chapter 12 and 13 financial accounting

indirect method

A method of preparing a statement of cash flows in which net income is adjusted for items that do not affect cash, to determine net cash provided by operating activities.

Long term: Balance sheet, income statement Short term: Balance sheet, statement of cash flows

Long term and short term solvency cues

ability to stay in buisness

Solvency

Direct Method

adjusts the items on the income statement to directly show the cash inflows and outflows from operations, such as cash received from customers and cash paid for inventory, salaries, rent, interest, and taxes

Operating Activities

Flows directly related to sales such as revenues and operating expenses

Financing Activities

Flows from issue or retirement of debt or equity

Receipt of cash from interest and dividend revenues--> OPERATIONS Cash related to the purchase and sale of marketable securities--> INVESTING Cash for interest expense - OPERATING Cash from issue or redemption of debt or equity - FINANCING Dividends a firm pays to its shareholders - FINANCING

Tricky Classification Items

A

Which of the following ratios is not considered to be a test of profitability? A) Current ratio B) Net profit margin C) Return on assets D) Earnings per share E) None of the above

E

Which of the following statements about the statement of cash flows is correct? A) Cash dividends paid are classified as cash flows from operating activities B) Cash dividends received on stock investments are classified as cash flows from investing activities C) A gain on the sale of equipment is classified as a cash inflow from investing activities D) A company with a net loss on the income statement will always have a net cash outflow from operating activities E) None of the above

Cash equivalents are short-term, highly liquid investments that are purchased within three months of the maturity date. The statement of cash flows does not separately report the details of purchases and sales of cash equivalents because these transactions affect only the composition of total cash and cash equivalents. The statement of cash flows reports the change in total cash and cash equivalents from one period to the next.

What are cash equivalents? How are purchases and sales of cash equivalents reported on the statement of cash flows?

Cash expenditures for purchases and salaries are not reported on the statement of cash flows, indirect method, because that method does not report cash inflows and outflows for each operating activity. Rather, it reports only net income, changes in accounts payable and wages payable, and net cash flow from operating activities.

Explain why cash payments during the period for purchases and for salaries are not specifically reported as cash outflows on the statement of cash flows, under the indirect method.

Investing Activities

Flows from purchase or sale of long-lived assets such as land, buildings & equipment and investments

The major categories of business activities reported on the statement of cash flows are operating, investing, and financing activities. Operating activities of a business arise from the production and sale of goods and/or services. Investing activities arise from acquiring and disposing of property, plant, and equipment and investments. Financing activities arise from transactions with investors and creditors.

What are the major categories of business activities reported on the statement of cash flows? Define each of these activities.

The income statement reports revenues earned and expenses incurred during a period of time. It is prepared on an accrual basis. The balance sheet reports the assets, liabilities, and equity of a business at a point in time. The statement of cash flows reports cash receipts and cash payments of a business, from three broad categories of business activities: operating, investing, and financing.

Compare the purposes of the income statement, the balance sheet, and the statement of cash flows.

The two methods of reporting cash flows from operating activities are the direct method and the indirect method. The direct method reports the gross amounts of cash receipts and cash payments arising from the revenues and expenses reported on the income statement. The indirect method reports the net amount of cash provided or used by operating activities by reporting the adjustments to net income for the net effects of noncash revenues and expenses and changes in accruals and deferrals. The two approaches differ in the way they report cash flows from operating activities, but net cash provided by operating activities is the same amount.

Compare the two methods of reporting cash flows from operating activities in the statement of cash flows.

B

If the current ratio is 2 to 1, the receipt of a payment for an account receivable will A) invalidate earnings per share B) have no effect on the current ratio C) decrease the current ratio D) increase the current ratio E) None of the above

Noncash investing and financing activities are activities that would normally be classified as investing or financing activities, except no cash was received or paid. Examples of noncash investing and financing include the purchase of assets by issuing stock or bonds, the repayment of loans using noncash assets, and the conversion of bonds into stock. Noncash investing and financing activities are not reported in the statement of cash flows, because there was no cash received or cash paid; however, the activities are disclosed in a separate schedule beneath the cash flow statement or in the financial statement notes.

What are noncash investing and financing activities? Give two examples. How are they reported on the statement of cash flows?

Cash inflows from financing activities include cash received from issuing stock, the sale of treasury stock, and borrowings. Cash outflows from financing activities include cash payments for dividends, the purchase of treasury stock, and principal payments on borrowings.

What are the typical cash inflows from financing activities? What are the typical cash outflows from financing activities?

Cash inflows from investing activities include cash received from the sale of property, plant, and equipment, intangibles, and investments, the maturity value of bond investments, and principal collections on certain notes receivable. Cash outflows from investing activities include cash payments to purchase property, plant, and equipment, intangibles, and investments and to make certain loans.

What are the typical cash inflows from investing activities? What are the typical cash outflows from investing activities?

Cash inflows from operating activities include cash sales, collections on accounts and notes receivable arising from sales, dividends on investments, and interest on loans to others and investments. Cash outflows from operating activities include payments to suppliers and employees, and payments for operating expenses, taxes, and interest.

What are the typical cash inflows from operating activities? What are the typical cash outflows from operating activities?

The statement of cash flows reports cash receipts and cash payments from three broad categories of business activities: operating, investing, and financing. While the income statement reports operating activities, it reports them on the accrual basis: revenues when earned, and expenses when incurred, regardless of the timing of the cash received or paid. The statement of cash flows reports the cash flows arising from operating activities. The balance sheet reports assets, liabilities, and equity at a point in time. The statement of cash flows and related schedules indirectly report changes in the balance sheet by reporting operating, investing, and financing activities during a period of time, which caused changes in the balance sheet from one period to the next. In this way, the statement of cash flows reports information to link together the financial statements from one period to the next, by explaining the changes in cash and other balance sheet accounts, while summarizing the information into operating, investing, and financing activities.

What information does the statement of cash flows report that is not reported on the other required financial statements?

B

Which of the following statements is correct? A) When cost of goods sold as a percentage of sales decreases, the gross profit percentage will decrease B) It is possible that when cost of goods sold in dollars increases, cost of goods sold as a percentage of sales decreases C) If gross profit percentage is the same for the current and past year, then sales and cost of goods sold in dollars did not change D) If gross profit percentage increases from one year to the next, then the net income percentage will also increase from one year to the next E) None of the above

C

Which of the following statements is not correct? A) Purchasing fixed assets using cash decreases the current ratio B) Accruing a commission expense will affect the net profit margin ratio C) Increasing the financial leverage ratio guarantees the net profit margin ratio will increase D) Purchasing treasury stock results in a decrease in the current ratio E) All of the above are correct

C

Which of the following statements is true? A) It is always preferable to compare a company's performance to industry-wide ratios rather than to use a competitor's ratios B) Ratios compare items from the same financial statement C) One of the advantages of ratio analysis is that it allows companies of different sizes to be compared D) Comparing companies from different industries is made possible via ratios E) None of the above

B

Which of the following transactions would not create a cash flow? A) Sale of equipment at book value (i.e. no gain or loss) B) Declaration of a cash dividend C) Purchase of a patent D) The company purchased some of its own stock from a stockholder E) All of the above create cash flows.

Crucial to the presentation of a complete picture of the financial status of a business Many businesses with great ideas have failed due to their failure to manage their cash flows

Why is cash flow important

D

Company's 2020 income statement reported total sales revenue of $1,500,000. The 2019-2020 comparative balance sheets showed that accounts receivable increased by $120,000. The 2020 "cash receipts from customers" would be A) $240,000 B) $1,500,000 C) $1,620,000 D) $1,380,000. E) None of the above

The direct method provides more detail about cash from operating activities Shows individual operating cash flows Shows reconciliation of operating cash flows to net income in a supplemental schedule Investing and Financing sections are identical for each method Net cash flow is the same for both methods

Differences between direct and indirect methods

The $50,000 increase in inventory must be used in the statement of cash flows' calculations because it increases the outflow of cash all other things equal. It is used as follows:Direct method—added to cost of goods sold, accrual basis to compute cost of goods sold, cash basis. (The other related adjustment would involve accounts payable.)Indirect method—subtracted from net income as a reconciling item to obtain cash flows from operating activities.

Explain why a $50,000 increase in inventory during the year must be included in developing cash flows from operating activities under both the direct and indirect methods.

When equipment is sold, any cash received is reported as a cash inflow from investing activities. When using the indirect method, a gain on sale of equipment must be reported as a deduction from net income because the gain was included in net income but did not provide any cash from operating activities. When using the indirect method, the loss on sale of equipment is added to net income because the loss was included in net income but did not require an operating cash outflow

How is the sale of equipment reported on the statement of cash flows under the indirect method?

E

McGee Company gathered the following data to prepare its 2020 statement of cash flows: Net income $70,000Depreciation expense 10,000Accounts receivable decrease 5,000Wages payable increase 6,000Amortization of patent 2,000Dividends paid 1,000Income tax payable decrease 4,000Based only on the above data, the net cash inflow from operating activities during 2019 was A) $97,000.B) $91,000.C) $88,000.D) $83,000.E) None of the above

E

The base amount in preparing component percentages for a balance sheet is which of the following? A) Total liabilities B) Gross profit C) Net income D) Total shareholders' equity E) None of the above

Depreciation expense is added to net income to adjust for the effects of a non cash expense that was deducted in determining net income. It does not involve an inflow of cash.

Under the indirect method, depreciation expense is added to net income to report cash flows from operating activities. Does depreciation cause an inflow of cash?