CHAP TER

17

In a Set of Financial
Statements, What
Information Is Conveyed by
the Statement of Cash Flows?
Video Clip
In this video, Professor Joe Hoyle introduces the essential points covered in Chapter 17.

View the video online at: http://bit.ly/hoyle17-1

1. THE STRUCTURE OF A STATEMENT OF CASH FLOWS

L E A R N I N G

O B J E C T I V E S

At the end of this section, students should be able to meet the following objectives:
1. Describe the purpose of a statement of cash ows.
2. Dene cash and cash equivalents.
3. Identify the three categories disclosed within a statement of cash ows.
4. Indicate the type of transactions that are reported as operating activities and provide common
examples.
5. Indicate the type of transactions that are reported as investing activities and provide common
examples.
6. Indicate the type of transactions that are reported as nancing activities and provide common
examples.

1.1 The Importance of a Statement of Cash Flows

Question: Thus far in this textbook, the balance sheet and income statement have been studied in comprehensive detail along with the computation of retained earnings. By this point, a student should be able
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FINANCIAL ACCOUNTING VERSION 2.0

to access a set of nancial statements (on the Internet, for example) and understand much of the reported
information. Terms such as FIFO, accumulated depreciation, goodwill, common stock, bad debt
expense, and the like that might have sounded like a foreign language at rst should now be
understandable.
Examination of one last nancial statement is necessary to complete the portrait presented of a reporting entity by nancial accounting and the rules of U.S. GAAP. That is the statement of cash ows.
This statement was introduced briey in an earlier chapter but will be covered here in detail. Why is it
needed by decision makers? What is the rationale for presenting a statement of cash ows?
Answer: Coverage of the statement of cash ows has been postponed until now because its construction is unique. For this one statement, the gures do not come directly from ending T-account
balances found in a general ledger. Instead, the accounts and amounts are derived from the other nancial statements. Thus, an understanding of those statements is a helpful prerequisite when considering the creation of a statement of cash ows.
The delay in examining the statement of cash ows should not be taken as an indication of its lack
of signicance. In fact, some decision makers view it as the most important of the nancial statements.
They are able to see how corporate ocials managed to get and then make use of the ultimate asset:
cash. The acquisition of other assets, the payment of debts, and the distribution of dividends inevitably
leads back to a companys ability to generate sucient amounts of cash. Consequently, presentation of
a statement of cash ows is required by U.S. GAAP for every period in which an income statement is
reported.
To reiterate the importance of this information, Michael Dell, founder of Dell Inc., states in his
book Direct from Dell: Strategies That Revolutionized an Industry (written with Catherine Fredman):
We were always focused on our prot and loss statement. But cash ow was not a regularly discussed
topic. It was as if we were driving along, watching only the speedometer, when in fact we were running
out of gas.[1]
The income statement and the statement of cash ows connect the balance sheets from the beginning of the year to the end. During that time, total reported net assets either increase or decrease as
does the entitys cash balance. The individual causes of those changes are explained by means of the income statement and the statement of cash ows.
The purpose of the statement of cash ows is virtually self-evident: It reports the cash receipts
(cash inows) and the cash disbursements (cash outows) to explain the changes in cash that took
place during the year. However, the physical structure of this statement is not self-evident. As illustrated previously, all cash ows are classied within three distinct categories. Coverage here is designed
to demonstrate the logic of this classication system and the method by which the reported numbers
are derived.

1.2 Cash and Cash Equivalents

cash equivalents
Short-term, highly liquid
investments with original
maturities of ninety days or
fewer that can be readily
converted into known
amounts of cash.

Question: Because current assets are listed in order of liquidity, most businesses present cash and cash
equivalents as the rst account on their balance sheets. For example, as of December 31, 2010, Ball
Corporation reported holding cash and cash equivalents totaling $152.0 million. This same terminology
is used on Balls statement of cash ows which explains the drop of $58.6 million in cash and cash equivalents that took place during 2010. What constitutes cash and what are cash equivalents?
Answer: Cash consists of coins, currencies, bank deposits (both checking accounts and savings accounts) and some negotiable instruments (money orders, checks, and bank drafts). Cash equivalents
are short-term, highly liquid investments that are readily convertible into known amounts of cash.
They are so near their maturity date that signicant changes in value are unlikely. Only securities with
original maturities of ninety days or fewer are classied as cash equivalents. Cash equivalents held by
most companies include Treasury bills,[2] commercial paper,[3] and money market funds.
For the past few years, FASB has been considering the elimination of the cash equivalents category.
If a change is made, such assets (other than cash) will likely appear on the balance sheet as temporary
investments. As with all such debates, both pros and cons exist for making such an ocial change. For
simplicity purposes, cash will be used in the examples presented throughout this chapter. However, until new authoritative rules are passed, accounting for cash equivalents is the same as that for cash.

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CHAPTER 17

IN A SET OF FINANCIAL STATEMENTS, WHAT INFORMATION IS CONVEYED BY THE STATEMENT OF CASH FLOWS?

T E S T

573

Y O U R S E L F

Question:
Which of the following assets is least likely to be considered a cash equivalent?
a.
b.
c.
d.

Treasury bills
Commercial paper
Money market funds
Corporate bonds

Answer:
The correct answer is choice d: Corporate bonds.
Explanation:
Treasury bills, commercial paper, and money market funds are all considered to be cash equivalents as long as
they can be converted into cash and had an original maturity of ninety days or fewer. Most corporate bonds
have maturity dates much longer than ninety days, often many years.

1.3 Cash Flows from Operating Activities

Question: For reporting purposes all cash ows are classied within one of three categories: operating
activities, investing activities, and nancing activities. What transactions are specically identied as
operating activities?
Answer: Operating activities generally involve producing and delivering goods and providing
services to customers. These events are those that transpire on virtually a daily basis as a result of the
organizations primary function. For a business like Barnes & Noble, operating activities include the
buying and selling of books (and other inventory items) as well as the multitude of other tasks required
by that companys retail function. As shown in Figure 17.1, operating activities are those that are expected to take place regularly in the normal course of business.

operating activities
A statement of cash ow
category used to disclose
cash receipts and
disbursements arising from
the primary activities of the
reporting organization.

FIGURE 17.1 Typical Operating Activity Cash Inflows and Outflows

The net number for the period (the inows compared to the outows) is presented as the cash ows
generated from operating activities. This gure is viewed by many decision makers as a good measure
of a companys ability to prosper. Investors obviously prefer to see a positive number, one that increases from year to year. Some analysts believe that this gure is a better reection of a companys nancial health than reported net income because the ultimate goal of a business is to generate cash.
For example, International Paper Company reported a net loss on its income statement for the
year ended December 31, 2008, of $1.282 billion (considerably worse than any of the previous ve
years). However, its statement of cash ows for the same period reported a net cash inow from operating activities of $2.669 million (considerably better than any of the previous ve years). That is nearly
a $4 billion dierence. No one could blame a decision maker for being puzzled. Did the company do
poorly that year or wonderfully well?
That is the problem with relying on only a few of the numbers in a set of nancial statements
without a closer and more complete inspection. What caused this company to lose over $1.2 billion
dollars? How did the company manage to generate nearly $2.7 billion in cash from its operating
activities? In-depth analysis of nancial statements is never quick and easy. It requires patience and
knowledge and the willingness to dig through all the available information.

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FINANCIAL ACCOUNTING VERSION 2.0

1.4 Investing Activity Cash Flows

Question: On the statement of cash ows for the year ended August 31, 2011, Walgreen Co. reported that
a net of over $1.5 billion in cash was spent in connection with a variety of investing activities. This companys management obviously made decisions that required the use of considerable sums of money. Details about those expenditures should be of interest to virtually any party analyzing this company. What
cash transactions are specically identied as investing activities?
investing activities
A statement of cash ow
category used to disclose
cash receipts and
disbursements arising from
an asset transaction other
than one relating to the
primary activities of the
reporting organization.

Answer: Investing activities encompass the acquisition and disposition of assets in transactions
that are separate from the central activity of the reporting organization. In simple terms, these cash exchanges do not occur as part of daily operations.
For a delicatessen, the purchase of bread, mustard, or onions is an operating activity, but the
acquisition of a refrigerator or stove is an investing activity.
< For a pharmacy, the sale of aspirin or a decongestant is an operating activity, but the disposal of a
delivery vehicle or cash register is an investing activity.
<

All of these cash transactions involve assets but, to be classied as an investing activity, they can only be
tangentially related to the day-to-day operation of the business. For example, Figure 17.2 shows the
three biggest investing activity cash ows reported by Walgreen.
FIGURE 17.2 The Three Biggest Investing Activity Cash Flows Identified on Walgreens Statement of
Cash Flows for the Year Ended August 31, 2011

Healthy, growing companies normally expect cash ows from investing activities to be negative (a net
outow) as money is invested by management especially in new noncurrent assets. As can be seen in
Figure 17.2, Walgreen Co. spent over $1.2 billion in cash during this one year to buy property and
equipment. The company apparently had sucient cash available to fund this signicant expansion.

1.5 Financing Activity Cash Flows

Question: The third category of cash ows lists the amounts received and disbursed by a business through
nancing activities. For the year ended July 2, 2011, Sara Lee Corporation reported that its cash balance
had been reduced by over $1.7 billion as a result of such nancing activities. Again, that is a lot of money
leaving the company. What transactions are specically identied in a statement of cash ows as nancing activities?
nancing activities
A statement of cash ow
category used to disclose
cash receipts and
disbursements arising from a
liability or stockholders
equity transaction other than
one relating to the primary
activities of the organization.

Answer: Financing activities are transactions separate from the central, day-to-day activities of
an organization that involve either liabilities or shareholders equity accounts. Cash inows from nancing activities include issuing capital stock and incurring liabilities such as bonds or notes payable.
Outows are created by the distribution of dividends, the acquisition of treasury stock, the payment of
noncurrent liabilities, and other similar cash transactions.
As can be seen in Figure 17.3, Sara Lees three biggest changes in cash that resulted from nancing
activities were the repayments of other debt, purchases of common stock, and borrowing of other debt.
Signicant information about managements decisions is readily apparent from an analysis of the cash
ows from both investing and nancing activities.

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CHAPTER 17

IN A SET OF FINANCIAL STATEMENTS, WHAT INFORMATION IS CONVEYED BY THE STATEMENT OF CASH FLOWS?

575

FIGURE 17.3 The Three Biggest Financing Activity Cash Flows Identified on Sara Lees Statement of
Cash Flows for the Year Ended July 2, 2011

The net result reported for nancing activities is frequently positive in some years and negative in others. When a company borrows money or sells capital stock, an overall positive inow of cash is likely.
In years when a large dividend is distributed or debt is settled, the net gure for nancing activities is
more likely to be negative.
T E S T

Y O U R S E L F

Question:
The Reardon Company paid salary to its employees totaling $527,000 during the current year. Into which category on a statement of cash ows will these payments be placed?
a.
b.
c.
d.

Operating activities
Investing activities
Financing activities
Capital activities

Answer:
The correct answer is choice a: Operating activities.
Explanation:
The payment of salary is a regular operating activity. The expenditure takes place as a direct result of the dayto-day operations of the business.

T E S T

Y O U R S E L F

Question:
The McGuire Company, located in Wilcox, Texas, issued 10,000 shares of its $3 par value common stock during
this year for $9 in cash per share. Into which category on a statement of cash ows will this $90,000 capital
contribution be placed?
a.
b.
c.
d.

Operating activities
Investing activities
Financing activities
Capital activities

Answer:
The correct answer is choice c: Financing activities.
Explanation:
This issuance of common (and preferred) stock is identied as a nancing activity. It represents a change in a
shareholders equity account. However, the cash inow is not directly related to the daily operations of the
business.

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576

FINANCIAL ACCOUNTING VERSION 2.0

T E S T

Y O U R S E L F

Question:
The Staunton Corporation owns and operates several restaurants in eastern Iowa. Looking to expand operations, Staunton bought a piece of land recently for $500,000. The business paid $100,000 and a noncurrent
note payable was signed for the remaining $400,000. How is this transaction reported on a statement of cash
ows?
a.
b.
c.
d.

Investing activity as an outow of $100,000

Investing activity as an outow of $500,000
Financing activity as an outow of $100,000
Financing activity as an outow of $500,000

Answer:
The correct answer is choice a: Investing activity as an outow of $100,000.
Explanation:
The purpose of the transaction is to acquire land. Land is an asset and this event did not take place as a normal part of Stauntons daily operations. Thus, the transaction is an investing activity. Because $100,000 in cash
was spent for this acquisition, the transaction is reported as an outow of that amount. The $500,000 cost of
the land and the $400,000 note payable will be recorded on the corporations balance sheet.

1.6 Disclosure of Noncash Transactions

Question: Signicant investing and nancing transactions can occur without any cash component. Land,
for example, might be obtained by issuing common stock. Buildings are often bought through the signing
of a long-term note payable with all cash payments deferred into the future. Is that information omitted
entirely from the statement of cash ows? If no cash is received or expended, should a transaction be reported on a statement of cash ows?
Answer: All investing and nancing transactions need to be reported in some manner because of
the informational value. They represent choices made by the organizations management. Even if no
cash is involved, such events must still be disclosed in a separate schedule (often attached to the statement of cash ows) or explained in the notes to the nancial statements. This information is valuable
to the interested parties who want a complete picture of the investing and nancing decisions that were
made during the period.
For example, on the statement for Duke Energy Corporation for the year ended December 31,
2010, a signicant noncash transaction was identied as accrued capital expenditures of $361 million.
Although cash was not involved, inclusion of this information was still deemed to be important.
Stock dividends and stock splits, though, are omitted entirely in creating a statement of cash ows.
As discussed previously, they are viewed as techniques to reduce the price of a corporations stock and
are not decisions that impact the allocation of nancial resources.
K E Y

T A K E A W A Y

A statement of cash ows is required by U.S. GAAP whenever an income statement is presented. It explains all
changes occurring in cash and cash equivalents during the reporting period. The various cash inows and outows are classied into one of three categories. Operating activities result from the primary or central function
of the business. Investing activities are not part of normal operations and aect an asset (such as the cash acquisition of a truck or the sale of a patent). Financing activities are not part of normal operations and involve a
liability or a stockholders equity account (borrowing money on a note, for example, or the reacquisition of
treasury stock). Signicant investing and nancing activities that do not impact cash must still be disclosed because they reect decisions made by management.

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CHAPTER 17

IN A SET OF FINANCIAL STATEMENTS, WHAT INFORMATION IS CONVEYED BY THE STATEMENT OF CASH FLOWS?

577

2. CASH FLOWS FROM OPERATING ACTIVITIES: THE

DIRECT METHOD
L E A R N I N G

O B J E C T I V E S

At the end of this section, students should be able to meet the following objectives:
1. Identify the two methods available for reporting cash ows from operating activities.
2. Indicate the method of reporting cash ows from operating activities that is preferred by FASB
as well as the one that is most commonly used in practice.
3. List the steps to be followed in determining cash ows from operating activities.
4. List the income statement accounts that are removed entirely in computing cash ows from
operating activities and explain this procedure when the direct method is applied.
5. Identify common connector accounts that are used to convert accrual accounting gures to
the change taking place in the cash balance as a result of these transactions.
6. Compute the cash inows and outows resulting from common revenues and expenses such
as sales, cost of goods sold, rent expense, salary expense, and the like.

2.1 The Handling of Noncash and Nonoperating Transactions by the

Direct Method
Question: The net cash inow or outow generated by operating activities is especially signicant information to any person looking at an organizations nancial health and future prospects. According to U.S.
GAAP, that information can be presented within the statement of cash ows by either of two approaches:
the direct method or the indirect method.
The numerical amount of the change in cash resulting from a companys daily operations is not impacted by this reporting choice. The increase or decrease in cash is a fact that will not vary because of the
manner of presentation. Both methods arrive at the same total. The informational value to decision
makers, though, is potentially aected by the approach selected.
FASB has indicated a preference for the direct method. In contrast, reporting companies (by an extremely wide margin) continue to use the more traditional indirect method. Thus, both will be demonstrated here. The direct method is more logical and will be discussed rst. How is information presented
when the direct method is selected to disclose a companys cash ows from operating activities?
Answer: The direct method starts with the entire income statement for the period. Then, each of
the separately reported gures is converted into the amount of cash received or spent in carrying on
this operating activity. Sales, for example, is turned into cash collected from customers. Salary expense and rent expense are recomputed as cash paid to employees and cash paid to rent
facilities.
For illustration purposes, assume that Liberto Company prepared its income statement for the
year ended December 31, Year One, as shown in Figure 17.4. This statement has been kept rather
simple so that the conversion to cash ows from operating activities is not unnecessarily complex. For
example, income tax expense has been omitted.

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direct method
A mechanical method of
reporting the amount of cash
ows that a company
generates from its operating
activities; it is preferred by
FASB because the
information is easier to
understand but it is only
rarely encountered in
practice.
indirect method
A mechanical method of
reporting the amount of cash
ows that a company
generates from its operating
activities; it is allowed by
FASB (although the direct
method is viewed as
superior) but is used by a vast
majority of businesses in the
United States.

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578

FINANCIAL ACCOUNTING VERSION 2.0

FIGURE 17.4 Liberto Company Income Statement Year Ended December 31, Year One

The $100,000 net income gure reported here by Liberto is based on the application of U.S. GAAP.
However, the amount of cash generated by the companys operating activities might be considerably
more or much less than that income gure. It is a dierent piece of information.
To transform a companys income statement into its cash ows from operating activities, several
distinct steps must be taken. These steps are basically the same regardless of whether the direct method
or the indirect method is applied.
The rst step is the complete elimination of any income statement account that does not involve cash.
Although such balances are important in arriving at net income, they are not relevant to the cash generated and spent in connection with daily operations. By far the most obvious example is depreciation.
This expense appears on virtually all income statements but has no direct impact on a companys cash.
In determining cash ows from operating activities, it is omitted because depreciation is neither a
source nor use of cash. It is an allocation of a historical cost to expense over an assets useful life. To begin the calculation of the cash ows resulting from Libertos operating activities, the $80,000 depreciation expense must be removed.
The second step is the removal of any gains and losses that resulted from investing or nancing activities. Although cash was likely involved in these transactions, this inow or outow is reported elsewhere in the statement of cash ows and not within the companys operating activities. For example,
Libertos $40,000 gain on the sale of equipment is germane to the reporting of investing activities, not
operating activities. The cash received in this disposal is included on the statement of cash ows but as
an investing activity.
Neither (a) noncash items such as depreciation nor (b) nonoperating gains and losses are included
when an income statement is converted to the cash ows from operating activities.

2.2 Converting Accrual Accounts to Cash FlowsThe Direct Method

Question: After all noncash and nonoperating balances are deleted, Liberto is left with four income statement accounts:
1. Sales to customers$480,000
2. Cost of goods sold$250,000
3. Salary expense$60,000
4. Rent expense$30,000
These balances all relate to operating activities. However, the numbers reect the application of U.S.
GAAP and accrual accounting rather than the amount of cash exchanged. The cash eects must be determined individually for these accounts. How are income statement gures such as sales or rent expense
converted to the amount of cash received or expended?
Answer: The third step in the process of determining cash ows from operating activities is the individual conversion to cash of all remaining income statement accounts. For these balances, a dierence
usually exists between the time of recognition as specied by accrual accounting and the exchange of
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CHAPTER 17

IN A SET OF FINANCIAL STATEMENTS, WHAT INFORMATION IS CONVEYED BY THE STATEMENT OF CASH FLOWS?

579

cash. A sale is made on Monday (revenue is recognized), but the money is not collected until Friday.
An employee performs work on Monday (expense is recognized) but payment is not made until Friday.
These timing dierences occur because accrual accounting is required by U.S. GAAP. Thus, many
revenues and expenses are not recorded at the same time as the related cash transactions. In the interim, recognition of an asset or liability balance is necessary. Between the sale on Monday and the collection on Friday, the business reports an account receivable. This asset goes up when the sale is made and
down when the cash is collected. Between the employees work on Monday and the payment on Friday,
the business reports a salary payable. This liability goes up when the money is earned and down when
the cash payment is made. In this textbook, these interim accounts (such as accounts receivable and
salary payable) will be referred to as connector accounts because they connect the recording mandated by accrual accounting with the cash transaction.
Each income statement account (other than the noncash and nonoperating numbers that have
already been eliminated) has at least one asset or liability that is recorded between the time of accounting recognition and the exchange of cash. The changes in these connector accounts can be used to convert the individual income statement gures to their cash equivalents. Basically, the increase or decrease is removed to revert the reported number back to the amount of cash involved. As can be seen in
Figure 17.5, connector accounts are mostly receivables, payables, and prepaid expenses.
FIGURE 17.5 Common Connector Accounts for Libertos Four Income Statement Balances[4]

If a connector account is an asset and the balance goes up, the business has less cash (the receivable was
not collected, for example). If a connector account is an asset and goes down, the business has more
cash (such as when receivables from previous years are collected in the current period). Therefore, for a
connector account that is an asset, an inverse relationship exists between the change in the balance during the year and the reporting entitys cash balance.
<
<

Increase in connector account that is an asset Lower cash balance

Decrease in connector account that is an asset Higher cash balance

If a connector account is a liability and the balance goes up, the business has saved its cash and holds
more (an expense has been incurred but not yet paid, for example). If a connector account is a liability
and this balance falls, the business must have used its cash to reduce the debt and has less remaining.
Consequently, a direct relationship exists between the change in a connector account that is a liability
and the cash balance.
Increase in connector account that is a liability Higher cash balance
< Decrease in connector account that is a liability Lower cash balance
<

2.3 Applying the Direct Method to Determine Cash Revenues and

Expenses
Question: Liberto has one revenue and three expenses left on its income statement after removal of noncash and nonoperating items. To arrive at the net cash ows from operating activities, the cash inow or
outow relating to each must be determined. Assume that the following changes took place during this
year in the related balance sheet connector accounts:
Accounts receivable: up $19,000
< Inventory: down $12,000
< Prepaid rent: up $4,000
< Accounts payable: up $9,000
< Salary payable: down $5,000
<

In applying the direct method to determine operating activity cash ows, how are the individual gures
to be disclosed computed?
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580

FINANCIAL ACCOUNTING VERSION 2.0

Answer:
Sales to customers were reported on the income statement as $480,000. During that same period,
accounts receivable increased by $19,000. Thus, less money was collected than the amount of the
companys credit sales. That is the cause for a rise in receivables. To reect the collection of less
cash, a reduction is needed. Consequently, the cash received from customers was only $461,000
($480,000 less $19,000).
< Salary expense was reported as $60,000. During that time period, salary payable went down by
$5,000. More cash must have been paid to cause this drop in the liability. The amount actually
paid to employees was $65,000 ($60,000 plus $5,000).
< Rent expense was reported as $30,000. Prepaid rent increased by $4,000 from the rst of the year
to the end. This connector account is an asset. Because this asset increased, Liberto must have
paid an extra amount for rent. Cash paid for rent was $34,000 ($30,000 plus $4,000).
< Cost of goods sold has been left to last because it requires an extra step. The company rst
determines the quantity of inventory bought during this period. Only then can the cash payment
made for those acquisitions be determined.
<

Cost of goods sold is reported as $250,000. However, the balance held in inventory fell by
$12,000. Thus, the company bought $12,000 less inventory than it sold. Fewer purchases
cause a drop in inventory. The amount of inventory acquired during the period was only
$238,000 ($250,000 less $12,000).
< Next, the cash paid for those purchases is calculated. As indicated, accounts payable went
up $9,000. Liabilities increase because less money is paid. Although $238,000 of
merchandise was acquired, only $229,000 in cash payments were made ($238,000 less
$9,000).
<

After each of these four income statement accounts is converted to the amount of cash received or paid
this period, the operating activity section of the statement of cash ows can be created by the direct
method as shown in Figure 17.6.
FIGURE 17.6 Liberto Company Statement of Cash Flows for Year One, Operating Activities Reported
by Direct Method

Libertos income statement reported net income of $100,000. However, the cash generated by operating activities during this same period was $133,000. The conversion from accrual accounting to operating cash inows and outows required three steps.
1. All noncash revenues and expenses (depreciation, in this example) were removed. These accounts
do not represent cash transactions.
2. All nonoperating gains and losses (the gain on sale of equipment, in this example) were removed.
These accounts reect investing and nancing activities and the resulting cash ows are reported
in those sections of the statement of cash ows rather than within the operating activities.
3. All remaining income statement accounts are adjusted to the amount of cash physically
exchanged this period by applying the change in each related connector account. By this process,
accrual accounting gures are converted to cash balances.

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CHAPTER 17

IN A SET OF FINANCIAL STATEMENTS, WHAT INFORMATION IS CONVEYED BY THE STATEMENT OF CASH FLOWS?

T E S T

581

Y O U R S E L F

Question:
The Giotto Company reported sales in its latest year of $800,000. Giotto held $170,000 in accounts receivable
at the beginning of the period but only $144,000 at the end. Assume that all of these receivables are viewed
as collectible so that no allowance is needed. What amount of cash did the company collect this period from
its customers?
a.
b.
c.
d.

$774,000
$776,000
$824,000
$826,000

Answer:
The correct answer is choice d: $826,000.
Explanation:
During this year, the accounts receivable balance dropped by $26,000 ($170,000 to $144,000). Thus, more cash
was collected than the amount of sales. Receivables decrease because cash is received. These additional receipts indicate that a total of $826,000 was collected from the Giottos customers ($800,000 plus $26,000).

T E S T

Y O U R S E L F

Question:
The Lessain Company reported salary expense of $345,000 on its income statement for the year ended
December 31, Year One. At the beginning of that year, salary payable was shown as $31,000 but rose to
$40,000 by December 31. In reporting the Lessains cash ows generated from operating activities, what
amount should be shown as the cash paid to employees?
a.
b.
c.
d.

$336,000
$345,000
$354,000
$376,000

Answer:
The correct answer is choice a: $336,000.
Explanation:
Lessains salary payable went up by $9,000. Accrued liabilities rise because fewer payments are made than the
expenses incurred. Although employees earned $345,000 during this year, only $336,000 was paid to them as
salary ($345,000 less $9,000). It is this reduction in the cash payment that caused the salary payable account to
increase by $9,000 during Year One.

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582

FINANCIAL ACCOUNTING VERSION 2.0

T E S T

Y O U R S E L F

Question:
The TJ Corporation reported cost of goods sold for Year One of $564,000. During that same period, this companys inventory balance rose by $22,000 while its accounts payable fell by $7,000. In creating a statement of
cash ows using the direct method, what amount should be reported by the TJ Corporation as the cash spent
to acquire inventory?
a.
b.
c.
d.

$535,000
$549,000
$579,000
$593,000

Answer:
The correct answer is choice d: $593,000.
Explanation:
Although cost of goods sold was reported as $564,000, the inventory on hand increased $22,000. More inventory was bought that year than sold. TJ acquired $586,000 in inventory during Year One ($564,000 sold plus the
$22,000 increase). At the same time, accounts payable dropped. This decrease indicates that more in cash was
paid than the amount bought. Spending an extra $7,000 caused the reduction. Thus, cash paid out this year to
acquire inventory was $593,000 ($586,000 plus $7,000).

T E S T

Y O U R S E L F

Question:
Sales reported by a local shoe store are $470,000. Accounts receivable decreased by $27,000 this year while
unearned revenues rose by $14,000. If the direct method is used to report cash ows from operating activities,
how much should be shown as the stores cash collected from its customers?
a.
b.
c.
d.

$429,000
$467,000
$483,000
$511,000

Answer:
The correct answer is choice d: $511,000.
Explanation:
A new connector account (unearned revenues) is included here. This balance represents cash received where
revenue has not yet been earned. This increase indicates that $14,000 more in cash was collected from customers than the amount reported as revenue. Also, accounts receivable fell by $27,000. Receivables are reduced through collection. The shoe store must have received that much more cash than it earned. Cash received during this period is $511,000 ($470,000 plus $14,000 and $27,000).

K E Y

T A K E A W A Y

An entitys cash ows from operating activities can be derived and reported by either the direct method or the
indirect method. FASB has expressed preference for the direct method but the indirect method has been adopted by virtually all businesses in the United States. The process always begins with the income for the period (the entire income statement is used when the direct method is applied). First noncash items (such as depreciation) and then nonoperating gains and losses are eliminated entirely because they are not related to operating activity cash ows. In the direct method, the remaining revenue and expense accounts are individually
converted into cash gures. For each, the change in one or more related balance sheet connector accounts is
used to adjust these accrual accounting numbers to their corresponding cash balances. Thus, income statement balances are returned to their underlying cash inows and outows for reporting purposes.

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CHAPTER 17

IN A SET OF FINANCIAL STATEMENTS, WHAT INFORMATION IS CONVEYED BY THE STATEMENT OF CASH FLOWS?

583

3. CASH FLOWS FROM OPERATING ACTIVITIES: THE

INDIRECT METHOD
L E A R N I N G

O B J E C T I V E S

At the end of this section, students should be able to meet the following objectives:
1. Explain the dierence in the start of the operating activities section of the statement of cash
ows when the indirect method is used rather than the direct method.
2. Demonstrate the removal of both noncash items and nonoperating gains and losses in the application of the indirect method.
3. Determine the eect caused by the change in the various connector accounts when the indirect method is used to present cash ows from operating activities.
4. Identify the reporting classication for interest revenues, dividend revenues, and interest expense in creating a statement of cash ows and explain the controversy that resulted from this
handling.

3.1 The Steps Followed in Applying the Indirect Method

Question: As mentioned, most organizations do not choose to present their operating activity cash ows
using the direct method despite the preference of FASB. Instead, this information is almost universally
shown within a statement of cash ows by means of the indirect method. How does the indirect method
of reporting operating activity cash ows dier from the direct method?
Answer: The indirect method actually follows the same set of procedures as the direct method except that it begins with net income rather than the businesss entire income statement. After that, the
same three steps demonstrated previously to determine the net cash ows from operating activities are
followed although the mechanical application here is dierent.
1. Noncash items are removed.
2. Nonoperational gains and losses are removed.
3. Adjustments are made, based on the monetary change occurring during the period in the various
balance sheet connector accounts, to switch all remaining revenues and expenses from accrual
accounting to cash accounting.

3.2 Removing Noncash and Nonoperating ItemsThe Indirect Method

Question: In the income statement presented in Figure 17.4 for the Liberto Company, net income was reported as $100,000. This gure included depreciation expense (a noncash item) of $80,000 and a gain on
the sale of equipment (an investing activity rather than an operating activity) of $40,000. In applying the
indirect method, how are noncash items and nonoperating gains and losses removed from net income?
Answer: First, all noncash items within net income are eliminated. Depreciation is the example included here. As an expense, it is a negative component found within net income. To remove a negative,
it is oset by a positive. Thus, adding back $80,000 serves to remove the impact of depreciation from
the reporting companys net income.
Second, all nonoperating items within net income are eliminated. Libertos gain on sale of equipment is reported within reported income. As a gain, it is a positive gure; it helped increase prots this
period. To eliminate this gain, $40,000 must be subtracted from net income. The cash ows resulting
from this transaction came from an investing activity and not an operating activity.
In applying the indirect method, as shown in Figure 17.7, a negative is removed by addition; a positive is removed by subtraction.

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FINANCIAL ACCOUNTING VERSION 2.0

FIGURE 17.7 Operating Activity Cash Flows, Indirect MethodElimination of Noncash and
Nonoperating Balances

In the direct method, these two income statement amounts were simply omitted in arriving at the
individual cash ows from operating activities.
< In the indirect method, they are both physically removed from income by reversing their eect.
<

The impact is the same in the indirect method as in the direct method; the balances are removed.

3.3 Converting Accrual Accounting Figures to Cash BalancesThe

Indirect Method
Question: After all noncash and nonoperating items are removed from net income, only the changes in
the balance sheet connector accounts must be utilized to complete the conversion to cash. For Liberto,
those balances were shown previously.
Accounts receivable: up $19,000
Inventory: down $12,000
< Prepaid rent: up $4,000
< Accounts payable: up $9,000
< Salary payable: down $5,000
<
<

Each of these increases and decreases was used in the direct method to turn accrual accounting gures into cash balances. That same process is followed in the indirect method. In determining cash ows from
operating activities, how are changes in an entitys connector accounts reected in the application of
the indirect method?
Answer: Although the procedures appear to be dierent, the same logic is applied in the indirect
method as in the direct method. The change in each of the previous connector accounts discloses the
dierence in the accrual accounting amounts recognized in the income statement and the actual
changes in cash. Here, though, the eect is measured on net income as a whole rather than on the individual revenue and expense accounts.
Accounts receivable increased by $19,000. This rise in the receivable balance shows that less money
was collected than the sales made by Liberto during the period. Receivables go up because customers
are slow to pay. This change results in a lower cash balance. Thus, the $19,000 is subtracted in arriving
at the cash ow amount generated by operating activities. The cash received was actually less than the
gure reported for sales that appears within the companys net income. Subtract $19,000.
Inventory decreased by $12,000. A drop in the amount of inventory on hand indicates that less
merchandise was purchased during the period. Buying less requires a smaller amount of cash to be
paid. That leaves the cash balance higher. The $12,000 is added in arriving at the operating activity
change in cash. Add $12,000.
Prepaid rent increased by $4,000. An increase in any prepaid expense shows that more of the asset
was acquired during the year than was consumed. This additional purchase requires the use of cash;
thus, the resulting cash balance is lower. The increase in prepaid rent necessitates a $4,000 subtraction
in the operating activity cash ow computation. Subtract $4,000.
Accounts payable increased by $9,000. Any jump in a liability means that Liberto paid less cash
during the period than the debts that were incurred. Postponing liability payments is a common method for saving cash to keep the reported balance high. In determining cash ows from operating activities, the $9,000 liability increase is added. Add $9,000.
Salary payable decreased by $5,000. Liability balances fall when additional payments are made.
Such cash transactions are reected in applying the indirect method by a $5,000 subtraction from net
income. Subtract $5,000.
Therefore, if Liberto Company uses the indirect method to report its cash ows from operating
activities, the information will be presented to decision makers as shown in Figure 17.8.
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IN A SET OF FINANCIAL STATEMENTS, WHAT INFORMATION IS CONVEYED BY THE STATEMENT OF CASH FLOWS?

585

FIGURE 17.8 Liberto Company Statement of Cash Flows for Year One, Operating Activities Reported
by Indirect Method

As with the direct method (Figure 17.6), the total here reects a net cash inow of $133,000 from the
operating activities of this company. In both cases, the starting spot was net income (either as the entire
income statement or as the single number). Then, all noncash items were removed as well as nonoperating gains and losses. Finally, the eect of changes in the various connector accounts that bridge the
time period between accrual accounting recognition and the cash exchange are included so that only
the cash ows from operating activities remain.
In reporting operating activity cash ows by means of the indirect method (Figure 17.8), the following pattern can be seen.
A change in a connector account that is an asset is reected on the statement in the opposite
fashion. As shown previously, increases in both accounts receivable and prepaid rent are
subtracted while a decrease in inventory is added.
< A change in a connector account that is a liability is included on the statement in an identical
change. An increase in accounts payable is added whereas a decrease in salary payable is
subtracted.
<

A quick visual comparison of the direct method (Figure 17.6) and the indirect method (Figure 17.8)
makes the two appear almost completely unrelated. However, when analyzed more closely, the same
series of steps can be seen in each. They both begin with the income for the period. Noncash items and
nonoperating gains and losses are removed. Changes in the connector accounts for the period are
factored in so that only the cash from operating activities remains.

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FINANCIAL ACCOUNTING VERSION 2.0

T E S T

Y O U R S E L F

Question:
The Hemingway Company reported net income last year of $354,000. Within that gure, depreciation expense
of $37,000 was included. In addition, accounts receivable increased by $11,000 during the period. What
amount of cash did this company generate from its operating activities?
a.
b.
c.
d.

$306,000
$328,000
$380,000
$402,000

Answer:
The correct answer is choice c: $380,000.
Explanation:
Depreciation is a noncash expense that appears within net income as a negative. To remove it, the $37,000
gure is added. Addition counterbalances the original negative eect. The increase in accounts receivable
means that customers were slow to pay this year. Credit sales were greater than the amount of cash received.
The $11,000 is subtracted from net income to arrive at the lower cash gure. Thus, cash inow from operating
activities is $380,000 ($354,000 + $37,000 $11,000).

T E S T

Y O U R S E L F

Question:
The Faulkner Corporation reported net income in Year One of $437,000. Accounts receivable at the start of the
period totaled $26,000 but grew to $41,000 by the end of Year One. Beginning insurance payable was $7,000
but fell to an ending balance of $4,000. What amount of cash did Faulkner collect as a result of its operating
activities?
a.
b.
c.
d.

$419,000
$425,000
$449,000
$455,000

Answer:
The correct answer is choice a: $419,000.
Explanation:
Accounts receivable went from $26,000 to $41,000. The $15,000 increase indicates that credit sales were
greater than cash collected. The $15,000 is subtracted from net income. Insurance payable fell by $3,000
($7,000 to $4,000); thus, the amount paid was greater than the expense recognized. Cash was spent to reduce
the liability. The $3,000 is also subtracted in arriving at the cash change. The cash inow from operating activities is $419,000 ($437,000 net income $15,000 and $3,000).

3.4 The Reporting of Dividends and Interest on the Statement of Cash

Flows
Question: When listing cash ows from operating activities for the year ended December 31, 2010, EMC
Corporation (a technology company) included an inow of nearly $103 million labeled as dividends and
interest received as well as an outow of over $76 million shown as interest paid.
Unless a company is a bank or nancing institution, dividend and interest revenues do not appear to
relate to its central operating function. For most businesses, these cash inows are fundamentally dierent from the normal sale of goods and services. Monetary amounts collected as dividends and interest resemble investing activity cash inows because they are often generated from noncurrent assets. Similarly,
interest expense payments are normally associated with noncurrent liabilities rather than resulting from
daily operations. Interest expenditures could certainly be viewed as a nancing activity cash outow.
Dividend distributions are not in question here. They are labeled as nancing activity cash outows
because they are made directly to stockholders. The issue is the classication of dividend and interest revenue collections and interest expense payments. Why is cash received as dividends and interest and cash
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IN A SET OF FINANCIAL STATEMENTS, WHAT INFORMATION IS CONVEYED BY THE STATEMENT OF CASH FLOWS?

587

paid as interest expense reported within operating activities on a statement of cash ows rather than as
investing activities and nancing activities?
Answer: Authoritative pronouncements that create U.S. GAAP are the subject of years of intense
study, discussion, and debate. In this process, controversies often arise. When FASB issued its ocial
standard on cash ows in 1987, three of the seven board members voted against passage. Their opposition, at least in part, came from the handling of interest and dividends. On page ten of Statement 95,
Statement of Cash Flows, these three argue that interest and dividends received are returns on investments in debt and equity securities that should be classied as cash inows from investing activities.
They believe that interest paid is a cost of obtaining nancial resources that should be classied as a
cash outow for nancing activities.
The other board members were not convinced. Thus, inclusion of dividends collected, interest collected, and interest paid within an entitys operating activity cash ows became a requirement of U.S.
GAAP. Such disagreements arise frequently in the creation of ocial accounting rules.
The majority of the board apparently felt thatbecause these transactions occur on a regular ongoing basisa better portrait of the organizations cash ows is provided by inclusion within operating
activities. At every juncture of nancial accounting, multiple possibilities for reporting exist. Rarely is
complete consensus ever achieved as to the most appropriate method of presenting nancial
information.

Talking With an Independent Auditor about International Financial Reporting

Standards
Following is the conclusion of our interview with Robert A. Vallejo, partner with the accounting rm
PricewaterhouseCoopers.
Question: Any company that follows U.S. GAAP and issues an income statement must also present a statement
of cash ows. Cash ows are classied as resulting from operating activities, investing activities, or nancing
activities. Are IFRS rules the same for the statement of cash ows as those found in U.S. GAAP?
Rob Vallejo: Dierences do exist between the two frameworks for the presentation of the statement of cash
ows, but they are relatively minor. Probably the most obvious issue involves the reporting of interest and dividends that are received and paid. Under IFRS, interest and dividend collections may be classied as either
operating or investing cash ows whereas, in U.S. GAAP, they are both required to be shown within operating
activities. A similar dierence exists for interest and dividend payments. These cash outows can be classied
as either operating or nancing activities according to IFRS. For U.S. GAAP, interest payments are viewed as operating activities whereas dividend payments are considered nancing activities.

K E Y

T A K E A W A Y

Most reporting entities use the indirect method to report net cash ows from operating activities. This
presentation begins with net income and then eliminates any noncash items (such as depreciation expense)
as well as nonoperating gains and losses. Their impact on net income is reversed to create this removal. In addition, changes in each balance sheet connector account (such as accounts receivables, inventory, accounts
payable, and salary payable) must also be utilized in converting from accrual accounting to cash. Changes in
asset connectors are reversed in arriving at cash ows from operating activities whereas changes in liability
connectors have the same impact (increases are added and decreases are subtracted). Cash transactions that
result from interest revenue, dividend revenue, and interest expense are all reported within operating activities
because they happen on a regular ongoing basis. However, some argue that interest and dividend collections
are really derived from investing activities and interest payments relate to nancing activities.

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FINANCIAL ACCOUNTING VERSION 2.0

4. CASH FLOWS FROM INVESTING AND FINANCING

ACTIVITIES
L E A R N I N G

O B J E C T I V E S

At the end of this section, students should be able to meet the following objectives:
1. Analyze the changes in assets that are not operating assets to determine cash inows and outows from investing activities.
2. Analyze the changes in liabilities (that are not operating liabilities) and stockholders equity accounts to determine cash inows and outows from nancing activities.
3. Recreate journal entries to determine the individual eects on ledger accounts where several
cash transactions have occurred.

4.1 Determining Cash Flows from Investing Activities

Question: As shown in Figure 17.9, The Walt Disney Company reported a net cash outow of over $4.5
billion as a result of investing activities undertaken during the year ended October 2, 2010.
FIGURE 17.9 The Walt Disney Company Investing Activity Cash Flows for Year Ended October 2, 2010

This section of Disneys statement of cash ows shows that a number of transactions involving assets
(other than operating assets such as inventory and accounts receivable) created this $4.5 billion reduction
in cash. Information about management decisions is readily available. For example, a potential investor
can see that ocials chose to spend over $2.1 billion in cash during this year in connection with Disneys
parks, resorts and other property. Interestingly, this expenditure level is approximately 20 percent higher
than the monetary amount invested in those assets the previous year. With a strong knowledge of nancial accounting, a portrait of a business and its activities begins to become clear.
After the various cash amounts are determined, conveyance of this information does not appear particularly complicated. How does a company arrive at the investing activity gures that are disclosed
within the statement of cash ows?
Answer: Here, the accountant is not interested in assets such as inventory, accounts receivable, and
prepaid rent because they are included within operating activities. Instead, each of the other asset accounts (land, buildings, equipment, patents, trademarks, and the like) is investigated to determine the
individual transactions that took place during the year. The amount of every cash change is identied
and reported. A sale of land can create a cash inow whereas the acquisition of a building may well require the payment of some amount of cash.
The diculty in this process frequently comes from having to sort through multiple purchases and
sales to compute the exact amount of cash involved in each transaction. At times, determining the individual cash eects can resemble the work needed to solve a puzzle with many connecting pieces. Often,
the journal entries that were made originally must be replicated. Even then, the cash portion of these
transactions may have to be determined by mathematical logic. To illustrate, assume that the Hastings
Company reports the account balances that appear in Figure 17.10.

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CHAPTER 17

IN A SET OF FINANCIAL STATEMENTS, WHAT INFORMATION IS CONVEYED BY THE STATEMENT OF CASH FLOWS?

589

FIGURE 17.10 Account Balances to Illustrate Cash Flows from Investing Activities

In looking through the nancial records maintained by this business, assume the accountant nds two
additional pieces of information about the accounts in Figure 17.10:
Equipment costing $600,000 was sold this year for cash.
< Other equipment was acquired, also for cash.
<

Sale of equipment. This transaction is analyzed rst because the cost of the equipment is already
provided. However, the accumulated depreciation relating to the disposed asset is not known. The accountant must study the available data to determine that missing number because that balance is also
removed when the asset is sold.
Accumulated depreciation at the start of the year was $300,000 but depreciation expense of
$230,000 was then reported as shown in Figure 17.10. This expense was apparently recognized through
the year-end adjustment recreated in Figure 17.11.
FIGURE 17.11 Assumed Adjusting Entry for Depreciation

The depreciation entry increases the accumulated depreciation account to $530,000 ($300,000 plus
$230,000). However, the end-of-year balance is not $530,000 but only $450,000. What caused the
$80,000 drop in this contra asset account?
Accumulated depreciation represents the cost of a long-lived asset that has already been expensed.
Virtually the only situation in which accumulated depreciation is reduced is the disposal of the related
asset. Here, the accountant knows equipment was sold. Although the amount of accumulated depreciation relating to that asset is unknown, the assumption can be made that the sale caused this reduction
of $80,000. No other possible decrease in accumulated depreciation is mentioned.
Thus, the accountant believes equipment costing $600,000 but with accumulated depreciation of
$80,000 (and, hence, a net book value of $520,000) was sold. The amount received must have created
the $74,000 gain that is shown in the reported balances in Figure 17.10.
A hypothetical journal entry can be constructed in Figure 17.12 from this information.
FIGURE 17.12 Assumed Journal Entry for Sale of Equipment

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FINANCIAL ACCOUNTING VERSION 2.0

This journal entry only balances if the cash received is $594,000. Equipment with a book value of
$520,000 was sold during the year at a reported gain of $74,000. Apparently, $594,000 was the cash received. How does all of this information aect the statement of cash ows?
A cash inow of $594,000 is reported within investing activities. It is labeled something like cash
received from sale of equipment.
< Depreciation of $230,000 is eliminated from net income in computing the cash ows from
operating activities because this expense had no impact on cash ows.
< In determining the cash ows from operating activities, the $74,000 gain is also eliminated from
net income. The $594,000 cash collection comes from an investing activity rather than an
operating activity.
<

Purchase of equipment. According to the information provided, another asset was acquired this year
but its cost is not provided. Once again, the accountant must puzzle out the amount of cash involved in
the transaction.
The equipment account began the year with a $730,000 balance. The sale of equipment costing
$600,000 was just discussed. This transaction should have dropped the ledger account to $130,000
($730,000 less $600,000). However, at the end of the period, the amount reported for this asset is actually $967,000. How did the cost of equipment rise from $130,000 to $967,000? If no other transaction is
mentioned, the most reasonable explanation is that additional equipment was acquired at a cost of
$837,000 ($967,000 less $130,000). Unless information is available indicating that part of this purchase
was made on credit, the journal entry that was recorded originally must have been made as shown in
Figure 17.13.
FIGURE 17.13 Assumed Journal Entry for Purchase of Equipment

At this point, the changes in all related accounts (equipment, accumulated depreciation, depreciation
expense, and the gain on sale of equipment) have been used to determine the two transactions for the
period and their related cash inows and outows. In the statement of cash ows for this company, the
investing activities are listed as shown in Figure 17.14.
FIGURE 17.14 Statement of Cash FlowsInvesting Activities

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CHAPTER 17

IN A SET OF FINANCIAL STATEMENTS, WHAT INFORMATION IS CONVEYED BY THE STATEMENT OF CASH FLOWS?

T E S T

591

Y O U R S E L F

Question:
The following accounts appear on Red Companys balance sheets at the beginning and end of Year One:

FIGURE 17.15

During Year One, equipment with an original cost of $30,000 and accumulated depreciation of $18,000 was
sold at a loss of $3,000. What is the cash received on the sale of that equipment?
a.
b.
c.
d.

$9,000
$12,000
$15,000
$16,000

Answer:
The correct answer is choice a: $9,000.
Explanation:
The book value of this equipment is $12,000 ($30,000 cost less $18,000 accumulated depreciation). Because
the equipment was sold at a loss of $3,000, cash received must have been only $9,000 ($12,000 less $3,000).
The transaction can also be recreated through the following entry.

FIGURE 17.16

The loss is eliminated from income in determining the cash ows from operating activities. If the direct method is used, the loss is simply omitted. If the indirect method is used, the loss (because it is a negative within
net income) is added back to net income. The $9,000 cash inow appears in the investing activity section of
the statement of cash ows.

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FINANCIAL ACCOUNTING VERSION 2.0

T E S T

Y O U R S E L F

Question:
The following accounts appear on White Companys balance sheets at the beginning and end of Year One.

FIGURE 17.17

One piece of equipmentwith an original cost of $30,000 and accumulated depreciation of $18,000was
sold at a loss of $3,000. On a statement of cash ows, what amount should be reported as cash paid for additional equipment bought during the period?
a.
b.
c.
d.

$145,000
$175,000
$205,000
$235,000

Answer:
The correct answer is choice c: $205,000.
Explanation:
Based on the information provided, the equipment account decreased by the $30,000 cost of the asset that
was sold. The reported balance would have fallen from $220,000 to $190,000. At years end, equipment was
not reported as $190,000 but rather as $395,000. With no other transactions mentioned, the $205,000 increase
from $190,000 to $395,000 must have been created by purchase of additional equipment. This $205,000 acquisition appears in the investing activities section as a cash outow.

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CHAPTER 17

IN A SET OF FINANCIAL STATEMENTS, WHAT INFORMATION IS CONVEYED BY THE STATEMENT OF CASH FLOWS?

T E S T

593

Y O U R S E L F

Question:
The following accounts appear on Blue Companys balance sheets at the beginning and end of Year One.

FIGURE 17.18

Equipment with an original cost of $30,000 and accumulated depreciation of $18,000 was sold at a loss of
$3,000. What is the depreciation expense recognized during the year and, if the indirect method is used, how
is this reported in the statement of cash ows?
a.
b.
c.
d.

$19,000 is subtracted from net income

$28,000 is added to net income
$34,000 is added to net income
$46,000 is subtracted from net income

Answer:
The correct answer is choice c: $34,000 is added to net income.
Explanation:
Because of the sale of equipment, accumulated depreciation drops by $18,000 from $140,000 to $122,000. By
the end of Year One, the account is $156,000. Accumulated depreciation only increases as a result of recording depreciation expense. The increase from $122,000 to $156,000 points to an expense of $34,000. Depreciation is a negative noncash item in net income and is removed in presenting cash ows from operating activities. With the indirect method is used, depreciation is added back.

4.2 Determining Cash Flows from Financing Activities

Question: For the year ended January 2, 2011, Johnson & Johnson reported a net cash outow from nancing activities of over $4.9 billion. Within the statement of cash ows, this total was broken down into
seven specic categories as replicated in Figure 17.19.

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FINANCIAL ACCOUNTING VERSION 2.0

FIGURE 17.19 Financing Activity Cash Flows Reported by Johnson & Johnson for Year Ended January
2, 2011

In preparing a statement of cash ows, how does a company such as Johnson & Johnson determine the
amounts that were paid and received as a result of its various nancing activities?
Answer: As has been indicated, nancing activities reect transactions that are not part of a companys central operations and involve either a liability or a stockholders equity account. Johnson &
Johnson paid over $5.8 billion in cash dividends in this year and nearly $2.8 billion to repurchase common stock (treasury shares). During the same period, approximately $7.9 billion in cash was received
from borrowing money on short-term debt and another $1.1 billion from long-term debt. None of
these amounts are directly associated with the companys operating activities. However, they do involve either liabilities or stockholders equity accounts and are appropriately reported as nancing
activities.
The procedures used in determining the cash amounts to be reported as nancing activities are the
same as demonstrated above for investing activities. The change in each relevant balance sheet account
is analyzed to determine cash payments and receipts. In starting this process, many liabilities such as
accounts payable, rent payable, and salaries payable are ignored because they relate only to operating
activities. However, the remaining liabilities and all stockholders equity accounts must be studied. The
recording of individual transactions can be replicated so that the cash eect is isolated.
To illustrate, various account balances for the Hastings Corporation are presented in the schedule
included in Figure 17.20.
FIGURE 17.20 Account Balances to Illustrate Cash Flows from Financing Activities

In examining the nancial records for the Hastings Corporation for this year, the accountant nds several additional pieces of information:
1. Cash of $400,000 was borrowed by signing a note payable with a local bank.
2. Another note payable was paid o prior to its maturity date because of a drop in interest rates.
3. Treasury stock was reissued to the public for cash.
4. A cash dividend was declared and distributed.
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595

Once again, the various changes in each account balance can be analyzed to determine the cash ows,
this time to be reported as nancing activities.
Borrowing on note payable. Complete information about this transaction is available. Hastings
Corporation received $400,000 in cash from a bank by signing a note payable. Figure 17.21 provides
the journal entry to record the incurrence of this liability.
FIGURE 17.21 Assumed Journal Entry for Signing of Note Payable

On a statement of cash ows, this transaction is listed within the nancing activities as a $400,000 cash
inow.
Paying note payable. Incurring the $400,000 debt raises the note payable balance from $680,000 to
$1,080,000. By the end of the year, this account only shows a total of $876,000. The companys notes
payable have decreased in some way by $204,000 ($1,080,000 less $876,000). According to the information gathered by the accountant, a debt was paid o this year prior to maturity. In addition, the general
ledger reports a $25,000 loss on the early extinguishment of a debt. When a bond or note is settled before its maturity, a penalty payment is often required. Once again, the journal entry for this transaction
can be recreated by logical reasoning as shown in Figure 17.22.
FIGURE 17.22 Assumed Journal Entry for Extinguishment of Debt

To balance this entry, cash of $229,000 must have been paid. Spending this amount of money to extinguish a $204,000 liability creates the $25,000 reported loss. The cash outow of $229,000 relates to a liability and is, thus, listed on the statement of cash ows as a nancing activity.
Issuance of treasury stock. This equity balance reects the cost of all repurchased shares. During the
year, the total in the T-account fell by $100,000 from $400,000 to $300,000. Apparently, $100,000 was
the cost of the companys shares reissued to the public. At the same time, the capital in excess of cost
balance rose from $120,000 to $160,000. That $40,000 increase in contributed capital must have been
created by this issuance since no other stock transaction is mentioned. The shares were sold for more
than their purchase price. The journal entry must have looked like the one presented in Figure 17.23.
FIGURE 17.23 Assumed Journal Entry for Sale of Treasury Stock

If the original cost of the treasury stock was $100,000 and $40,000 was added to the capital in excess of
cost, the cash inow from this transaction had to be $140,000. Cash received from the issuance of treasury stock is reported as a nancing activity of $140,000 because it relates to a stockholders equity
account.
Distribution of dividend. A dividend has been paid to the companys stockholders, but the amount
is not shown in the information provided. However, other information is available. Net income for the
period was reported as $200,000. Those prots increase retained earnings. As a result, the beginning
balance of $454,000 increases to $654,000. Instead, retained earnings only rose to $619,000 by the end
of the year. The unexplained drop of $35,000 ($654,000 less $619,000) must have resulted from the
payment of the dividend. No other possible reason is given for this reduction. The appropriate journal
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entry is found in Figure 17.24. Hence, a cash dividend distribution of $35,000 is shown within the
statement of cash ows as a nancing activity.
FIGURE 17.24 Assumed Journal Entry for Payment of Dividend

In this example, four specic nancing activity transactions have been identied as created changes in
cash. This section of Hastings statement of cash ows can be created in Figure 17.25. All the sources
and uses of this companys cash (as related to nancing activities) are apparent from this schedule.
Determining the cash amounts can take some computational logic, but the information is then clear
and useful.
FIGURE 17.25 Statement of Cash FlowsFinancing Activities

T E S T

Y O U R S E L F

Question:
The Abraham Company begins the year with bonds payable having a reported balance of $600,000. The ending balance is $700,000. This companys income statement for the year reports a gain on extinguishment of
bond of $9,000. During the year, new bonds were issued at their face value of $300,000. How much cash was
paid for the bonds that were extinguished?
a.
b.
c.
d.

$191,000
$209,000
$291,000
$309,000

Answer:
The correct answer is choice a: $191,000.
Explanation:
The issuance of $300,000 in new debt would increase the liability balance from $600,000 to $900,000.
However, the account ended the year at only $700,000. The unexplained reduction of $200,000 must have
been the face value of the debt paid o ($900,000 less $700,000). Because a gain of $9,000 was recognized on
this transaction, the company managed to eliminate the debt by paying only $191,000.

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IN A SET OF FINANCIAL STATEMENTS, WHAT INFORMATION IS CONVEYED BY THE STATEMENT OF CASH FLOWS?

T E S T

597

Y O U R S E L F

Question:
The Oregon Companys total stockholders equity on January 1 was $870,000. By the end of the year, stockholders equity had risen to $990,000. This company bought treasury stock this year. The shares had originally
been issued for $120,000 but were reacquired for $150,000. In addition, Oregon reported net income for the
year of $340,000. No other stock transactions occurred but a cash dividend was paid. How much should Oregon report on the statement of cash ows for the dividend distribution?
a.
b.
c.
d.

$50,000
$60,000
$70,000
$80,000

Answer:
The correct answer is choice c: $70,000.
Explanation:
Acquisition of the treasury stock reduces stockholders equity by $150,000 while net income increases it by
$340,000. If nothing else took place, stockholders equity at the end of the period would be $1,060,000
($870,000 less $150,000 but plus $340,000). Instead, the ending total is actually $990,000. Because only the dividend distribution is left to include, it must have been the amount needed to reduce stockholders equity to
its nal reported total ($70,000 or $1,060,000 less $990,000).

K E Y

T A K E A W A Y

In determining cash ows from investing activities, current assets such as inventory, accounts receivable, and
prepaid rent are ignored because they relate to operating activities. The accountant then analyzes all changes
that have taken place in each remaining asset such as buildings and equipment. Hypothetical journal entries
can be recreated to replicate the impact of each transaction and lead to the amount of cash involved. For nancing activities, a similar process is applied. Liabilities such as accounts payable, interest payable, and salaries
payable are not excluded; they only impact operating activities. Monetary changes in the remaining liabilities
(notes and bonds payable, for example) and all stockholders equity accounts are analyzed. Again, the journal
entries that were recorded to report individual events can be recreated so that the cash amounts are known.
Once all changes in these accounts have been determined, the various sections of the statement of cash ows
can be produced.

Talking with a Real Investing Pro (Continued)

Following is the conclusion of our interview with Kevin G. Burns.
Question: Many investors watch the movement of a companys reported net income and earnings per share
and make investment decisions based on increases or decreases. Other investors argue that the amount of
cash ows generated by operating activities is really a more useful gure. When you make investing decisions
are you more inclined to look at net income or the cash ows generated by operating activities?
Kevin Burns: As I have said previously, net income and earnings per share have a lot of subjectivity to them. Unfortunately, cash ow information can be badly misused also. A lot of investors seem fascinated by the calculation of EBITDA which is the companys earnings before interest, taxes, depreciation, and amortization. I guess
you could say that determining EBITDA is like blending net income and cash ows. But, to me, interest and
taxes are real cash expenses so why exclude them? The biggest mistake I ever made as an investor or nancial
advisor was putting too much credence in EBITDA as a technique for valuing a business. Earnings are earnings
and that is important information. A lot of analysts now believe that dierent cash ow models should be constructed for dierent industries. If you look around, you can nd cable industry cash ow models, theater cash
ow models, entertainment industry cash ow models, and the like. I think that is a lot of nonsense. You have
to obtain a whole picture to know if an investment is worthwhile. While cash generation is important in creating that picture so are actual earnings and a whole lot of other nancial information found in a companys annual report.

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FINANCIAL ACCOUNTING VERSION 2.0

5. APPENDIX: COMPREHENSIVE
ILLUSTRATIONSTATEMENT OF CASH FLOWS
5.1 The Creation of a Complete Statement of Cash Flows
Question: All three sections of the statement of cash ows are presented in this chapter but in separate
coverage. Now, through a comprehensive illustration, these categories will be combined into a formal and
complete statement.
The following information has been uncovered within the internal records maintained by the Ashe
Corporation for Year Seven. The company is a small organization that was incorporated several years ago
in the western part of North Carolina.
A few of the signicant nancial events that occurred during the current year are as follows:
Land that had cost Ashe $7,000 several years ago was sold to an outside buyer.
A building was also sold but for $210,000 in cash. This property had an original cost of $230,000.
Accumulated depreciation to date on this building was $30,000. This building was replaced with a
new purchase made for cash during the year.
< Equipment was purchased for $44,000 in cash to replace other equipment that was sold at the
beginning of the year.
< Additional cash of $110,000 was borrowed on a note payable.
< Common stock was issued to an investor for cash of $5,000.
< A cash dividend was declared and paid to the owners near the end of the year.
<
<

The accountant for the Ashe Corporation is now attempting to prepare the companys rst complete
set of nancial statements as part of an application for a new loan. As part of this process, the accountant has created informal balance sheets (Figure 17.26) and an income statement (Figure 17.27).
FIGURE 17.26 Ashe CorporationBeginning and Ending Balance Sheets for Year Seven

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IN A SET OF FINANCIAL STATEMENTS, WHAT INFORMATION IS CONVEYED BY THE STATEMENT OF CASH FLOWS?

599

FIGURE 17.27 Ashe CorporationIncome Statement for Year Ended December 31, Year Seven

A statement of cash ows is now needed for the Ashe Corporation. As shown in Figure 17.26, cash increased from $1,000 to $27,000 during the course of this year. That $26,000 change should be explained.
How does a company construct an entire statement of cash ows? Application of the indirect method for
presenting operating activities is so prevalent that company ocials have decided to use it.

Operating Activities
Answer:
In both the direct and indirect methods, net cash ows from operating activities are derived by following several specic steps:
1. Start with net income, either the balance for the period (the indirect method) or the income
statement as a whole (the direct method). Because the indirect method is being used here, the
preparation of the operating activities section begins with Ashe Corporations reported net
income of $40,000 (from Figure 17.27).
2. Remove noncash expenses. Here, depreciation must be eliminated. This year, the reported amount
is $70,000 (buildings) and $30,000 (equipment). As expenses, depreciation is a negative within
net income. To remove these two negative amounts, they are added back to the net income gure.
Negatives are removed by the inclusion of a positive.
3. Remove nonoperating gains and losses because they relate to either investing activities or nancing
activities. Consequently, both the loss on the sale of land ($5,000) and the gain on sale of a
building ($10,000) are removed. Neither relates to an operating activity. The loss (a negative) is
eliminated by an addition to net income while the gain (a positive) is oset by means of a
subtraction.
4. Convert the remaining revenue and expense balances from accrual accounting to cash accounting
by adjusting for changes occurring during the year in related balance sheet connector accounts. The
identity of these connector accounts and the amount of each change is reported in Figure 17.28.
The increases and decreases were computed from the beginning and ending balance sheets
shown previously in Figure 17.26.
FIGURE 17.28 Ashe CorporationChange in Connector Accounts

The change in each of these six connector accountsaccounts receivable, inventory, accounts payable,
wages payable, interest payable, and taxes payableis factored into the computation of cash ows from
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FINANCIAL ACCOUNTING VERSION 2.0

operating activities to arrive at the actual eect on cash for the period. In this way, the accrual accounting gures reported on the income statement are changed to their cash equivalents.
Accounts receivableincrease of $15,000. A receivables balance can only rise in this manner when
more sales are made on credit than cash is collected. The reduction in the cash received causes the receivable to increase. This decrease in cash collections is reected by subtracting the $15,000 from net
income.
Inventorydecrease of $4,000. The inventory balance dropped, which indicates that less inventory
was bought this year than was sold. Fewer purchases take less money, keeping the cash balance high.
The decrease in inventory and its impact on cash are reported within operating activities through an addition to net income.
Accounts payableincrease of $4,000. Liabilities increase because more debt is acquired than the
amount of cash that is paid. Slowness of payment increases accounts payable but also helps keep the
companys cash balance high. This increase in accounts payable is added to net income as another step in
arriving at the cash ows from operating activities.
Wages payableincrease of $3,000; interest payableincrease of $1,000. The balance of both of
these accrued liabilities went up during this year. Once again, as with accounts payable, an increase in a
liability indicates a reduction in payments. This saving of cash is shown when using the indirect method
by adding the increases in wages payable and interest payable to net income.
Taxes payabledecrease of $1,000. A liability goes down because cash payments are made that reduce the obligation. However, those payments also shrink the amount of cash held. This eect is
mirrored by subtracted the decrease in the liability from net income.
The steps for determining cash ows generated by operating activities have been completed (using
the indirect method), and this part of the statement of cash ows can be prepared as shown in Figure
17.29.
FIGURE 17.29 Ashe CorporationCash Flows from Operating Activities for Year Ended December 31,
Year Seven (Indirect Method)

As can be seen by comparing Figure 17.29 to the companys income statement (Figure 17.27), cash
generated by operating activities ($131,000) is considerably higher than the net income reported for
that same period ($40,000). Such dierences are not uncommon in the business world especially since
depreciation is often a large expense that does not require cash.

Investing Activities
After accounting for operating activities, only three asset accounts remain to be examined (along with
accumulated depreciation balances where appropriate): land, buildings, and equipment. The accountant analyzes each individually and attempts to recreate the transactions that brought about the various
changes during the year.
Land decreased by $7,000 ($21,000 to $14,000). The information provided by the accountant states
that land costing $7,000 was sold but does not indicate the amount of cash received. However, the income statement discloses a $5,000 loss on the sale of land. If land costing $7,000 is sold at a loss of
$5,000, only $2,000 in cash is received. The journal entry shown in Figure 17.30 was apparently
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601

recorded by Ashe Corporation for this transaction. Land is an asset, so this $2,000 inow of cash will be
reported as an investing activity.
FIGURE 17.30 Assumed Journal Entry for Sale of Land

Buildings increased by $30,000 ($390,000 to $420,000). According to the introductory information, one
building with a cost of $230,000 but a net book value of $200,000 (related accumulated depreciation
was identied as $30,000) was sold during this year for $210,000. The company received $10,000 more
than net book value which creates the $10,000 gain that appears on the companys income statement.
Because all account balances are known here, the journal entry made by the Ashe Corporation can be
replicated in Figure 17.31. This transaction will be listed as a $210,000 cash inow within investing
activities on the statement of cash ows.
FIGURE 17.31 Assumed Journal Entry for Sale of Building

The entry made in Figure 17.31 does not fully explain the monetary change appearing in the buildings
account during this period. This sale drops that account from $390,000 to $160,000 (because of the
$230,000 reduction in cost). However, the nal balance for the year was not $160,000 but rather
$420,000, an increase of $260,000. The introductory information does indicate that a new building was
acquired as a replacement. Without mention of any other building transaction, the assumption must be
made that this asset was acquired for $260,000 through the entry presented in Figure 17.32. The cash
payment will be disclosed on the statement of cash ows as a $260,000 investing activity outow.
FIGURE 17.32 Assumed Journal Entry for Purchase of Building

Equipment increased by $14,000 ($36,000 to $50,000). The information provided by the companys accountant states that one piece of equipment was purchased during the year for $44,000 in cash. This
transaction is recorded in Figure 17.33 and identies another cash outow to be reported within the investing activities.
FIGURE 17.33 Assumed Journal Entry for Purchase of Equipment

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FINANCIAL ACCOUNTING VERSION 2.0

This journal entry does not entirely explain the change that occurred in the equipment account. The
beginning balance of $36,000 grew to $80,000 as a result of this $44,000 purchase. Yet, the ending balance was just $50,000. Apparently, during the year, another $30,000 reduction ($80,000 less $50,000)
took place. Equipment accounts decrease as the result of a sale or some other type of disposal. Equipment was sold this period; its cost must have been the cause of this $30,000 decrease.
In recording the disposal of a long-lived asset, removal of any related accumulated depreciation is
also necessary. For the equipment owned by Ashe Corporation, beginning accumulated depreciation
was $17,000a gure that increased by $30,000 due to the depreciation for that year (to a balance of
$47,000). However, the ending accumulated depreciation account shows a balance of only $20,000.
Another change in this contra account, a reduction of $27,000 ($47,000 less $20,000), still needs to be
explained. This gure is the accumulated depreciation for the equipment that was sold. That balance
was removed in recording the disposal of this asset.
Because no gain or loss on the disposal of equipment is reported in the income statement, the
amount received must have been equal to the $3,000 net book value of the asset ($30,000 less $27,000).
With that assumption, the journal entry shown in Figure 17.34 can be constructed. The $3,000 collection will be reported as a cash inow from an investing activity.
FIGURE 17.34 Assumed Journal Entry for Sale of Equipment

All changes in the land, buildings, and equipment accounts have now been examined. Each individual
transaction was recreated and the change in cash calculated. The investing activity section of the statement of cash ows can then be prepared in Figure 17.35 based on the information that has been
gathered.
FIGURE 17.35 Ashe CorporationCash Flows from Investing Activities for Year Ended December 31,
Year Seven

Financing Activities
Only three accounts remain unexamined: notes payable, capital stock, and retained earnings. They are
either liabilities or stockholders equity accounts and, thus, lead to nancing activities.
Notes payable increased by $10,000 ($120,000 to $130,000). The information gathered from the
company disclosed the signing of a note payable for $110,000 in cash. The journal entry is made in Figure 17.36. This transaction is obviously an inow of that amount of cash that will be reported as a nancing activity.
FIGURE 17.36 Assumed Journal Entry for Signing of Note Payable

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IN A SET OF FINANCIAL STATEMENTS, WHAT INFORMATION IS CONVEYED BY THE STATEMENT OF CASH FLOWS?

603

According to the beginning and ending balance sheets, notes payable did not actually increase by
$110,000 but only by $10,000. Thus, another transaction must have taken place that reduced this liability by $100,000. Except in unusual situations, notes payable only decrease because of cash payments.
Because no gain or loss on extinguishment of debt is reported in the income statement, Ashe Corporation must have paid exactly $100,000 to retire that same amount of debt. The journal entry is shown in
Figure 17.37 and the accountant has located another nancing activity cash ow (a $100,000 payment).
FIGURE 17.37 Assumed Journal Entry for Extinguishment of Note Payable

The recording of this second transaction (Figure 17.37) leads to the appropriate change in notes payable (the $10,000 account increase was created by $110,000 in additional borrowing and a $100,000 decrease payment).
Capital stock increased by $5,000 ($50,000 to $55,000). The information provided by the accountant states that Ashe Corporation issued stock to an investor for $5,000. This contribution created the
change seen in this account, which is recorded in Figure 17.38. The business received this money and
must report a nancing activity cash inow of $5,000. No other stock transactions are indicated for
Ashe Corporation.
FIGURE 17.38 Assumed Journal Entry for Issuance of Capital Stock

Retained earnings increased by $9,000 ($140,000 to $149,000). This nal balance sheet account increased by $40,000 because of the net income earned by Ashe Corporation as reported on its income
statement. At the end of the year, this amount is closed into retained earnings. The cash ows relating
to net income have already been presented within operating activities.
To create the overall change of $9,000, retained earnings must have also declined by $31,000. As
mentioned several times in this textbook, other than net income, retained earnings are changed by virtually only one other event: the distribution of dividends. The information provided by the accountant
mentions that a dividend was paid this year. That dividend must have caused the remaining $31,000
drop. Net income of $40,000 and a dividend distribution of $31,000 provide the reported increase in
retained earnings of $9,000. The dividend entry is presented in Figure 17.39.
FIGURE 17.39 Assumed Journal Entry for Payment of Cash Dividend

With this nal nancing activity, an entire statement of cash ows can be created for the Ashe Corporation in Figure 17.40. All the transactions that aected cash during the current period are included
within one of the three categories. Investors and other interested parties can gain a complete picture of
the cash results of operations as well as the investing and nancing decisions made by management.
This portrait provides an excellent complement to the income statement, statement of retained earnings, and balance sheet.

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FIGURE 17.40 Ashe CorporationStatement of Cash Flows Year Ended December 31, Year Seven

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IN A SET OF FINANCIAL STATEMENTS, WHAT INFORMATION IS CONVEYED BY THE STATEMENT OF CASH FLOWS?

605

Video Clip
Professor Joe Hoyle talks about the ve most important points in Chapter 17.

View the video online at: http://bit.ly/hoyle17-2

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606

FINANCIAL ACCOUNTING VERSION 2.0

6. END-OF-CHAPTER EXERCISES
Q U E S T I O N S
1. James Hartwell is preparing nancial statements for the Ashton Corporation. Hartwell wants these
statements to conform to U.S. GAAP so they are more credible with decision makers. Only a balance sheet
has been prepared so far. Is Hartwell required to prepare a statement of cash ows according to U.S.
GAAP?
2. As of December 31, Year One, the Midlothian Corporation reports cash of $318,455. What might be
included in this gure?
3. As of December 31, Year One, the Midlothian Corporation reports cash equivalents of $74,329. What
might be included in this gure?
4. Sashya Douglas is analyzing a statement of cash ows reported by a company that has securities traded
on the New York Stock Exchange. Is the direct method or the indirect method more likely to be seen? How
can Douglas tell whether the direct method or the indirect method has been applied?
5. What are the three sections of a statement of cash ows? What types of transactions are included in each
of these categories?
6. During the current year, the Durham Corporation issued 10,000 shares of $1 par value common stock with
a stock market value of $18 per share in exchange for 2 acres of land. How is this transaction reported on a
statement of cash ows?
7. A company reports rent expense for the current year of $74,000. Why is this gure not the same as the
cash paid by the company for rent?
8. The Ames Corporation reports salary expense of $875,000. During that period of time, the salary payable
balance rose by $39,000. How much cash did the company pay its employees this period?
9. The Lewiston Corporation reported cost of goods sold of $376,000 for Year One. During that period, its
inventory went up by $72,000 while its accounts payable fell by $19,000. How much cash did the
company pay for inventory purchases during Year One?
10. The Clarkson Corporation reported depreciation expense of $107,000 in Year One. In a statement of cash
ows where the direct method is applied, how is this expense reported? If the indirect method is applied,
how is this expense reported?
11. For the year ended December 31, Year One, the Maeburry Corporation reports an $85,000 gain on the sale
of land. Several acres attached to a warehouse were sold during the year for cash. If cash ows from
operating activities are reported by the direct method, how is this gain reported? If the indirect method is
applied, how is this gain reported?
12. During the current year, the Leftowich Company reported that its accounts receivable had gone down
while salary payable went up. If the indirect method is applied to determine cash ows from operating
activities, how are these changes shown?
13. The Central Western Corporation reports its cash ows from operating activities by means of the indirect
method. In the current year, the companys prepaid rent account increased by $11,000. At the same time,
its accounts payable balance fell by $23,000. If the indirect method is used to present cash ows from
operating activities, how are these two changes reported?
14. The Harbaugh Corporation paid a $39,000 cash dividend this year but also received $11,000 as a dividend
from one of the companys investments. If U.S. GAAP is applied, how are these two transactions reported
within a statement of cash ows? If IFRS is applied, how are these two transactions reported within a
statement of cash ows?
15. The Anna Company sells a building with an original cost of $950,000 and accumulated depreciation of
$400,000 to another company at a gain of $18,000. What reporting is necessary on a statement of cash
ows?
16. During the current year, a company repurchases 10,000 shares of common stock that were originally
issued several years ago for $32 per share. The stock is acquired this year for $37 per share. Later, in the
year, 3,000 of these shares are reissued to the public for $40 each. How are these transactions reported in
the statement of cash ows for this period?

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CHAPTER 17

IN A SET OF FINANCIAL STATEMENTS, WHAT INFORMATION IS CONVEYED BY THE STATEMENT OF CASH FLOWS?

T R U E

O R

607

F A L S E

1. ____ A company reports cash equivalents as an asset. The term cash equivalents has the same meaning
as cash.
2. ____ If the cash ows from operating activities begins with cash collected from customers, the indirect
method is being applied.
3. ____ When the direct method of reporting cash ows from operating activities is applied, depreciation
expense is added to net income.
4. ____ When the indirect method of reporting cash ows from operating activities is applied, a loss on the
sale of equipment is added to net income.
5. ____ The Walsingham Corporation reported rent expense of $75,000 this year. At the same time, prepaid
rent increased by $9,000. The company paid $84,000 in rent this period.
6. ____ The Trigger Company reported rent expense of $43,000 this year. At the same time, rent payable
increases by $9,000. The company paid $52,000 in rent this period.
7. ____ A company reports net income for the current year of $200,000. During that year, depreciation
expense of $30,000 was reported as well as an $8,000 gain on the cash sale of a building. In addition,
accounts receivable increased by $9,000. The net cash ows from operating activities for the period was
$213,000.
8. ____ A company reports cost of goods sold of $500,000. During that period, inventory fell by $34,000
while accounts payable rose by $9,000. The company paid $475,000 in cash this period for the purchase of
merchandise.
9. ____ Purchasing treasury stock is an example of a nancing activity.
10. ____ Signicant investing and nancing activities not involving cash still need to be disclosed.
11. ____ During the current year, the Baxter Corporation paid $100,000 on a long-term note payable and
$13,000 in related interest expense. According to U.S. GAAP, these two payments must be shown in
separate sections of a statement of cash ows.
12. ____ During the current year, the Frances Corporation paid $200,000 on a long-term note payable and
$22,000 in related interest expense. According to IFRS, these two payments must be shown in separate
sections of a statement of cash ows.
13. ____ Equipment costing $320,000 but with accumulated depreciation of $240,000 was sold at a loss of
$22,000. The company reports a cash inow of $58,000 as a nancing activity.

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FINANCIAL ACCOUNTING VERSION 2.0

M U L T I P L E

C H O I C E

1. Where does cash that is collected from customers appear on a statement of cash ows?
a.
b.
c.
d.

Operating activities section

Investing activities section
Financing activities section
Capital activities section

2. Fritz Corporation began the year with $900,000 in accounts receivable. During the year, sales revenue
totaled $7,000,000. Fritz ended the year with $750,000 in accounts receivable. How much cash did Fritz
collect from its customers during the year?
a.
b.
c.
d.

$6,850,000
$7,150,000
$7,750,000
$7,900,000

3. The Willson Company pays o one of its bonds before it came due because interest rates have fallen
rather signicantly. Where does the cash paid to redeem a bond payable appear on a companys
statement of cash ows?
a.
b.
c.
d.

Operating activities section

Investing activities section
Financing activities section
Capital activities section

4. Which of the following is true about the reporting of cash ows from operating activities?
a.
b.
c.
d.

Most companies use the indirect method although FASB prefers the direct method.
Most companies use the indirect method because it is preferred by FASB.
Most companies use the direct method because it is preferred by FASB.
Most companies use the direct method, although FASB prefers the indirect method.

5. During the current year, Rafael Corporation distributed dividends of $23,000, received cash by signing a
note payable of $105,000, purchased a piece of equipment for $29,000 in cash, and received dividend
income of $12,000. What is reported as Rafaels net cash inow from nancing activities for the year?
a.
b.
c.
d.

$53,000
$65,000
$82,000
$94,000

6. Happy Toy Company began Year Nine with $1,000 in inventory and $4,500 in accounts payable. During
the year, Happy Toy incurred cost of goods sold of $25,000. Happy Toy ended Year Nine with $2,700 in
inventory and $3,800 in accounts payable. How much cash did Happy Toy pay for its merchandise
purchases during Year Nine?
a.
b.
c.
d.

$22,600
$24,000
$26,000
$27,400

7. Crystal Bell Company generated $48,900 in net income during the year. Included in this number are
depreciation expense of $13,000 and a gain on the sale of equipment of $4,000. In addition, accounts
receivable increased by $16,000, inventory decreased by $5,090, accounts payable decreased $4,330, and
interest payable increased $1,200. Based on the above information, what is Crystal Bells net cash inow
from operating activities?
a.
b.
c.
d.

$43,860
$48,900
$54,120
$71,940

8. Transportation Inc. incurred rent expense of $98,000 during the year on a large warehouse. During that
same period, prepaid rent increased by $34,000. How much cash did Transportation pay for rent during
the year?
a. $34,000
b. $64,000
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IN A SET OF FINANCIAL STATEMENTS, WHAT INFORMATION IS CONVEYED BY THE STATEMENT OF CASH FLOWS?

609

c. $98,000
d. $132,000
9. The Robious Company presents cash ows from operating activities by the direct method. On its income
statement for the current year, Robious reports rent expense of $60,000. This gure relates to two dierent
buildings in use by the company. For Building One, prepaid rent went up by $9,000 during the year. For
Building Two, rent payable went down by $5,000. How much cash did the company pay this year for rent?
a.
b.
c.
d.

$46,000
$56,000
$64,000
$74,000

10. A building is bought on October 1, Year One, for $500,000 in cash. It is depreciated using the straight-line
method over an expected life of twenty years. A residual value of $20,000 is anticipated. The half-year
convention is applied. On April 1, Year Four, the building is sold for cash at a loss of $13,000. Which of the
following appears on the companys Year Four statement of cash ows?
a.
b.
c.
d.

Investing activities cash inow of $395,000

Investing activities cash inow of $415,000
Investing activities cash inow of $428,000
Investing activities cash inow of $441,000

11. The Hamster Company determines its cash ows from operating activities by the indirect method. Net
income is reported for the current period as $400,000, which included depreciation expense of $70,000
and a gain on sale of land of $30,000. In addition, accounts receivable went down $2,000 during the year
while accounts payable went up $7,000. What is the amount of cash generated by the Hamster
Companys operating activities this year?
a.
b.
c.
d.

$431,000
$435,000
$445,000
$449,000

12. In Year One, the Karsenti Company reported net income of $30,000. Among many other accounts, the
income statement included sales revenue of $500,000, cost of goods sold of $300,000, depreciation
expenseequipment of $50,000, and a gain on sale of equipment of $23,000. Included on the balance
sheet were a number of accounts such as bonds payable (increased $23,000), accounts payable,
(decreased $6,000), retained earnings (increased $11,000), equipment (decreased $70,000), accumulated
depreciationequipment (increased $29,000), accounts receivable (decreased $17,000), and inventory
(increased $3,000). No capital stock was issued or reacquired during the year. How much cash did this
company spend on inventory during the year?
a.
b.
c.
d.

$291,000
$297,000
$303,000
$309,000

13. Use the same information as presented in problem 12. Using the indirect method, how much cash did
Karsenti generate this year from its operating activities?
a.
b.
c.
d.

$57,000
$65,000
$69,000
$71,000

14. Use the same information as presented in problem 12. One piece of equipment was sold by Karsenti this
year for cash, and none was bought. Which of the following is true about this sale of equipment?
a.
b.
c.
d.

It is an investing activity cash inow of $49,000.

It is an investing activity cash inow of $63,000.
It is an investing activity cash inow of $72,000.
It is an investing activity cash inow of $93,000.

15. Use the same information as presented in problem 12. Karsenti paid a cash dividend to shareholders this
year. How should this distribution be shown on a statement of cash ows?
a. Operating activity cash outow of $19,000.
b. Investing activity cash outow of $30,000.

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FINANCIAL ACCOUNTING VERSION 2.0

c. Operating activity cash outow of $30,000.

d. Financing activity cash outow of $19,000.

V I D E O

P R O B L E M S

Professor Joe Hoyle discusses the answers to these two problems at the links that are indicated. After formulating your answers, watch each video to see how Professor Hoyle answers these questions.
1. Your roommate is an English major. The roommates parents own a chain of ice cream shops located
throughout Florida. One day, while the two of you are taking a study break, your roommate asks you the
following question: I was recently looking at the nancial statements my parents prepare for their
business. I happened to see the statement of cash ows. I studied it more carefully because I was
interested in the amount of cash that the business has been making. One of the biggest positive numbers
on the entire statement was depreciation expense. It was listed right there under operating activities with
a big plus sign. I dont understand. How are they able to get so much cash from depreciation? I
understand how they get cash by selling ice cream, but how does a company get that cash from
something called depreciation? How would you respond?

View the video online at: http://bit.ly/hoyle17-3

2. Your uncle and two friends started a small oce supply store several years ago. The company has grown
and now has several large locations. Your uncle knows that you are taking a nancial accounting class and
asks you the following question: Weve been having cash ow problems recently. We are making roughly
the same net income as in the past, but our cash reserves are shrinking. How can we possibly be selling so
much merchandise and making a reasonable prot and still see our cash dwindling? This makes no sense
to me. Im mystied. How would you respond?

View the video online at: http://bit.ly/hoyle17-4

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CHAPTER 17

IN A SET OF FINANCIAL STATEMENTS, WHAT INFORMATION IS CONVEYED BY THE STATEMENT OF CASH FLOWS?

611

P R O B L E M S
1. For each of the following transactions, indicate whether the cash ows are reported in the operating
activities section of the statement of cash ows, the investing activities section, or the nancing activities
section.
a.
b.
c.
d.
e.
f.
g.
h.
i.

Issuance of bonds payable

Cash paid for interest
Cash collected from customers
Paid dividends
Sold equipment for cash
Issued preferred stock for cash
Cash paid for inventory purchases
Purchased a small percentage of the ownership shares of another company
Cash received from dividend income

2. For each of the following transactions, indicate what is reported on the statement of cash ows and the
section in which it is listed. Assume the indirect method is used to present the cash ows from operating
activities.
a. Equipment costing $33,000 but with accumulated depreciation of $14,000 is sold for cash
creating a reported gain of $5,000.
b. A note is signed at the bank on a $200,000 loan.
c. A building with a cost of $700,000 but a net book value of only $111,000 is destroyed by re.
d. A new truck is acquired for $56,000 by signing a long-term note payable.
e. A new owner invests cash of $49,000 into the business in exchange for 10,000 shares of $1 par
value common stock.
f. The rst payment of $11,000 is made on the truck bought in problem 2(d). Of that total, $10,000
is paid on the note with the rest paid as interest.
g. A building costing $530,000 with accumulated depreciation of $170,000 is sold for cash at a loss
of $15,000.
3. The Starmer Corporation begins the current year with equipment costing $900,000. This gure rises to
$1.2 million by the end of the period. Accumulated depreciation was $200,000 on the rst of the year but
$260,000 at the end. During the year, the following events took place:
<
<
<

Equipment costing $450,000 was bought by signing a note for $180,000 and paying cash for the
remainder.
Depreciation expense recognized for the year on equipment was $110,000.
Equipment was sold during the year for cash; a gain of $13,000 was recognized.

In connection with this companys equipment account, what will be the eects reported on the statement
of cash ows?
4. Roy Company generated sales during Year Two of $120,000. Roy began the year with $56,000 in accounts
receivable and ended the year with $79,000 in accounts receivable. Determine the amount of cash Roy
collected from its customers during Year Two.
5. Below are gures found in the beginning and ending trial balances for the DeFaul Company for Year
Three.
1/1/3
Equipment

12/31/3

$420,000 debit $460,000 debit

Accumulated depreciation $350,000 credit $370,000 credit

Note payable

$320,000 credit $350,000 credit

Loss on sale of equipment

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$24,000 debit

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FINANCIAL ACCOUNTING VERSION 2.0

Additional information:
<
<
<
<

A $50,000 cash payment was made on the note payable this year as well as a $20,000 payment
for interest expense.
New equipment was bought this year by signing a note payable and making a cash payment.
Equipment costing $100,000 but with a net book value of $60,000 was sold for cash.
The company uses the indirect method for presenting its cash ows from operating activities.

a. Based on the previous information, this company has two cash ows that need to be reported as
investing activities. What are they and what monetary amount should be included?
b. Based on the previous information, this company has one cash ow that needs to be reported as
a nancing activity. What is it and what monetary amount should be included?
6. The Pasley Company prepares an income statement that reports cost of goods sold of $320,000, rent
expense of $30,000, and salary expense of $90,000. During the year, prepaid rent went up $5,000, accounts
payable went down $4,000, salary payable went up $3,000, and inventory went down $2,000.
a. What is the amount of cash the company spent this year to purchase inventory?
b. What is the amount of cash the company spent this year on rent?
c. What is the amount of cash the company paid this year to its employees as salaries?
7. Jamison Companys income statement for 20X6 is below.

FIGURE 17.41 Jamison Company Income Statement as of 12/31/X6

FIGURE 17.42 Selected Balance Sheet Accounts from the Beginning and End of 20X6

Determine Jamisons net cash inow or outow from operating activities for this year using both the direct
and indirect methods.
8. The following information is found in the year-end nancial statements reported by Barney Corporation.

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CHAPTER 17

IN A SET OF FINANCIAL STATEMENTS, WHAT INFORMATION IS CONVEYED BY THE STATEMENT OF CASH FLOWS?

613

FIGURE 17.43 Income Statement

FIGURE 17.44 Current Asset and Liability Accounts

Prepare the operating activities section of a statement of cash ows by means of the indirect method.
9. For each of the following transactions, indicate what is shown on a statement of cash ows as either an
investing activity, a nancing activity, or an operating activity. What kind of activity is it? Is it a cash inow
or outow? How much cash is reported?
a. One thousand shares of $1 per share par value common stock is issued for $19,000.
b. A cash dividend of $16,000 is distributed to stockholders.
c. A cash dividend of $9,000 is collected from another company because of the ownership of shares
of stock.
d. A $7,000 payment is made on a long-term note payable with $6,000 reducing the principal and
the remaining $1,000 for interest.
e. A building is sold with a historical cost of $400,000 and accumulated depreciation of $210,000 for
cash at a loss of $17,000.
10. A company creates the following operating activities section of its statement of cash ows.

FIGURE 17.45 Company Prepared Operating Activities Cash Flows

What was the correct amount of cash that was received during this period from the companys operating
activities?
11. A company computed its cash payments for rent expense for the most recent period as $127,000, as
shown next. What was the correct amount of cash the company paid for rent?

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FINANCIAL ACCOUNTING VERSION 2.0

FIGURE 17.46 Company Computed Payments for Rent

12. Killian Corporation had several transactions during the year that impacted long-term assets, long-term
liabilities, and stockholders equity. Determine if the cash amount in each of the following transactions is
shown as an investing activity, as a nancing activity, or as neither.

FIGURE 17.47 Determination of Cash Flow Balances

13. Ruthers Corporation began business on January 1, 20X5. The nancial statements for Rutherss rst year
are given here. Because 20X5 is the rst year in business, the balance sheet accounts have no beginning
balances.

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CHAPTER 17

IN A SET OF FINANCIAL STATEMENTS, WHAT INFORMATION IS CONVEYED BY THE STATEMENT OF CASH FLOWS?

615

FIGURE 17.48 Ruthers Corporation Income Statement as of 12/31/X5

FIGURE 17.49 Ruthers Corporation Balance Sheet 12/31/X5

Additional Information:
a. Ruthers purchased land for $14,000 cash.
b. Common stock was issued for $4,500 in cash.
c. A note payable was signed for $10,000 cash.
Prepare Rutherss statement of cash ows for 20X5 using the indirect method of calculating cash ows
from operating activities.
14. Looney Company is in the process of preparing nancial statements for the year ended 12/31/X9. The
income statement as of 12/31/X9 and comparative balance sheets are presented here.

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FINANCIAL ACCOUNTING VERSION 2.0

FIGURE 17.50 Looney Company Income Statement as of 12/31/X9

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IN A SET OF FINANCIAL STATEMENTS, WHAT INFORMATION IS CONVEYED BY THE STATEMENT OF CASH FLOWS?

617

FIGURE 17.51 Looney Company Balance Sheet December 31, 20X9 and 20X8

The following additional information has been assembled by Looneys accounting department:
a. Equipment was purchased for $90 in cash.
b. Long-term debt of $70 was issued for cash.
c. Looney issued eleven shares of common stock for cash during 20X9.
Prepare Looneys statement of cash ows as of 12/31/X9 using the direct method.
15. The following information relates to Henrichs Hat Store Inc. for the year ended December 31, 20X8.

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FINANCIAL ACCOUNTING VERSION 2.0

FIGURE 17.52 Henrichs Hat Store Inc. Balance Sheet, December 31, 20X8

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IN A SET OF FINANCIAL STATEMENTS, WHAT INFORMATION IS CONVEYED BY THE STATEMENT OF CASH FLOWS?

619

FIGURE 17.53 Henrichs Hat Store Inc. Income Statement for the Year Ended December
31, 20X8

Other information:
a.
b.
c.
d.

The company purchased a building and xtures with cash during the year, but none were sold.
Dividends of $170,000 were declared and paid.
Cash proceeds from the sale of common stock totaled $520,000.
Land was purchased for $300,000 cash.

Prepare the statement of cash ows for Henrichs Hat Store Inc. for the year ended December 31, 20X8
using the indirect method of calculating cash ows from operations.

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FINANCIAL ACCOUNTING VERSION 2.0

C O M P R E H E N S I V E

P R O B L E M

This problem has carried through several chapters, building in diculty. Hopefully, it has allowed students to
continually practice skills and knowledge learned in previous chapters.
In Chapter 16, nancial statements for April were prepared for Webworks. They are included here as a starting
point for the required recording for May.
This will be your nal month of preparing nancial statements for Webworks. This month, the statement of
cash ows will be added. To simplify the construction of that statement, fewer transactions than usual are
included.

FIGURE 17.54 Webworks Financial Statements

FIGURE 17.55

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CHAPTER 17

IN A SET OF FINANCIAL STATEMENTS, WHAT INFORMATION IS CONVEYED BY THE STATEMENT OF CASH FLOWS?

621

FIGURE 17.56

The following events occur during May:

a. Webworks starts and completes twelve more sites and bills clients for $9,000.
b. Webworks purchases supplies worth $140 on account.
c. At the beginning of March, Webworks had twenty-two keyboards costing $121 each and twenty-eight
ash drives costing $25 each. Webworks uses periodic FIFO to cost its inventory.
d. On account, Webworks purchases eighty-three keyboards for $122 each and ninety ash drives for $26
each.
e. Webworks sells 98 keyboards for $14,700 and 100 of the ash drives for $3,000 cash.
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FINANCIAL ACCOUNTING VERSION 2.0

f.
g.
h.
i.
j.
k.
l.
m.

Webworks collects $9,000 in accounts receivable.

Webworks pays its $500 rent.
Webworks pays o $14,000 of its accounts payable.
Webworks sells all of its shares of QRS stock for $14 per share.
Webworks pays Juan $750 for his work during the rst three weeks of May.
Webworks pays o its salaries payable from April.
Webworks pays the owners (Leon Jackson and Nancy Po) a salary of $4,000 each.
Webworkss note payable permits early payment with no penalty. Leon Jackson and Nancy Po decide to
use some of their excess cash and pay o the note and interest payable. The note was paid at the
beginning of May, so no interest accrued during May.
n. Webworks pays taxes of $740 in cash.
Required:
A.
B.
C.
D.

Prepare journal entries for the previous events.

Post the journal entries to T-accounts.
Prepare an unadjusted trial balance for Webworks for May.
Prepare adjusting entries for the following, and post them to your T-accounts.

o.
p.
q.
r.
s.

Webworks owes Juan Marcon (an employee) $200 for his work during the last week of May.
Webworks receives an electric bill for $450. Webworks will pay the bill in June.
Webworks determines that it has $70 worth of supplies remaining at the end of May.
Webworks is continuing to accrue bad debts at 10 percent of accounts receivable.
Webworks continues to depreciate its equipment over four years and its furniture over ve years, using the
straight-line method.
t. The license agreement should be amortized over its one-year life.
u. Record cost of goods sold.
E. Prepare an adjusted trial balance.
F. Prepare nancial statements, including the statement of cash ows, for May. Prepare the
operating section using the indirect method.

R E S E A R C H

A S S I G N M E N T

Assume that you take a job as a summer employee for an investment advisory service. One of the partners for
that rm is currently looking at the possibility of investing in Caribou Coee Company Inc. The partner is interested in knowing how much money the company has available for growth. The partner also wants to know
how much growth has taken place in recent years. The partner asks you to look at the 2010 nancial statements for Caribou Coee by following this path:
<
<
<
<
<
<
<

Go to http://www.cariboucoee.com.
At the bottom of this screen, click on Our Company.
In the upper right side of the next screen, click on Investors.
On the left side of the next screen, click on Financial Reports.
On the next screen, click on 2010 Annual Report to download.
Scroll to page 26 and nd the companys statement of operations (income statement) for the years ended
January 2, 2011, and January 3, 2010. Note the amount of net income reported for each year.
Scroll down to page 28 and, for each of these two years, note the amount of cash inow generated by
operating activities. Then, look under Investing Activities for the cash outows labeled as payments for
property and equipment.

a. What net income is reported for each of these two years? Scan the statements of operation to determine
any obvious causes for the dierence in these two years.
b. What is the net cash inow from operating activities for each of these two years? How do each of these
numbers compare to the net income gures reported for the same periods of time? Scan the statement of
cash ows to determine any obvious causes for the dierence in these two years.
c. In each year, how much cash was spent as payments on property and equipment? What does that say
about the growth of the company?

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CHAPTER 17

IN A SET OF FINANCIAL STATEMENTS, WHAT INFORMATION IS CONVEYED BY THE STATEMENT OF CASH FLOWS?

ENDNOTES
1.

Michael Dell with Catherine Fredman, Direct from Dell: Strategies That Revolutionized
an Industry (New York: HarperBusiness, 1999), 47.

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623

2.

A Treasury bill is a popular U.S. government security with a maturity date of one-year
or less.

3.

The term commercial paper refers to securities issued by corporations to meet their
short-term cash needs.

4.

For convenience, the allowance for doubtful accounts will not be included with accounts receivable. The possibility of bad debts makes the conversion to cash more
complicated and is covered in upper-level accounting textbooks.

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FINANCIAL ACCOUNTING VERSION 2.0

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