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com 2,100 FREE Questions and Answers to Help YOU Pass the CPA Exam Content - What You Really Need To Know Financial Accounting and Reporting


A. Objectives of the Statement of Cash Flows

When financial statements are prepared, a statement of cash flows is required for any period for which an income statement is presented. To help financial statement users in making assessments, a statement of cash flows reports cash receipts and cash payments resulting from an entitys operations, its investing transactions, and its financing transac tions. A separate schedule accompanying the statement should also report the effects of significant investing and financing transactions that do not affect cash (such as buying equipment by issuing common stock). The statement of cash flows is prepared to present changes during the period in cash and cash equivalents. Cash equivalents include short-term, highly liquid investments that (1) are readily convertible to known amounts of cash and (2) are so near their maturity (original maturity of three months or less from date of purchase by the enterprise) that they present little risk of changes in value because of possible changes in interest rates.

B. Statement of Cash Flows Classifications

Cash receipts and cash payments are classified as operating, financing, and investing activities.

Operating activities are those events that happen on a regular basis as part of normal operations. They include delivering or producing goods for sale and providing services for customers. This category includes cash payments for rent, advertising, salaries, maintenance, and the like as well as cash receipts from the sale of goods and services. Although there have been some disagreements about this FASB decision, cash received or paid from interest revenue, dividend revenue, and interest expense are all classified as operating activities. Investing activities are all transactions that do not occur within the normal operations of the business and involve an asset. They happen occasionally. The sale of equipment and the purchase of land are the type of transactions labeled as investing activities. Financing activities are all transactions that do not occur within the normal operations of the business and involve either a liability or a stockholders equity account. Issuing a bond payable, paying a long-term note, issuing common or preferred stock, paying cash dividends, and buying treasury stock all fall under the heading of financing activities.

Note that noncash investing and financing activities should be excluded from the statement itself. These transactions involve no cash inflows or outflows, but they often have a significant effect on the prospective cash flows of a company. Therefore, they must be distinguished from activities that involve cash receipts and payments and must be reported in a separate schedule or in the footnotes to the financial statements.

C. Direct Versus Indirect Presentation for Reporting Operating Activities

FASB decided that the preferable method of presenting net cash flows from operating activities is by the direct method which shows major classes of operating cash receipts and payments individually (cash received from sales, cash paid for inventory, cash paid for salaries, and the like). However, the indirect (or reconciliation) method is also permitted and is almost universally used by reporting entities. When the direct method is used, it is also necessary to present a accompanying schedule showing the indirect method. The direct method will be presented first below, followed by a discussion of the indirect method. Both methods use the same four basic steps: (1) start with the income for the period, (2) eliminate any amounts from income that relate to investing or financing activities and not operating activities (for example, gain on sale of equipment or loss on payment of bond), (3) eliminate any amounts from income that do not create changes in cash (depreciation expense), and (4) convert all remaining figures from accrual accounting numbers to cash numbers.

Direct Approach. The direct approach begins with the entire income statement for the period (step 1). All gains and losses on investing and financing activities are dropped (step 2). All noncash revenues and expenses (primarily depreciation expense) are also dropped from the income statement (step 3). Finally (step 4), the remaining figures such as sales, cost of goods sold, rent expense, and salary expense are converted from accrual based figures to cash based figures.

Going from accrual accounting figures to cash based figures. For each of the remaining income statement accounts, one or two balance sheet accounts bridge the gap from the time of accounting recognition to the time of cash being paid or collected. ---For example, a sale is made on Monday and recognized then but cash is not collected until Friday. An account receivable bridges the gap from Monday to Friday. ---Work is done by an employee on Tuesday but payment is not made until Thursday. A salary payable is recognized in the interim. ---Rent is paid on Wednesday but the property is not used until Saturday. Prepaid rent is recorded between the cash payment and the recognition of the expense.

Accounts receivable, salary payable, prepaid rent and the like are converter accounts that bridge the gap between the income statement recognition and the cash exchange. To turn income statement figures into their cash amounts, the converter account(s) for each one must be determined:

Income Statement Account --Sales --Cost of goods sold --Salary expense --Rent expense --Insurance expense

Converter Account(s) --Accounts receivable --Inventory and accounts payable --Salary payable --Prepaid rent and rent payable --Prepaid insurance

However, it is not the converter account that is important in determining operating cash flows for the period but rather the change in the converter account during that year. Using the income statement account and the change in the converter account(s), a hypothetical journal entry for the entire year can be constructed. To balance this entry, cash is recorded. It is that amount that will be shown for operating activities on the statement of cash flows if the direct method is used.

Example 1 Sales for the period total $500,000 while accounts receivable went down by $19,000. Hypothetical entry for the year with accounts receivable credited to show its reduction:

Sales Accounts Receivable Cash (plugged to balance) 519,000

500,000 19,000

On the statement of cash flows, within operating activities, cash collected from sales is reported as $519,000.

Example 2 Cost of goods sold is reported for the current period as $300,000. Within this year, the reported inventory figure fell by $13,000 while accounts payable rose by $9,000. Hypothetical entry for the year with the asset decreasing (a credit) and the liability increasing (a credit).

Cost of goods sold (debit) Inventory (credit) Accounts payable (credit)

300,000 13,000 9,000

Cash (plugged to balance) (credit)


On the statement of cash flows, within operating activities, cash paid for inventory is shown as $278,000.

Indirect Approach. Although the results of the indirect approach look different, the same basic process is followed with the same final balance. The indirect approach begins with the single net income number for the year (step 1) rather than the entire income statement. Gains and losses from investing and financing activities are eliminated (step 2). Gains (a positive balance) are removed by subtraction. Losses (a negative balance) are removed by addition. Next, noncash items within net income (primarily depreciation expense) are also removed (step 3). Noncash expenses (a negative) are removed by addition. Noncash revenues (a positive) are subtracted. That only leaves the adjustments from accrual to cash accounting (step 4). Again, this is based on the changes in the various converter accounts mentioned above such as accounts receivable, inventory, prepaid expenses, accrued liabilities, and accounts payable. Those changes must be removed and a rather simple formula can be used for the indirect method:

To Remove a Change in a Converter AssetDo the Opposite (an increase is subtracted while a decrease is added)

To Remove a Change in a Converter LiabilityDo the Same (an increase is added while a decrease is subtracted)

Example. A company reports net income of $200,000 which includes a gain on selling equipment of $13,000 and a loss on paying off a bond of $5,000. The income figure also includes depreciation expense of $29,000. During the year, accounts receivable went up $6,000 while inventory dropped $9,000. In addition, accounts payable rose by $17,000 while salary payable dropped by $4,000 Using the indirect method, the operating activities section of this companys statem ent of cash flows looks as follows: Net income Remove: --Gain on sale of equipment --Loss on paying off bond --Depreciation expense Adjustments from accrual to cash: --Increase in accounts receivable --Decrease in inventory ( 6,000) + 9,000 ( 13,000) + 5,000 +29,000 $200,000

--Increase in accounts payable --Decrease in salary payable Cash inflow from operating activities

+17,000 ( 4,000) $237,000

D. Investing and Financing Activities

In producing the statement of cash flows, individual investing and financing activities are listed with their cash effect. Examples might be as follows. Only the change in cash is reported.

Investing Activities Proceeds from sale of equipment Payment to acquire building Proceeds from sale of patent Cash outflow from investing activities $39,000 (120,000) 17,000 $(64,000)

Financing Activities Proceeds from issuance of bonds Payment of note payable Proceeds from issuance of preferred stock Payment to acquire treasury stock Payment of cash dividend Cash inflow from financing activities $212,000 (130,000) 67,000 (25,000) (82,000) $ 42,000

Determining the individual cash flows from investing and financing activities requires the candidate to investigate or recreate the changes that occurred during the year in each nonoperational asset or liability (land, building, and equipment, notes and bonds payable, common and preferred stock, and the like). For example if a building account went from $700,000 at the start of the year to $940,000 at the end of the year while the related accumulated depreciation account went from $200,000 to $230,000, one or more transactions led to those changes. Enough information has to be provided to allow the candidate to replicate the journal entries that were made during the year.

To illustrate, assume this building account and related accumulated depreciation had the changes indicated above during the year. In addition, three other pieces of information are provided: ---Depreciate expense recorded for the year on the buildings was $90,000. ---One building costing $320,000 was sold for cash at a gain of $30,000. ---One building was bought by signing a note for $250,000 and paying the rest in cash.

Determining the investing and financing activity cash flows resembles the solving of a puzzle. Analyze the changes in each nonoperational asset or liability. Prepare the hypothetical journal entries that are easiest and then work to fill in the unknown spaces for the remaining journal entries for the period. Hypothetical Entry 1 Depreciation would be recorded based on the above information.

Depreciation expense (debit) Accumulated depreciation (credit)

90,000 90,000

No cash effect comes from this entry. However, it raises accumulated depreciation from $200,000 to $290,000. In the information provided, ending accumulated depreciation was only $230,000 and not $290,000. Accumulated depreciation (under normal circumstances) only decreases when an asset is disposed of in some way. The $60,000 decline in accumulated depreciation ($290,000 down to $230,000) must have been created by the sale of the building costing $320,000. That is a logical conclusion from the information given. This provides the information needed to make the assumed entry for the sale of that asset. The cost of the building ($320,000) and the gain ($30,000) are listed in the basic information.

Hypothetical Entry 2 Sale of building for $320,000.

Accumulated depreciation (debit) Building (credit) Gain on sale of building (credit) Cash (plugged amount to balance) (debit)

60,000 320,000 30,000 290,000

Therefore, one listing within the investing activities will be Cash proceeds from sale of building - $290,000. This sale dropped the Buildings account by $320,000 from $700,000 to $380,000. At the end of the year, the Buildings account had risen by $560,000 to a total of $940,000. This increase must have been the cost of the building that was acquired. Because a note for $250,000 was signed as a part of the purchase, the transaction must have been recorded as follows:

Hypothetical Entry 3 Purchase of building for $560,000. Building (debit) Note payable (credit) Cash (plugged amount to balance) (credit) 560,000 250,000 310,000

Listed within the investing activities will be Cash payment to acquire building - $310,000.

The Reporting of Cash on the Balance Sheet The reported amount of cash includes both cash on hand and demand deposits and cash equivalents (short-term, highly liquid investments). Common examples of cash equivalents include Treasury bills, commercial paper, and money market funds. Unrestricted cash and cash equivalents available for general use are presented as the first current asset. 1. Bank Reconciliations -- Bank reconciliations are prepared by businesses when they receive their monthly bank statements. Reconciliation is made to determine any required adjustments to the cash balance in the general ledger and to ensure that theft has not occurred. Two types of reconciling items are usually found. a. Reconciling items not requiring adjustment on the books (type A) b. Reconciling items requiring adjustment on the books (type B) There are normally three type A reconciling items. The first two are simply timing issues that occur because checks and deposits have been made but not yet recorded by the bank. The last requires a change by the bank. (1) Outstanding checks (2) Deposits in transit (3) Bank error All other reconciling items (type B) require adjusting journal entries by the business. These are changes in the amount of cash that have not yet been recorded. Examples of type B items include (1) Unrecorded returned nonsufficient funds (NSF) checks from customers, (2) Unrecorded bank charges, and (3) Errors in the cash account recorded by the owner of the account. Several formats are used in bank reconciliations but the most common takes the bank balance and adjusts it for type A items and takes the book balance and adjusts it for type B items and the two resulting totals should agree. YOU CAN DO IT! DO THE WORK AND YOU CAN PASS THE CPA EXAM! www.CPAreviewforFREE.com