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Statement of cash flows indirect method.

Statement of Cash Flows Indirect Method

The following question related to the Statement of Cash Flows was part of a recent examination for public accountants. Try it and see how you do. Then read the remainder of this column for an explanation of the correct answers.

The Make-it Corporation uses the indirect method for preparation of its Statement of Cash Flows. The statement includes the following sections and related disclosures.

Operating Activities

A. Additions to Net Income B. Deductions to Net Income

Investing Activities

C. Cash received from investing

activities D. Cash payments for investing


Financing Activities

E. Cash received from financing

activities F. Cash payments for financing


Related Disclosures

G. Disclosed in notes to

financial statements or presented

in supplementary schedules

Classify each of the following events using the selections listed above. Indicate with an "X" any item that is not included in either the Statement of Cash Flows or related disclosures. 1. Gain of $3,000 on sale of

Equipment for $15,000 2. Depreciation Expense of

$18,000 3. Increase of $22,000 in

Merchandise Inventory 4. Increase of $4,500 in the

Accounts Payable Balance 5. Payment of $10,000 Received

on Note Receivable for Prior

Sale of Building 6. Decrease of $2,100 in

Prepaid Insurance 7. Payments of $5,000 made to

bank on a mortgage note

payable 8. Interest Paid of $350 9. Acquisition of land by

issuance of $100,000 in long-term

debt, $800,000 in

common stock, and payment of

$40,000 cash 10. Distribution of a 5% stock



1. (B) The gain of $3,000 on the sale of equipment is subtracted from net income. When calculating cash flow from operations, net income as the starting amount is then adjusted for all non-cash activities. Since the gain on the sale of the equipment does not represent the cash effect of the transaction, the gain is eliminated from net income. The actual cash received of $15,000 is shown as a cash inflow from investing activities.

2. (A) Depreciation expense of $18,000 is added back to net income. Net income already includes this expense. However depreciation has no effect on the cash account and must be eliminated in order to calculated cash flow from operations. Cash was reduced when the equipment was purchased and should have been shown on the statement at that time as a use of cash for investments.

3. (B) The increase of $22,000 would have to be deducted from net income. When inventory increases, Cost of Sales decreases and as a result net income also increases. However, the $22,000 represents an outflow of cash in order to acquire the inventory. By adjusting net income for this amount, the cash used is reflected in operations on the Cash Flow Statement.

4. (A) The increase of $4,500 in the accounts payable is added back to net income. When a payable increases during a period, it means that less cash was used than was actually recorded on the accrual based income statement and the increase must therefore be added back to net income. To make this clearer, let's assume that the supplies account was debited for the $4,500 and accounts payable was credited. It is now evident that an expense account increased with no outflow of cash, but net income was certainly reduced by that expense.

5. (C) The payment of $10,000 is a cash inflow from investing activities. Any adjustment for the gain or loss on the original transaction would have been made in the year of sale. Since we are dealing with a note receivable related to the sale of a building, the cash amount is shown as part of investing activities.

6. (A) The decrease of $2,100 in prepaid insurance is added back to net income. The decrease in the prepaid account means that the amount of cash used for insurance expense was less than the amount shown on the income statement. Therefore net income must be increased by that amount in order to represent the actual cash used.

7. (F) The payment of $5,000 is considered an outflow of cash for financing activities. Whenever a payment of principal is made, cash used is classified by FASB 95 as a financing activity.

8. (G) Interest expense of $350 is already shown as a part of net income and no adjustment is necessary. However, the amount of interest paid or received should be disclosed either in a note or as part of a supplementary schedule. Although cash flows from interest or dividends might be classified as investing or financing activities, the FASB has decided to classify them as operating activities. This does tie in to their presentation on the income statement.

9. (D & G) The payment of $40,000 cash for the land should be shown as an outflow of cash for investing activities. The assumption of long-term debt of $100,000 and the issuance of $800,000 in common stock is shown in a supplemental schedule of non-cash investing or financing activities or in a note to the financial statement.

10. (X) It is not necessary to show the 5% stock dividend on the Statement of Cash Flows. No cash is involved. If the amount was significant, it would be shown in a note to the financial statements, but does not have to be related to the Statement of Cash Flows.

The Statement of Cash Flows can be confusing, but taken step by step, it becomes easier. I hope that working through the above problem helped show some of the basic concepts involved.

Marlyn A. Schwartz Director of Education & Professional Development
COPYRIGHT 1991 National Society of Public Accountants
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Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Title Annotation:Accounting Scene
Author:Schwartz, Marilyn A.
Publication:The National Public Accountant
Article Type:column
Date:Feb 1, 1991
Previous Article:Taxview Professional Tax Software Series.
Next Article:The Uniform Accountancy Act--an adventure into the land of uniform state laws.

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