company must add back to net income the total depreciation of $33,000($10,000 � $23,000) charged to the income statement, to determine net cash flow fromoperating activities.

Loss on Sale of Equipment. Tax Consultants Inc. sold for $34,000 equipment that cost$41,000 and had a book value of $36,000. As a result, the company reported a loss of $2,000on its sale. To arrive at net cash flow from operating activities, it must add back to net in-come the loss on the sale of the equipment. The reason is that the loss is a noncash chargeto the income statement. The loss did not reduce cash, but it did reduce net income.5

From the foregoing items, the company prepares the operating activities section ofthe statement of cash flows, as shown in Illustration 23-16.

5A similar adjustment is required for unrealized gains or losses recorded on tradingsecurity investments or other financial assets and liabilities accounted for under the fairvalue option. Marking these assets and liabilities to fair value results in an increase ordecrease in income, but there is no effect on cash flows.

ILLUSTRATION 23-16Operating ActivitiesSection of Cash FlowsStatement


net cash provided by operating activities:Depreciation expense $33,000Loss on sale of equipment 2,000Increase in accounts receivable (42,000)Increase in inventories (54,000)Decrease in prepaid expenses 2,000Decrease in accounts payable (7,000) (66,000)


Step 3: Determine Net Cash Flows from Investing and Financing ActivitiesBy analyzing the remaining changes in the balance sheet accounts, Tax Consultantsidentifies cash flows from investing and financing activities.




Land. Land decreased $25,000 during the period. As indicated from the informationpresented, the company sold land for cash at its book value. This transaction is aninvesting activity, reported as a $25,000 source of cash.

Equipment. An analysis of the equipment account indicates the following.Beginning balance $ 68,000Purchase of equipment 166,000

234,000Sale of equipment 41,000

Ending balance $193,000

The company used cash to purchase equipment with a fair value of $166,000—aninvesting transaction reported as a cash outflow. The sale of the equipment for $34,000is also an investing activity, but one that generates a cash inflow.

Bonds Payable. Bonds payable decreased $40,000 during the year. As indicated fromthe additional information, the company redeemed the bonds at their book value. Thisfinancing transaction used $40,000 of cash.

Common Stock. The common stock account increased $160,000 during the year. As in-dicated from the additional information, Tax Consultants issued common stock of$160,000 at par. This financing transaction provided cash of $160,000.

Retained Earnings. Retained earnings changed $70,000 ($206,000 � $136,000) duringthe year. The $70,000 change in retained earnings results from net income of $125,000from operations and the financing activity of paying cash dividends of $55,000.

Statement of Cash Flows—2011Tax Consultants Inc. combines the foregoing items to prepare the statement of cashflows shown in Illustration 23-17.




net cash provided by operating activities:Depreciation expense $ 33,000Loss on sale of equipment 2,000Increase in accounts receivable (42,000)Increase in inventories (54,000)Decrease in prepaid expenses 2,000Decrease in accounts payable (7,000) (66,000)


Cash flows from investing activitiesSale of land 25,000Sale of equipment 34,000Purchase of equipment (166,000)


Cash flows from financing activitiesRedemption of bonds (40,000)Sale of common stock 160,000Payment of dividends (55,000)


Net increase in cash 17,000Cash, January 1, 2011 37,000

Cash, December 31, 2011 $ 54,000




Objective•7Identify sources of information fora statement of cash flows.

Net Cash Flow from Operating Activities—Indirect versus Direct Method · 1259

ILLUSTRATION 23-18Adjustments Needed toDetermine Net Cash Flowfrom OperatingActivities—IndirectMethod

Net Income

Additions

Depreciation expenseAmortization of intangibles and deferred chargesAmortization of bond discountIncrease in deferred income tax liabilityLoss on investment in common stock using equity methodLoss on sale of plant assetsLoss on impairment of assetsDecrease in receivablesDecrease in inventoriesDecrease in prepaid expenseIncrease in accounts payableIncrease in accrued liabilities

Deductions

Amortization of bond premiumDecrease in deferred income tax liabilityIncome on investment in common stock

using equity methodGain on sale of plant assetsIncrease in receivablesIncrease in inventoriesIncrease in prepaid expenseDecrease in accounts payableDecrease in accrued liabilities

�

Net Cash Flow from Operating Activities

↑↑

↑

↑

SOURCES OF INFORMATION FOR THESTATEMENT OF CASH FLOWSImportant points to remember in the preparation of the statement of cash flowsare these:

1. Comparative balance sheets provide the basic information from which to preparethe report. Additional information obtained from analyses of specific accounts isalso included.

2. An analysis of the Retained Earnings account is necessary. The net increase ordecrease in Retained Earnings without any explanation is a meaningless amountin the statement. Without explanation, it might represent the effect of net income,dividends declared, or prior period adjustments.

3. The statement includes all changes that have passed through cash or have resultedin an increase or decrease in cash.

4. Write-downs, amortization charges, and similar “book” entries, such as depreciationof plant assets, represent neither inflows nor outflows of cash, because they haveno effect on cash. To the extent that they have entered into the determination of netincome, however, the company must add them back to or subtract them from netincome, to arrive at net cash provided (used) by operating activities.

NET CASH FLOW FROM OPERATING ACTIVITIES—INDIRECTVERSUS DIRECT METHODAs we discussed previously, the two different methods available to adjust income fromoperations on an accrual basis to net cash flow from operating activities are the indi-rect (reconciliation) method and the direct (income statement) method.

The FASB encourages use of the direct method and permits use of the indirectmethod. Yet, if the direct method is used, the Board requires that companies providein a separate schedule a reconciliation of net income to net cash flow from operatingactivities. Therefore, under either method, companies must prepare and report infor-mation from the indirect (reconciliation) method.

Indirect MethodFor consistency and comparability and because it is the most widely used method inpractice, we used the indirect method in the examples just presented. We determinednet cash flows from operating activities by adding back to or deducting from net in-come those items that had no effect on cash. Illustration 23-18 presents more completely




the common types of adjustments that companies make to net income to arrive at netcash flow from operating activities.

The additions and deductions in Illustration 23-18 reconcile net income to net cashflow from operating activities, illustrating why the indirect method is also called thereconciliation method.

Direct Method—An ExampleUnder the direct method the statement of cash flows reports net cash flow from oper-ating activities as major classes of operating cash receipts (e.g., cash collected from cus-tomers and cash received from interest and dividends) and cash disbursements (e.g., cashpaid to suppliers for goods, to employees for services, to creditors for interest, and togovernment authorities for taxes).

We illustrate the direct method here in more detail to help you understand the dif-ference between accrual-based income and net cash flow from operating activities. Thisexample also illustrates the data needed to apply the direct method. Emig Company,which began business on January 1, 2010, has the following selected balance sheetinformation.

ILLUSTRATION 23-19Balance Sheet Accounts,Emig Co.

December 31, January 1,2010 2010

Cash $159,000 –0–Accounts receivable 15,000 –0–Inventory 160,000 –0–Prepaid expenses 8,000 –0–Property, plant, and equipment (net) 90,000 –0–Accounts payable 60,000 –0–Accrued expenses payable 20,000 –0–

ILLUSTRATION 23-20Income Statement, Emig Co.

Revenues from sales $780,000Cost of goods sold 450,000

Gross profit 330,000Operating expenses $160,000Depreciation 10,000 170,000


Net income $112,000

Additional Information:(a) Dividends of $70,000 were declared and paid in cash.(b) The accounts payable increase resulted from the purchase of merchandise.(c) Prepaid expenses and accrued expenses payable relate to operating expenses.

Emig Company’s December 31, 2010, income statement and additional informationare as follows.

Under the direct method, companies compute net cash provided by operating ac-tivities by adjusting each item in the income statement from the accrual basis to thecash basis. To simplify and condense the operating activities section, only major classes




of operating cash receipts and cash payments are reported. As Illustration 23-21 shows,the difference between these major classes of cash receipts and cash payments is thenet cash provided by operating activities.

An efficient way to apply the direct method is to analyze the revenues and ex-penses reported in the income statement in the order in which they are listed. The com-pany then determines cash receipts and cash payments related to these revenues andexpenses. In the following sections, we present the direct method adjustments for EmigCompany in 2010, to determine net cash provided by operating activities.

Cash Receipts from Customers. The income statement for Emig Company reportedrevenues from customers of $780,000. To determine cash receipts from customers, thecompany considers the change in accounts receivable during the year.

When accounts receivable increase during the year, revenues on an accrual basisare higher than cash receipts from customers. In other words, operations led to in-creased revenues, but not all of these revenues resulted in cash receipts. To determinethe amount of increase in cash receipts, deduct the amount of the increase in accountsreceivable from the total sales revenues. Conversely, a decrease in accounts receiv-able is added to sales revenues, because cash receipts from customers then exceedsales revenues.

For Emig Company, accounts receivable increased $15,000. Thus, cash receipts fromcustomers were $765,000, computed as follows.

Revenues from sales $780,000Deduct: Increase in accounts receivable 15,000

Cash receipts from customers $765,000

Emig could also determine cash receipts from customers by analyzing the AccountsReceivable account as shown below.

Accounts Receivable

1/1/10 Balance –0– Receipts from customers 765,000Revenue from sales 780,000

12/31/10 Balance 15,000

To suppliers

To employees

For operating expenses

For interest

For taxes

From sales of goodsand services to

customers

From receipts ofinterest and dividends

on loans and investments

Net Cash Providedby Operating

Activities

Cash Receipts Minus Cash Payments Equals Net Cash Providedby Operating Activities

ILLUSTRATION 23-21Major Classes of CashReceipts and Payments




Illustration 23-22 shows the relationships between cash receipts from customers,revenues from sales, and changes in accounts receivable.

Cash receipts � Decrease in accounts receivablefrom �

Revenuesor

customersfrom sales

� Increase in accounts receivable

ILLUSTRATION 23-22Formula to Compute CashReceipts from Customers

⎫⎬⎭

Cash Payments to Suppliers. Emig Company reported cost of goods sold on its incomestatement of $450,000. To determine cash payments to suppliers, the company first findspurchases for the year, by adjusting cost of goods sold for the change in inventory.When inventory increases during the year, purchases this year exceed cost of goodssold. As a result, the company adds the increase in inventory to cost of goods sold, toarrive at purchases.

In 2010, Emig Company’s inventory increased $160,000. The company computespurchases as follows.

Cost of goods sold $450,000Add: Increase in inventory 160,000

Purchases $610,000

After computing purchases, Emig determines cash payments to suppliers by ad-justing purchases for the change in accounts payable. When accounts payable increaseduring the year, purchases on an accrual basis are higher than they are on a cash basis.As a result, it deducts from purchases the increase in accounts payable to arrive at cashpayments to suppliers. Conversely, if cash payments to suppliers exceed purchases,Emig adds to purchases the decrease in accounts payable. Cash payments to supplierswere $550,000, computed as follows.

Purchases $610,000Deduct: Increase in accounts payable 60,000

Cash payments to suppliers $550,000

Emig also can determine cash payments to suppliers by analyzing AccountsPayable, as shown below.

Accounts Payable

Payments to suppliers 550,000 1/1/10 Balance –0–Purchases 610,000

12/31/10 Balance 60,000

Illustration 23-23 shows the relationships between cash payments to suppliers, costof goods sold, changes in inventory, and changes in accounts payable.

� Decrease in� Increase in inventory accounts payable

Cash payments � Cost of or orto suppliers goods sold � Decrease in inventory � Increase in

accounts payable

ILLUSTRATION 23-23Formula to Compute CashPayments to Suppliers

⎫⎟⎬⎟⎭

⎫⎬⎭

Cash Payments for Operating Expenses. Emig reported operating expenses of $160,000on its income statement. To determine the cash paid for operating expenses, it mustadjust this amount for any changes in prepaid expenses and accrued expenses payable.




For example, when prepaid expenses increased $8,000 during the year, cash paidfor operating expenses was $8,000 higher than operating expenses reported on theincome statement. To convert operating expenses to cash payments for operatingexpenses, the company adds to operating expenses the increase of $8,000. Conversely,if prepaid expenses decrease during the year, it deducts from operating expenses theamount of the decrease.

Emig also must adjust operating expenses for changes in accrued expenses payable.When accrued expenses payable increase during the year, operating expenses on an ac-crual basis are higher than they are on a cash basis. As a result, the company deductsfrom operating expenses an increase in accrued expenses payable, to arrive at cash pay-ments for operating expenses. Conversely, it adds to operating expenses a decrease inaccrued expenses payable, because cash payments exceed operating expenses.

Emig Company’s cash payments for operating expenses were $148,000, computedas follows.

Operating expenses $160,000Add: Increase in prepaid expenses 8,000Deduct: Increase in accrued expenses payable (20,000)

Cash payments for operating expenses $148,000

The relationships among cash payments for operating expenses, changes in prepaidexpenses, and changes in accrued expenses payable are shown in Illustration 23-24.

� Increase in � Decrease in accruedCash payments prepaid expense expenses payable

for operating � Operating or orexpenses expenses � Decrease in � Increase in accrued

prepaid expense expenses payable

ILLUSTRATION 23-24Formula to Compute CashPayments for OperatingExpenses⎫

⎟⎬⎟⎭

⎫⎟⎬⎟⎭

Note that the company did not consider depreciation expense, because it is a non-cash charge.

Cash Payments for Income Taxes. The income statement for Emig shows income taxexpense of $48,000. This amount equals the cash paid. How do we know that? Becausethe comparative balance sheet indicated no income taxes payable at either the begin-ning or end of the year.

Summary of Net Cash Flow from Operating Activities—Direct MethodThe following schedule summarizes the computations illustrated above.

ILLUSTRATION 23-25Accrual Basis to CashBasis

AddAccrual Basis Adjustment (Subtract) Cash Basis

Revenues from sales $780,000 � Increase in accountsreceivable $(15,000) $765,000

Cost of goods sold 450,000 � Increase in inventory 160,000� Increase in accounts payable (60,000) 550,000

Operating expenses 160,000 � Increase in prepaid expenses 8,000� Increase in accrued

expenses payable (20,000) 148,000Depreciation expense 10,000 � Depreciation expense (10,000) –0–Income tax expense 48,000 48,000

Total expense 668,000 746,000

Net income $112,000 Net cash provided by operating activities $ 19,000




Illustration 23-26 shows the presentation of the direct method for reporting net cashflow from operating activities for the Emig Company illustration.

ILLUSTRATION 23-26Operating ActivitiesSection—Direct Method,2010

EMIG COMPANYSTATEMENT OF CASH FLOWS (PARTIAL)

Cash flows from operating activitiesCash received from customers $765,000Cash payments:

To suppliers $550,000For operating expenses 148,000For income taxes 48,000 746,000


ILLUSTRATION 23-27Reconciliation of NetIncome to Net CashProvided by OperatingActivities

EMIG COMPANYRECONCILIATION

Net income $112,000Adjustments to reconcile net income to net cash

provided by operating activities:Depreciation expense $ 10,000Increase in accounts receivable (15,000)Increase in inventory (160,000)Increase in prepaid expenses (8,000)Increase in accounts payable 60,000Increase in accrued expense payable 20,000 (93,000)


If Emig Company uses the direct method to present the net cash flows from oper-ating activities, it must provide in a separate schedule the reconciliation of net incometo net cash provided by operating activities. The reconciliation assumes the identicalform and content of the indirect method of presentation, as shown below.

When the direct method is used, the company may present this reconciliation atthe bottom of the statement of cash flows or in a separate schedule.

Direct versus Indirect ControversyThe most contentious decision that the FASB faced related to cash flow reporting waschoosing between the direct method and the indirect method of determining net cashflow from operating activities. Companies lobbied against the direct method, urgingadoption of the indirect method. Commercial lending officers expressed to the FASB astrong preference in favor of the direct method. In the next two sections, we considerthe arguments in favor of each of the methods.

In Favor of the Direct MethodThe principal advantage of the direct method is that it shows operating cash receiptsand payments. Thus, it is more consistent with the objective of a statement of cashflows—to provide information about cash receipts and cash payments—than the indi-rect method, which does not report operating cash receipts and payments.

Supporters of the direct method contend that knowledge of the specific sourcesof operating cash receipts and the purposes for which operating cash payments weremade in past periods is useful in estimating future operating cash flows. Furthermore,information about amounts of major classes of operating cash receipts and paymentsis more useful than information only about their arithmetic sum (the net cash flow from




operating activities). Such information is more revealing of a company’s ability (1) togenerate sufficient cash from operating activities to pay its debts, (2) to reinvest in itsoperations, and (3) to make distributions to its owners. [4]

Many companies indicate that they do not currently collect information in a man-ner that allows them to determine amounts such as cash received from customers orcash paid to suppliers directly from their accounting systems. But supporters of the di-rect method contend that the incremental cost of determining operating cash receiptsand payments is not significant.

In Favor of the Indirect MethodThe principal advantage of the indirect method is that it focuses on the differencesbetween net income and net cash flow from operating activities. That is, it providesa useful link between the statement of cash flows and the income statement and bal-ance sheet.

Many companies contend that it is less costly to adjust net income to net cash flowfrom operating activities (indirect) than it is to report gross operating cash receipts andpayments (direct). Supporters of the indirect method also state that the direct method,which effectively reports income statement information on a cash rather than an ac-crual basis, may erroneously suggest that net cash flow from operating activities is asgood as, or better than, net income as a measure of performance.

Special Rules Applying to Direct and Indirect MethodsCompanies that use the direct method are required, at a minimum, to report separatelythe following classes of operating cash receipts and payments:

Receipts1. Cash collected from customers (including lessees, licensees, etc.).2. Interest and dividends received.3. Other operating cash receipts, if any.

Payments1. Cash paid to employees and suppliers of goods or services (including suppliers

of insurance, advertising, etc.).2. Interest paid.3. Income taxes paid.4. Other operating cash payments, if any.

The FASB encourages companies to provide further breakdowns of operating cashreceipts and payments that they consider meaningful.

Companies using the indirect method must disclose separately changes in inven-tory, receivables, and payables in order to reconcile net income to net cash flow fromoperating activities. In addition, they must disclose, elsewhere in the financial state-ments or in accompanying notes, interest paid (net of amount capitalized) and incometaxes paid.6 The FASB requires these separate and additional disclosures so that usersmay approximate the direct method. Also, an acceptable alternative presentation of theindirect method is to report net cash flow from operating activities as a single line itemin the statement of cash flows and to present the reconciliation details elsewhere in thefinancial statements.

Consolidated statements of cash flows may be of limited use toanalysts evaluating multinational companies. Without disaggregation,users of such statements are not ableto determine “where in the world” thefunds are sourced and used.


6Accounting Trends and Techniques—2007 reports that of the 600 companies surveyed, 298disclosed interest paid in notes to the financial statements, 282 disclosed interest paid at the bottom of the statement of cash flows, 6 disclosed interest paid within the statement ofcash flows, and 14 reported no separate amount. Income taxes paid during the year weredisclosed in a manner similar to interest payments.





The controversy over direct and indirect methods highlights the importance that the market attrib-utes to operating cash flow. By showing an improving cash flow, a company can give a favorableimpression of its ongoing operations. For example, WorldCom concealed declines in its operationsby capitalizing certain operating expenses—to the tune of $3.8 billion! This practice not only “juicedup” income but also made it possible to report the cash payments in the investing section of thecash flow statement rather than as a deduction from operating cash flow.

The SEC recently addressed a similar cash flow classification issue with automakers like Ford,GM, and Chrysler. For years, automakers classified lease receivables and other dealer-financingarrangements as investment cash flows. Thus, they reported an increase in lease or loan receivablesfrom cars sold as a use of cash in the investing section of the statement of cash flows. The SEC ob-jected and now requires automakers to report these receivables as operating cash flows, since theleases and loans are used to facilitate car sales. At GM, these reclassifications reduced its operatingcash flows from $7.6 billion to $3 billion in the year before the change. So while the overall cashflow—from operations, investing, and financing—remained the same, operating cash flow at thesecompanies looked better than it really was.

Source: Peter Elstrom, “How to Hide $3.8 Billion in Expenses,” BusinessWeek Online (July 8, 2002); and JudithBurns, “SEC Tells US Automakers to Retool Cash-Flow Accounting,” Wall Street Journal Online (February 28, 2005).

NOT WHAT IT SEEMS

We discussed some of the special problems related to preparing the statementof cash flows in connection with the preceding illustrations. Other problemsthat arise with some frequency in the preparation of this statement include thefollowing.

1. Adjustments similar to depreciation.2. Accounts receivable (net).3. Other working capital changes.4. Net losses.5. Gains.6. Stock options.7. Postretirement benefit cost.8. Extraordinary items.9. Significant noncash transactions.

ADJUSTMENTS SIMILAR TO DEPRECIATIONDepreciation expense is the most common adjustment to net income that companiesmake to arrive at net cash flow from operating activities. But there are numerous othernoncash expense or revenue items. Examples of expense items that companies mustadd back to net income are the amortization of limited-life intangible assets such aspatents, and the amortization of deferred costs such as bond issue costs. These chargesto expense involve expenditures made in prior periods that a company amortizes cur-rently. These charges reduce net income without affecting cash in the current period.

Also, amortization of bond discount or premium on long-term bonds payableaffects the amount of interest expense. However, neither changes cash. As a result, a

SECTION 2 • SPECIAL PROBLEMS I N STATEMENTPREPARATION

Objective•8Discuss special problems in prepar-ing a statement of cash flows.



Accounts Receivable (Net) · 1267

company should add back discount amortization and subtract premium amortizationfrom net income to arrive at net cash flow from operating activities.

In a similar manner, changes in deferred income taxes affect net income but haveno effect on cash. For example, Delta Airlines reported an increase in its liability fordeferred taxes of approximately $1.2 billion. This change in the liability increased taxexpense and decreased net income, but did not affect cash. Therefore, Delta added back$1.2 billion to net income on its statement of cash flows.

Another common adjustment to net income is a change related to an investmentin common stock when recording income or loss under the equity method. Recall thatunder the equity method, the investor (1) debits the investment account and creditsrevenue for its share of the investee’s net income, and (2) credits dividends received tothe investment account. Therefore, the net increase in the investment account does notaffect cash flow. A company must deduct the net increase from net income to arrive atnet cash flow from operating activities.

Assume that Victor Co. owns 40 percent of Milo Inc. During the year Milo reportsnet income of $100,000 and pays a cash dividend of $30,000. Victor reports this in itsstatement of cash flows as a deduction from net income in the following manner—Equity in earnings of Milo, net of dividends, $28,000 [($100,000 � $30,000) � 40%].

If Victor Co. does not exercise significant influence over Milo, it cannot use theequity method. Instead, it uses the fair value method. Under the fair value method,Victor does not recognize any of Milo’s net income. Further, it records any cash dividendreceived as revenue. As a result, the company makes no adjustment to net income inthe statement of cash flows because cash dividends received are included in income.

ACCOUNTS RECEIVABLE (NET)Up to this point, we assumed no allowance for doubtful accounts—a contra account—to offset accounts receivable. However, if a company needs an allowance for doubtfulaccounts, how does that allowance affect the company’s determination of net cash flowfrom operating activities? For example, assume that Redmark Co. reports net incomeof $40,000. It has the accounts receivable balances as shown in Illustration 23-28.

Change2010 2009 Increase/Decrease

Accounts receivable $105,000 $90,000 $15,000 IncreaseAllowance for doubtful accounts (10,000) (4,000) 6,000 Increase

Accounts receivable (net) $ 95,000 $86,000 9,000 Increase

ILLUSTRATION 23-28Accounts ReceivableBalances, Redmark Co.

REDMARK CO.STATEMENT OF CASH FLOWS (PARTIAL)

FOR THE YEAR 2010


cash provided by operating activities:Increase in accounts receivable $(15,000)Increase in allowance for doubtful accounts 6,000 (9,000)

$31,000

ILLUSTRATION 23-29Presentation of Allowancefor Doubtful Accounts—Indirect Method

Indirect MethodBecause an increase in the Allowance for Doubtful Accounts results from a charge tobad debt expense, a company should add back an increase in the Allowance for Doubt-ful Accounts to net income to arrive at net cash flow from operating activities. Illustra-tion 23-29 shows one method for presenting this information in a statement of cash flows.




As we indicated, the increase in the Allowance for Doubtful Accounts balance re-sults from a charge to bad debt expense for the year. Because bad debt expense is anoncash charge, a company must add it back to net income in arriving at net cash flowfrom operating activities.

Instead of separately analyzing the allowance account, a short-cut approach is tonet the allowance balance against the receivable balance and compare the change inaccounts receivable on a net basis. Illustration 23-30 shows this presentation.

ILLUSTRATION 23-30Net Approach toAllowance for DoubtfulAccounts—IndirectMethod


FOR THE YEAR 2010


net cash provided by operating activities:Increase in accounts receivable (net) (9,000)

$31,000

ILLUSTRATION 23-31Income Statement,Redmark Co.

REDMARK CO.INCOME STATEMENTFOR THE YEAR 2010

Sales $100,000Expenses

Salaries $46,000Utilities 8,000Bad debts 6,000 60,000

Net income $ 40,000

This short-cut procedure works also if the change in the allowance account resultsfrom a write-off of accounts receivable. This reduces both the Accounts Receivable andthe Allowance for Doubtful Accounts. No effect on cash flows occurs. Because of itssimplicity, use the net approach for your homework assignments.

Direct MethodIf using the direct method, a company should not net the Allowance for DoubtfulAccounts against Accounts Receivable. To illustrate, assume that Redmark Co.’s netincome of $40,000 consisted of the following items.

ILLUSTRATION 23-32Bad Debts—DirectMethod


FOR THE YEAR 2010

Cash flows from operating activitiesCash received from customers $85,000Salaries paid $46,000Utilities paid 8,000 54,000

Net cash provided by operating activities $31,000

If Redmark deducts the $9,000 increase in accounts receivable (net) from sales forthe year, it would report cash sales at $91,000 ($100,000 � $9,000) and cash paymentsfor operating expenses at $60,000. Both items would be misstated: Cash sales shouldbe reported at $85,000 ($100,000 � $15,000), and total cash payments for operating ex-penses should be reported at $54,000 ($60,000 � $6,000). Illustration 23-32 shows theproper presentation.



Net Losses · 1269

An added complication develops when a company writes off accounts receivable.Simply adjusting sales for the change in accounts receivable will not provide the properamount of cash sales. The reason is that the write-off of the accounts receivable is nota cash collection. Thus an additional adjustment is necessary.

OTHER WORKING CAPITAL CHANGESUp to this point, we showed how companies handled all of the changes in workingcapital items (current asset and current liability items) as adjustments to net incomein determining net cash flow from operating activities. You must be careful, how-ever, because some changes in working capital, although they affect cash, do notaffect net income. Generally, these are investing or financing activities of a currentnature.

One activity is the purchase of short-term available-for-sale securities. For exam-ple, the purchase of short-term available-for-sale securities for $50,000 cash has noeffect on net income but it does cause a $50,000 decrease in cash.7 A company reportsthis transaction as a cash flow from investing activities as follows. [5]

Cash flows from investing activities

Purchase of short-term available-for-sale securities $(50,000)

What about trading securities? Because companies hold these investments princi-pally for the purpose of selling them in the near term, companies should classify thecash flows from purchases and sales of trading securities as cash flows from operatingactivities. [6]

Another example is the issuance of a short-term nontrade note payable for cash.This change in a working capital item has no effect on income from operations but itincreases cash by the amount of the note payable. For example, a company reports theissuance of a $10,000 short-term note payable for cash in the statement of cash flowsas follows.

Cash flows from financing activities

Issuance of short-term note $10,000

Another change in a working capital item that has no effect on income from oper-ations or on cash is a cash dividend payable. Although a company will report the cashdividends when paid as a financing activity, it does not report the declared but unpaiddividend on the statement of cash flows.

NET LOSSESIf a company reports a net loss instead of a net income, it must adjust the net loss forthose items that do not result in a cash inflow or outflow. The net loss, after adjustingfor the charges or credits not affecting cash, may result in a negative or a positive cashflow from operating activities.

For example, if the net loss is $50,000 and the total amount of charges to add backis $60,000, then net cash provided by operating activities is $10,000. Illustration 23-33(on page 1270) shows this computation.

7If the basis of the statement of cash flows is cash and cash equivalents and the short-terminvestment is considered a cash equivalent, then a company reports nothing in thestatement because the transaction does not affect the balance of cash and cash equivalents.The Board notes that cash purchases of short term investments generally are part of thecompany’s cash management activities rather than part of its operating, investing, orfinancing activities.




If the company experiences a net loss of $80,000 and the total amount of the chargesto add back is $25,000, the presentation appears as follows.

ILLUSTRATION 23-33Computation of Net CashFlow from OperatingActivities—Cash Inflow

Net loss $(50,000)Adjustments to reconcile net income to net

cash provided by operating activities:Depreciation of plant assets $55,000Amortization of patents 5,000 60,000


ILLUSTRATION 23-34Computation of Net CashFlow from OperatingActivities—Cash Outflow

Net loss $(80,000)Adjustments to reconcile net income to

net cash used by operating activities:Depreciation of plant assets 25,000

Net cash used by operating activities $(55,000)

Although not illustrated in this chapter, a negative cash flow may result even if thecompany reports a net income.

GAINSIn the illustration for Tax Consultants, the company experienced a loss of $2,000 from thesale of equipment. The company added this loss to net income to compute net cash flowfrom operating activities because the loss is a noncash charge in the income statement.

If Tax Consultants experiences a gain from a sale of equipment it too requires anadjustment to net income. Because a company reports the gain in the statement of cashflows as part of the cash proceeds from the sale of equipment under investing activi-ties, it deducts the gain from net income to avoid double counting—once as part ofnet income, and again as part of the cash proceeds from the sale.

STOCK OPTIONSRecall for share-based compensation plans that companies are required to use the fairvalue method to determine total compensation cost. The compensation cost is then rec-ognized as an expense in the periods in which the employee provides services. WhenCompensation Expense is debited, Paid-in Capital—Stock Options is often credited.Cash is not affected by recording the expense. Therefore, the company must increasenet income by the amount of compensation expense from stock options in comput-ing net cash flow from operating activities.

To illustrate how this information should be reported on a statement of cash flows,assume that First Wave Inc. grants 5,000 options to its CEO, Ann Johnson. Each optionentitles Johnson to purchase one share of First Wave’s $1 par value common stock at $50per share at any time in the next two years (the service period). The fair value of the op-tions is $200,000. First Wave records compensation expense in the first year as follows:

Compensation Expense ($200,000 � 2) 100,000

Paid-in Capital—Stock Options 100,000

In addition, if we assume that First Wave has a 35 percent tax rate, it would rec-ognize a deferred tax asset of $35,000 ($100,000 � 35%) in the first year as follows:

Deferred Tax Asset 35,000

Income Tax Expense 35,000



Extraordinary Items · 1271

Therefore, on the statement of cash flows for the first year, First Wave reports thefollowing (assuming a net income of $600,000).

Net income $600,000

Adjustments to reconcile net income to net cashprovided by operating activities:

Share-based compensation expense 100,000

Increase in deferred tax asset (35,000)

As shown in First Wave’s statement of cash flows, it adds the share-based compen-sation expense to net income because it is a noncash expense. The increase in thedeferred tax asset and the related reduction in income tax expense increase net income.Although the negative income tax expense increases net income, it does not increasecash. Therefore it should be deducted.

Subsequently, if Ann Johnson exercises her options, Third Wave reports “Cash pro-vided by exercise of stock options” in the financing section of the statement of cashflows.8

POSTRETIREMENT BENEFIT COSTSIf a company has postretirement costs such as an employee pension plan, chances arethat the pension expense recorded during a period will either be higher or lower thanthe cash funded. It will be higher when there is an unfunded liability and will be lowerwhen there is a prepaid pension cost. When the expense is higher or lower than thecash paid, the company must adjust net income by the difference between cash paidand the expense reported in computing net cash flow from operating activities.

EXTRAORDINARY ITEMSCompanies should report either as investing activities or as financing activities cashflows from extraordinary transactions and other events whose effects are included innet income, but which are not related to operations.

For example, assume that Tax Consultants had land with a carrying value of $200,000,which was condemned by the state of Maine for a highway project. The condemnationproceeds received were $205,000, resulting in a gain of $5,000 less $2,000 of taxes. In thestatement of cash flows (indirect method), the company would deduct the $5,000 gainfrom net income in the operating activities section. It would report the $205,000 cashinflow from the condemnation as an investing activity, as follows.

Cash flows from investing activities

Condemnation of land $205,000

Note that Tax Consultants handles the gain at its gross amount ($5,000), notnet of tax. The company reports the cash received in the condemnation as aninvesting activity at $205,000, also exclusive of the tax effect.

The FASB requires companies to classify all income taxes paid as operatingcash outflows. Some suggested that income taxes paid be allocated to investingand financing transactions. But the Board decided that allocation of income taxespaid to operating, investing, and financing activities would be so complex and

8Companies receive a tax deduction related to share-based compensation plans at the timeemployees exercise their options. The amount of the deduction is equal to the differencebetween the market price of the stock and the exercise price at the date the employeepurchases the stock, which in most cases, is much larger than the total compensation expenserecorded. When the tax deduction exceeds the total compensation recorded, this provides anadditional cash inflow to the company. For example, in a recent year Cisco Systems reportedan additional cash inflow related to its stock option plans equal to $537 million. UnderGAAP, this tax-related cash inflow is reported in the financing section of the statement ofcash flows. [7]

Underlying ConceptsBy rejecting the requirement to allo-cate taxes to the various activities,the Board invoked the cost-benefitconstraint. The information would bebeneficial, but the cost of providingsuch information would exceed thebenefits of providing it.




arbitrary that the benefits, if any, would not justify the costs involved. Under both thedirect method and the indirect method, companies must disclose the total amount of in-come taxes paid.9

SIGNIFICANT NONCASH TRANSACTIONSBecause the statement of cash flows reports only the effects of operating, investing, andfinancing activities in terms of cash flows, it omits some significant noncash transactionsand other events that are investing or financing activities. Among the more commonof these noncash transactions that a company should report or disclose in some mannerare the following.

1. Acquisition of assets by assuming liabilities (including capital lease obligations) orby issuing equity securities.

2. Exchanges of nonmonetary assets.3. Refinancing of long-term debt.4. Conversion of debt or preferred stock to common stock.5. Issuance of equity securities to retire debt.

A company does not incorporate these noncash items in the statement of cashflows. If material in amount, these disclosures may be either narrative or summarizedin a separate schedule at the bottom of the statement, or they may appear in a sepa-rate note or supplementary schedule to the financial statements.10 Illustration 23-35shows the presentation of these significant noncash transactions or other events in aseparate schedule at the bottom of the statement of cash flows.

9For an insightful article on some weaknesses and limitations in the statement of cash flows,see Hugo Nurnberg,“Inconsistencies and Ambiguities in Cash Flow Statements Under FASB Statement No. 95,” Accounting Horizons (June 1993), pp. 60–73. Nurnberg identifies theinconsistencies caused by the three-way classification of all cash receipts and cash payments,gross versus net of tax, the ambiguous disclosure requirements for noncash investing andfinancing transactions, and the ambiguous presentation of third-party financing transactions.See also Paul B. W. Miller, and Bruce P. Budge,“Nonarticulation in Cash Flow Statementsand Implications for Education, Research, and Practice,” Accounting Horizons (December 1996),pp. 1–15; and Charles Mulford and Michael Ely,“Calculating Sustainable Cash Flow: A Studyof the S&P 100,” Georgia Tech Financial Analysis Lab (October 2004).10Some noncash investing and financing activities are part cash and part noncash. Companiesshould report only the cash portion on the statement of cash flows. The noncash componentshould be reported at the bottom of the statement or in a separate note.

Examples of Cash FlowStatements

w

iley.com/col

leg

e/k

ieso

ILLUSTRATION 23-35Schedule Presentation ofNoncash Investing andFinancing Activities

Net increase in cash $3,717,000Cash at beginning of year 5,208,000

Cash at end of year $8,925,000

Noncash investing and financing activitiesPurchase of land and building through issuance of 250,000 shares of

common stock $1,750,000Exchange of Steadfast, NY, land for Bedford, PA, land $2,000,000Conversion of 12% bonds to 50,000 shares of common stock $500,000

ILLUSTRATION 23-36Note Presentation ofNoncash Investing andFinancing Activities

Note G: Significant noncash transactions. During the year the company engaged in the followingsignificant noncash investing and financing transactions:

Issued 250,000 shares of common stock to purchase land and building $1,750,000Exchanged land in Steadfast, NY, for land in Bedford, PA $2,000,000Converted 12% bonds to 50,000 shares of common stock $500,000

Or, companies may present these noncash transactions in a separate note, as shownin Illustration 23-36.



Use of a Worksheet · 1273

Companies do not generally report certain other significant noncash transactionsor other events in conjunction with the statement of cash flows. Examples of these typesof transactions are stock dividends, stock splits, and restrictions on retained earn-ings. Companies generally report these items, neither financing nor investing activi-ties, in conjunction with the statement of stockholders’ equity or schedules and notespertaining to changes in capital accounts.


By understanding the relationship between cash flow and income measures, analysts can gain bet-ter insights into company performance. Because earnings altered through creative accounting prac-tices generally do not change operating cash flows, analysts can use the relationship between earn-ings and operating cash flow to detect suspicious accounting practices. Also, by monitoring the ratiobetween cash flow from operations and operating income, they can get a clearer picture of devel-oping problems in a company.

For example, the chart below plots the ratio of operating cash flows to earnings for Xerox Corp.in the years leading up to the SEC singling it out in 2000 for aggressive revenue recognition prac-tices on its leases.

CASH FLOW TOOL

When numerous adjustments are necessary or other complicating factors arepresent, companies often use a worksheet to assemble and classify the data thatwill appear on the statement of cash flows. The worksheet (a spreadsheet whenusing computer software) is merely a device that aids in the preparation of the

Similar to W. T. Grant in the chapter opening story, Xerox was reporting earnings growth in theyears leading up to its financial breakdown in 2000 but teetering near bankruptcy in 2001. However,Xerox’s ratio of cash flow to earnings showed a declining trend and became negative well before itsrevenue recognition practices were revealed. The trend revealed in the graph should have given anyanalyst reason to investigate Xerox further. As one analyst noted, “Earnings growth that exceeds thegrowth in operating cash flow cannot continue for extended periods and should be investigated.”

Source: Adapted from Charles Mulford and Eugene Comiskey, The Financial Numbers Game: Detecting CreativeAccounting Practices (New York: John Wiley & Sons, 2002), Chapter 11, by permission.

1994

Ratio of Cash Flow to Operating Income

1995 1996 1997 1998 1999−0.80

−0.60

−0.40

−0.20

0.00

0.20

0.40

0.60

0.80

1.00

1.20

SECTION 3 • USE OF A WORKSH EET

Objective•9Explain the use of a worksheet inpreparing a statement of cash flows.




The following guidelines are important in using a worksheet.

1. In the balance sheet accounts section, list accounts with debit balances separatelyfrom those with credit balances. This means, for example, that Accumulated De-preciation is listed under credit balances and not as a contra account under debitbalances. Enter the beginning and ending balances of each account in the appropriatecolumns. Then, enter the transactions that caused the change in the account balanceduring the year as reconciling items in the two middle columns.

After all reconciling items have been entered, each line pertaining to a balancesheet account should foot across. That is, the beginning balance plus or minus thereconciling item(s) must equal the ending balance. When this agreement exists forall balance sheet accounts, all changes in account balances have been reconciled.

2. The bottom portion of the worksheet consists of the operating, investing, and fi-nancing activities sections. Accordingly, it provides the information necessary to pre-pare the formal statement of cash flows. Enter inflows of cash as debits in thereconciling columns, and outflows of cash as credits in the reconciling columns.Thus, in this section, a company would enter the sale of equipment for cash at bookvalue as a debit under inflows of cash from investing activities. Similarly, it wouldenter the purchase of land for cash as a credit under outflows of cash from invest-ing activities.

3. Do not enter in any journal or post to any account the reconciling items shownin the worksheet. These items do not represent either adjustments or corrections ofthe balance sheet accounts. They are used only to facilitate the preparation of thestatement of cash flows.

XX XX XX

XX

XXX

XX

XX

XXX

XX XX

XX XX

XX XX

Balance Sheet Accounts

Debit balance accounts

Totals

Totals

Totals

Credit balance accounts

Operating activities

Investing activities

Increase (decrease) in cash

Financing activities

Statement ofCash Flows Effects

Totals

Net income

Adjustments

Receipts and payments

Receipts and payments

End ofPrior YearBalances

XX

XX

XX

XX

XXX

XX

XX

XX

XX

XXX

(XX)

XXX

XXX

XX

XX

XXX

XX

XX

XXX

End ofCurrent Year

Balances

Reconciling Items

Debits Credits

XYZ COMPANYStatement of Cash Flows For the Year Ended...

1234567

89101112131415161718

Sheet1

A B C D E

statement. Its use is optional. Illustration 23-37 shows the skeleton format of the work-sheet for preparation of the statement of cash flows using the indirect method.

ILLUSTRATION 23-37Format of Worksheet forPreparation of Statementof Cash Flows



Preparation of the Worksheet · 1275

PREPARATION OF THE WORKSHEETThe preparation of a worksheet involves the following steps.

Step 1. Enter the balance sheet accounts and their beginning and ending balancesin the balance sheet accounts section.Step 2. Enter the data that explain the changes in the balance sheet accounts (otherthan cash) and their effects on the statement of cash flows in the reconciling columnsof the worksheet.Step 3. Enter the increase or decrease in cash on the cash line and at the bottom ofthe worksheet. This entry should enable the totals of the reconciling columns to bein agreement.

To illustrate the preparation and use of a worksheet and to illustrate the reportingof some of the special problems discussed in the prior section, we present a compre-hensive example for Satellite Corporation. Again, the indirect method serves as the basisfor the computation of net cash provided by operating activities. Illustrations 23-38 and23-39 (on page 1276) present the balance sheet, combined statement of income and retained

$ 59,000Cash

104,000Accounts receivable (net)

493,000Inventories

16,500Prepaid expenses

131,500Land

187,000Equipment

(29,000)Accumulated depreciation—equipment

262,000Buildings

(74,100)Accumulated depreciation—buildings

7,600Trademark

$1,176,000Total assets

$ 132,000Accounts payable

43,000Accrued liabilities

3,000Income tax payable

60,000Notes payable (long-term)

100,000Bonds payable

7,000Premium on bonds payable

9,000Deferred tax liability (long-term)

354,000Total liabilities

60,000Common stock ($1 par)

187,000Additional paid-in capital

592,000Retained earnings

(17,000)Treasury stock

822,000Total stockholders’ equity

$1,176,000Total liabilities and stockholders’ equity

18,500Investments in stock of Porter Co. (equity method)

Assets

2010

SATELLITE CORPORATIONComparative Balance Sheet–December 31, 2010 and 2009

Liabilities

Stockholders’ Equity

$ 66,000

51,000

341,000

17,000

82,000

142,000

(31,000)

262,000

(71,000)

10,000

$884,000

$ 131,000

39,000

16,000

—

—

—

—

100,000

8,000

6,000

300,000

50,000

38,000

496,000

584,000

$884,000

15,000

2009

$ (7,000)

53,000

152,000

(500)

49,500

45,000

(2,000)

3,100

(2,400)

1,000

4,000

(13,000)

60,000

(1,000)

3,000

10,000

149,000

96,000

17,000

3,500

Increaseor (Decrease)

A B C D12

3456

789

101112131415

1617

18192021222324252627282930

Sheet1

ILLUSTRATION 23-38Comparative BalanceSheet, SatelliteCorporation




ILLUSTRATION 23-39Income and RetainedEarnings Statements,Satellite Corporation

SATELLITE CORPORATIONCOMBINED STATEMENT OF INCOME AND RETAINED EARNINGS


Net sales $526,500Other revenue 3,500

Total revenues 530,000

ExpenseCost of goods sold 310,000Selling and administrative expenses 47,000Other expenses and losses 12,000

Total expenses 369,000

Income before income tax and extraordinary item 161,000

Income taxCurrent $47,000Deferred 3,000 50,000

Income before extraordinary item 111,000Gain on condemnation of land (net of $2,000 tax) 6,000

Net income 117,000Retained earnings, January 1 496,000Less:

Cash dividends 6,000Stock dividend 15,000 21,000

Retained earnings, December 31 $592,000

Per share:Income before extraordinary item $2.02Extraordinary item .11

Net income $2.13

Additional Information(a) Other income of $3,500 represents Satellite’s equity share in the net income of Porter Co., an

equity investee. Satellite owns 22% of Porter Co.(b) An analysis of the equipment account and related accumulated depreciation indicates the

following:

Equipment Accum. Dep. Gain orDr./(Cr.) Dr./(Cr.) (Loss)

Balance at end of 2009 $142,000 $(31,000)Purchases of equipment 53,000Sale of equipment (8,000) 2,500 $(1,500)Depreciation for the period (11,500)Major repair charged to

accumulated depreciation 11,000

Balance at end of 2010 $187,000 $(29,000)

(c) Land in the amount of $60,000 was purchased through the issuance of a long-term note; inaddition, certain parcels of land costing $10,500 were condemned. The state government paidSatellite $18,500, resulting in an $8,000 gain which has a $2,000 tax effect.

(d) The change in the accumulated depreciation—buildings, trademark, and premium on bondspayable accounts resulted from depreciation and amortization entries.

(e) An analysis of the paid-in capital accounts in stockholders’ equity discloses the following:

Common Additional Paid-InStock Capital

Balance at end of 2009 $50,000 $ 38,000Issuance of 2% stock dividend 1,000 14,000Sale of stock for cash 9,000 135,000

Balance at end of 2010 $60,000 $187,000

(f) Interest paid (net of amount capitalized) is $9,000; income taxes paid is $62,000.



Analysis of Transactions · 1277

earnings, and additional information for Satellite Corporation. The discussion that followsthese financial statements provides additional explanations related to the preparationof the worksheet.

ANALYSIS OF TRANSACTIONSThe following discussion explains the individual adjustments that appear on the work-sheet in Illustration 23-40 (page 1281). Because cash is the basis for the analysis, Satel-lite reconciles the cash account last. Because income is the first item that appears onthe statement of cash flows, it is handled first.

Change in Retained EarningsNet income for the period is $117,000. The entry for it on the worksheet is as follows.

(1)

Operating—Net Income 117,000

Retained Earnings 117,000

Satellite reports net income on the bottom section of the worksheet. This is thestarting point for preparation of the statement of cash flows (under the indirectmethod).

A stock dividend and a cash dividend also affected retained earnings. The retainedearnings statement reports a stock dividend of $15,000. The worksheet entry for thistransaction is as follows.

(2)


Common Stock 1,000

Additional Paid-in Capital 14,000

The issuance of stock dividends is not a cash operating, investing, or financingitem. Therefore, although the company enters this transaction on the worksheet forreconciling purposes, it does not report it in the statement of cash flows.

The $6,000 cash dividend paid represents a financing activity cash outflow. Satel-lite makes the following worksheet entry:

(3)


Financing—Cash Dividends 6,000

The company reconciles the beginning and ending balances of retained earningsby entry of the three items above.

Accounts Receivable (Net)The increase in accounts receivable (net) of $53,000 represents adjustments that did notresult in cash inflows during 2010. As a result, the company would deduct from netincome the increase of $53,000. Satellite makes the following worksheet entry.

(4)

Accounts Receivable (net) 53,000

Operating—Increase in Accounts Receivable (net) 53,000




InventoriesThe increase in inventories of $152,000 represents an operating use of cash. The incre-mental investment in inventories during the year reduces cash without increasing thecost of goods sold. Satellite makes the following worksheet entry.

(5)

Inventories 152,000

Operating—Increase in Inventories 152,000

Prepaid ExpenseThe decrease in prepaid expenses of $500 represents a charge in the income statementfor which there was no cash outflow in the current period. Satellite should add thatamount back to net income through the following entry.

(6)

Operating—Decrease in Prepaid Expenses 500

Prepaid Expenses 500

Investment in StockSatellite’s investment in the stock of Porter Co. increased $3,500. This amount reflectsSatellite’s share of net income earned by Porter (its equity investee) during the currentyear. Although Satellite’s revenue, and therefore its net income increased $3,500 byrecording Satellite’s share of Porter Co.’s net income, no cash (dividend) was provided.Satellite makes the following worksheet entry.

(7)

Investment in Stock of Porter Co. 3,500

Operating—Equity in Earnings of Porter Co. 3,500

LandSatellite purchased land in the amount of $60,000 through the issuance of a long-termnote payable. This transaction did not affect cash. It is a significant noncash investing/financing transaction that the company would disclose either in a separate schedulebelow the statement of cash flows or in the accompanying notes. Satellite makes thefollowing entry to reconcile the worksheet.

(8)

Land 60,000

Notes Payable 60,000

In addition to the noncash transaction involving the issuance of a note to purchaseland, the Land account was decreased by the condemnation proceedings. The follow-ing worksheet entry records the receipt of $18,500 for land having a book value of$10,500.

(9)

Investing—Proceeds from Condemnation of Land 18,500

Land 10,500

Operating—Gain on Condemnation of Land 8,000

In reconciling net income to net cash flow from operating activities, Satellite deductsfrom net income the extraordinary gain of $8,000. The reason is that the transaction thatgave rise to the gain is an item whose cash effect is already classified as an investingcash inflow. The Land account is now reconciled.




Equipment and Accumulated DepreciationAn analysis of Equipment and Accumulated Depreciation shows that a number oftransactions have affected these accounts. The company purchased equipment in theamount of $53,000 during the year. Satellite records this transaction on the worksheetas follows.

(10)

Equipment 53,000

Investing—Purchase of Equipment 53,000

In addition, Satellite sold at a loss of $1,500 equipment with a book value of $5,500.It records this transaction as follows.

(11)

Investing—Sale of Equipment 4,000

Operating—Loss on Sale of Equipment 1,500

Accumulated Depreciation—Equipment 2,500

Equipment 8,000

The proceeds from the sale of the equipment provided cash of $4,000. In addition,the loss on the sale of the equipment has reduced net income, but did not affect cash.Therefore, the company adds back to net income the amount of the loss, in order toaccurately report cash provided by operating activities.

Satellite reported depreciation on the equipment at $11,500 and recorded it on theworksheet as follows.

(12)

Operating—Depreciation Expense—Equipment 11,500


The company adds depreciation expense back to net income because that expensereduced income but did not affect cash.

Finally, the company made a major repair to the equipment. It charged this expen-diture, in the amount of $11,000, to Accumulated Depreciation—Equipment. Thisexpenditure required cash, and so Satellite makes the following worksheet entry.

(13)


Investing—Major Repairs of Equipment 11,000

After adjusting for the foregoing items, Satellite has reconciled the balances in theEquipment and related Accumulated Depreciation accounts.

Building Depreciation and Amortization of TrademarkDepreciation expense on the buildings of $3,100 and amortization of trademark of $2,400are both expenses in the income statement that reduced net income but did not requirecash outflows in the current period. Satellite makes the following worksheet entry.

(14)

Operating—Depreciation Expense—Buildings 3,100

Operating—Amortization of Trademark 2,400

Accumulated Depreciation—Buildings 3,100

Trademark 2,400

Other Noncash Charges or CreditsAnalysis of the remaining accounts indicates that changes in the Accounts Payable,Accrued Liabilities, Income Tax Payable, Premium on Bonds Payable, and DeferredTax Liability balances resulted from charges or credits to net income that did not




affect cash. The company should individually analyze each of these items and enterthem in the worksheet. The following compound entry summarizes these noncash,income-related items.

(15)

Income Tax Payable 13,000

Premium on Bonds Payable 1,000

Operating—Increase in Accounts Payable 1,000

Operating—Increase in Accrued Liabilities 4,000

Operating—Increase in Deferred Tax Liability 3,000

Operating—Decrease in Income Tax Payable 13,000

Operating—Amortization of Bond Premium 1,000

Accounts Payable 1,000

Accrued Liabilities 4,000

Deferred Tax Liability 3,000

Common Stock and Related AccountsComparison of the common stock balances and the additional paid-in capitalbalances shows that transactions during the year affected these accounts. First,Satellite issues a stock dividend of 2 percent to stockholders. As the discussion ofworksheet entry (2) indicated, no cash was provided or used by the stock dividendtransaction. In addition to the shares issued via the stock dividend, Satellite soldshares of common stock at $16 per share. The company records this transaction asfollows.

(16)

Financing—Sale of Common Stock 144,000

Common Stock 9,000

Additional Paid-in Capital 135,000

Also, the company purchased shares of its common stock in the amount of $17,000.It records this transaction on the worksheet as follows.

(17)

Treasury Stock 17,000

Financing—Purchase of Treasury Stock 17,000

Final Reconciling EntryThe final entry to reconcile the change in cash and to balance the worksheet is shownbelow. The $7,000 amount is the difference between the beginning and ending cashbalance.

(18)

Decrease in Cash 7,000

Cash 7,000

Once the company has determined that the differences between the beginning andending balances per the worksheet columns have been accounted for, it can total thereconciling transactions columns, and they should balance. Satellite can prepare thestatement of cash flows entirely from the items and amounts that appear at the bot-tom of the worksheet under “Statement of Cash Flows Effects,” as shown in Illustra-tion 23-40 (on page 1281).




$ 66,000

$ 31,000

51,000

71,000

131,00039,000

16,000

100,000

8,000

6,000

50,000

38,000

496,000

$986,000 $1,296,100

-0-

$ 53,000

152,000

3,500

60,000

53,000

17,000

2,500

11,000

13,000

1,000

15,000

6,000

117,000

2,400

11,500

3,100

1,000

4,000

60,000

3,000

1,000

9,000

14,000

135,000

117,000

53,000

152,000

3,500

8,000

13,000

1,000

53,000

11,000

17,000

$704,500

704,500

6,000

500

1,500

11,500

3,100

2,400

1,000

4,000

3,000

18,500

4,000

144,000

697,500

$704,500

7,000

8,000

10,500

500

7,000

341,000

17,000

15,000

82,000

142,000

262,000

10,000

$ 59,000

104,000

493,000

16,500

18,500

131,500

187,000

262,000

$ 29,000

74,100

132,000

43,000

3,000

60,000

100,000

7,000

9,000

60,000

187,000

592,000

7,600

17,000

$986,000

Debits

Credits

Cash

Accounts receivable (net)

Accum. depr.–equipment

Accum. depr.–building

Accounts payable

Accrued liabilities

Income tax payableNotes payable

Bonds payable

Premium on bonds payable

Deferred tax liability

Common stock

Net income

Increase in accounts receivable (net)

Increase in inventories

Decrease in prepaid expenses

Equity in earnings of Porter Co.

Gain on condemnation of land

Loss on sale of equipment

Depr. expense–equipment

Depr. expense–building

Amortization of trademark

Increase in accounts payable

Increase in accrued liabilities

Increase in deferred tax liability

Decrease in income tax payable

Amortization of bond premium

Investing activities

Proceeds from condemnation of land

Purchase of equipment

Sale of equipment

Major repairs of equipment

Financing activities

Payment of cash dividend

Issuance of common stock

Purchase of treasury stock

Totals

Decrease in cash

Totals

Additional paid-in capital

Retained earnings

Total credits

Statement of Cash Flows Effects

Operating activities

Total debits

Treasury stock

Trademark

Building

Equipment

Land

Investment (equity method)

Prepaid expenses

Inventories

Balance12/31/09

Balance12/31/10Debits Credits

$1,296,100

(10)

(17)

(11)

(13)

(15)

(15)

(2)

(3)

(1)

(6)

(11)

(12)

(14)

(14)

(15)

(15)

(15)

(9)

(11)

(16)

(18)

(17)

(3)

(13)

(10)

(15)

(15)

(9)

(7)

(5)

(4)

(1)

(2)

(16)

(2)

(15)

(8)

(15)

(15)

(14)

(12)

(14)

(11)

(9)

(6)

(18)

(16)

(8)

(7)

(5)

(4)

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SATELLITE CORPORATIONWorksheet for Preparation of Statement of Cash Flows For the Year Ended December 31, 2010

Sheet1

A B C D E F GReconciling Items–2010

ILLUSTRATION 23-40Completed Worksheet forPreparation of Statementof Cash Flows, SatelliteCorporation




PREPARATION OF FINAL STATEMENTIllustration 23-41 presents a formal statement of cash flows prepared from the datacompiled in the lower portion of the worksheet.

ILLUSTRATION 23-41Statement of Cash Flows,Satellite Corporation

SATELLITE CORPORATIONSTATEMENT OF CASH FLOWS



cash used by operating activities:Depreciation expense $ 14,600Amortization of trademark 2,400Amortization of bond premium (1,000)Equity in earnings of Porter Co. (3,500)Gain on condemnation of land (8,000)Loss on sale of equipment 1,500Increase in deferred tax liability 3,000Increase in accounts receivable (net) (53,000)Increase in inventories (152,000)Decrease in prepaid expenses 500Increase in accounts payable 1,000Increase in accrued liabilities 4,000Decrease in income tax payable (13,000) (203,500)

Net cash used by operating activities (86,500)

Cash flows from investing activitiesProceeds from condemnation of land 18,500Purchase of equipment (53,000)Sale of equipment 4,000Major repairs of equipment (11,000)


Cash flows from financing activitiesPayment of cash dividend (6,000)Issuance of common stock 144,000Purchase of treasury stock (17,000)


Net decrease in cash (7,000)Cash, January 1, 2010 66,000

Cash, December 31, 2010 $ 59,000

Supplemental Disclosures of Cash Flow Information:Cash paid during the year for:

Interest (net of amount capitalized) $ 9,000Income taxes $ 62,000

Supplemental Schedule of Noncash Investing and Financing Activities:Purchase of land for $60,000 in exchange for a $60,000 long-term note.

Discussion of the T-Account Approach toPreparation of theStatement of Cash Flows

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You will want to readthe CONVERGENCE CORNER on page 1283

For discussion of howinternational conver-gence efforts relate tothe statement of cashflows.



1283

O N T H E H O R I Z O N

Presently, the FASB and the IASB are involved in a joint project on the presentation and organization of informa-tion in the financial statements. With respect to the cash flow statement specifically, the notion of cash equivalentswill probably not be retained. The definition of cash in the existing literature would be retained, and the state-ment of cash flows would present information on changes in cash only. In addition, the FASB favors presentationof operating cash flows using the direct method only. However, the majority of IASB members express a prefer-ence for not requiring use of the direct method of reporting operating cash flows. So the two Boards will have toresolve their differences in this area in order to issue a converged standard for the statement of cash flows.

A B O U T T H E N U M B E R S

One area where there can be substantive differences between iGAAPand U.S. GAAP relates to the classification of interest, dividends, andtaxes. The following table indicates the differences between the twoapproaches.

R E L E VA N T FA C T S

• Companies preparing financial statements underiGAAP must prepare a statement of cash flows as anintegral part of the financial statements.

• Both iGAAP and U.S. GAAP require that the statementof cash flows should have three major sections—operating, investing, and financing—along with changesin cash and cash equivalents.

• Similar to U.S. GAAP, the cash flow statement can beprepared using either the indirect or direct method underiGAAP. In both U.S. and international settings, companieschoose for the most part to use the indirect method forreporting net cash flows from operating activities.

• iGAAP encourages companies to disclose the aggre-gate amount of cash flows that are attributable to the in-crease in operating capacity separately from those cashflows that are required to maintain operating capacity.

• The definition of cash equivalents used in iGAAP issimilar to that used in U.S. GAAP. A major difference isthat in certain situations bank overdrafts are consideredpart of cash and cash equivalents under iGAAP (whichis not the case in U.S. GAAP). Under U.S. GAAP, bankoverdrafts are classified as financing activities.

C O N V E R G E N C E C O R N E R

As in U.S. GAAP, the statement of cash flows is a required statement for iGAAP. In addition, the content and pres-entation of an iGAAP balance sheet is similar to one used for U.S. GAAP. However, the disclosure requirementsrelated to the statement of cash flows are more extensive under U.S. GAAP. IAS 7 (“Cash Flow Statements”) pro-vides the overall iGAAP requirements for cash flow information.


Item iGAAP U.S. GAAP

Interest paid Operating or financing OperatingInterest received Operating or investing OperatingDividends paid Operating or financing FinancingDividends received Operating or investing OperatingTaxes paid Operating—unless specific Operating1, 2

identification with financingor investing

• iGAAP requires that noncash investing and financing activities be excluded from the statement of cash flows. Instead, these noncash activities should be reported elsewhere. This requirement is interpreted to mean that noncash investing and financing activities should bedisclosed in the notes to the financial statements instead of in the financial statements. Under U.S. GAAP, companies may present this information in the cash flow statement.

1U.S. GAAP has additional disclosure rules2U.S. GAAP has specific rules regarding the classification of the benefitassociated with share-based compensation arrangements and theclassification of derivatives that contain a financing element

Source: PricewaterhouseCoopers, Similarities and Difference–AComparison of IFRS and U.S. GAAP (October 2007).

As indicated, the major difference is that iGAAP provides more alter-natives for disclosing certain items.




SUMMARY OF LEARNING OBJECTIVES

Describe the purpose of the statement of cash flows. The primary purpose of thestatement of cash flows is to provide information about cash receipts and cash paymentsof an entity during a period. A secondary objective is to report the entity’s operating,investing, and financing activities during the period.

Identify the major classifications of cash flows. Companies classify cash flows as:(1) Operating activities—transactions that result in the revenues, expenses, gains, and lossesthat determine net income. (2) Investing activities—lending money and collecting onthose loans, and acquiring and disposing of investments, plant assets, and intangibleassets. (3) Financing activities—obtaining cash from creditors and repaying loans, issuingand reacquiring capital stock, and paying cash dividends.

Differentiate between net income and net cash flows from operating activities. Com-panies must adjust net income on an accrual basis to determine net cash flow fromoperating activities because some expenses and losses do not cause cash outflows, andsome revenues and gains do not provide cash inflows.

Contrast the direct and indirect methods of calculating net cash flow from operatingactivities. Under the direct approach, companies calculate the major classes of operat-ing cash receipts and cash disbursements. Companies summarize the computations ina schedule of changes from the accrual to the cash basis income statement. Presenta-tion of the direct approach of reporting net cash flow from operating activities takesthe form of a condensed cash-basis income statement. The indirect method adds backto net income the noncash expenses and losses and subtracts the noncash revenuesand gains.

Determine net cash flows from investing and financing activities. Once a companyhas computed the net cash flow from operating activities, the next step is to determinewhether any other changes in balance sheet accounts caused an increase or decreasein cash. Net cash flows from investing and financing activities can be determined byexamining the changes in noncurrent balance sheet accounts.

Prepare a statement of cash flows. Preparing the statement involves three majorsteps: (1) Determine the change in cash. This is the difference between the beginning andthe ending cash balance shown on the comparative balance sheets. (2) Determine thenet cash flow from operating activities. This procedure is complex; it involves analyzingnot only the current year’s income statement but also the comparative balance sheetsand the selected transaction data. (3) Determine cash flows from investing and financingactivities. Analyze all other changes in the balance sheet accounts to determine theeffects on cash.

Identify sources of information for a statement of cash flows. The information toprepare the statement usually comes from three sources: (1) Comparative balance sheets.Information in these statements indicates the amount of the changes in assets, liabil-ities, and equities during the period. (2) Current income statement. Information in thisstatement is used in determining the cash provided by operations during the period.(3) Selected transaction data. These data from the general ledger provide additional de-tailed information needed to determine how cash was provided or used during theperiod.

Discuss special problems in preparing a statement of cash flows. These special prob-lems are: (1) adjustments similar to depreciation; (2) accounts receivable (net); (3) otherworking capital changes; (4) net losses; (5) gains; (6) stock options; (7) postretirementbenefit costs; (8) extraordinary items; and (9) significant noncash transactions.

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KEY TERMS

cash equivalents, 1245(n)direct method, 1250financing activities, 1245indirect method, 1250investing activities, 1245operating activities, 1245significant noncash

transactions, 1272statement of cash flows,

1244



FASB Codification · 1285

Explain the use of a worksheet in preparing a statement of cash flows. When numer-ous adjustments are necessary, or other complicating factors are present, companies of-ten use a worksheet to assemble and classify the data that will appear on the statementof cash flows. The worksheet is merely a device that aids in the preparation of the state-ment. Its use is optional.

•9

ExercisesAccess the FASB Codification at http://asc.fasb.org/home to prepare responses to the following exercises. ProvideCodification references for your responses.

CE23-1 Access the glossary (“Master Glossary”) to answer the following.

(a) What are cash equivalents?(b) What are financing activities?(c) What are investing activities?(d) What are operating activities?

CE23-2 Name five cash inflows that would qualify as a “financing activity.”

CE23-3 How should cash flows from purchases, sales, and maturities of available-for-sale securities be classifiedand reported in the statement of cash flows?

CE23-4 Do companies need to disclose information about investing and financing activities that do not affectcash receipts or cash payments? If so, how should such information be disclosed?

An additional codification case can be found in the Using Your Judgment section, on page 1311.

FASB Codification References[1] FASB ASC 230-10-10-2. [Predecessor literature: “The Statement of Cash Flows,” Statement of Financial

Accounting Standards No. 95 (Stamford, Conn.: FASB, 1987), pars. 4 and 5.][2] FASB ASC 230-10-45-18 through 21. [Predecessor literature: “Statement of Cash Flows—Exemption of

Certain Enterprises and Classification of Cash Flows from Certain Securities Acquired for Resale (amended),”Statement of Financial Accounting Standards No. 102 (February 1989).]

[3] FASB ASC 230-10-45-31. [Predecessor literature: “The Statement of Cash Flows,” Statement of FinancialAccounting Standards No. 95 (Stamford, Conn.: FASB, 1987), pars. 27 and 30.]

[4] FASB ASC 230-10-45-25. [Predecessor literature: “Statement of Cash Flows,” Statement of Financial AccountingStandards No. 95 (Stamford, Conn.: FASB, 1987), pars. 107 and 111.]

[5] FASB ASC 320-10-45-11. [Predecessor literature: “Accounting for Certain Investments in Debt and EquitySecurities,” Statement of Financial Accounting Standards No. 115 (Norwalk, Conn.: 1993), par. 118.]

[6] FASB ASC 320-10-45-11. [Predecessor literature: “Accounting for Certain Investments in Debt and EquitySecurities,” Statement of Financial Accounting Standards No. 115 (Norwalk, Conn.: 1993), par. 118.]

[7] FASB ASC 230-10-45-14. [Predecessor literature: “Share-Based Payment,” Statement of Financial AccountingStandard No. 123(R) (Norwalk, Conn.: FASB, 2004), par. 68.]

FASB CODIFICATION

Be sure to check the companion website for a Review and Analysis Exercise, with solution. w

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QUESTIONS

1. What is the purpose of the statement of cash flows? Whatinformation does it provide?

2. Of what use is the statement of cash flows?

3. Differentiate between investing activities, financing activ-ities, and operating activities.

4. What are the major sources of cash (inflows) in a statementof cash flows? What are the major uses (outflows) of cash?

5. Identify and explain the major steps involved in prepar-ing the statement of cash flows.

6. Identify the following items as (1) operating, (2) invest-ing, or (3) financing activities: purchase of land; paymentof dividends; cash sales; and purchase of treasury stock.

7. Unlike the other major financial statements, the statementof cash flows is not prepared from the adjusted trial balance.From what sources does the information to prepare this state-ment come, and what information does each source provide?

8. Why is it necessary to convert accrual-based net incometo a cash basis when preparing a statement of cash flows?

9. Differentiate between the direct method and the indirectmethod by discussing each method.

10. Broussard Company reported net income of $3.5 millionin 2010. Depreciation for the year was $520,000; accountsreceivable increased $500,000; and accounts payable in-creased $300,000. Compute net cash flow from operatingactivities using the indirect method.

11. Collinsworth Co. reported sales on an accrual basis of$100,000. If accounts receivable increased $30,000, and theallowance for doubtful accounts increased $9,000 after awrite-off of $2,000, compute cash sales.

12. Your roommate is puzzled. During the last year, the com-pany in which she is a stockholder reported a net loss of$675,000, yet its cash increased $321,000 during the sameperiod of time. Explain to your roommate how this situ-ation could occur.

13. The board of directors of Gifford Corp. declared cash div-idends of $260,000 during the current year. If dividendspayable was $85,000 at the beginning of the year and$90,000 at the end of the year, how much cash was paidin dividends during the year?

14. Explain how the amount of cash payments to suppliers iscomputed under the direct method.

15. The net income for Letterman Company for 2010 was$320,000. During 2010, depreciation on plant assets was$124,000, amortization of patent was $40,000, and the com-pany incurred a loss on sale of plant assets of $21,000.Compute net cash flow from operating activities.

16. Each of the following items must be considered in prepar-ing a statement of cash flows for Blackwell Inc. for theyear ended December 31, 2010. State where each item isto be shown in the statement, if at all.

(a) Plant assets that had cost $18,000 61⁄2 years before andwere being depreciated on a straight-line basis over10 years with no estimated scrap value were sold for$4,000.

(b) During the year, 10,000 shares of common stock with astated value of $20 a share were issued for $41 a share.

(c) Uncollectible accounts receivable in the amount of$22,000 were written off against the Allowance forDoubtful Accounts.

(d) The company sustained a net loss for the year of$50,000. Depreciation amounted to $22,000, and a gainof $9,000 was realized on the sale of available-for-salesecurities for $38,000 cash.

17. Classify the following items as (1) operating, (2) invest-ing, (3) financing, or (4) significant noncash investing andfinancing activities, using the direct method.

(a) Cash payments to employees.

(b) Redemption of bonds payable.

(c) Sale of building at book value.

(d) Cash payments to suppliers.

(e) Exchange of equipment for furniture.

(f) Issuance of preferred stock.

(g) Cash received from customers.

(h) Purchase of treasury stock.

(i) Issuance of bonds for land.

(j) Payment of dividends.

(k) Purchase of equipment.

(l) Cash payments for operating expenses.

18. Stan Conner and Mark Stein were discussing the presen-tation format of the statement of cash flows of BombeckCo. At the bottom of Bombeck’s statement of cash flowswas a separate section entitled “Noncash investing andfinancing activities.” Give three examples of significantnoncash transactions that would be reported in this section.

19. During 2010, Simms Company redeemed $2,000,000 ofbonds payable for $1,880,000 cash. Indicate how this trans-action would be reported on a statement of cash flows, ifat all.

20. What are some of the arguments in favor of using theindirect (reconciliation) method as opposed to the directmethod for reporting a statement of cash flows?

21. Why is it desirable to use a worksheet when preparinga statement of cash flows? Is a worksheet required toprepare a statement of cash flows?

22. Where can authoritative iGAAP related to the statementof cash flows be found?

23. Briefly describe some of the similarities and differencesbetween U.S. GAAP and iGAAP with respect to cash flowreporting.



Brief Exercises · 1287

24. Some believe that iGAAP provides too many choiceswithin its accounting guidance. Is this a possible concernin the area of cash flow reporting? Explain.

25. What are some of the key obstacles for the FASB and IASBin their convergence project for the statement of cashflows?

BE23-1 Wainwright Corporation had the following activities in 2010.

1. Sale of land $180,000 4. Purchase of equipment $415,0002. Purchase of inventory $845,000 5. Issuance of common stock $320,0003. Purchase of treasury stock $72,000 6. Purchase of available-for-sale securities $59,000

Compute the amount Wainwright should report as net cash provided (used) by investing activities in itsstatement of cash flows.

BE23-2 Stansfield Corporation had the following activities in 2010.

1. Payment of accounts payable $770,000 4. Collection of note receivable $100,0002. Issuance of common stock $250,000 5. Issuance of bonds payable $510,0003. Payment of dividends $350,000 6. Purchase of treasury stock $46,000

Compute the amount Stansfield should report as net cash provided (used) by financing activities in its2010 statement of cash flows.

BE23-3 Novak Corporation is preparing its 2010 statement of cash flows, using the indirect method. Pre-sented below is a list of items that may affect the statement. Using the code below, indicate how each itemwill affect Novak’s 2010 statement of cash flows.

Code Letter Effect

A Added to net income in the operating sectionD Deducted from net income in the operating sectionR-I Cash receipt in investing sectionP-I Cash payment in investing sectionR-F Cash receipt in financing sectionP-F Cash payment in financing sectionN Noncash investing and/or financing activity

Items____ (a) Purchase of land and building. ____ (j) Increase in accounts payable.____ (b) Decrease in accounts receivable. ____ (k) Decrease in accounts payable.____ (c) Issuance of stock. ____ (l) Loan from bank by signing note.____ (d) Depreciation expense. ____ (m) Purchase of equipment using a note.____ (e) Sale of land at book value. ____ (n) Increase in inventory.____ (f) Sale of land at a gain. ____ (o) Issuance of bonds.____ (g) Payment of dividends. ____ (p) Retirement of bonds payable.____ (h) Increase in accounts receivable. ____ (q) Sale of equipment at a loss.____ (i) Purchase of available-for-sale investment. ____ (r) Purchase of treasury stock.

BE23-4 Bloom Corporation had the following 2010 income statement.

Sales $200,000Cost of goods sold 120,000

Gross profit 80,000Operating expenses (includes depreciation

of $21,000) 50,000

Net income $ 30,000

The following accounts increased during 2010: accounts receivable $12,000; inventory $11,000; accountspayable $13,000. Prepare the cash flows from operating activities section of Bloom’s 2010 statement ofcash flows using the direct method.

BE23-5 Use the information from BE23-4 for Bloom Corporation. Prepare the cash flows from operatingactivities section of Bloom’s 2010 statement of cash flows using the indirect method.

BE23-6 At January 1, 2010, Eikenberry Inc. had accounts receivable of $72,000. At December 31, 2010,accounts receivable is $54,000. Sales for 2010 total $420,000. Compute Eikenberry’s 2010 cash receipts fromcustomers.

BRIEF EXERCISES

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BE23-7 Moxley Corporation had January 1 and December 31 balances as follows.

1/1/10 12/31/10

Inventory $95,000 $113,000Accounts payable 61,000 69,000

For 2010, cost of goods sold was $500,000. Compute Moxley’s 2010 cash payments to suppliers.

BE23-8 In 2010, Elbert Corporation had net cash provided by operating activities of $531,000; net cashused by investing activities of $963,000; and net cash provided by financing activities of $585,000. AtJanuary 1, 2010, the cash balance was $333,000. Compute December 31, 2010, cash.

BE23-9 Loveless Corporation had the following 2010 income statement.

Revenues $100,000Expenses 60,000

$ 40,000

In 2010, Loveless had the following activity in selected accounts.

Allowance forAccounts Receivable Doubtful Accounts

1/1/10 20,000 1,200 1/1/10Revenues 100,000 1,000 Write-offs Write-offs 1,000 1,840 Bad debt expense

90,000 Collections

12/31/10 29,000 2,040 12/31/10

Prepare Loveless’s cash flows from operating activities section of the statement of cash flows using (a)the direct method and (b) the indirect method.

BE23-10 Hendrickson Corporation reported net income of $50,000 in 2010. Depreciation expense was$17,000. The following working capital accounts changed.

Accounts receivable $11,000 increaseAvailable-for-sale securities 16,000 increaseInventory 7,400 increaseNontrade note payable 15,000 decreaseAccounts payable 12,300 increase

Compute net cash provided by operating activities.

BE23-11 In 2010, Wild Corporation reported a net loss of $70,000. Wild’s only net income adjustmentswere depreciation expense $81,000, and increase in accounts receivable $8,100. Compute Wild’s net cashprovided (used) by operating activities.

BE23-12 In 2010, Leppard Inc. issued 1,000 shares of $10 par value common stock for land worth $40,000.

(a) Prepare Leppard’s journal entry to record the transaction.(b) Indicate the effect the transaction has on cash.(c) Indicate how the transaction is reported on the statement of cash flows.

BE23-13 Indicate in general journal form how the items below would be entered in a worksheet for thepreparation of the statement of cash flows.

(a) Net income is $317,000.(b) Cash dividends declared and paid totaled $120,000.(c) Equipment was purchased for $114,000.(d) Equipment that originally cost $40,000 and had accumulated depreciation of $32,000 was sold for

$10,000.

E23-1 (Classification of Transactions) Springsteen Co. had the following activity in its most recentyear of operations.

(a) Pension expense exceeds amount funded. (e) Exchange of equipment for furniture.(b) Redemption of bonds payable. (f) Issuance of capital stock.(c) Sale of building at book value. (g) Amortization of intangible assets.(d) Depreciation. (h) Purchase of treasury stock.

EXERCISES

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Exercises · 1289

(i) Issuance of bonds for land. (k) Increase in interest receivable on notes receivable.(j) Payment of dividends. (l) Purchase of equipment.

InstructionsClassify the items as (1) operating—add to net income; (2) operating—deduct from net income; (3) invest-ing; (4) financing; or (5) significant noncash investing and financing activities. Use the indirect method.

E23-2 (Statement Presentation of Transactions—Indirect Method) Each of the following items mustbe considered in preparing a statement of cash flows (indirect method) for Granderson Inc. for the yearended December 31, 2010.

(a) Plant assets that had cost $25,000 6 years before and were being depreciated on a straight-line ba-sis over 10 years with no estimated scrap value were sold at the beginning of the year for $5,300.

(b) During the year, 10,000 shares of common stock with a stated value of $10 a share were issued for$33 a share.

(c) Uncollectible accounts receivable in the amount of $27,000 were written off against the Allowancefor Doubtful Accounts.

(d) The company sustained a net loss for the year of $50,000. Depreciation amounted to $22,000, anda gain of $9,000 was realized on the sale of land for $39,000 cash.

(e) A 3-month U.S. Treasury bill was purchased for $100,000. The company uses a cash and cash-equivalent basis for its cash flow statement.

(f) Patent amortization for the year was $20,000.(g) The company exchanged common stock for a 70% interest in Plumlee Co. for $900,000.(h) During the year, treasury stock costing $47,000 was purchased.

InstructionsState where each item is to be shown in the statement of cash flows, if at all.

E23-3 (Preparation of Operating Activities Section—Indirect Method, Periodic Inventory) The in-come statement of Rodriquez Company is shown below.

RODRIQUEZ COMPANYINCOME STATEMENT


Sales $6,900,000Cost of goods sold

Beginning inventory $1,900,000Purchases 4,400,000

Goods available for sale 6,300,000Ending inventory 1,600,000

Cost of goods sold 4,700,000

Gross profit 2,200,000Operating expenses

Selling expenses 450,000Administrative expenses 700,000 1,150,000

Net income $1,050,000

Additional information:

1. Accounts receivable decreased $310,000 during the year.2. Prepaid expenses increased $170,000 during the year.3. Accounts payable to suppliers of merchandise decreased $275,000 during the year.4. Accrued expenses payable decreased $120,000 during the year.5. Administrative expenses include depreciation expense of $60,000.

InstructionsPrepare the operating activities section of the statement of cash flows for the year ended December 31,2010, for Rodriquez Company, using the indirect method.

E23-4 (Preparation of Operating Activities Section—Direct Method) Data for the Rodriquez Companyare presented in E23-3.

InstructionsPrepare the operating activities section of the statement of cash flows using the direct method.

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E23-5 (Preparation of Operating Activities Section—Direct Method) Norman Company’s incomestatement for the year ended December 31, 2010, contained the following condensed information.

Revenue from fees $840,000Operating expenses (excluding depreciation) $624,000Depreciation expense 60,000Loss on sale of equipment 26,000 710,000


Net income $ 90,000

Norman’s balance sheet contained the following comparative data at December 31.

2010 2009

Accounts receivable $37,000 $59,000Accounts payable 46,000 31,000Income taxes payable 4,000 8,500

(Accounts payable pertains to operating expenses.)

InstructionsPrepare the operating activities section of the statement of cash flows using the direct method.

E23-6 (Preparation of Operating Activities Section—Indirect Method) Data for Norman Companyare presented in E23-5.

InstructionsPrepare the operating activities section of the statement of cash flows using the indirect method.

E23-7 (Computation of Operating Activities—Direct Method) Presented below are two independentsituations.

Situation A:Chenowith Co. reports revenues of $200,000 and operating expenses of $110,000 in its first year ofoperations, 2010. Accounts receivable and accounts payable at year-end were $71,000 and $39,000,respectively. Assume that the accounts payable related to operating expenses. Ignore income taxes.

InstructionsUsing the direct method, compute net cash provided (used) by operating activities.

Situation B:The income statement for Edgebrook Company shows cost of goods sold $310,000 and operating expenses(exclusive of depreciation) $230,000. The comparative balance sheet for the year shows that inventory in-creased $21,000, prepaid expenses decreased $8,000, accounts payable (related to merchandise) decreased$17,000, and accrued expenses payable increased $11,000.

InstructionsCompute (a) cash payments to suppliers and (b) cash payments for operating expenses.

E23-8 (Schedule of Net Cash Flow from Operating Activities—Indirect Method) Messner Co. re-ported $145,000 of net income for 2010. The accountant, in preparing the statement of cash flows, notedseveral items occurring during 2010 that might affect cash flows from operating activities. These itemsare listed below and on page 1291.

1. Messner purchased 100 shares of treasury stock at a cost of $20 per share. These shares were thenresold at $25 per share.

2. Messner sold 100 shares of IBM common at $200 per share. The acquisition cost of these shareswas $165 per share. This investment was shown on Messner’s December 31, 2009, balance sheetas an available-for-sale security.

3. Messner revised its estimate for bad debts. Before 2010, Messner’s bad debt expense was 1% of itsnet sales. In 2010, this percentage was increased to 2%. Net sales for 2010 were $500,000, and netaccounts receivable decreased by $12,000 during 2010.

4. Messner issued 500 shares of its $10 par common stock for a patent. The market value of the shareson the date of the transaction was $23 per share.

5. Depreciation expense is $39,000.6. Messner Co. holds 30% of the Sanchez Company’s common stock as a long-term investment.

Sanchez Company reported $27,000 of net income for 2010.

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Exercises · 1291

7. Sanchez Company paid a total of $2,000 of cash dividends to all investees in 2010.8. Messner declared a 10% stock dividend. One thousand shares of $10 par common stock were dis-

tributed. The market price at date of issuance was $20 per share.

InstructionsPrepare a schedule that shows the net cash flow from operating activities using the indirect method.Assume no items other than those listed above affected the computation of 2010 net cash flow fromoperating activities.

E23-9 (SCF—Direct Method) Waubansee Corp. uses the direct method to prepare its statement of cashflows. Waubansee’s trial balances at December 31, 2010 and 2009, are as follows.

December 31

2010 2009

Debits

Cash $ 35,000 $ 32,000Accounts receivable 33,000 30,000Inventory 31,000 47,000Property, plant, & equipment 100,000 95,000Unamortized bond discount 4,500 5,000Cost of goods sold 250,000 380,000Selling expenses 141,500 172,000General and administrative expenses 137,000 151,300Interest expense 4,300 2,600Income tax expense 20,400 61,200

$756,700 $976,100

Credits

Allowance for doubtful accounts $ 1,300 $ 1,100Accumulated depreciation 16,500 13,500Trade accounts payable 25,000 17,000Income taxes payable 21,000 29,100Deferred income taxes 5,300 4,6008% callable bonds payable 45,000 20,000Common stock 50,000 40,000Additional paid-in capital 9,100 7,500Retained earnings 44,700 64,600Sales 538,800 778,700

$756,700 $976,100


1. Waubansee purchased $5,000 in equipment during 2010.2. Waubansee allocated one-third of its depreciation expense to selling expenses and the remainder

to general and administrative expenses.3. Bad debt expense for 2010 was $5,000, and writeoffs of uncollectible accounts totaled $3,800.

InstructionsDetermine what amounts Waubansee should report in its statement of cash flows for the year endedDecember 31, 2010, for the following items.

1. Cash collected from customers. 4. Cash paid for income taxes.2. Cash paid to suppliers. 5. Cash paid for selling expenses.3. Cash paid for interest.

E23-10 (Classification of Transactions) Following are selected balance sheet accounts of Sander Bros.Corp. at December 31, 2010 and 2009, and the increases or decreases in each account from 2009 to 2010.Also presented is selected income statement information for the year ended December 31, 2010, andadditional information.

IncreaseSelected balance sheet accounts 2010 2009 (Decrease)

Assets

Accounts receivable $ 34,000 $ 24,000 $ 10,000Property, plant, and equipment 277,000 247,000 30,000Accumulated depreciation (178,000) (167,000) (11,000)

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2010 2009 Increase

Liabilities and stockholders’ equity

Bonds payable $ 49,000 $46,000 $ 3,000 Dividends payable 8,000 5,000 3,000 Common stock, $1 par 22,000 19,000 3,000 Additional paid-in capital 9,000 3,000 6,000 Retained earnings 104,000 91,000 13,000

Selected income statement information for the year ended December 31, 2010

Sales revenue $155,000 Depreciation 38,000 Gain on sale of equipment 14,500 Net income 31,000


1. During 2010, equipment costing $45,000 was sold for cash.2. Accounts receivable relate to sales of merchandise.3. During 2010, $25,000 of bonds payable were issued in exchange for property, plant, and equip-

ment. There was no amortization of bond discount or premium.

InstructionsDetermine the category (operating, investing, or financing) and the amount that should be reported inthe statement of cash flows for the following items.

1. Payments for purchase of property, plant, and equipment.2. Proceeds from the sale of equipment.3. Cash dividends paid.4. Redemption of bonds payable.

E23-11 (SCF—Indirect Method) Condensed financial data of Fairchild Company for 2010 and 2009 arepresented below.

FAIRCHILD COMPANYCOMPARATIVE BALANCE SHEET

AS OF DECEMBER 31, 2010 AND 2009

2011 2010

Cash $1,800 $1,100 Receivables 1,750 1,300 Inventory 1,600 1,900 Plant assets 1,900 1,700 Accumulated depreciation (1,200) (1,170)Long-term investments (Held-to-maturity) 1,300 1,470

$7,150 $6,300

Accounts payable $1,200 $ 800 Accrued liabilities 200 250 Bonds payable 1,400 1,650 Capital stock 1,900 1,700 Retained earnings 2,450 1,900

$7,150 $6,300

FAIRCHILD COMPANYINCOME STATEMENT



Gross margin 2,200Selling and administrative expense 930

Income from operations 1,270Other revenues and gains

Gain on sale of investments 80

Income before tax 1,350Income tax expense 540

Net income $ 810

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Exercises · 1293


During the year, $70 of common stock was issued in exchange for plant assets. No plant assets were soldin 2010. Cash dividends were $260.

InstructionsPrepare a statement of cash flows using the indirect method.

E23-12 (SCF—Direct Method) Data for Fairchild Company are presented in E23-11.

InstructionsPrepare a statement of cash flows using the direct method. (Do not prepare a reconciliation schedule.)

E23-13 (SCF—Direct Method) Andrews Inc., a greeting card company, had the following statementsprepared as of December 31, 2010.

ANDREWS INC.COMPARATIVE BALANCE SHEET


12/31/10 12/31/09

Cash $ 6,000 $ 9,000 Accounts receivable 62,000 49,000 Short-term investments (Available-for-sale) 35,000 18,000 Inventories 40,000 60,000 Prepaid rent 5,000 4,000 Printing equipment 154,000 130,000 Accumulated depr.—equipment (35,000) (25,000)Copyrights 46,000 50,000

Total assets $313,000 $295,000

Accounts payable $ 46,000 $ 42,000 Income taxes payable 4,000 6,000 Wages payable 8,000 4,000 Short-term loans payable 8,000 10,000 Long-term loans payable 60,000 67,000 Common stock, $10 par 100,000 100,000 Contributed capital, common stock 30,000 30,000 Retained earnings 57,000 36,000

Total liabilities & stockholders’ equity $313,000 $295,000

ANDREWS INC.INCOME STATEMENT

FOR THE YEAR ENDING DECEMBER 31, 2010


Gross margin 163,150Operating expenses 120,000

Operating income 43,150Interest expense $11,400Gain on sale of equipment 2,000 9,400

Income before tax 33,750Income tax expense 6,750

Net income $ 27,000


1. Dividends in the amount of $6,000 were declared and paid during 2010.2. Depreciation expense and amortization expense are included in operating expenses.3. No unrealized gains or losses have occurred on the investments during the year.4. Equipment that had a cost of $30,000 and was 70% depreciated was sold during 2010.

InstructionsPrepare a statement of cash flows using the direct method. (Do not prepare a reconciliation schedule.)

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E23-14 (SCF—Indirect Method) Data for Andrews Inc. are presented in E23-13.

InstructionsPrepare a statement of cash flows using the indirect method.

E23-15 (SCF—Indirect Method) Presented below are data taken from the records of MorgansternCompany.

December 31, December 31,2010 2009

Cash $ 15,000 $ 10,000Current assets other than cash 85,000 58,000Long-term investments 10,000 53,000Plant assets 335,000 215,000

$445,000 $336,000

Accumulated depreciation $ 20,000 $ 40,000Current liabilities 40,000 22,000Bonds payable 75,000 –0– Capital stock 254,000 254,000Retained earnings 56,000 20,000

$445,000 $336,000


1. Held-to-maturity securities carried at a cost of $43,000 on December 31, 2009, were sold in 2010 for$34,000. The loss (not extraordinary) was incorrectly charged directly to Retained Earnings.

2. Plant assets that cost $60,000 and were 80% depreciated were sold during 2010 for $8,000. The loss(not extraordinary) was incorrectly charged directly to Retained Earnings.

3. Net income as reported on the income statement for the year was $59,000.4. Dividends paid amounted to $10,000.5. Depreciation charged for the year was $28,000.

InstructionsPrepare a statement of cash flows for the year 2010 using the indirect method.

E23-16 (Cash Provided by Operating, Investing, and Financing Activities) The balance sheet data ofWyeth Company at the end of 2010 and 2009 follow.

2010 2009

Cash $ 30,000 $ 35,000 Accounts receivable (net) 55,000 45,000 Merchandise inventory 65,000 45,000 Prepaid expenses 15,000 25,000 Equipment 90,000 75,000 Accumulated depreciation—equipment (18,000) (8,000)Land 70,000 40,000

$307,000 $257,000

Accounts payable $ 65,000 $ 52,000 Accrued expenses 15,000 18,000 Notes payable—bank, long-term –0– 23,000 Bonds payable 30,000 –0–Common stock, $10 par 189,000 159,000 Retained earnings 8,000 5,000

$307,000 $257,000

Land was acquired for $30,000 in exchange for common stock, par $30,000, during the year; all equip-ment purchased was for cash. Equipment costing $13,000 was sold for $3,000; book value of the equip-ment was $6,000. Cash dividends of $9,000 were declared and paid during the year.

InstructionsCompute net cash provided (used) by:

(a) Operating activities.(b) Investing activities.(c) Financing activities.

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Exercises · 1295

E23-17 (SCF—Indirect Method and Balance Sheet) Ochoa Inc., had the following condensed balancesheet at the end of operations for 2009.

OCHOA INC.BALANCE SHEET

DECEMBER 31, 2009

Cash $ 8,500 Current liabilities $ 15,000Current assets other than cash 29,000 Long-term notes payable 25,500Investments 20,000 Bonds payable 25,000Plant assets (net) 67,500 Capital stock 75,000Land 40,000 Retained earnings 24,500

$165,000 $165,000

During 2010 the following occurred.

1. A tract of land was purchased for $11,000.2. Bonds payable in the amount of $20,000 were retired at par.3. An additional $10,000 in capital stock was issued at par.4. Dividends totaling $9,375 were paid to stockholders.5. Net income was $30,250 after deducting depreciation of $13,500.6. Land was purchased through the issuance of $22,500 in bonds.7. Ochoa Inc. sold part of its investment portfolio for $12,875. This transaction resulted in a gain of

$2,000 for the company. The company classifies the investments as available-for-sale.8. Both current assets (other than cash) and current liabilities remained at the same amount.

Instructions(a) Prepare a statement of cash flows for 2010 using the indirect method.(b) Prepare the condensed balance sheet for Ochoa Inc. as it would appear at December 31, 2010.

E23-18 (Partial SCF—Indirect Method) The accounts below appear in the ledger of Popovich Company.

Retained Earnings Dr. Cr. Bal.

Jan. 1, 2010 Credit Balance $ 42,000Aug. 15 Dividends (cash) $15,000 27,000Dec. 31 Net Income for 2010 $50,000 77,000

Machinery Dr. Cr. Bal.

Jan. 1, 2010 Debit Balance $140,000Aug. 3 Purchase of Machinery $62,000 202,000Sept. 10 Cost of Machinery Constructed 48,000 250,000Nov. 15 Machinery Sold $66,000 184,000

Accumulated Depreciation—Machinery Dr. Cr. Bal.

Jan. 1, 2010 Credit Balance $ 84,000Apr. 8 Extraordinary Repairs $21,000 63,000Nov. 15 Accum. Depreciation on

Machinery Sold 25,200 37,800Dec. 31 Depreciation for 2010 $16,800 54,600

InstructionsFrom the postings in the accounts above, indicate how the information is reported on a statement of cashflows by preparing a partial statement of cash flows using the indirect method. The loss on sale of equip-ment (November 15) was $5,800.

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E23-19 (Worksheet Analysis of Selected Accounts) Data for Popovich Company are presented inE23-18.

InstructionsPrepare entries in journal form for all adjustments that should be made on a worksheet for a statementof cash flows.

E23-20 (Worksheet Analysis of Selected Transactions) The transactions below took place during theyear 2010.

1. Convertible bonds payable with a par value of $300,000 were exchanged for unissued commonstock with a par value of $300,000. The market price of both types of securities was par.

2. The net income for the year was $360,000.3. Depreciation expense for the building was $90,000.4. Some old office equipment was traded in on the purchase of some newer office equipment and the

following entry was made. (The exchange has commercial substance.)

Office Equipment 45,000Accum. Depreciation—Office Equipment 30,000

Office Equipment 40,000Cash 34,000Gain on Disposal of Plant Assets 1,000

The Gain on Disposal of Plant Assets was credited to current operations as ordinary income.5. Dividends in the amount of $123,000 were declared. They are payable in January of next year.

InstructionsShow by journal entries the adjustments that would be made on a worksheet for a statement of cashflows.

E23-21 (Worksheet Preparation) Below is the comparative balance sheet for LowensteinCorporation.

Dec. 31, Dec. 31,2010 2009

Cash $ 16,500 $ 24,000 Short-term investments 25,000 19,000 Accounts receivable 43,000 45,000 Allowance for doubtful accounts (1,800) (2,000)Prepaid expenses 4,200 2,500 Inventories 81,500 57,000 Land 50,000 50,000 Buildings 125,000 78,500 Accumulated depreciation—buildings (30,000) (23,000)Equipment 53,000 46,000 Accumulated depreciation—equipment (19,000) (15,500)Delivery equipment 39,000 39,000 Accumulated depreciation—delivery equipment (22,000) (20,500)Patents 15,000 –0–

$379,400 $300,000

Accounts payable $ 26,000 $ 16,000Short-term notes payable (trade) 4,000 6,000Accrued payables 3,000 4,600Mortgage payable 73,000 53,400Bonds payable 50,000 62,500Capital stock 140,000 102,000Additional paid-in capital 10,000 4,000Retained earnings 73,400 51,500

$379,400 $300,000

Dividends in the amount of $10,000 were declared and paid in 2010.

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Problems · 1297

InstructionsFrom this information, prepare a worksheet for a statement of cash flows. Make reasonable assumptionsas appropriate. The short-term investments are considered available-for-sale, and no unrealized gains orlosses have occurred on these securities.

See the book’s companion website, www.wiley.com/college/kieso, for a set of B Exercises.

w

iley.com/col

leg

e/k

ieso

P23-1 (SCF—Indirect Method) The following is Sullivan Corp.’s comparative balance sheet accountsat December 31, 2010 and 2009, with a column showing the increase (decrease) from 2009 to 2010.

COMPARATIVE BALANCE SHEETS

Increase2010 2009 (Decrease)

Cash $ 815,000 $ 700,000 $115,000 Accounts receivable 1,128,000 1,168,000 (40,000)Inventories 1,850,000 1,715,000 135,000 Property, plant and equipment 3,307,000 2,967,000 340,000 Accumulated depreciation (1,165,000) (1,040,000) (125,000)Investment in Myers Co. 310,000 275,000 35,000 Loan receivable 250,000 — 250,000

Total assets $6,495,000 $5,785,000 $710,000

Accounts payable $1,015,000 $ 955,000 $ 60,000 Income taxes payable 30,000 50,000 (20,000)Dividends payable 80,000 100,000 (20,000)Capital lease obligation 400,000 — 400,000 Capital stock, common, $1 par 500,000 500,000 — Additional paid-in capital 1,500,000 1,500,000 — Retained earnings 2,970,000 2,680,000 290,000

Total liabilities and stockholders’ equity $6,495,000 $5,785,000 $710,000


1. On December 31, 2009, Sullivan acquired 25% of Myers Co.’s common stock for $275,000. On thatdate, the carrying value of Myers’s assets and liabilities, which approximated their fair values, was$1,100,000. Myers reported income of $140,000 for the year ended December 31, 2010. No dividendwas paid on Myers’s common stock during the year.

2. During 2010, Sullivan loaned $300,000 to TLC Co., an unrelated company. TLC made the first semi-annual principal repayment of $50,000, plus interest at 10%, on December 31, 2010.

3. On January 2, 2010, Sullivan sold equipment costing $60,000, with a carrying amount of $38,000, for$40,000 cash.

4. On December 31, 2010, Sullivan entered into a capital lease for an office building. The present valueof the annual rental payments is $400,000, which equals the fair value of the building. Sullivanmade the first rental payment of $60,000 when due on January 2, 2011.

5. Net income for 2010 was $370,000.6. Sullivan declared and paid cash dividends for 2010 and 2009 as shown below.

2010 2009

Declared December 15, 2010 December 15, 2009Paid February 28, 2011 February 28, 2010Amount $80,000 $100,000

PROBLEMS

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InstructionsPrepare a statement of cash flows for Sullivan Corp. for the year ended December 31, 2010, using theindirect method.

(AICPA adapted)

P23-2 (SCF—Indirect Method) The comparative balance sheets for Hinckley Corporation show the fol-lowing information.

December 31

2010 2009

Cash $ 33,500 $13,000Accounts receivable 12,250 10,000Inventory 12,000 9,000Investments –0– 3,000Building –0– 29,750Equipment 45,000 20,000Patent 5,000 6,250

$107,750 $91,000

Allowance for doubtful accounts $ 3,000 $ 4,500Accumulated depreciation on equipment 2,000 4,500Accumulated depreciation on building –0– 6,000Accounts payable 5,000 3,000Dividends payable –0– 5,000Notes payable, short-term (nontrade) 3,000 4,000Long-term notes payable 31,000 25,000Common stock 43,000 33,000Retained earnings 20,750 6,000

$107,750 $91,000

Additional data related to 2010 are as follows.

1. Equipment that had cost $11,000 and was 40% depreciated at time of disposal was sold for $2,500.2. $10,000 of the long-term note payable was paid by issuing common stock.3. Cash dividends paid were $5,000.4. On January 1, 2010, the building was completely destroyed by a flood. Insurance proceeds on the

building were $30,000 (net of $2,000 taxes).5. Investments (available-for-sale) were sold at $1,700 above their cost. The company has made sim-

ilar sales and investments in the past.6. Cash was paid for the acquisition of equipment.7. A long-term note for $16,000 was issued for the acquisition of equipment.8. Interest of $2,000 and income taxes of $6,500 were paid in cash.

InstructionsPrepare a statement of cash flows using the indirect method. Flood damage is unusual and infrequent inthat part of the country.

P23-3 (SCF—Direct Method) Mortonson Company has not yet prepared a formal statement of cashflows for the 2010 fiscal year. Comparative balance sheets as of December 31, 2009 and 2010, and a state-ment of income and retained earnings for the year ended December 31, 2010, are presented below.

MORTONSON COMPANYSTATEMENT OF INCOME AND RETAINED EARNINGS

FOR THE YEAR ENDED DECEMBER 31, 2010($000 OMITTED)

Sales $3,800Expenses

Cost of goods sold $1,200Salaries and benefits 725Heat, light, and power 75Depreciation 80Property taxes 19Patent amortization 25Miscellaneous expenses 10Interest 30 2,164

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MORTONSON COMPANYSTATEMENT OF INCOME AND RETAINED EARNINGS

FOR THE YEAR ENDED DECEMBER 31, 2010(CONTINUED)

Income before income taxes 1,636Income taxes 818

Net income 818Retained earnings—Jan. 1, 2010 310

1,128Stock dividend declared and issued 600

Retained earnings—Dec. 31, 2010 $ 528

MORTONSON COMPANYCOMPARATIVE BALANCE SHEETS

AS OF DECEMBER 31($000 OMITTED)

Assets 2010 2009

Current assetsCash $ 333 $ 100 U.S. Treasury notes (Available-for-sale) 10 50 Accounts receivable 780 500 Inventory 720 560

Total current assets 1,843 1,210

Long-term assetsLand 150 70 Buildings and equipment 910 600 Accumulated depreciation (200) (120)Patents (less amortization) 105 130

Total long-term assets 965 680

Total assets $2,808 $1,890

Liabilities and Stockholders’ EquityCurrent liabilities

Accounts payable $ 420 $ 330 Income taxes payable 40 30 Notes payable 320 320

Total current liabilities 780 680 Long-term notes payable—due 2012 200 200

Total liabilities 980 880

Stockholders’ equityCommon stock 1,300 700 Retained earnings 528 310

Total stockholders’ equity 1,828 1,010

Total liabilities and stockholders’ equity $2,808 $1,890

InstructionsPrepare a statement of cash flows using the direct method. Changes in accounts receivable and accountspayable relate to sales and cost of goods sold. Do not prepare a reconciliation schedule.

(CMA adapted)

P23-4 (SCF—Direct Method) Michaels Company had available at the end of 2010 the information onpage 1300.

Problems · 1299

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MICHAELS COMPANYCOMPARATIVE BALANCE SHEETS


2010 2009

Cash $ 10,000 $ 4,000 Accounts receivable 20,500 12,950 Short-term investments 22,000 30,000 Inventory 42,000 35,000 Prepaid rent 3,000 12,000 Prepaid insurance 2,100 900 Office supplies 1,000 750 Land 125,000 175,000 Building 350,000 350,000 Accumulated depreciation (105,000) (87,500)Equipment 525,000 400,000 Accumulated depreciation (130,000) (112,000)Patent 45,000 50,000

Total assets $910,600 $871,100

Accounts payable $ 22,000 $ 32,000 Income taxes payable 5,000 4,000 Wages payable 5,000 3,000 Short-term notes payable 10,000 10,000 Long-term notes payable 60,000 70,000 Bonds payable 400,000 400,000 Premium on bonds payable 20,303 25,853 Common stock 240,000 220,000 Paid-in capital in excess of par 25,000 17,500 Retained earnings 123,297 88,747

Total liabilities and stockholders’ equity $910,600 $871,100

MICHAELS COMPANYINCOME STATEMENT


Sales revenue $1,160,000 Cost of goods sold (748,000)

412,000Gross marginOperating expenses

Selling expenses $ 79,200 Administrative expenses 156,700 Depreciation/Amortization expense 40,500

Total operating expenses (276,400)

Income from operations 135,600 Other revenues/expenses

Gain on sale of land 8,000 Gain on sale of short-term investment 4,000 Dividend revenue 2,400 Interest expense (51,750) (37,350)

Income before taxes 98,250 Income tax expense (39,400)

Net income 58,850 Dividends to common stockholders (24,300)

To retained earnings $ 34,550

InstructionsPrepare a statement of cash flows for Michaels Company using the direct method accompanied by a rec-onciliation schedule. Assume the short-term investments are available-for-sale securities.

P23-5 (SCF—Indirect Method) You have completed the field work in connection with your audit ofAlexander Corporation for the year ended December 31, 2010. The balance sheet accounts at the begin-ning and end of the year are shown on the next page.

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Problems · 1301

IncreaseDec. 31, Dec. 31, or

2010 2009 (Decrease)

Cash $ 277,900 $ 298,000 ($20,100)Accounts receivable 469,424 353,000 116,424 Inventory 741,700 610,000 131,700 Prepaid expenses 12,000 8,000 4,000 Investment in subsidiary 110,500 –0– 110,500 Cash surrender value of life insurance 2,304 1,800 504 Machinery 207,000 190,000 17,000 Buildings 535,200 407,900 127,300 Land 52,500 52,500 –0–Patents 69,000 64,000 5,000 Copyright 40,000 50,000 (10,000)Bond discount and issue cost 4,502 –0– 4,502

$2,522,030 $2,035,200 $486,830

Accrued taxes payable $ 90,250 $ 79,600 $ 10,650 Accounts payable 299,280 280,000 19,280 Dividends payable 70,000 –0– 70,000 Bonds payable—8% 125,000 –0– 125,000 Bonds payable—12% –0– 100,000 (100,000)Allowance for doubtful accounts 35,300 40,000 (4,700)Accumulated depreciation—buildings 424,000 400,000 24,000 Accumulated depreciation—machinery 173,000 130,000 43,000 Premium on bonds payable –0– 2,400 (2,400)Capital stock—no par 1,176,200 1,453,200 (277,000)Additional paid-in capital 109,000 –0– 109,000 Retained earnings—unappropriated 20,000 (450,000) 470,000

$2,522,030 $2,035,200 $486,830

STATEMENT OF RETAINED EARNINGSFOR THE YEAR ENDED DECEMBER 31, 2010

January 1, 2010 Balance (deficit) $(450,000)March 31, 2010 Net income for first quarter of 2010 25,000 April 1, 2010 Transfer from paid-in capital 425,000

Balance –0– December 31, 2010 Net income for last three quarters of 2010 90,000

Dividend declared—payable January 21, 2011 (70,000)

Balance $ 20,000

Your working papers from the audit contain the following information:

1. On April 1, 2010, the existing deficit was written off against paid-in capital created by reducingthe stated value of the no-par stock.

2. On November 1, 2010, 29,600 shares of no-par stock were sold for $257,000. The board of directorsvoted to regard $5 per share as stated capital.

3. A patent was purchased for $15,000.4. During the year, machinery that had a cost basis of $16,400 and on which there was accumulated

depreciation of $5,200 was sold for $9,000. No other plant assets were sold during the year.5. The 12%, 20-year bonds were dated and issued on January 2, 1998. Interest was payable on June 30

and December 31. They were sold originally at 106. These bonds were retired at 100.9 plus accruedinterest on March 31, 2010.

6. The 8%, 40-year bonds were dated January 1, 2010, and were sold on March 31 at 97 plus accruedinterest. Interest is payable semiannually on June 30 and December 31. Expense of issuance was $839.

7. Alexander Corporation acquired 70% control in Crimson Company on January 2, 2010, for $100,000.The income statement of Crimson Company for 2010 shows a net income of $15,000.

8. Extraordinary repairs to buildings of $7,200 were charged to Accumulated Depreciation—Buildings.9. Interest paid in 2010 was $10,500 and income taxes paid were $34,000.




InstructionsFrom the information given, prepare a statement of cash flows using the indirect method. A worksheet isnot necessary, but the principal computations should be supported by schedules or skeleton ledgeraccounts. The company uses straight-line amortization for bond interest.

P23-6 (SCF—Indirect Method, and Net Cash Flow from Operating Activities, Direct Method) Com-parative balance sheet accounts of Marcus Inc. are presented below.

MARCUS INC.COMPARATIVE BALANCE SHEET ACCOUNTS


December 31

Debit Accounts 2010 2009

Cash $ 42,000 $ 33,750Accounts Receivable 70,500 60,000Merchandise Inventory 30,000 24,000Investments (available-for-sale) 22,250 38,500Machinery 30,000 18,750Buildings 67,500 56,250Land 7,500 7,500

$269,750 $238,750

Credit AccountsAllowance for Doubtful Accounts $ 2,250 $ 1,500Accumulated Depreciation—Machinery 5,625 2,250Accumulated Depreciation—Buildings 13,500 9,000Accounts Payable 35,000 24,750Accrued Payables 3,375 2,625Long-Term Note Payable 21,000 31,000Common Stock, no par 150,000 125,000Retained Earnings 39,000 42,625

$269,750 $238,750

Additional data (ignoring taxes):

1. Net income for the year was $42,500.2. Cash dividends declared and paid during the year were $21,125.3. A 20% stock dividend was declared during the year. $25,000 of retained earnings was capitalized.4. Investments that cost $25,000 were sold during the year for $28,750.5. Machinery that cost $3,750, on which $750 of depreciation had accumulated, was sold for $2,200.

Marcus’s 2010 income statement follows (ignoring taxes).

Sales $540,000Less: Cost of goods sold 380,000

Gross margin 160,000Less: Operating expenses (includes $8,625 depreciation and $5,400

bad debts) 120,450

Income from operations 39,550Other: Gain on sale of investments $3,750

Loss on sale of machinery (800) 2,950

Net income $ 42,500

Instructions(a) Compute net cash flow from operating activities using the direct method.(b) Prepare a statement of cash flows using the indirect method.

P23-7 (SCF—Direct and Indirect Methods from Comparative Financial Statements) ChapmanCompany, a major retailer of bicycles and accessories, operates several stores and is a publicly tradedcompany. The comparative statement of financial position and income statement for Chapman as ofMay 31, 2010, are shown on the next page. The company is preparing its statement of cash flows.

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Problems · 1303

CHAPMAN COMPANYCOMPARATIVE STATEMENT OF FINANCIAL POSITION

AS OF MAY 31

2010 2009

Current assetsCash $ 28,250 $ 20,000Accounts receivable 75,000 58,000Merchandise inventory 220,000 250,000Prepaid expenses 9,000 7,000

Total current assets 332,250 335,000

Plant assetsPlant assets 600,000 502,000Less: Accumulated depreciation 150,000 125,000

Net plant assets 450,000 377,000

Total assets $782,250 $712,000

Current liabilitiesAccounts payable $123,000 $115,000Salaries payable 47,250 72,000Interest payable 27,000 25,000

Total current liabilities 197,250 212,000

Long-term debtBonds payable 70,000 100,000

Total liabilities 267,250 312,000

Shareholders’ equityCommon stock, $10 par 370,000 280,000Retained earnings 145,000 120,000

Total shareholders’ equity 515,000 400,000

Total liabilities and shareholders’ equity $782,250 $712,000

CHAPMAN COMPANYINCOME STATEMENT

FOR THE YEAR ENDED MAY 31, 2010

Sales $1,255,250Cost of merchandise sold 722,000

Gross profit 533,250

ExpensesSalary expense 252,100Interest expense 75,000Other expenses 8,150Depreciation expense 25,000

Total expenses 360,250

Operating income 173,000Income tax expense 43,000

Net income $ 130,000

The following is additional information concerning Chapman’s transactions during the year endedMay 31, 2010.

1. All sales during the year were made on account.2. All merchandise was purchased on account, comprising the total accounts payable account.3. Plant assets costing $98,000 were purchased by paying $28,000 in cash and issuing 7,000 shares of

stock.4. The “other expenses” are related to prepaid items.5. All income taxes incurred during the year were paid during the year.6. In order to supplement its cash, Chapman issued 2,000 shares of common stock at par value.7. There were no penalties assessed for the retirement of bonds.8. Cash dividends of $105,000 were declared and paid at the end of the fiscal year.




Instructions(a) Compare and contrast the direct method and the indirect method for reporting cash flows from

operating activities.(b) Prepare a statement of cash flows for Chapman Company for the year ended May 31, 2010, using

the direct method. Be sure to support the statement with appropriate calculations. (A reconcilia-tion of net income to net cash provided is not required.)

(c) Using the indirect method, calculate only the net cash flow from operating activities for ChapmanCompany for the year ended May 31, 2010.

P23-8 (SCF—Direct and Indirect Methods) Comparative balance sheet accounts of Sharpe Companyare presented below.

SHARPE COMPANYCOMPARATIVE BALANCE SHEET ACCOUNTS

AS OF DECEMBER 31

Debit Balances 2010 2009

Cash $ 70,000 $ 51,000Accounts Receivable 155,000 130,000Merchandise Inventory 75,000 61,000Investments (Available-for-sale) 55,000 85,000Equipment 70,000 48,000Buildings 145,000 145,000Land 40,000 25,000

Totals $610,000 $545,000

Credit Balances

Allowance for Doubtful Accounts $ 10,000 $ 8,000Accumulated Depreciation—Equipment 21,000 14,000Accumulated Depreciation—Building 37,000 28,000Accounts Payable 66,000 60,000Income Taxes Payable 12,000 10,000Long-Term Notes Payable 62,000 70,000Common Stock 310,000 260,000Retained Earnings 92,000 95,000

Totals $610,000 $545,000

Additional data:

1. Equipment that cost $10,000 and was 60% depreciated was sold in 2010.2. Cash dividends were declared and paid during the year.3. Common stock was issued in exchange for land.4. Investments that cost $35,000 were sold during the year.5. There were no write-offs of uncollectible accounts during the year.

Sharpe’s 2010 income statement is as follows.

Sales $950,000Less: Cost of goods sold 600,000

Gross profit 350,000Less: Operating expenses (includes depreciation expense and bad debt expense) 250,000

Income from operations 100,000Other revenues and expenses

Gain on sale of investments $15,000 Loss on sale of equipment (3,000) 12,000

Income before taxes 112,000Income taxes 45,000

Net income $ 67,000

Instructions(a) Compute net cash provided by operating activities under the direct method.(b) Prepare a statement of cash flows using the indirect method.

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Concepts for Analysis · 1305

P23-9 (Indirect SCF) Dingel Corporation has contracted with you to prepare a statement of cash flows.The controller has provided the following information.

December 31

2010 2009

Cash $ 38,500 $13,000Accounts receivable 12,250 10,000Inventory 12,000 10,000Investments –0– 3,000Building –0– 29,750Equipment 40,000 20,000Copyright 5,000 5,250

Totals $107,750 $91,000

Allowance for doubtful accounts $ 3,000 $ 4,500Accumulated depreciation on equipment 2,000 4,500Accumulated depreciation on building –0– 6,000Accounts payable 5,000 4,000Dividends payable –0– 5,000Notes payable, short-term (nontrade) 3,000 4,000Long-term notes payable 36,000 25,000Common stock 38,000 33,000Retained earnings 20,750 5,000

$107,750 $91,000

Additional data related to 2010 are as follows.

1. Equipment that had cost $11,000 and was 30% depreciated at time of disposal was sold for $2,500.2. $5,000 of the long-term note payable was paid by issuing common stock.3. Cash dividends paid were $5,000.4. On January 1, 2010, the building was completely destroyed by a flood. Insurance proceeds on the

building were $33,000 (net of $4,000 taxes).5. Investments (available-for-sale) were sold at $1,500 above their cost. The company has made sim-

ilar sales and investments in the past.6. Cash and long-term note for $16,000 were given for the acquisition of equipment.7. Interest of $2,000 and income taxes of $5,000 were paid in cash.

Instructions(a) Use the indirect method to analyze the above information and prepare a statement of cash flows

for Dingel. Flood damage is unusual and infrequent in that part of the country.(b) What would you expect to observe in the operating, investing, and financing sections of a state-

ment of cash flows of:(1) A severely financially troubled firm?(2) A recently formed firm that is experiencing rapid growth?

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CA23-1 (Analysis of Improper SCF) The following statement was prepared by Maloney Corporation’saccountant.

MALONEY CORPORATIONSTATEMENT OF SOURCES AND APPLICATION OF CASH

FOR THE YEAR ENDED SEPTEMBER 30, 2010

Sources of cashNet income $111,000Depreciation and depletion 70,000Increase in long-term debt 179,000Changes in current receivables and inventories, less current

liabilities (excluding current maturities of long-term debt) 14,000

$374,000

CONCEPTS FOR ANALYSIS




Application of cashCash dividends $ 60,000Expenditure for property, plant, and equipment 214,000Investments and other uses 20,000Change in cash 80,000

$374,000

The following additional information relating to Maloney Corporation is available for the year endedSeptember 30, 2010.

1. Wage and salary expense attributable to stock option plans was $25,000 for the year.2. Expenditures for property, plant, and equipment $250,000

Proceeds from retirements of property, plant, and equipment 36,000

Net expenditures $214,000

3. A stock dividend of 10,000 shares of Maloney Corporation common stock was distributed to com-mon stockholders on April 1, 2010, when the per share market price was $7 and par value was $1.

4. On July 1, 2010, when its market price was $6 per share, 16,000 shares of Maloney Corporationcommon stock were issued in exchange for 4,000 shares of preferred stock.

5. Depreciation expense $ 65,000Depletion expense 5,000

$ 70,000

6. Increase in long-term debt $620,000Retirement of debt 441,000

Net increase $179,000

Instructions(a) In general, what are the objectives of a statement of the type shown above for Maloney Corpora-

tion? Explain.(b) Identify the weaknesses in the form and format of Maloney Corporation’s statement of cash flows

without reference to the additional information. (Assume adoption of the indirect method.)(c) For each of the six items of additional information for the statement of cash flows, indicate the

preferable treatment and explain why the suggested treatment is preferable. (AICPA adapted)

CA23-2 (SCF Theory and Analysis of Improper SCF) Teresa Ramirez and Lenny Traylor are examin-ing the following statement of cash flows for Pacific Clothing Store’s first year of operations.

PACIFIC CLOTHING STORESTATEMENT OF CASH FLOWS

FOR THE YEAR ENDED JANUARY 31, 2010

Sources of cashFrom sales of merchandise $ 382,000From sale of capital stock 380,000From sale of investment 120,000From depreciation 80,000From issuance of note for truck 30,000From interest on investments 8,000

Total sources of cash 1,000,000

Uses of cashFor purchase of fixtures and equipment 330,000For merchandise purchased for resale 253,000For operating expenses (including depreciation) 170,000For purchase of investment 95,000For purchase of truck by issuance of note 30,000For purchase of treasury stock 10,000For interest on note 3,000

Total uses of cash 891,000

Net increase in cash $ 109,000

Teresa claims that Pacific’s statement of cash flows is an excellent portrayal of a superb first year, withcash increasing $109,000. Lenny replies that it was not a superb first year—that the year was an operatingfailure, the statement was incorrectly presented, and $109,000 is not the actual increase in cash.



Concepts for Analysis · 1307

Instructions(a) With whom do you agree, Teresa or Lenny? Explain your position.(b) Using the data provided, prepare a statement of cash flows in proper indirect method form. The

only noncash items in income are depreciation and the gain from the sale of the investment (pur-chase and sale are related).

CA23-3 (SCF Theory and Analysis of Transactions) Ashley Company is a young and growing producerof electronic measuring instruments and technical equipment. You have been retained by Ashley to advise itin the preparation of a statement of cash flows using the indirect method. For the fiscal year ended October31, 2010, you have obtained the following information concerning certain events and transactions of Ashley.

1. The amount of reported earnings for the fiscal year was $700,000, which included a deduction foran extraordinary loss of $110,000 (see item 5 below).

2. Depreciation expense of $315,000 was included in the income statement.3. Uncollectible accounts receivable of $40,000 were written off against the allowance for doubtful ac-

counts. Also, $51,000 of bad debt expense was included in determining income for the fiscal year,and the same amount was added to the allowance for doubtful accounts.

4. A gain of $6,000 was realized on the sale of a machine. It originally cost $75,000, of which $30,000was undepreciated on the date of sale.

5. On April 1, 2010, lightning caused an uninsured building loss of $110,000 ($180,000 loss, less re-duction in income taxes of $70,000). This extraordinary loss was included in determining incomeas indicated in 1 above.

6. On July 3, 2010, building and land were purchased for $700,000. Ashley gave in payment $75,000 cash,$200,000 market value of its unissued common stock, and signed a $425,000 mortgage note payable.

7. On August 3, 2010, $800,000 face value of Ashley’s 10% convertible debentures was converted into$150,000 par value of its common stock. The bonds were originally issued at face value.

InstructionsExplain whether each of the seven numbered items above is a source or use of cash, and explain how itshould be disclosed in Ashley’s statement of cash flows for the fiscal year ended October 31, 2010. If anyitem is neither a source nor a use of cash, explain why it is not, and indicate the disclosure, if any, thatshould be made of the item in Ashley’s statement of cash flows for the fiscal year ended October 31, 2010.

CA23-4 (Analysis of Transactions’ Effect on SCF) Each of the following items must be considered inpreparing a statement of cash flows for Cruz Fashions Inc. for the year ended December 31, 2010.

1. Fixed assets that had cost $20,000 61⁄2 years before and were being depreciated on a 10-year basis,with no estimated scrap value, were sold for $4,750.

2. During the year, goodwill of $15,000 was considered impaired and was completely written off toexpense.

3. During the year, 500 shares of common stock with a stated value of $25 a share were issued for$32 a share.

4. The company sustained a net loss for the year of $2,100. Depreciation amounted to $2,000 andpatent amortization was $400.

5. Uncollectible accounts receivable in the amount of $2,000 were written off against the Allowancefor Doubtful Accounts.

6. Investments (available-for-sale) that cost $12,000 when purchased 4 years earlier were sold for$10,600. The loss was considered ordinary.

7. Bonds payable with a par value of $24,000 on which there was an unamortized bond premium of$2,000 were redeemed at 101. The gain was credited to ordinary income.

InstructionsFor each item, state where it is to be shown in the statement and then how you would present the nec-essary information, including the amount. Consider each item to be independent of the others. Assumethat correct entries were made for all transactions as they took place.

CA23-5 (Purpose and Elements of SCF) GAAP requires the statement of cash flows be presented whenfinancial statements are prepared.

Instructions(a) Explain the purposes of the statement of cash flows.(b) List and describe the three categories of activities that must be reported in the statement of cash

flows.(c) Identify and describe the two methods that are allowed for reporting cash flows from operations.(d) Describe the financial statement presentation of noncash investing and financing transactions.

Include in your description an example of a noncash investing and financing transaction.



FI NANCIAL REPORTI NG

Financial Reporting ProblemThe Procter & Gamble Company (P&G)The financial statements of P&G are presented in Appendix 5B or can be accessed at the book’s compan-ion website, www.wiley.com/college/kieso.

Instructions

Refer to P&G’s financial statements and the accompanying notes to answer the following questions.(a) Which method of computing net cash provided by operating activities does P&G use? What were

the amounts of net cash provided by operating activities for the years 2005, 2006, and 2007? Whichtwo items were most responsible for the increase in net cash provided by operating activities in 2007?

(b) What was the most significant item in the cash flows used for investing activities section in 2007? What was the most significant item in the cash flows used for financing activities section in 2007?

(c) Where is “deferred income taxes” reported in P&G’s statement of cash flows? Why does it appear inthat section of the statement of cash flows?

(d) Where is depreciation reported in P&G’s statement of cash flows? Why is depreciation added to netincome in the statement of cash flows?

Comparative Analysis CaseThe Coca-Cola Company and PepsiCo, Inc.Instructions

Go to the book’s companion website and use information found there to answer the following questionsrelated to The Coca-Cola Company and PepsiCo, Inc.(a) What method of computing net cash provided by operating activities does Coca-Cola use? What

method does PepsiCo use? What were the amounts of cash provided by operating activities reportedby Coca-Cola and PepsiCo in 2007?

(b) What was the most significant item reported by Coca-Cola and PepsiCo in 2007 in their investingactivities sections? What is the most significant item reported by Coca-Cola and PepsiCo in 2007 intheir financing activities sections?

(c) What were these two companies’ trends in net cash provided by operating activities over the period2005 to 2007?

USING YOUR JUDGMENT

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CA23-6 (Cash Flow Reporting) Brockman Guitar Company is in the business of manufacturing top-quality, steel-string folk guitars. In recent years the company has experienced working capital problemsresulting from the procurement of factory equipment, the unanticipated buildup of receivables andinventories, and the payoff of a balloon mortgage on a new manufacturing facility. The founder and presi-dent of the company, Barbara Brockman, has attempted to raise cash from various financial institutions, butto no avail because of the company’s poor performance in recent years. In particular, the company’s leadbank, First Financial, is especially concerned about Brockman’s inability to maintain a positive cash posi-tion. The commercial loan officer from First Financial told Barbara, “I can’t even consider your request forcapital financing unless I see that your company is able to generate positive cash flows from operations.”

Thinking about the banker’s comment, Barbara came up with what she believes is a good plan: Witha more attractive statement of cash flows, the bank might be willing to provide long-term financing. To“window dress” cash flows, the company can sell its accounts receivables to factors and liquidate its rawmaterials inventories. These rather costly transactions would generate lots of cash. As the chief account-ant for Brockman Guitar, it is your job to tell Barbara what you think of her plan.

InstructionsAnswer the following questions.

(a) What are the ethical issues related to Barbara Brockman’s idea?(b) What would you tell Barbara Brockman?

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Using Your Judgment · 1309

(d) Where is “depreciation and amortization” reported by Coca-Cola and PepsiCo in their statements ofcash flows? What is the amount and why does it appear in that section of the statement of cash flows?

(e) Based on the information contained in Coca-Cola’s and PepsiCo’s financial statements, compute thefollowing 2007 ratios for each company. These ratios require the use of statement of cash flows data.(These ratios were covered in Chapter 5.)(1) Current cash debt coverage ratio.(2) Cash debt coverage ratio.

(f) What conclusions concerning the management of cash can be drawn from the ratios computed in (e)?

Financial Statement Analysis CaseVermont Teddy Bear Co.Founded in the early 1980s, the Vermont Teddy Bear Co. designs and manufactures American-made teddybears and markets them primarily as gifts called Bear-Grams or Teddy Bear-Grams. Bear-Grams are per-sonalized teddy bears delivered directly to the recipient for special occasions such as birthdays andanniversaries. The Shelburne, Vermont, company’s primary markets are New York, Boston, and Chicago.Sales have jumped dramatically in recent years. Such dramatic growth has significant implications forcash flows. Provided below are the cash flow statements for two recent years for the company.

Current Year Prior Year

Cash flows from operating activities:Net income $ 17,523 $ 838,955Adjustments to reconcile net income to net

cash provided by operating activitiesDeferred income taxes (69,524) (146,590)Depreciation and amortization 316,416 181,348Changes in assets and liabilities:

Accounts receivable, trade (38,267) (25,947)Inventories (1,599,014) (1,289,293)Prepaid and other current assets (444,794) (113,205)Deposits and other assets (24,240) (83,044)Accounts payable 2,017,059 (284,567)Accrued expenses 61,321 170,755Accrued interest payable, debentures — (58,219)Other — (8,960)Income taxes payable — 117,810

Net cash provided by (used for)operating activities 236,480 (700,957)

Net cash used for investing activities (2,102,892) (4,422,953)Net cash (used for) provided by financing

activities (315,353) 9,685,435Net change in cash and cash equivalents (2,181,765) 4,561,525

Other information:Current liabilities $ 4,055,465 $ 1,995,600Total liabilities 4,620,085 2,184,386Net sales 20,560,566 17,025,856

Instructions

(a) Note that net income in the current year was only $17,523 compared to prior-year income of $838,955,but cash flow from operations was $236,480 in the current year and a negative $700,957 in the prioryear. Explain the causes of this apparent paradox.

(b) Evaluate Vermont Teddy Bear’s liquidity, solvency, and profitability for the current year using cashflow-based ratios.

International Reporting CaseAs noted in the chapter, there is international diversity in the preparation of the statement of cash flows.For example, under International Accounting Standards companies may choose how to classify dividendsand interest in the cash flow statement. In some countries, like Brazil, a cash flow statement is not re-quired. Embraer, a Brazilian aircraft manufacturer, prepared a statement of changes in financial position,rather than a statement of cash flows.




Instructions

Refer to Embraer’s recent statement of changes in financial position below, to answer the followingquestions.(a) Briefly discuss at least two similarities between Embraer’s statement of changes in financial position

and a statement of cash flows prepared according to U.S. GAAP.(b) Briefly discuss at least two differences between Embraer’s statement of changes in financial position

and a statement of cash flows prepared according to U.S. GAAP.

EmbraerConsolidated Statement of Changes in Financial Position(in thousands of Brazilian reals)

Sources of Funds

Provided from operationsNet income 1,255,833Items not affecting working capital

Equity in unconsolidated subsidiaryTranslation losses on foreign investments 19,613Minority interest 8,618Depreciation and amortization 221,554Net book value of permanent asset disposal 799Interest on long-term items added to principal, net (25,759)Net monetary and exchange variations on long-term items (201,030)Provision for losses 34,268Long-term deferred income and social contribution taxes (47,765)Provisions for contingencies 57,930

Funds provided from operations 1,324,061

From shareholders

Capital increase 9,524

From third partiesIncrease in long-term liabilities

Customers’ advances 257,528Loans 1,317,535Accounts payable and other liabilities 964,260

Tax incentives 5,672Transfers to current asset 1,042,182Increase in minority interest 17,997

Funds provided from third parties 3,605,174

Total sources 4,938,759

Applications of Funds

Increase in noncurrent assets 1,390,520Investments 41,219Property plant and equipment 109,656Deferred charges 415,954Transfers to current liabilities 731,098Interest on capital 585,173

Total applications 3,273,620

Increase in working capital 1,665,139

Working capital—end of yearCurrent assets 10,329,032Current liabilities 5,420,966

4,908,066

Working capital—beginning of year 3,242,927

Increase in working capital 1,665,139



Using Your Judgment · 1311

BRI DGE TO TH E PROFESSION

Professional Research: FASB CodificationAs part of the year-end accounting process for your company, you are preparing the statement of cashflows according to GAAP. One of your team, a finance major, believes the statement should be preparedto report the change in working capital, because analysts many times use working capital in ratio analy-sis. Your supervisor would like research conducted to verify the basis for preparing the statement ofcash flows.

Instructions

Access the FASB Codification at http://asc.fasb.org/home to conduct research using the CodificationResearch System to prepare responses to the following items. Provide Codification references for yourresponses.(a) What is the primary objective for the statement of cash flows? Is working capital the basis for meet-

ing this objective? (b) What information is provided in a statement of cash flows? (c) List some of the typical cash inflows and outflows from operations.

Professional SimulationGo to the book’s companion website, at www.wiley.com/college/kieso, to find an interactive problem thatsimulates the computerized CPA exam. The professional simulation for this chapter asks you to addressquestions related to the accounting for the statement of cash flows.

Remember to check the book’s companion website to find additional resources for this chapter.

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Mensur Boydaş, Vahdi Boydaş: Accounting Principles: Ch23

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Transcript of Mensur Boydaş, Vahdi Boydaş: Accounting Principles: Ch23