Intermediate II Accounting - Chapter 21-Statement of Cash Flows Revisited - End of Chapter Questions

Does the statement of cash flows report only transactions that cause an increase or a decrease in cash? Explain.

A statement of cash flows reports transactions that cause an increase or a decrease in cash. However, some transactions that do not increase or decrease cash, but which result in significant investing and financing activities, must be reported in related disclosures. Entering a significant investing activity and a significant financing activity as two parts of a single transaction that would be reported: 1. Acquiring an asset by incurring a debt payable to the seller 2. Acquiring an asset by entering into a lease agreement 3. Converting debt into common stock or other equity securities 4. Exchanging noncash assets or liabilities for other noncash assets or liabilities

Investing activities include the acquisition and disposition of assets. Provide four specific examples. Identify two exceptions.

"Cash flows from investing activities" are both outflows and inflows of cash due to the acquisition and disposition of assets. This classification includes cash payments to acquire (1) property, plant and equipment and other productive assets; (2) investment in securities; and (3) non trade receivables. When these assets later are liquidated, any cash receipts from their disposition also are classified as investing activities. The four specific examples can come from any combination of these categories. Two exceptions are inventories and cash equivalents. The purchase and sale of inventories are not considered investing activities because inventories and purchased for the purpose of being sold as part of the firm's primary operations and are classified as operating activities. The purchase and sale of assets classified as cash equivalents are not reported on the statement of cash flows unless the total of cash and cash equivalents changes from the sale of a cash equivalent at a gain or loss.

What are the differences between cash flows from operating activities and the elements of an income statement?

"Cash flows from operating activities" are both inflows and outflows of cash that result from the same activities that are reported on the income statement. However, the income statement reports the activities on an accrual basis (revenues earned during the reporting period, regardless of when cash was paid). Cash flows from operating activities, on the other hand, report those activities when the cash is exchanged (on a cash basis).

Effects of all cash flows affect the balances of various accounts reported in the balance sheet. Also, the activities that cause some of these cash flows are reported in the income statement. What, then, is the need for an additional financial statement that reports cash flows?

Every cash flow eventually affects the balance of one or more account in the balance sheet, and the cash flows related to income-producing activities also are represented in the income statement. The activities, though, are not necessarily reported in the balance sheet and income statement in the period the cash flows occur. This is because the income statement measures activities on an accrual basis rather than a cash basis. The statement of cash flows fills the information gap by reporting the cash flows directly and in the period the cash flows occur.

Is an investment in Treasury bills always classified as a cash equivalent? Explain.

No, an investment in Treasury bills need not always be classified as cash equivalent. A guideline- not a rule- for cash equivalents is that these investments must have a maturity date not longer than three months from the date of purchase. However, flexibility is permitted and each company must establish a policy regarding which short-term, highly liquid investments it classifies as cash equivalents. The designation must be consistent with the company's customary motivation for acquiring various investments and the policy should be described in disclosure notes.

How would the acquisition of a building be reported on a statement of cash flows if purchased by issuing a mortgage note payable in addition to a significant cash down payment?

The acquisition of a building purchase by issuing a mortgage note payable in addition to a cash down payment is an example of a transaction involving a significant investing and financing activity that is part cash and part noncash. The cash portion would be reported under the caption "cash flows from investing activities," and the noncash portion of the transaction would be reported as a "noncash investing and financing activity."

Compare the manner in which investing activities are reported on a statement of cash flows prepared by the direct method and by the indirect method.

The direct and indirect methods are alternative approaches to deriving net cash flows from operating activities only. Regardless of which method is used for that purpose, the way cash flows from investing and financing activities are presented is precisely the same.

Do cash flows from operating activities report all the elements of the income statement on a cash basis? Explain.

The generalization that "cash flows from operating activities" report all the elements of the income statement on a cash basis is not strictly true for all elements of the income statement. No cash effects are reported for depreciation and amortization of assets, or for gains and losses from the sale of those assets. Cash outflows occur when assets acquired, and cash inflows occur when the assets are sold. However, the acquisition and subsequent resale of noncurrent assets are classified as investing activities, rather than as operating activities.

The statement of cash flows provides a list of all the cash inflows and cash outflows during the reporting period. To make the list more informative, the cash flows are classified according to the nature of the activities that create the cash flows. What are the three primary classifications?

The informational value of the presentation is enhanced if the cash flows are classified according to the nature of the activities that create the cash flows. The three primary classifications of cash flows are (1) cash flows from operating activities, (2) cash flows from investing activities, and (3) cash flows from financing activities. Categorizing each cash flow by source (operating, investing, or financing activities) is more information than simply listing the various cash flows.

The sale of stock and the sale of bonds are reported as financing activities. Are payments of dividends to shareholders and payments of interest to bondholders also reported as financing activities? Explain.

The payment of cash dividends to shareholders is classified as a financing activity but paying to creditors is classified as an operating activity. This is because "cash flows from operating activities" should reflect the cash effects of items that enter into the determination of net income. Interest expense is a determinant of net income. A dividend, on the other hand, is a distribution of net income and not an expense.

Transactions that involve merely purchases or sales of cash equivalents generally are not reported in a statement of cash flows. Describe an exception to this generalization. What is the essential characteristic of the transaction that qualifies as an exception?

Transaction that involve merely transfers from cash to cash equivalents such as the purchase of a three-month Treasury bill or from cash equivalents to cash such as the sale of a Treasury bill, should not be reported on the statement of cash flows. A dollar amount is simply transferred from on "cash" account to another "cash" account so that the total of cash and cash equivalents is not altered by such transactions. An exception is the sale of a cash equivalent at a gain or loss. In this case, the total of cash and cash equivalents actually increases or decreases. The increase or decrease is reported as a cash flow from operating activities.

When an asset is sold at a gain, why is the gain not reported as a cash inflow from operating activities?

When an asset is sold at a gain, the gain is not reported as a cash inflow from operating activities. A gain (or loss) is simply the difference between cash received in the sale of an asset and the book value of the asset-not a cash flow. The cash effect of the sale is reported as an investing activity. To report the gain as a cash flow from operating activities, in addition to reporting the entire cash flow from investing activities, would be to report the gain twice.

When using the indirect method of determining net cash flows from operating activities, how is warranty expense reported? Why? What other expenses are reported in a like manner?

When using the indirect method of determining net cash flows from operating activities, the net cash increase or decrease from operating activities is derived indirectly by starting with reported net income and "working backwards" to convert that amount to a cash basis. Amounts that were subtracted in determining net income, but which did not reduce cash, are added back to net income to reverse the effect of the amounts having been subtracted. Warranty expense is one example. As we learned in Chapter 13, warranty expense is estimated based on what is expected to be paid in the future, but does not reduce cash currently. Other examples of noncash reductions of net income that must be added back are depreciation expense, amortization of other intangibles, depletion, and a loss on the sale of assets.