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C. Direct or Indirect Presentation in Reporting Operating Activities

C. Direct or Indirect Presentation in Reporting Operating Activities

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Module 17: Statement of Cash Flows



690



Accrual basis



Additions



Net sales



+



Cost of goods

sold



+



Operating

expenses



+



(



Ending inventory

Beginning Ap



(



(







Beginning AR



)



Ending prepaid expenses

Beginning accrued

expenses payable







(



) (





Deductions

Ending AR

AR written off



Cash basis



)



Depreciation and amortization*

Beginning inventory

Ending Ap



)



Depreciation and amortization

Beginning prepaid expenses

Ending accrued expenses payable



)



=



Cash received

from customers



=



Cash paid to

suppliers



=



Cash paid

for operating

expenses



* Applies to a manufacturing entity









b. A T-account analysis method may be used instead of the above formulas to determine cash received and

cash paid. T-account analysis provides a quick, systematic way to accumulate the information needed to

prepare the statement.

c. The direct approach would be presented in the statement of cash flows as follows:

Cash flows from operating activities

Cash received from dividends



$ 500



Cash received from interest



1,000



Cash received from sale of goods



9,000



Cash provided by operating activities

Cash paid to suppliers























c14.indd 690



$10,500

5,000



Cash paid for operating expenses



500



Cash paid for interest



500



Cash paid for taxes



500



Cash disbursed from operating activities



6,500



Net cash flows from operating activities



$ 4,000



3. The other way of reporting net cash flows from operations is known as the indirect method.

a. This is done by starting with income from continuing operations and adjusting for changes in operating

related accounts (e.g., inventory and accounts payable) and noncash expenses, revenues, losses, and gains.

(1) Noncash items that were subtracted in determining income must be added back in determining net cash flows

from operations. Each of these noncash items is a charge against income but does not decrease cash.

(2) Items to be added back include depreciation, amortization of intangibles, amortization of discount on

bonds payable, bad debt expense, and any increase in the deferred tax liability. Note each of these items

is charged against income but does not decrease cash.

(3) Noncash items that were added in determining income must be subtracted from net income in

determining net cash flows from operations. Each of these noncash items is an increase to income but

does not increase cash.

(4) Items to be deducted from income include decreases in the deferred tax liability and amortization of the

premium on bonds payable.

(5) Finally, gains (losses) on fixed assets require adjustment, since the cash received is not measured by the

gain (loss), that is, a fixed asset with a book value of $10, sold for $15 in cash, provides $15 in cash but

is reported as only a $5 gain on the income statement. The $15 is shown as a separate item on the cash

flow statement under investing activities and the $5 gain is subtracted from income. Losses on asset

disposals are added back to income.

b. When preparing the cash flows from operating activities section of a Statement of Cash Flows under the

indirect method, reconstructing journal entries may help in determining if an item should be added or

subtracted to net income.



13-05-2014 07:46:14







Module 17: Statement of Cash Flows



691



EXAMPLE

If accounts receivable increased by $20,000 over the year, the journal entry that would result in an increase to

accounts receivable would be

Accounts receivable



xx



Sales



xx



This entry results in an increase to net income (through sales), but cash is not affected. Therefore, the amount of

the increase is deducted from net income in determining cash flows from operating activities.

If accounts payable decreased by $35,000, the entry for a decrease in accounts payable would be

Accounts payable

Cash



xx

xx



Since the corresponding credit results in a decrease to cash, the amount of this decrease should be deducted from

net income in determining cash flows from operating activities.











c. When the indirect method is used, separate disclosure of cash flows related to extraordinary items and

discontinued operations is permitted, but is not required.

(1) If an entity chooses to disclose this information, disclosure must be consistent for all periods affected.

(2) Extraordinary items, if disclosed, should be added to (or subtracted from) operating activities

(adjustment to net income) at the gross amount, not the net-of-tax amount.







(a) Under either method, the extraordinary item should be included in financing or investing activities,

whichever is appropriate.

ADJUSTMENTS TO NET INCOME FOR INDIRECT METHOD

Add to net income

Decreases in:

Accounts receivable (net)



Accounts receivable (net)



Inventories



Inventories



Prepaid expenses



Prepaid expenses



Deferred tax asset

Increases in:



Accounts payable



Income taxes payable



Income taxes payable



Deferred tax liability



Deferred tax liability



Interest payable



Interest payable



Other accrued payables



Other accrued payables



Unearned revenue



Unearned revenue



• Losses from disposals of property, plant, and











c14.indd 691



Deferred tax asset

Decreases in:



Accounts payable



Other items:







Deduct from net income

Increases in:



equipment and available-for-sale investments

Depreciation expense

Amortization expense related to intangible assets and

bond discounts

Bad debts expense (if adjustment for accounts

receivable is based upon the gross, not the net, change

in accounts receivable)

Losses from early extinguishments of debt



Other items:



• Gains from disposals of property, plant and equipment

and available-for-sale investments



• Undistributed income from equity method investments

(equity income less the cash dividends received during

the period)

• Amortization of a bond premium

• Gains from early extinguishments of debt



5. The direct and indirect approaches will both be illustrated throughout the remainder of this module.



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Module 17: Statement of Cash Flows



692



NOW REVIEW MULTIPLE-CHOICE QUESTIONS 16 THROUGH 29







D. Example of Statement of Cash Flows

The following information pertains to the Haner Company at December 31, year 1. Comparative balance sheets for

year 1 and year 2 are as follows:



EXAMPLE

Cash



Year 2



Year 1



Net change



$ 9,000



$ 8,000



$ 1,000



Treasury bills



4,000



3,000



1,000



Accounts receivable



4,000



5,000



(1,000)



Inventory



1,000



2,000



(1,000)



2,000



3,000



(1,000)



15,000



15,000







Prepaid insurance

Investment in Simba Co. (held-for-trading)

Market increase adjustment (trading)

Investment in ABC Co. (available-for-sale)



3,000







3,000



15,400



22,000



(6,600)



Market decrease adjustment (available-for-sale)



(3,500)







(3,500)



Fixed assets



22,000



17,000



5,000



Accumulated depreciation



(5,000)



(4,000)



(1,000)



Deferred tax asset

Accounts payable



1,400



  –



$68,300



$71,000



$(2,700)



1,400

$(3,000)



$ 4,000



$ 7,000



Income tax payable



3,000



1,000



Deferred tax liability



6,360



3,000



3,360



Bonds payable



5,000



10,000



(5,000)



Common stock



20,000



20,000







(2,100)







(2,100)



2,000



Accumulated other comprehensive income

Unrealized loss on available-for-sale securities (net of tax)



32,040



30,000



2,040



$68,300



$71,000



$(2,700)



Retained earnings



Income Statement for year 2 is as follows:

Net sales



$50,000



Net income



Cost of goods sold



(20,000)



Other comprehensive income



Gross profit



30,000



Operating expenses



(17,000)



Income from operations



Other revenue and gains



c14.indd 692



Statement of Comprehensive Income for year 2 is as

follows:



13,000



$5,000



Unrealized loss on availablefor-sale securities, (net of tax of

$2,000)



$7,080



$(3,000)



Less:

Reclassification on sale of

available-for-sale securities, (net

of tax of $600)

Comprehensive income



(900)



(2,100)

$4,980



13-05-2014 07:46:15







Module 17: Statement of Cash Flows



Other expenses and losses



(2,560)



693



2,440



Income before

extraordinary item and

income taxes



15,440



Income tax expense:

Current portion



5,000



Deferred portion



3,360



Net income



8,360

$ 7,080



Additional information includes





















Treasury bills have a maturity of less than three months from date of purchase.

Fixed assets costing $5,000 with a book value of $2,000 were sold for $4,000.

Three-year insurance policy was purchased in year 1.

At 12/31/Y2, available-for-sale investments with a book value of $6,600 at 12/31/Y1 and $5,100

at 12/31/Y2 sold for $5,100.

Additional bonds were issued on 12/31/Y2 for $4,000. There was no premium or discount.

Bonds with a book value of $9,000 were retired on 12/31/Y2.

Other revenue and gains include a $3,000 unrealized gain recognized for trading securities.

Other expenses and losses consist of $1,060 interest paid and $1,500 realized loss on available-for-sale securities.

Changes in investments:

• No changes in fair value of the investments occurred prior to year 2.

• There were no sales or purchases of trading securities during year 2.

• The tax rate is 40%.



1.  Procedural Steps





a. The first step is to calculate the change in cash and cash equivalents.

Cash

Treasury bills



Year 2



Year 1



Change



$9,000



$8,000



+$1,000



4,000



3,000







+ 1,000

+$2,000



Net change in cash and cash equivalents

b. Calculate net cash flows from operating activities

(1)  Indirect approach

Net income

Decrease in accounts receivable



1,000



(a)



Decrease in inventory



1,000



(b)



Decrease in prepaid insurance



1,000



(c)



Decrease in accounts payable



(3,000)



(d)



Increase in income tax payable



2,000



(e)



Increase in deferred tax liability



3,360



(f)



(3,000)



(g)



Unrealized gain on trading securities

Realized loss on available-for-sale

securities

Gain on sale of fixed assets

Depreciation expense

Net cash flows from operating

activities



c14.indd 693



$ 7,080



(h)

1,500

(2,000)



(i)



4,000



(j)

$12,940



13-05-2014 07:46:15



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