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Chapter 20: Statement of Cash Flows

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  • Chapter 20: Statement of Cash Flows

     

    The Importance of Cash Flow – For Better, For Worse, For Richer, For Poorer...

    A business is a lot like a marriage. It takes work to make it succeed. One of the keys to business success is managing and maintaining adequate cash flows. In the field of financial management, there is an old saying that revenue is vanity, profits are sanity, but cash is king. In other words, a firm's revenues and profits may look spectacular, but this does not guarantee there will be cash in the bank. Without cash, a business cannot pay its bills and it will ultimately not survive.

    Let's take a look at the distinctions between revenue and profits, and cash, using a numeric example for a new business:

    Income Statement Cash Flows
    Revenue* $ 1,000,000 Revenue (cash received) $ 400,000
    Cost of goods sold** (500,000) Cost of goods sold (paid in cash) (300,000)
    Gross profit 500,000 Net cash 100,000
    Operating expenses*** 200,000 Operating expenses (paid in cash) 90,000
    Net income/net profit $ 300,000 Net cash $ 10,000

    * Sales of $400,000 were paid in cash
    ** Purchases of $300,000 were paid in cash
    *** Operating expenses of $90,000 were cash paid

    Revenue is reported in the income statement as $1 million which is a sizeable amount, but only $400,000 was cash paid by customers. (The rest is reported as accounts receivable.) Gross profit is reported in the income statement as $500,000. This is also a respectable number, but only $100,000 translates into a positive cash flow, because some of the inventory purchases were paid in cash. (The rest of the inventory is reported as accounts payable.) The company must still pay some of its operating expenses, leaving only $10,000 cash in the bank.

    When investors and creditors review the income statement, they will see $1 million in revenue with gross profits of one-half million or 50%, and a respectable net income of $300,000 or 30% of revenue. They could conclude that this looks pretty good for the first year of operations and incorrectly assume that the company now has $300,000 available to spend.

    However, lurking deeper in the financial statements is the cash position of the company–the amount of cash left over from this operating cycle. Sadly, there is only $10,000 cash in the bank, so the company cannot even pay its remaining accounts payable in the short term. So, how can management keep track of its cash?

    The statement of cash flows is the definitive financial statement to bridge the gaps between revenues and profits, and cash. Therefore, it is vital to understand the statement of cash flows.

    Chapter 20 Learning Objectives

    After completing this chapter, you should be able to:

    1. Describe the statement of cash flows (SCF) in accounting and business.

    2. Explain the purpose of the statement of cash flows and the two methods used.

    3. Describe the statement of cash flows using the direct method and explain the difference in format from the indirect method.

    4. Describe how the results from the statement of cash flows are interpreted.

    5. Describe the required disclosures for the statement of cash flows.

    6. Describe the types of analysis techniques used for the statement of cash flows.

    7. Review and understand a comprehensive example of an indirect and direct statement of cash flows that includes complex transactions from intermediate accounting courses.

    8. Discuss specific items that affect the statement of cash flows.

    9. Summarize the differences between ASPE and IFRS regarding reporting and disclosure requirements of the statement of cash flows.

    Introduction

    The statement of cash flows is a critical financial report used to assess a company's financial status and its current cash position, as uniquely demonstrated in the opening story about revenue and profits versus cash. As cash is generally viewed by many as the most critical asset to success, this chapter will focus on how to correctly prepare and interpret the statement of cash flows.

    Chapter Organization

    img765.png

    20.1 Financial Reports: Overview

    As discussed in previous chapters, shareholders, potential investors, and creditors use published financial statements to assess a company's overall financial health. Recall how the five core financial statements link together into a cohesive network of financial information. One of these links is the match between the ending cash balance reported in the statement of cash flows (SCF) and the ending cash balance in the statement of financial position (IFRS), or balance sheet (ASPE).

    For example, below is the statement of cash flows for the year ended December 31, 2020, and the statement of financial position (SFP) for Wellbourn Services Ltd. at December 31, 2020.

    img766.png

    Note how Wellbourn's ending cash balance of $135,500, from the statement of cash flows for the year ended December 31, matches the ending cash balance in the SFP on that date. This is a critical relationship between these two financial statements. The SFP provides information about a company's resources (assets) at a specific point in time, and whether these resources are financed mainly by debt (current and long-term liabilities) or equity (shareholders' equity). The statement of cash flows identifies how the company utilized its cash inflows and outflows over the reporting period and, ultimately, ends with its current cash and cash equivalents position at the statement of financial position date. As well, since the statement of cash flows is prepared on a cash basis, it excludes non-cash accruals like depreciation and interest, making the statement of cash flows harder to manipulate than the other financial statements.

    Since the statement of cash flows separates cash flows into those resulting from ongoing operating activities versus investing and financing activities, investors and creditors can quickly see where the main sources of cash originate. If cash inflows are originating mainly from operating activities, then this provides insight into a company's ability to generate sufficient cash to maintain its operations, pay its debts, and make new investments without the need for external financing. If cash sources originate more from investing activities, then this means that the company is likely selling off some of its assets to cover its obligations. This may be appropriate if these assets are idle and are no longer generating profit; otherwise it may suggest a downward spiral resulting in plummeting profits. If cash sources are originating mainly from financing activities, then the company is likely sourcing more cash from debt or from issuing shares (equity). Higher debt means that more cash reserves are needed to make the principal and interest payments. Higher equity means more shares issued and more dividends to be paid out, not to mention the dilution of existing shareholders investments. Either scenario is cause for concern for both shareholders and creditors.

    Even if the majority of cash inflows are mainly from operating activities, if there is a large difference between net income and the total cash inflows from operating activities then that is a warning sign that shareholders and creditors should be digging deeper. This is because a company's quality of earnings, and hence its reliability, relates to how closely reported net income corresponds to net cash flows. For example, if reported net income is consistently close to, or less than, net cash operating activities, the company's earnings are considered to be high quality and, therefore, reliable. Conversely, if reported net income is significantly more than net cash flows from operating activities, then reported net income is not matched by a corresponding increase in cash, creating a need to investigate the cause. After reviewing the statement of cash flows and the balance sheet, the bottom line is: if debt is high and cash balances are low, the greater the risk of business failure.

    This chapter will explain how to prepare the statement of cash flows using either the direct or indirect method, and how to interpret the results.

    20.2 Statement of Cash Flows: Indirect Method Review

    The statement of cash flows using the indirect method has been discussed in most introductory accounting courses. Since the statement of cash flows can be challenging, a review of the basic concepts is presented below.

    The purpose of the statement of cash flows is to provide a means "to assess the enterprise's capacity to generate cash and cash equivalents, and to enable users to compare cash flows of different entities" (CPA Canada, 2016, Accounting, Part II, Section 1540.01 and IAS 7.4). This statement is an integral part of the financial statements for three reasons. First, this statement helps readers to understand where these cash flows in (out) originated from during the current year. This helps management, shareholders, and creditors to assess a company's liquidity, solvency, and financial flexibility. Second, these historic cash flows in (out) can be used to predict future company performance. Third, the statement of cash flows can shed light on a company's quality of earnings and if there may be a disconnect between reported earnings and net cash flows from operating activities, as explained earlier.

    Two methods are used to prepare a statement of cash flows, namely the indirect method and the direct method. The indirect method was discussed in previous accounting courses and will be reviewed again in this chapter. The direct method introduced in this chapter may be new for many students. Both methods organize the reported cash flows into three activities: operating, investing, and financing. As discussed next, the difference between the two methods occurs only in the first section for operating activities.

    The indirect method reports cash flows from operating activities into categories such as:

    • Net income/loss is reported.

    • A series of adjustments to net income/loss for non-cash items are reported in the income statement.

    • Changes in each non-cash working capital account. The current portion of long-term debt, including lease obligations and dividends payable, are not considered to be working capital accounts. They are included with their respective account to which they relate. For example, the current portion of long-term debt or lease is included with its related long-term liability account. Dividends payable is included with its related retained earnings account.

    The direct method reports cash flows from operating activities into categories based on the nature of the cash flows, such as:

    • cash received for sales

    • cash paid for goods and services

    • cash paid to or on behalf of employees

    • cash received and paid for interest

    • cash received and paid for dividends

    • cash paid for income taxes

    The statement of cash flows above for Wellbourn Services Ltd. is an example of a statement using the direct method. Note that the operating section line items using the direct method are based on the nature of the cash flows, whereas the indirect method line items are based on their connections with the income statement and working capital accounts.

    There are some similarities between the two methods. For instance, the net cash flows from operating activities is the same for both methods, and the investing and financing activities are identical for both methods as well.

    Below is an example of the format using the indirect method. Note the connections to the other financial statements.

    img767.png

    20.2.1. Differences Between IFRS and ASPE

    There are differences in some of the reporting items between IFRS and ASPE. For example, ASPE has mandatory disclosures as follows:

    • cash dividends received and interest received or paid if reported in net income – operating section

    • interest or cash dividends debited to retained earnings – financing section

    • Cash paid income taxes are often reported separately but it is not a reporting requirement.

    For IFRS, there are policy choices that, once made, should be applied consistently:

    • interest received – choice of operating or investing section

    • interest paid – choice of operating or financing section

    • dividends received – choice of operating or investing section

    • dividends paid – choice of operating or financing section

    • cash paid income taxes – separately reported

    For simplicity, this chapter will use the following norms for both IFRS and ASPE:

    • interest received – operating section

    • interest paid – operating section

    • dividends received – operating section

    • dividends paid – financing section

    • income taxes paid – separately reported

    As illustrated above, when using the indirect method, the sum of the non-cash adjustments to net income and changes to non-cash working capital accounts result in the total cash flows in (out) from operating activities. The other two activities for investing and financing follow. Any non-cash transactions occurring in the investing or financing sections are not reported in a statement of cash flows. Instead, they are disclosed separately in the notes to the financial statements. Examples of non-cash transactions would be an exchange of property, plant, or equipment for common shares, or the conversion of convertible bonds payable to common shares and stock dividends. If the transaction is a mix of cash and non-cash, the cash-related portion of the transaction is reported in the statement of cash flows with a note in financial statements detailing the non-cash and cash elements. The final section of the statement reconciles the net change in cash flows of the three activities, with the opening and closing cash and cash equivalents balances taken from the balance sheet.

    20.2.2. Preparing a Statement of Cash Flows: Indirect Method

    Presented below is the balance sheet and income statement for Watson Ltd.

    Watson Ltd.
    Balance Sheet
    As at December 31, 2020
      
      2020 2019
    Assets  
     
    Current assets
      
     
    Cash
     $307,500 $250,000
     
    Investments (Held for trading at fair value)
     12,000 10,000
     
    Accounts receivable (net)
     249,510 165,000
     
    Notes receivable
     18,450 22,000
     
    Inventory (at lower of FIFO cost and NRV)
     708,970 650,000
     
    Prepaid insurance expenses
     18,450 15,000
     
    Total current assets
     1,314,880 1,112,000
     
    Long term investments (Held to maturity at cost)
     30,750 0
     
    Property, plant, and equipment
      
     
    Land
     92,250 92,250
     
    Building (net)
     232,000 325,000
     324,250 417,250
     
    Intangible assets (net)
     110,700 125,000
    Total assets $1,780,580 $1,654,250
    Liabilities and Shareholders' Equity  
     
    Current liabilities
      
     
    Accounts payable
     $221,000 $78,000
     
    Accrued interest payable
     24,600 33,000
     
    Income taxes payable
     54,120 60,000
     
    Unearned revenue
     25,000 225,000
     
    Current portion of long-term notes payable
     60,000 45,000
     
    Total current liabilities
     384,720 441,000
     
    Long-term notes payable (due June 30, 2025)
     246,000 280,000
     
    Total liabilities
     630,720 721,000
     
    Shareholders' equity
      
     
    Paid in capital
      
     
    Preferred, ($2, cumulative, participating – authorized
      
     
    issued and outstanding, 15,000 shares)
     184,500 184,500
     
    Common (authorized, 400,000 shares; issued and
      
     
    outstanding (O/S) 250,000 shares for 2020);
      
     
    (2019: 200,000 shares issued and O/S)
     862,500 680,300
     
    Contributed surplus
     18,450 18,450
     1,065,450 883,250
     
    Retained earnings
     84,410 50,000
     1,149,860 933,250
     
    Total liabilities and shareholders' equity
     $1,780,580 $1,654,250
    Watson Ltd.
    Income Statement
    For the Year Ended December 31, 2020
     
    Sales $3,500,000
    Cost of goods sold 2,100,000
     
    Gross profit
     1,400,000
     
    Operating expenses 
     
    Salaries and benefits expense
     800,000
     
    Depreciation expense
      43,000
     
    Travel and entertainment expense
     134,000
     
    Advertising expense
     35,000
     
    Freight-out expenses
     50,000
     
    Supplies and postage expense
     12,000
     
    Telephone and internet expense
     125,000
     
    Legal and professional expenses
     48,000
     
    Insurance expense
     50,000
     1,297,000
     
    Income from operations
     103,000
    Other revenue and expenses 
     
    Dividend income
     3,000
     
    Interest income from investments
     2,000
     
    Gain from sale of building
      5,000
     
    Interest expense
     (3,000)
     7,000
    Income from continuing operations before income tax 110,000
     
    Income tax expense
     33,000
    Net income $77,000

    Additional information:

    • The trading investment does not meet the criteria to be classified as a cash equivalent (see section 20.8 Specific Items for a discussion on cash equivalents) and no purchases or sales took place in the current year.

    • An examination of the intangible assets sub-ledger revealed that a patent had been sold in the current year. The intangible assets have an indefinite life.

    • No long-term investments were sold during the year.

    • No buildings or patents were purchased during the year.

    • There were no other additions to the long-term note payable during the year.

    • Common shares were sold for cash. No other share transactions occurred during the year.

    • Cash dividends were declared and paid.

    • The note receivable maturity date is January 31, 2021, and was for a sale.

    The statement of cash flows is the most complex statement to prepare. This is because preparation of the entries requires analysis of multiple accounts. Moreover, the transactions resulting in cash inflows are to be differentiated from the transactions resulting in cash outflows for each account. Preparing a statement of cash flows is made much easier if specific sequential steps are followed. Below is a summary of those steps.

    • Complete the statement headings.

    • Operating activities section – record the net income/(loss).

    • Adjust out any non-cash line items reported in the income statement to remove them from the statement of cash flows. Examples of these are depreciation, amortization, and most gains or losses such as gains/losses from the sale of assets, gain/loss from redemption of debt, impairment losses, and fair value changes reported in net income.

    • Record the description and change amount for each non-cash working capital account (current assets and current liabilities) except for the current portion of long-term debt line item since it is not a working capital account. Subtotal the operating activities section.

    • Investment activities section – using T-accounts or other techniques, determine the change for each non-current (long-term) asset account. Analyze and determine the reason for the change(s). Record the reason and change amount(s) as cash inflows or outflows.

    • Financing activities section – add back to long-term debt any current portion identified in the SFP/BS for both years, if any. Using T-accounts, or other techniques, determine the change for each non-current (long-term) liability and equity account. Analyze and determine the reason for the change(s). Record the reason and change amount(s) as cash inflows or outflows. One anomaly occurs with pension benefit liability. This liability is non-current, but it is not a financing activity as its nature is to benefit employees. For this reason, any change in funding for the pension liability, even though classified as non-current, is to be reported in operating activities.

    • Subtotal the three sections. Record the opening and closing cash, including cash equivalents, if any. Reconcile the opening balance plus the subtotal from the three sections to the closing balance to ensure that the accounts balance correctly.

    • Complete any required disclosures.

    Here is a summary of the steps above, labelled with a key word or phrase for you to remember:

    1. Headings

    2. Record net income/(loss)

    3. Adjust out non-cash items

    4. Current assets and current liabilities changes

    5. Non-current asset accounts changes

    6. Non-current liabilities and equity accounts changes

    7. Subtotal and reconcile

    8. Disclosures

    Applying the Steps:

    Step 1. Headings:

    Watson Ltd.
    Statement of Cash Flows
    For the Year Ended December 31, 2020
      
    Cash flows from operating activities 
     
     
     
     
    Net income (loss)
      
     
    Non-cash items (adjusted from net income):
      
      
      
      
      
    Net cash from operating activities  
    Cash flows from investing activities  
      
      
      
    Net cash from investing activities  
    Cash flows from financing activities  
      
      
      
      
    Net cash from financing activities  
    Net increase (decrease) in cash  
    Cash, January 1  
    Cash, December 31  

    Step 2. Record net income/(loss):

    As illustrated in step 3 below.

    Step 3. Adjustments:

    img768.png

    Enter the amount of the net income/(loss) as the first amount in the operating activities section. Next, review the income statement and select all the non-cash items. Look for items such as depreciation, depletion, amortization, and gains or losses (such as with the sale or disposal of assets). In this case, there are two non-cash items to adjust from net income. Record them as adjustments to net income in the statement of cash flows.

    Step 4. Current assets and liabilities:

    Calculate and record the change between the opening and closing balances for each non-cash working capital account as shown below (with the exception of the current portion of long-term notes payable, which is netted with its respective long-term notes payable account) as shown below:

    img769.png

    Cash inflows to the company are reported as positive numbers while cash outflows are reported as negative numbers using brackets. How does one determine if the amount is a positive or a negative number? A simple tool is to use the accounting equation to determine whether cash is increasing as a positive number or decreasing as a negative number. Recall the accounting equation:

    img770.png

    This must always remain in balance. This equation can be applied when analyzing the various accounts to record the changes. For example, accounts receivable has increased from $165,000 to $249,510 for a total increase of $84,510. Using the accounting equation, this can be expressed as:

    img771.png

    Expanding the equation a bit:

    img772.png

    If accounts receivable INCREASES by $84,510, then this can be expressed as a black up-arrow above the account in the equation:

    img773.png

    Holding everything in the equation constant, except for cash, if accounts receivable INCREASES, then the effect on the cash account must have a corresponding DECREASE in order to keep the equation balanced:

    img774.png

    If cash DECREASES, then it is a cash outflow and the number must be negative with brackets as shown in the statement above.

    Conversely, when analyzing liability or equity accounts, the same technique can be used. For example, an increase in account payable (liability) of $143,000 will affect the equation as follows:

    img775.png

    Again, holding everything else constant except for cash, if accounts payable INCREASES as shown by the black up-arrow above, then cash must also INCREASE by a corresponding amount in order to keep the equation in balance.

    img776.png

    If cash INCREASES, then it is a cash inflow and the number will be positive with no brackets as shown in the statement above.

    Step 5. Non-current asset changes:

    The next section to complete is the investing activities section. The analysis of all of the non-current assets accounts must also take into account whether there have been any current year purchases, disposals, or adjustments as part of the analysis. The use of T-accounts for this type of analysis provides a useful visual tool to help understand whether the changes that occurred in the account are cash inflows or outflows, as shown below.

    img777.png

    There are four non-current asset accounts: long-term investments, land, buildings, and intangible assets. The land account had no change, as there were no purchases or sales of land. Analyzing the investment account results in the following cash flows:

    Long-term investment
     
     
     
     
    ?? = purchase of investment
    30,750
    Additional information in note #3 above stated that there were no sales of long-term investments during the year, the entry would have been for a purchase:
    img778.png
    Cash paid for the investment was therefore $30,750.

    Analysis of the buildings account is a bit more complex because of the effects of the contra account for accumulated depreciation. In this case, the buildings account, and its contra account, must be merged together since the SFP/BS reports only the net carrying amount. Analyzing the buildings account results in the following cash flows:

    Building (net of accum. depr.)
     
    325,000
     
     
     
    43,000 current year accum. Depr.
    50,000 = X sale of building
    232,000
    Additional information note # 4 states that no buildings were purchased so the balancing amount of $50,000 must be for a sale of a building. Since there was a gain from the sale of buildings, the entry would have been:
    img779.png
    Cash proceeds were therefore $55,000.

    The sale of the patent is straightforward since there were no other sales, purchases, or amortization in the current year (as stated in steps 2 and 4).

    Step 6. Non-current liabilities and equity changes:

    img780.png

    There are five long-term liability and equity accounts: long-term notes payable, preferred shares, common shares, contributed surplus, and retained earnings. The preferred shares and contributed surplus accounts had no changes to report. Note that just because an account balance has no change during the year, this does not necessarily mean that there were no transactions. For example, old shares could be retired and new shares issued for the same face value. These transactions would need to be reported in the cash flow statement, even though the net change in the account is zero.

    Analyzing the long-term notes payable account results in the following cash flows:

    Long-term note payable
     
    325,000
     
     
    the sum of both the current and long-term amounts
     
    19,000 X = repayment
    306,000 the sum of both the current and long-term amounts
    Since there were no other transactions stated in the additional information note # 5 above, the entry would have been:
    img781.png
    Cash paid was therefore $19,000.

    Note how the current portion of long-term debt has been included in the analysis of the long-term note payable. The current portion line item is a reporting requirement relating to the principal amount owing one year after the reporting date. As it is not actually a working capital account, it is omitted from the operating section and included with its corresponding long-term liability account in the financing activities. For example, the opening balance of $325,000 above is the sum of the current portion ($45,000) plus the long-term portion ($280,000). Similarly, the ending balance of $306,000 is the sum of the current portion ($60,000) plus the long-term portion ($246,000).

    The common shares and retained earnings accounts are straightforward and the analysis of each is shown below.

    Common shares
     
     
    680,300
     
     
    182,200 X = share issuance
    862,500
    Since there were no other transactions stated in the additional information note #6 above, the entry would have been:
    img782.png
    Cash received was therefore $182,200.
    Retained earnings
     
     
    50,000
     
     
    77,000 net income
    X = 42,590 dividends paid
    84,410
    The additional information note #7 stated that cash dividends were declared and paid, so the entry would have been:
    img783.png
    Cash paid was therefore $42,590.

    Step 7. Subtotal and reconcile:

    The three activities total a net increase in cash of $57,500. When added to the opening cash balance of $250,000, the resulting total of $307,500 is equal to the ending cash balance for the year ending December 31, 2020. This can be seen in the completed statement of cash flows following step 8.

    Step 8. Required disclosures:

    The statement of cash flows using the indirect method must separately disclose the cash flows for:

    • Interest paid

    • Interest received

    • Dividends received (dividends paid are reported in the financing section)

    • Cash paid income taxes

    • Non-cash transactions that may have occurred in the current year.

    If not too lengthy, these items can be disclosed in the notes or at the bottom of the statement. The cash received for dividend income and interest income was taken directly from the income statement since no accrual accounts exist on the balance sheet for these items. Cash paid for interest charges and income taxes are calculated on the basis of an analysis of their respective liability accounts from the balance sheet and expense accounts from the income statement.

    Below is the completed statement of cash flows using the indirect method with required disclosures for Watson Ltd., for the year ending December 31, 2020:

    Watson Ltd.
    Statement of Cash Flows
    For the Year Ended December 31, 2020
     
    Cash flows from operating activities 
     
    Net income (loss)
     $77,000
     
    Non-cash items (adjusted from net income):
     
     
    Depreciation expense
     43,000
     
    Gain from sale of building
     (5,000)
     
     
    Cash in (out) from operating working capital:
     
     
    Increase in trading investments
     (2,000)
     
    Increase in accounts receivable
     (84,510)
     
    Decrease in notes receivable
     3,550
     
    Increase in inventory
     (58,970)
     
    Increase in prepaid expenses
     (3,450)
     
    Increase in accounts payable
     143,000
     
    Decrease in interest payable
     (8,400)
     
    Decrease in income taxes payable
     (5,880)
     
    Decrease in unearned revenue
     (200,000)
    Net cash flows from operating activities (101,660)
    Cash flows from investing activities 
     
    Purchase of HTM investments
     (30,750)
     
    Sales proceeds from sale of building
     55,000
     
    Sales proceeds from sale of patent
     14,300
    Net cash flows from investing activities 38,550
    Cash flows from financing activities 
     
    Repayment of long-term note
     (19,000)
     
    Proceeds from shares issuance
     182,200
     
    Dividends paid
     (42,590)
    Net cash flows from financing activities 120,610
    Net increase (decrease) in cash 57,500
    Cash, January 1 250,000
    Cash, December 31 $307,500
    Disclosures: 
    Cash paid for income taxes $38,880
    (img784.png) 
    Cash paid for interest charges 11,400
    (img785.png) 
    Cash received for dividend income 3,000

    Note that the interest income of $2,000 reported in the income statement is not included in the additional disclosures shown above. This is because the interest income was accrued as an adjusting entry regarding the trading investments, so it was not a cash-received item.

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    20.3 Statement of Cash Flows: Direct Method

    As mentioned earlier, the only difference when applying the direct method, as opposed to the indirect method, is in the operating activities section; the investing and financing sections are prepared exactly the same way. Typical reporting categories in the operating section for the direct method include:

    • Cash received from sales

    • Cash paid for goods and services

    • Cash paid to, or on behalf of, employees

    • Cash received for interest income

    • Cash paid for interest

    • Cash paid for income taxes

    • Cash received for dividends

    Recall that the categories above are based on the nature of the cash flows. Whereas with the indirect method the cash flows are based on the income statement and changes in each non-cash working capital (current) asset and liability account. Below is a comparison of the two methods:

    Indirect Method
     
    Direct Method
    Cash flows from operating activities: Cash flows from operating activities:
    Net income $$ Cash received from sales $$
    Adjust for non-cash items: Cash paid for goods and services ($$)
     
    Depreciation
    $$ Cash paid to or on behalf of employees ($$)
     
    Gain on sale of asset
    ($$) Cash received for interest income $$
    Increase in accounts receivable ($$) Cash paid for interest ($$)
    Decrease in inventory $$ Cash paid for income taxes ($$)
    Increase in accounts payable $$ Cash received for dividends $$
    Net cash flows from operating activities $$ Net cash flows from operating activities $$
    (supplementary disclosures for interest, (interest and income tax categories exist
    dividends and income tax are required) so no supplementary disclosures required)

    The direct method is straightforward due to the grouping of information by nature. This also makes interpretation of the statement more intuitive for stakeholders. However, companies record thousands of transactions every year and many of them do not involve cash. Since the accounting records are kept on an accrual basis, it can be a time-consuming and expensive task to separate and collect the cash-only data required for the direct method categories by nature. Also, providing disclosures about sensitive information, such as cash receipts from customers and cash payments to suppliers, is not in the best interest of the company. For these reasons, many companies prefer not to use the direct method. Instead, the indirect method may be easier to prepare because it collects much of its data directly from the existing income statement and balance sheet. However, it is less intuitive as evidenced by the accounts-based categories above.

    20.3.1. Preparing a Statement of Cash Flows: Direct Method

    As with the indirect method, preparing a statement of cash flows using the direct method is made much easier if specific steps are followed in sequence. Below is a summary of those steps to complete the operating section of the statement of cash flows using the direct method:

    Direct Method Steps:

    • Complete the headings and categories section of the operating activities. The example below includes seven categories based on the nature of the revenue and expenses.

    • Create three additional columns: Income Statement (I/S) Accounts, Changes to Working Capital (WC), and Accounts and Net Cash Flows In (Out).

    • Starting with the top of the income statement, record each income statement line item amount to the most appropriate direct method category in the I/S Accounts column. These would include sales, cost of goods sold, operating expenses, non-operating revenue, and various expenses items. Any non-cash items are also recorded, but only as memo items in the column. Examples of these would be depreciation, amortization, and most gains or losses. Such as gains or losses from the sale of assets, gains or losses from the redemption of debt, impairment losses, and from fair value changes reported in net income. The I/S Accounts column total must be equal to net income.

    • Under the Changes to Working Capital Accounts, record the net change amount for each non-cash working capital account (current assets and current liabilities) except for the "current portion of long term debt" line item. As it is not a working capital account, it is added back to its corresponding long-term liability. Also, record as an adjustment any additional non-cash items found in net income arising from the analysis of the non-current asset, liability, and equity accounts. The obvious non-cash items were recorded as memo items only in Step 3, but other non-cash items can be uncovered when analyzing the non-current assets, liabilities, and equity accounts. When these are discovered, they must be recorded as an adjustment to net income in this column.

    • Under the Net Cash Flows In (Out), calculate the net cash flows amount for each direct method category.

    • Calculate the subtotal of the operating activities section and transfer the information to the statement of cash flows operating activities section.

    Using the financial statements from Watson Ltd. presented previously, we will apply the steps below:

    Applying the Steps:

    Step 1 and Step 2. Headings, categories, and three additional columns.

    Watson Ltd.
    Operating Activities
    Changes to Net
    Working Capital Cash Flow
    Cash flows from operating activities I/S Accounts Accounts In (Out)
     
    Cash received from sales
     
    Cash paid for goods and services
     
    Cash paid to employees
     
    Cash received for interest income
     
    Cash paid for interest
     
    Cash paid for income taxes
     
    Cash received for dividends
    Net cash flows from operating activities

    Step 3. Record each income statement line item amount to its respective direct method category under the I/S Accounts column (non-cash items are memo items only):

    Step 4. Record the net change amount for each non-cash working capital account, except cash (also, record any adjustment amounts to net income resulting from analysis of non-current accounts):

    img786.png

    img787.png

    Note how items 13 and 17 on the operating activities statement, regarding the trading investments, cancel each other out. This is because the interest income from the trading investment was accrued and not actually received in cash.

    In this simple example, no adjustments to net income resulting from analysis of non-current assets, liabilities, and equity are identified. However, this situation will be illustrated in the comprehensive example later in this chapter.

    The change in each working capital account can be a positive or a negative cash flow (using brackets). To ensure that the cash flow is correctly identified as positive or negative, apply the principles using the accounting equation explained earlier:

    img788.png

    Refer to the earlier section in this chapter for more details regarding this technique.

    Step 5 and Step 6. Calculate the net cash flows amount for each category and calculate the subtotal for the operating activities section (transfer the information to the statement of cash flows):

    Watson Ltd.
    Operating Activities
    Changes to Net
    Working Capital Cash Flow
    Cash flows from operating activities I/S Accounts Accounts In (Out)
     
    Cash received from sales
    $ 3,500,000 1
     
    $
    (84,510) 18
    3,550 19
    (200,000) 25 $ 3,219,040
     
    Cash paid for goods and services
    (2,100,000) 2 (58,970) 20
    (134,000) 5 (3,450) 21
    (35,000) 6 143,000 22
    (50,000) 7
    (12,000) 8
    (125,000) 9
    (48,000) 10
    (50,000) 11 (2,473,420)
     
    Cash paid to employees
    (800,000) 3 (800,000)
     
    Cash received for interest income
    2,000 13 (2,000) 17 0
     
    Cash paid for interest
    (3,000) 15 (8,400) 23 (11,400)
     
    Cash paid for income taxes
    (33,000) 16 (5,880) 24 (38,880)
     
    Cash received for dividends
    3,000 12 3,000
     
    Memo items:
     
    Depreciation expense
    (43,000) 4
     
    Gain on sale of building
    5,000 14
    Net cash flows from operating activities $ 77,000 $ (216,660) $ (101,660)
    A comparison of the two methods, for the operating activities section for Watson Ltd., is presented below:

    Watson Ltd. Watson Ltd.
    Operating Activities – Indirect Method Operating Activities – Direct Method
    Cash flows from operating activities Cash flows from operating activities
     
    Net income (loss)
    $ 77,000
     
    Cash received from sales
    $ 3,219,040
     
    Non-cash items (adjusted from net income):
     
    Cash paid for goods and services
    (2,473,420)
     
    Depreciation expense
    43,000
     
    Cash paid to employees
    (800,000)
     
    Gain from sale of building
    (5,000)
     
    Cash received for interest income
    0
     
    Cash paid for interest
    (11,400)
     
    Cash in (out) from operating working capital:
     
    Cash paid for income taxes
    (38,880)
     
    Increase in trading investments
    (2,000)
     
    Cash received for dividends
    3,000
     
    Increase in accounts receivable
    (84,510)
     
    Decrease in notes receivable
    3,550 Net cash flows from operating activities $ (101,660)
     
    Increase in inventory
    (58,970)
     
    Increase in prepaid expenses
    (3,450)
     
    Increase in accounts payable
    143,000
     
    Decrease in interest payable
    (8,400)
     
    Decrease in income taxes payable
    (5,880)
     
    Decrease in unearned revenue
    (200,000)
    Net cash flows from operating activities $ (101,660)
    The cash received for interest income of zero dollars was included in the direct method example for illustrative purposes only. This line item would normally be removed when preparing the actual statement of cash flows. Also, additional disclosures for interest, dividends, and income taxes discussed previously are required when using the indirect method. With the direct method, these additional disclosures are not required as they are already reported as cash-paid line items within the statement (as shown in the example above).

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    20.4 Interpreting the Results

    This section will focus on interpreting the results using the indirect method statement of cash flows, as it is the method most widely used in business today. For convenience, the entire statement of cash flows indirect method for Watson Ltd. is reproduced below.

    Watson Ltd.
    Statement of Cash Flows – Indirect Method
    For the Year Ended December 31, 2020
     
    Cash flows from operating activities 
     
    Net income (loss)
     $77,000
     
    Non-cash items (adjusted from net income):
     
     
    Depreciation expense
     43,000
     
    Gain from sale of building
     (5,000)
     
     
    Cash in (out) from operating working capital:
     
     
    Increase in trading investments
     (2,000)
     
    Increase in accounts receivable
     (84,510)
     
    Decrease in notes receivable
     3,550
     
    Increase in inventory
     (58,970)
     
    Increase in prepaid expenses
     (3,450)
     
    Increase in accounts payable
     143,000
     
    Decrease in interest payable
     (8,400)
     
    Decrease in income taxes payable
     (5,880)
     
    Decrease in unearned revenue
     (200,000)
    Net cash flows from operating activities (101,660)
    Cash flows from investing activities 
     
    Purchase of HTM investments
     (30,750)
     
    Sales proceeds from sale of building
     55,000
     
    Sales proceeds from sale of patent
     14,300
    Net cash flows from investing activities 38,550
    Cash flows from financing activities 
     
    Repayment of long-term note
     (19,000)
     
    Proceeds from shares issuance
     182,200
     
    Dividends paid
     (42,590)
    Net cash flows from financing activities 120,610
    Net increase (decrease) in cash 57,500
    Cash, January 1 250,000
    Cash, December 31 $307,500
    Disclosures: 
    Cash paid for income taxes $38,880
    (img784.png) 
    Cash paid for interest charges 11,400
    (img785.png) 
    Cash received for dividend income 3,000

    The cash balance shows an increase of $57,500 for the current year. On the surface, a hasty conclusion could be drawn that all is well with Watson Ltd., as their bottom line is a positive cash flow. However, there is, in fact, trouble ahead for this company. We know this because the operating activities section, which represents the reason for being in business, is in a negative cash flow position. In other words, a company is expected to earn a profit, resulting in positive cash flows reflected in the operating activities section. However, in this case there is a negative cash flow of $101,660 from operating activities. Why?

    For Watson Ltd., both the accounts receivable and inventory have increased, resulting in a net decrease in cash of $143,480. An increase in accounts receivable may mean that sales have occurred but the collections are not keeping pace with the sales on account. An increase in inventory may be because there have not been enough sales in the current year to cycle the inventory from current asset, to sales/profit, and, ultimately, to cash. However, the risk of holding large amounts of inventory is the increased possibility that the inventory will become obsolete, damaged, and unsellable.

    In this example, an additional reason for decreased net cash from operating activities is due to a decrease in unearned revenue. Recall that unearned revenue is cash received from customers in advance of the company providing the goods and services. In this case, the cash would have been reported as a positive cash flow in the operating activities section in the previous reporting period when the cash was actually received. At that time, the cash generated from operating activities would have increased by the amount of cash received for the unearned revenue. The entry upon receipt of the cash would have been:

    img789.png

    When the company finally provides the goods and services to the customer, the net income reported at the top of the operating activities section will reflect the portion of the unearned revenue that has now been earned. However, the company did not obtain actual cash for this revenue in this reporting period since the cash was received in the prior reporting period. Keep in mind that unearned revenue is not normally an obligation that must be paid in cash to the customer, and getting customers to pay in advance is always a good cash management strategy. That said, once the goods and services are provided to the customer, the obligation ceases.

    Listed in the investing activities section, there was a sale of a building and a purchase of a long-term investment in Held to Maturity (HTM) Investments. The sales proceeds from the building may have been partially invested in the HTM to make a return on the cash proceeds until it can be used in the future for its intended purpose. However, more analysis would be required to confirm whether this was the case. The sale of the patent also generated a positive cash flow. There was no gain on the sale of the patent reported in the income statement, so the sales proceeds did not exceed its carrying value at the time it was sold. Ideally, the patent would not have been sold in a panic, in an effort to raise immediate additional cash at the expense of future cash flows it could have generated.

    Looking at the financing activities section, it is clear that the majority of cash inflows for this reporting period resulted from the issuance of additional common shares worth $182,200. This represents an increase in the share capital of more than 25%. Increased shares will have a negative impact on the earnings per share, and possibly the market price as well, which may give investors pause. The shareholders were also paid dividends of $42,590, but this amount only just covers the preferred shareholders dividend of $30,000 (img790.png) plus its share of the participating dividend. This leaves very little dividends for the common shareholders, a situation likely to cause concern among the common shareholder investors, made worse by the dilution of their holdings due to the large issuance of additional shares.

    When looking at the opening and closing cash balances for Watson Ltd., they seem like sizeable amounts. However, we must look at where the cash originated from. In this case, the $250,000 opening balance was due almost entirely to the $225,000 unearned revenue received in advance, which is not an ongoing source of capital. The ending cash balance of $307,500 was due to the issuance of additional share capital of $182,200 (a one-time transaction), plus an increase in accounts payable of $143,000 that will eventually have to be repaid. Consider also that during the year, the cash from the unearned revenues was being consumed and the issuance of the additional capital had not yet occurred. It would be no surprise, then, if cash at the mid-year point was insufficient to cover even the current liabilities, hence the increase in accounts payable and, ultimately, the issuance of additional capital shares.

    In summary, Watson Ltd. is currently unable to generate positive cash flows from its operating activities. The unearned revenue of $225,000 at the start of the year added some needed cash early on, but this reserve was depleted by the end of the reporting year. In the meantime, without a significant change in how the company manages its inventory and receivables, Watson Ltd. may continue to experience a shortage of cash from its operating activities. To compensate, it may continue to sell off assets, issue more shares, or incur more long-term debt in order to obtain the needed cash. In any case, these sources will eventually dry up when investors are no longer willing to invest, creditors are no longer willing to extend loans, and no assets remain worth selling. Watson Ltd.'s current negative cash position from operating activities is unsustainable and must be turned around quickly for the company to remain a going concern.

    20.5 Disclosures

    Throughout this chapter, various disclosures have been discussed. Below is a summary of the main required disclosures:

    • The change in cash (including cash equivalents) must be explained.

    • The components of cash and cash equivalents must be disclosed as well as the company policy used to determine its composition.

    • Cash flows are to be classified as either from operating, investing, or financing activities.

    • Cash flows from operating activities can be reported using the indirect or direct method.

    • Cash flows from interest received or paid, dividends received or paid (IFRS and ASPE), and income taxes paid (IFRS) are to be reported separately, either within the statement of cash flows or as a supplemental disclosure.

    • Major classes of cash flows in and out within the investing and financing section are to be separately reported.

    • Non-cash transactions are excluded from the statement of cash flows but must be disclosed as a supplemental disclosure.

    20.6 Analysis

    Ratio Analysis – Overview

    Ratio analysis occurs when relationships between selected financial data (presented in the numerator and denominator of the formula) provide key information about a company. Ratios from current year financial statements alone may not be as useful as when they are compared with benchmark ratios. Examples of benchmark ratios are a company's own historical ratio trends, future ratio targets set by management as part of its strategic plan, industry sector ratios from the sector that the company operates in, or ratios from competitors, if obtainable.

    Care must be taken when interpreting ratios because companies within an industry sector may use different accounting policies, which affect the comparison of ratios. In the end, ratios are based on a company's current and past performance and are merely indicators. Further investigation is needed to gather more business intelligence about the reasons why certain variances in the ratios occur.

    Statement of Cash Flows Analysis

    Not all companies who report profits are financially stable. This is because profits do not necessarily translate to cash. Looking at the statement of cash flows for Watson Ltd. above, we see that it reported a $77,000 net income (profit), but it is currently experiencing significant negative cash flows from its operating activities.

    As previously discussed, one of the most important aspects of the statement of cash flows is the cash flows generated from the operating activities, as this reflects the business's day-to-day operations. If sufficient cash is generated from operating activities, then the company will not have to increase its debt, issue shares, or sell off useful assets to pay its bills. However, as we saw the opposite was true for Watson Ltd. as it increased its short-term debt (accounts payable), sold off a building, and issued 25% more common shares.

    Another critical aspect is the sustainability of positive cash flows from operating activities. Perhaps Watson Ltd.'s negative cash flow from operating activities will turn itself around in the next reporting period, as this would be the company's best hope. Other companies who experience positive cash flows from operations must also ensure that it is sustainable and can be repeated consistently in the future.

    In summary, it is critical to monitor the trends regarding cash flows over time. Without benchmarks, such as historical trends or industry standards, ratio analysis is not as useful. If trends are tracked, ratio analysis can be a powerful tool to evaluate a company's cash flows.

    Statement of Cash Flows Ratios

    Below are some of the cash flows ratios currently used in business.

    Ratio Formula Purpose
    Liquidity ratios – ability to pay short term obligations
     
    Current cash debt coverage ratio
    img791.png ability to pay short term debt from its day-to day operations. A ratio of 1:1 is reasonable.
    Financial flexibility – ability to react to unexpected expenses and investment opportunities
     
    Cash debt coverage ratio
    img792.png the ability to pay debt from net cash from operating activities

    For Watson Ltd., since the net cash flow from operating activities is a loss of $101,660, the two ratios above would be unfavourable. For example, the current cash debt coverage ratio would be a negative 26.4% (img793.png) and the cash debt coverage ratio would be a negative 16.1% (img794.png). Without the historical trends for these ratios, it is impossible to say if Watson Ltd. can turn things around or not.

    Free Cash Flow (FCF) Analysis

    Another way to assess a company's cash flow liquidity is the free cash flow. Free cash flow is the cash flow remaining from operating activities after deducting cash spent on capital expenditures, such as purchasing property, plant and equipment. Some companies also deduct cash paid dividends. The remaining cash flow represents cash available to the company to do other things such as expand its operations, pay off long-term debt or reduce the number of outstanding shares. Below is the calculation using the data from Watson Ltd.'s statement of cash flows.

    Watson Ltd.
    Free Cash Flow
    December 31, 2020
    Cash flow provided by operating activities $ (101,660)
    Less capital expenditures 0
     
    Dividends
    (42,590)
    Free cash flow $ (144,250)

    It is no surprise that Watson Ltd. has no free cash flow and no financial flexibility, since its operating activities are in a negative position. Watson Ltd. met its current year dividend cash requirements by selling more common shares to raise additional cash, thus diluting the shareholders' investment position. When calculating the free cash flow, the capital expenditures amount should be limited to those that relate to daily operations that are intended to sustain ongoing operations, such as PPE expenditures. Meaning, capital expenditures purchased as investments are usually excluded from the free cash flow analysis.

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    20.7 Comprehensive Example: Both Methods

    The example below will incorporate some different transactions that were discussed earlier in this course, or the prerequisite courses. These include more complex transactions such as long-term investments such as Available for Sale investments, long-term liabilities such as accrued pension liabilities, deferred income taxes payable or bonds issued at a discount and equity items such as convertible securities, stock options and re-acquisition and retirement of shares.

    Below are three financial statements for Ace Ltd., as on December 31, 2020.

    Ace Ltd.
    Statement of Income
    For the Year Ended December 31, 2020
    Sales  $1,400,000
    Cost of golds sold  630,000
    Gross profit  770,000
    Operating expenses  
     
    Depreciation expense
     $43,000 
     
    Salaries and benefits expense
     120,000 
     
    Utilities expenses
     50,000 
     
    Travel expenses
     26,000 
     
    Operating expenses, including rent expense
     80,000 319,000
    Income from operations  451,000
    Other (non-operating) revenue and expenses:  
     
    Investment income
     3,000 
     
    Interest expense
     (30,000) 
     
    Gain on sale of AFS investment
     3,000 
     
    Loss on sale of machinery
     (15,000) (39,000)
    Income before taxes  412,000
    Income tax expense 79,000 
    Deferred tax recovery (12,000) 67,000
    Net income  $345,000
    Ace Ltd.
    Statement of Comprehensive Income
    For the Year Ended December 31, 2020
    Net income $345,000
    Other comprehensive income 
    Items that may be reclassified subsequently to net income or loss: 
    Increase in fair value, AFS investments (OCI)* 44,000
    Removal of unrealized gain on sale of AFS investment* (3,000)
    Actuarial loss on defined benefit pension plan* (20,000)
    Comprehensive income 366,000

    * In the interest of simplicity, income taxes have been ignored.

    Ace Ltd.
    Balance Sheet
    As at December 31, 2020
      2020 2019
    Assets  
    Current assets  
     
    Cash
     $50,000 $30,000
     
    Accounts receivable (net)
     110,000 145,000
     
    Inventory
     175,000 200,000
     
    Prepaid insurance expenses
     6,000 
     
    Total current assets
     341,000 375,000
      
    Investments – available for sale (OCI) 150,000 80,000
      
    Property, plant, and equipment  
     
    Land
     380,000 200,000
     
    Machinery
     1,700,000 1,500,000
     
    Accumulated depreciation
     (363,000) (400,000)
     
    Total property, plant, and equipment
     1,717,000 1,300,000
      
    Goodwill 300,000 300,000
      
    Total assets $2,508,000 $2,055,000
      
    Liabilities and Shareholders' Equity  
    Current liabilities  
     
    Accounts payable
     $200,000 $300,000
     
    Salaries payable
     128,000 125,000
     
    Income taxes payable
     115,000 120,000
     
    Total current liabilities
     443,000 545,000
      
    Long-term liabilities  
     
    6%, convertible bonds payable, net
      750,000
     
    7.2% bonds payable, net
     453,000 
     
    Deferred income tax payable
     38,000 50,000
     
    Accrued pension benefit liability
     85,000 75,000
     
    Total long-term liabilities
     576,000 875,000
    Total liabilities 1,019,000 1,420,000
      
    Shareholders' Equity  
    Paid-in capital  
     
    Common shares
     1,210,000 500,000
     
    Contributed capital, bond conversion rights
      35,000
     
    Contributed capital, stock options
     62,000 50,000
     
    Total paid-in capital
     1,272,000 585,000
    Retained earnings 192,000 46,000
    Accumulated Other Comprehensive Income, pension (40,000) (20,000)
    Accumulated Other Comprehensive Income, investments 65,000 24,000
    Total shareholders' equity 1,489,000 635,000
    Total liabilities and shareholders' equity $2,508,000 $2,055,000

    Additional information:

    • Issued additional 7.2%, $500,000, 10-year bonds payable for cash of $452,000.

    • Cash dividends were declared and paid.

    • An AFS investment (OCI) was sold for $50,000 cash on January 2, 2020. Its original cost was $47,000 and had a carrying value of $50,000 (fair value) at the time of the sale. All unrealized gains previously recorded to OCI/AOCI for the sold investment were reclassified to net income. AFS investments of $76,000 were purchased for cash.

    • There is a stock option plan for senior executives. In 2020, stock options with a book value of $15,000 were exchanged for common shares, along with $40,000 in cash. The remaining increase in the stock options account is due to the compensation expense included in the income statement as salaries and benefits.

    • The six percent convertible bond payable was converted into common shares at the beginning of 2020.

    • Land was acquired for cash.

    • Machinery, with an original cost of $100,000 and a net book value of $20,000, was sold at a loss of $15,000. Additional machinery for other activities was acquired in exchange for common shares.

    • Common shares with an average original issue price of $430,000 were retired for $485,000.

    • The accrued pension benefit liability was increased by $20,000, due to an actuarial revaluation, and $10,000, because of the difference between funding and the pension expense.

    • The company's policy is to report dividends received, interest received, and interest paid as operating activities, and dividends paid as financing activities.

    20.7.1. Preparing the Statement of Cash Flows: Indirect Method

    Indirect Method Steps:

    1. Headings

    2. Record net income/(loss)

    3. Adjust out non-cash items from the income statement

    4. Current assets and current liabilities changes

    5. Non-current asset accounts changes

    6. Non-current liabilities and equity accounts changes

    7. Subtotal and reconcile

    8. Disclosures

    Following the steps listed above, prepare a statement of cash flows using the indirect method. Details are provided below for each step, followed by the completed statement of cash flows.

    Notes to the Solutions and Details About Calculations:

    Step 1. Headings:

    Insert headings and subheadings, leaving spaces within each section to record the relevant line items resulting from the subsequent steps.

    Step 2. Record net income/(loss):

    Net income (and not comprehensive income) is the starting point for a statement of cash flows with the indirect method. Comprehensive income will become relevant if any of the AFS investments are actually sold. Recall that upon sale, any unrealized gains or losses previously recorded to OCI will be realized and moved to retained earnings from AOCI.

    Step 3. Adjustments:

    When reviewing the income statement, non-cash items for depreciation, loss on sale of machinery, and realized gain on sale of AFS investments are reported. However, since this is a more complex example, there could be other hidden non-cash items that will become apparent when analyzing the non-current asset, liability, and equity accounts. Leave some space in this section in case other non-cash items are discovered in the accounts analysis.

    Step 4. Current assets and liabilities:

    Continue to use the accounting equation, A = L + E, to determine if the change amount for each non-cash working capital account is a positive number or a negative number (requiring a bracket).

    Step 5. Non-current asset changes:

    Analyze all the non-current asset accounts to determine the reasons for the changes in the accounts. Additional information taken from the various accounting records has been provided. Items 3, 6, and 7 pertain to non-current assets so this information will be incorporated into the step 5 analysis.

    1. AFS investment (OCI):

      Long-term AFS investments
       
      80,000
       
       
       
      50,000 sale of investment
      76,000 purchase of AFS investment
      X = 44,000 increase in fair value (OCI)
      150,000
      AOCI, investments
      24,000
      44,000 increase in fair value (OCI)
      3,000 remove realized gain on sale
      65,000
      Additional information in note # 3 states that $50,000 of AFS investments (fair value = carrying value) was sold for $50,000 cash, so there's no gain or loss on the actual sale. However, the original cost was $47,000, so there is an accumulated unrealized gain of $3,000 (img795.png) for the sold investment that was reclassified from OCI/AOCI to net income. This is confirmed by reviewing the income statement. This non-cash entry has already been adjusted in operating activities in Step 3, so no further action is required. Entry for the sale:
      img796.png
      Entry to reclassify:
      img797.png
      Note # 3 also states that there was also a cash paid investment of $76,000. The T-account requires another debit for $44,000 to balance properly. This must be for fair value changes and that is confirmed by reviewing the comprehensive income statement. This non-cash entry is not included in the income statement so no further action is necessary.

      Analysis result: enter the cash amounts for the sale ($50,000) and the purchase of AFS investments ($76,000) highlighted in red in the investing activities section of the statement of cash flows.

    2. Land:

      Land
       
      200,000
       
       
       
      X = 180,000 purchase of land
      380,000
      Additional information in note # 6 states that land was purchased for cash. There is no other information about the land account so the balancing amount of $180,000 must be the purchase price of the land. Entry for the purchase:
      img798.png

      Analysis result: enter the cash amount for the purchase of land ($180,000) highlighted in red in the investing activities section of the statement of cash flows.

    3. Machinery:

      Machinery
       
      1,500,000
       
       
       
      100,000 sale of machinery
      X = 300,000 purchase of machinery for shares
      1,700,000
      Accumulated depreciation
      400,000
      80,000 sale of machinery
      43,000 X = current year depreciation
      363,000
      Additional information note # 7 states that there was a loss from the sale of machinery of $15,000 that originally cost $100,000. The carrying value at the time of the sale was $20,000. The cash amount for the sale would therefore be $5,000 (img799.png). The accumulated depreciation for the sold machinery would be $80,000 (img800.png). Entry for the sale:
      img801.png
      Accumulated depreciation requires another $43,000 credit to balance properly. This must be for the current year depreciation expense and that is confirmed by reviewing the income statement. This non-cash entry has already been adjusted in operating activities in Step 3, so no further action is required. Note # 7 also stated that additional machinery was purchased in exchange for common shares. The balancing amount of $300,000 would account for this non-cash transaction which is not included in the SCF except as a supplemental disclosure required for non-cash items.

      Analysis result: enter the cash amount for the sale of machinery ($5,000) highlighted in red in the investing activities section of the statement of cash flows.

    Step 6. Non-current liabilities and equity changes:

    Analyze all the non-current liability and equity accounts to determine the reasons for the changes in the accounts. Additional information taken from the various accounting records has been provided. Items 1, 2, 4, 5, 8, and 9 pertain to non-current liabilities and equity so this information will be incorporated into the step 6 analysis.

    1. 6% bonds payable:

      6% Convertible bonds payable
       
       
       
      750,000
       
      X = 750,000 conversion of bonds to shares
      Additional information note # 5 states that these bonds were converted into common shares in 2020. The equity portion for the conversion rights of $35,000 will also be removed from the contributed surplus account. Entry for the conversion:
      img802.png
      This is a non-cash entry which is not included in the SCF except as a supplemental disclosure required for non-cash items.

      Analysis result: no cash entries to record.

    2. 7.2% bonds payable:

      7.2% Bonds payable
       
       
       
       
      452,000 issuance of bonds
      1,000 X = amortized discount
      453,000
      Additional information note # 1 states that bonds with a face value of $500,000 were issued for cash of $452,000. The discount amount would be $48,000 (img803.png) which will be amortized. Entry for the bond issuance:
      img804.png
      The balancing amount of $1,000 must therefore be for amortization of the discount which will be included in net income as part of interest expense of $30,000. This $1,000 non-cash amount should be adjusted from net income in operating activities because it was not done in Step 3.

      Analysis result: enter the cash amount for the bond issuance ($452,000) and adjust the $1,000 amortization expense highlighted in red in the financing activities section of the statement of cash flows.

    3. Deferred income tax payable:

      Deferred Income Tax Payable
       
       
       
      50,000
       
      X = 12,000 reduction of taxes
      38,000
      There is no additional information regarding this account. The balancing amount of $12,000 must be for a deferred income tax recovery which is confirmed by a review of the income statement. This non-cash entry was included in net income but not adjusted in Step 3, so it should be adjusted in the operating section now.

      Analysis result: enter the non-cash amount for the deferred tax recovery ($12,000) highlighted in red in the operating activities section as an adjustment to net income.

    4. Accrued pension benefit liability:

      Accrued Pension Benefit Liability
       
       
       
      75,000
       
      20,000 actuarial revaluation
      X = 10,000 funding amount greater than
       
      pension expense
      85,000
      AOCI, Pension Benefits
      20,000
      20,000 actuarial revaluation
      40,000
      Additional information note # 9 states that this liability was increased by $20,000 due to an actuarial revaluation. This non-cash adjusting entry to OCI/AOCI was not included in net income so it will be omitted from the SCF. Note # 9 also states that the remaining difference was due to the difference between the funding (cash paid) and the pension expense. Entries for pension benefit:
      img805.png
      The pension expense amount is not known but the funding (cash) amount is known to be greater than the pension expense by $10,000. Even though this is a non-current liability, it's purpose is to benefit employees and not as a source of financing cash flow. For this reason, it is more appropriate to record this non-current liability reduction as an operating activity instead of a financing activity.

      Analysis result: enter the cash difference amount ($10,000) highlighted in red as an operating activity item for the reduction in the pension liability.

    5. Common shares:

      Common shares
       
       
       
      500,000
       
      300,000 machinery in exchange for shares
      785,000 6% bonds converted
      430,000 shares repurchase
      55,000 options exercise for shares
      1,210,000
      Contributed Surplus – Stock Options
      50,000
      15,000 options exercised for shares
      27,000 X = compensation expense (non-cash)
      62,000
      Additional information note # 8 states that shares with an original price of $430,000 were retired for $485,000 cash. The difference is to be debited to retained earnings. Entry for shares repurchase:
      img806.png
      Additional information note # 4 states that $15,000 of stock options were exercised along with an additional $40,000 in cash for common shares. The difference in the contributed surplus account was due to compensation expense. Entry for exercise of options:
      img807.png
      Entry for compensation expense:
      img808.png
      It is now evident that $27,000 of the compensation expense included in net income in salaries and benefits line item is a non-cash transaction that was not adjusted in Step 3. This amount should therefore be adjusted out of net income in operational activities now.

      Analysis result: enter the cash amount for the shares repurchase ($485,000) and the cash amount for stock options ($40,000) highlighted in red in the investing activities section of the statement of cash flows. Also, enter the adjusting entry ($27,000) highlighted in red in the operating activities section of the statement of cash flows.

    6. Retained earnings:

      Retained earnings
       
       
       
      46,000
       
      345,000 net income
      55,000 stock options
      X = 144,000 dividends paid
      192,000
      Additional information note # 2 states that dividends were declared and paid but no amount given. The balancing amount to retained earnings of $144,000 must therefore be the amount of the dividend. Entry for dividends paid:
      img809.png

      Analysis result: enter the dividend amount ($144,000) highlighted in red in the financing activities section of the statement of cash flows.

    Step 7. Subtotal and reconcile:

    Calculate subtotals for each section and also for net cash flows. Reconcile the net amount to the opening and closing cash balances from the balance sheet.

    Step 8. Required disclosures:

    Prepare the additional disclosures for cash paid interest and income taxes.

    Below is the prepared statement of cash flows based on the steps discussed above.

    img810.png

    img811.png

    Disclosures:

    Cash paid for income taxes img812.png

    Cash paid for interest charges img813.png

    Machinery ($300,000) was purchased in exchange for shares.

    Six percent convertible bonds ($750,000), and contributed surplus rights ($35,000), were converted to common shares.

    Stock options ($15,000) and cash ($40,000) were exercised for common shares.

    20.7.2. Operating Activities Section: Direct Method

    We will once again use the comprehensive illustration above for Ace Ltd. to demonstrate the completion of the operating activities section using the direct method. The first example explained below demonstrates how to prepare a direct method statement on its own. The second example demonstrates a quick technique to convert an already prepared indirect statement of cash flows into a direct method format.

    Direct Method Steps:

    1. Headings and categories

    2. Three additional columns

    3. Record each income statement reporting line amount to its respective direct method category under the Income Statement Accounts column. Non-cash items are shown as memo items only.

    4. Record the net change amount for each non-cash working capital account. Also record any adjustment amounts resulting from the analysis of non-current accounts from the investing or financing sections (highlighted in blue below).

    5. Calculate the net cash flow amount for each category.

    6. Calculate the subtotal for the operating activities section.

    img814.png

    In this example, steps 1 and 2 are self-explanatory. Steps 3, 4, and 5 are represented by entries in each of the columns in the schedule above. Note that this example is more complex as some non-cash costs were embedded with other income statement expenses initially treated as cash items and left unadjusted. There was also a reduction in the non-current pension liability which was more appropriately reported as an operating activity. These items were discovered when the analysis of the non-current assets (investing activities), liabilities and equity (financing activities) were completed. As a result, there are four additional adjusting entries (e, f, g and h) that must be adjusted in Step 4 of the operating section above (highlighted in blue).

    20.8 Specific Items

    The comprehensive illustration above included many of the more complex accounting transactions from the intermediate accounting courses (e.g., investments involving OCI, bonds issued at a discount, conversion of bonds to shares, deferred income taxes, exercising stock options, and accrued pension liabilities with funding changes). Below, however, is a brief discussion of further items to consider:

    • Cash equivalents

      Cash equivalents are short-term, highly liquid investments that are both readily convertible to cash and carry little risk. Treasury bills, and term deposits that mature within 90 days, are examples of financial instruments that meet these two criteria and, thus, can be treated as a cash equivalent and added to cash for purposes of a statement of cash flows. Other instruments, such as publicly traded stocks, do not meet both criteria. While they may be easily traded, they carry significant risk due to market price fluctuations. For this reason, they cannot be classified as a cash equivalent. However, companies can choose whether to include cash equivalents with cash when preparing a SCF. If they do not include them with cash, then they are to be treated the same as the other working capital accounts. In which case, the accounting policy is disclosed in the notes to the financial statements.

      Unrestricted cash and cash equivalents are treated as one reporting line item in a SCF. This means that changes between them are netted and are, therefore, not itemized. Simply speaking, the cash and cash equivalents accounts are added together and reported as a single amount for both the opening and closing balance.

    • Restricted cash or cash equivalents

      These are to be reported separately in the SCF.

    • Bank overdrafts

      Bank overdrafts are generally included in the opening and closing cash balances, provided that they are an integral part of the overall cash management for the company. However, depending on local practice or other conditions, they may be excluded. Line of credit accounts that are payable on demand are examples of accounts that would be netted with cash.

    • Discontinued operations

      The SCF begins with income before discontinued operations. Items from discontinued operations are shown separately in the operating, investing, or financing activities according to their nature. For companies following IFRS, they can also disclose cash flow information about discontinued operations in the notes to the financial statements.

    • Impairments of identifiable tangible or intangible assets

      Any impairment write-downs reported in net income are adjusted out of net income in the operating activities as non-cash items. This is also the case with impairment reversals.

    • Investments in associates

      The accounting treatment for investments in associates was discussed in the previous accounting courses. Companies that follow IFRS account for these investments using the equity method. With ASPE, a policy choice allows either the equity method or fair value through net income or cost, depending upon the type of investment. Since the SCF reports cash flows, the cash dividend income received would be included in the SCF. Any investment income accrued, or unrealized gains or losses included in net income, must be adjusted out of net income as a non-cash item in operating activities.

    • Comprehensive income

      As discussed earlier in the chapter, only net income is relevant with regard to the SCF. Comprehensive income items are excluded since they are non-cash items. For example, investments classified as "available for sale," have fair value adjustments every reporting period which are recorded to OCI rather than to net income. It is only when an AFS investment is sold that its respective accumulated unrealized gains are reclassified from OCI/AOCI to net income. When this occurs, an adjustment to net income is required in operating activities, since the gain or loss on the sale of the AFS investment is a non-cash item, the same way that a gain or loss on the sale of a building or an equipment asset is a non-cash item.

    • Liabilities

      Netting old and new debt in the SCF is not permitted and each individual debt instrument is to be individually reported. Amortization of a discount or premium is a non-cash component of interest expense, and since interest expense is reported in net income, amortization amounts are adjusted out of net income in operating activities.

    • Leases

      The increase in assets and liabilities due to a new finance lease is treated as a non-cash transaction and is excluded from the SCF, although supplementary disclosures are required. Cash payments made or received regarding a lease obligation are reported as a financing activity for the lessee.

    • Complex financial instruments

      Upon issuance of a hybrid instrument such as a convertible bond, only one cash inflow is recorded in the SCF for both the debt and the equity portion of the instrument. For more details regarding hybrid instruments, refer to the earlier complex financial instruments chapter.

    • Stock splits and dividends

      As these are non-cash transactions, they are excluded from the SCF, although supplementary disclosures are required.

    • Estimate for uncollectible accounts

      In cases where the balance sheet shows accounts receivable as a gross amount with a separate AFDA contra account, the indirect method will net the two accounts together and reports this net change as a change in the accounts receivable working capital account. However, with the direct method, an analysis is done on the AFDA to determine the current period estimate for uncollectible accounts and adjusts this amount from sales to cash paid for goods and services. This is done because the estimate for uncollectible accounts is debited to bad debt expense, which is usually included as other expenses within the cash paid for goods and services category.

    20.9 IFRS/ASPE Key Differences

    Earlier, we identified differences in the reporting items between ASPE and IFRS. For a review, please refer to sections 20.2 and 20.5 of this chapter.

    Chapter Summary

    LO 1: Describe the statement of cash flows (SCF) in accounting and business.

    The SCF reports on how a company obtains and utilizes its cash flows and how it reconciles with the opening and ending cash and cash equivalent balances of the statement of financial position. It is separated into operating, investing, and financing activities, and the combination of positive and negative cash flows from within each activity can provide important information about how a company is managing its cash flows. Large differences between reporting net income and the net cash flows from operations reduce the quality of earnings and the reliability of the financial statements, creating the need for further evaluation into the reasons for the differences.

    LO 2: Explain the purpose of the statement of cash flows and the two methods used.

    The statement of cash flows provides the means to assess a business's capacity to generate cash and to determine the source of their cash flows. The statement combines with the SFP/BS to evaluate a company's liquidity and solvency, which represents its financial flexibility. This information, based on past events, can be used to predict the future financial position and cash flows of the company. It can also shed light on a company's quality of earnings and whether there may be a disconnect between report earnings and net cash flows from operating activities.

    The SCF can be prepared using either the indirect or direct method. With the indirect method, the statement is presented in three distinct sections: operating activities (net income, current assets and liabilities), investing activities (non-current assets), and financing activities (long-term debt and equity), which follows the basic structure of the SFP/BS classifications. The changes between the opening and closing balances of the SFP/BS items are reported in the SCF as either cash inflows or cash outflows. The three sections net to a single net cash inflow or outflow, when combined with the cash and cash equivalent opening balance results in the same amount as the ending balance reported on the SFP/BS. The only difference between the methods is the categorization of cash flows by nature in operating activities, as occurs with the direct method. The investing and financing sections are identical for both methods.

    There are some reporting differences between IFRS and ASPE regarding interest received and paid, dividends received and paid, and income taxes paid. For simplicity's sake, the chapter focuses on reporting interest received and paid, dividends received in operating activities, and dividends paid in financing activities. Income taxes paid can be separately reported for ASPE but it is only mandatory for IFRS. Whereas, both accounting standards require that non-cash transactions be reported in the notes to the financial statements. Where transactions involve some cash flows, this portion of the transaction is included in the SCF with supplementary disclosures of the transactions in the notes.

    When preparing a statement of cash flows using the indirect method, the operating activities section begins with the net income/loss amount from the income statement. Entries for non-cash items such as depreciation, depletion, amortization, and gains/losses from sale/disposal of non-current assets are shown as adjustments to net income in order to remove the effects of non-cash items. The remainder of the operating activities section lists each non-cash working capital account change from opening to closing balances and reports as either cash flow in or out (cash flow out is prefixed by a minus sign). The investing activities are the change amounts between the opening and closing balances for any non-current assets such as long-term investments, property, plant, equipment, and intangible assets. Each line item from the non-current assets section of the SFP/BS is analyzed to determine if any non-current assets were purchased or sold during the year, and to report the cash paid or received. These amounts are reported as cash flows in or out. The financing section uses the same method as the investing for non-current liabilities and equities, such as any long-term debt, issuance or repurchase of shares for cash and dividends paid. These amounts are reported as cash flows in or out. Finally, the three sections are netted to a single amount and added to the cash and cash equivalent opening balance. The resulting sum should match the ending cash and cash equivalent balance reported in the SFP/BS, and the required disclosures (as described above) need to be prepared.

    LO 3: Describe the statement of cash flows using the direct method and explain the difference in format from the indirect method.

    With the direct method, the operating activities section is composed of major categories of cash flows in and out (determined by nature). Categories can include cash received from sales, cash paid for goods and services, cash paid to or on behalf of employees, as well as separate categories for interest received and paid and dividends received.

    To prepare a statement of cash flows using the direct method, the operating activities section begins with the income statement where each line item is assigned to the most appropriate category as either a positive cash flow in or a negative cash flow out. Non-cash items are recorded as a memo item only. Next, each non-cash working capital account change between its opening and closing balance is then assigned to the most appropriate category as either a positive or negative cash flow. The net cash flow from each category, and for operating activities, is calculated. The methods used to prepare the investing and financing activities are the same as with the indirect method.

    LO 4: Describe how the results from the statement of cash flows are interpreted.

    The SCF, using the indirect method, is the most commonly used format in business, and the most important section within it is the operating activities. This is because it shows the cash flows in or out that result from the company's daily operations, which allows us to determine if the company is solvent. If cash flows in this section are negative, then management must determine if this is due to a temporary condition or if fundamental changes are needed to better manage the collections of accounts receivables or levels of unsold inventory. In any case, if a company is in a negative cash flow position from operating activities, it will usually either increase its debt through borrowing, increase its equity by issuing more shares, or sell off some of its assets. If any of these steps are taken, they will be reported as cash inflows from either the investing or financing sections. While none of these options are ideal, they can be used for the short-term, but they are unsustainable in the long-run. Positive cash flows from operating activities must also be evaluated to determine if they are sustainable and to ensure that they will be consistent going forward.

    LO 5: Describe the required disclosures for the statement of cash flows.

    The main disclosures identified in this chapter included an explanation of the changes in the opening and closing cash balance (including cash equivalents) as well as the components and policy used to determine them. Cash flows in and out are classified as operating, investing, and financing–using either the indirect or direct method. The major classes of cash flows in and out are also to be separately reported within each of the three sections. Cash flows from interest, dividends, and income taxes are separately disclosed as explained above, while non-cash transactions require supplementary disclosure.

    LO 6: Describe the types of analysis techniques used for the statement of cash flows.

    While the statement of cash flows may report a positive net income, this does not guarantee a positive cash flow for that period. Also, determining which activity the positive cash flows originate from is critical analytical information for the stakeholders. At the end of the day, operating activities must be able to sustain a positive cash flow for the company to survive. There are ratios that assess the operating activities cash flow, but trends or industry standards are also needed in order for the results to be informative. Two of the common ratios used are the current cash debt coverage ratio and the cash debt coverage ratio. Free cash flow analysis is another technique used, and it calculates the remaining cash flow from the operating activities section after deducting cash spent on capital expenditures, such as purchasing property, plant and equipment. Some companies also deduct cash paid dividends. The cash flow remaining is available to the company for strategies such as expansion, repayment of long-term debt, or down-sizing share holdings to improve the share price, reduce the amount of dividends to pay, and to attract future investors.

    LO 7: Review and understand a comprehensive example of an indirect and direct statement of cash flows that includes complex transactions from intermediate accounting courses.

    Examples of how to prepare a SCF using the indirect and direct method are explained previously in the chapter. The examples include complex transactions including investments classified as available for sale, accrued pension liabilities, deferred income taxes, bonds issued as a discount with amortization, bonds converted to shares, stock options, and re-acquisition of shares.

    LO 8: Discuss specific items that affect the statement of cash flows.

    Several issues are identified, and discussed, in this section in terms of their effect on the SCF. These include what makes up cash equivalents, restricted cash or cash equivalents, bank overdrafts, discontinued operations, impairments of assets, investments in associates, comprehensive income, netting of old and new liabilities, leases, complex financial instruments, and stock splits and dividends.

    LO 9: Summarize the differences between ASPE and IFRS regarding reporting and disclosure requirements of the statement of cash flows.

    The differences are identified throughout the chapter.

    References

    CPA Canada. (2016). CPA handbook. Toronto, ON: CPA Canada.

    Exercises

    EXERCISE 20–1

    Below is a list of independent transactions:

    Description Section Cash Flow
    In (Out)
    Issue of bonds payable of $500 cash
     
     
    Sale of land and building of $60,000 cash
    Retirement of bonds payable of $20,000 cash
    Redemption of preferred shares classified as debt of $10,000
    Current portion of long-term debt changed from $56,000 to $50,000
    Repurchase of company's own shares of $120,000 cash
    Amortization of a bond discount of $500
    Issuance of common shares of $80,000 cash
    Payment of cash dividend of $25,000 recorded to retained earnings
    Purchase of land of $60,000 cash and a $100,000 note (the note would be a non-cash transaction that is not directly reported within the body of the SCF but requires disclosure in the notes to the SCF)
    Cash dividends received from a trading investment of $5,000
    Increase in an available for sale investment due to appreciation in the market price of $10,000
    Interest income received in cash from an investment of $2,000
    Leased new equipment under an operating lease for $12,000 per year
    Interest and finance charges paid of $15,000
    Purchase of equipment of $32,000
    Increase in accounts receivable of $75,000
    Leased new equipment under a finance lease with a present value of $40,000
    Purchase of 5% of the common shares of a supplier company for $30,000 cash
    Decrease in a sales related short term note payable of $10,000
    Made the annual contribution to the employee's pension benefit plan for $220,000
    Increase in income taxes payable of $3,000
    Purchase of equipment in exchange for a $14,000 long-term note

    Required: For each transaction, identify which section of the SCF it is to be reported under and indicate if it is a cash in-flow (positive) or cash out-flow (negative). Hint: recall the use of the accounting equation img815.png to help determine if an amount is positive or negative. Assume that the company policy is for interest paid or received, and dividends received, to be listed as operating cash flows, and for dividends paid to be listed as financing cash flows.

    EXERCISE 20–2

    Below are the unclassified financial statements for Rorrow Ltd. for the year ended December 31, 2020:

    Rorrow Ltd.
    Balance Sheet
    As at December 31, 2020
      2020 2019
     
    Cash
     $152,975 $86,000
     
    Accounts receivable (net)
     321,640 239,080
     
    Inventory
     801,410 855,700
     
    Prepaid insurance expenses
     37,840 30,100
     
    Equipment
     2,564,950 2,156,450
     
    Accumulated depreciation, equipment
     (625,220) (524,600)
     
    Total assets
     $3,253,595 $2,842,730
      
     
    Accounts payable
     $478,900 $494,500
     
    Salaries and wages payable
     312,300 309,600
     
    Accrued interest payable
     106,210 97,180
     
    Bonds payable, due July 31, 2028
     322,500 430,000
     
    Common shares
     1,509,300 1,204,000
     
    Retained earnings
     524,385 307,450
     
    Total liabilities and shareholders' equity
     $3,253,595 $2,842,730
    Rorrow Ltd.
    Income Statement
    For the Year Ended December 31, 2020
    Sales $5,258,246
    Expenses 
     
    Cost of goods sold
     3,150,180
     
    Salaries and benefits expense
     754,186
     
    Depreciation expense
     100,620
     
    Interest expense
     258,129
     
    Insurance expense
     95,976
     
    Income tax expense
     253,098
     4,612,189
    Net income $646,057

    Required:

    1. Complete the direct method worksheet for the operating activities section for the year ended December 31, 2020.

    2. Prepare the operating activities section for Rorrow Ltd. for the year ended December 31, 2020.

    EXERCISE 20–3

    Below is the unclassified balance sheet for Carmel Corp. as at December 31, 2020:

    Carmel Corp.
    Balance Sheet
    as at December 31, 2020
    Cash $ 84,000 Accounts payable $ 146,000
    Accounts receivable (net) 89,040 Mortgage payable 172,200
    Investments – trading 134,400 Common shares 400,000
    Buildings (net) 340,200 Retained earnings 297,440
    Equipment (net) 168,000 $ 1,015,640
    Land 200,000
    $ 1,015,640

    The net income for the year ended December 31, 2021 was broken down as follows:

    Revenues $1,000,000
    Gain 2,200
    Total revenue 1,002,200
    Expenses 
     
    Operating expenses
     809,200
     
    Interest expenses
     35,000
     
    Depreciation expense – building
     28,000
     
    Depreciation expense – equipment
     20,000
    Loss 5,000
     897,200
    Net income 105,000

    The following events occurred in 2021:

    1. Investments in traded securities are short-term securities and the entire portfolio was sold for cash at a gain of $2,200. No new investments were purchased in 2021.

    2. A building with a carrying value of $225,000 was sold for cash at a loss of $5,000.

    3. The cash proceeds from the sale of the building were used to purchase additional land for investment purposes.

    4. On December 31, 2021, specialized equipment was purchased in exchange for issuing an additional $50,000 in common shares.

    5. An additional $20,000 in common shares were issued and sold for cash.

    6. Dividends of $8,000 were declared and paid in cash to the shareholders.

    7. The cash payments for the mortgage payable during 2021 included principal of $30,000 and interest of $35,000. In 2022, the cash payments will consist of $32,000 principal and $33,000 interest.

    8. All sales to customers, and purchases from suppliers for operating expenses, were on account. During 2021, collections from customers totalled $980,000 and cash payments to suppliers totalled $900,000.

    9. Ignore income taxes for purposes of simplicity.

    10. The company's policy is to classify interest received and paid, and dividends received in operating activities. Dividends paid are classified in financing activities.

    11. Changes in other balance sheet accounts resulted from usual transactions and events.

    Required:

    1. Prepare a statement of cash flows in good form with all required disclosures for the year ended December 31, 2021. The company prepares this statement using the indirect method.

    2. Calculate the company's free cash flow, and discuss the company's cash flow pattern, including details about sources and uses of cash.

    3. How can the information from the statement of cash flows be beneficial to the company stakeholders (i.e., creditors, investors, management, and others)?

    EXERCISE 20–4

    Below is the comparative balance sheet for Lambrinetta Industries Ltd.:

    Lambrinetta Industries Ltd.
    Balance Sheet
      December 31
     
    Assets:
     2021 2020
    Cash $32,300 $40,800
    Accounts receivable 79,900 107,100
    Investments – trading 88,400 81,600
    Land 86,700 49,300
    Plant assets 425,000 345,100
    Accumulated depreciation – plant assets (147,900) (136,000)
     
    Total assets
     564,400 487,900
     
    Liabilities and Equity:
     
    Accounts payable $18,700 $6,800
    Current portion of long-term note 8,000 10,000
    Long-term note payable 119,500 75,000
    Common shares 130,900 81,600
    Retained earnings 287,300 314,500
     
    Total liabilities and equity
     $564,400 $487,900

    Additional information:

    1. Net income for the year ended December 31, 2021 was $161,500.

    2. Cash dividends were declared and paid during 2021.

    3. Plant assets with an original cost of $51,000, and with accumulated depreciation of $13,600, were sold for proceeds equal to book value during 2021.

    4. The investments are reported at their fair value on the balance sheet date. During 2021, investments with a cost of $12,000 were purchased. No other investment transactions occurred during the year. Fair value adjustments are reported directly on the income statement.

    5. In 2021, land was acquired through the issuance of common shares. There were no other land transactions during the year. The balance of the common shares issued were for cash.

    6. The company's policy is to classify interest received and paid, and dividends received, in operating activities, and to classify dividends paid in financing activities.

    7. Note that payable arose from a single transaction.

    8. Changes in other balance sheet accounts resulted from usual transactions and events.

    Required: Using the indirect method, prepare the statement of cash flows for the year ended December 31, 2021, in good form, including all required disclosures identified in the chapter material. The company follows ASPE.

    EXERCISE 20–5

    Below is a comparative statement of financial position for Egglestone Vibe Inc. as at December 31, 2021:

    Egglestone Vibe Inc.
    Statement of Financial Position
      December 31
     
    Assets:
     2021 2020
    Cash $84,500 $37,700
    Accounts receivable 113,100 76,700
    Inventory 302,900 235,300
    Investments – available for sale (OCI) 81,900 109,200
    Land 84,500 133,900
    Plant assets 507,000 560,000
    Accumulated depreciation – plant assets (152,100) (111,800)
    Goodwill (net) 161,200 224,900
     
    Total assets
     1,183,000 1,265,900
     
    Liabilities and Equity:
     
    Accounts payable $38,100 $66,300
    Dividend payable 19,500 41,600
    Notes payable 416,000 565,500
    Common shares 322,500 162,500
    Retained earnings 374,400 370,200
    Accumulated other comprehensive income 12,500 59,800
     
    Total liabilities and equity
     $1,183,000 $1,265,900

    Additional information:

    1. Net income for the 2021 fiscal year was $24,700.

    2. On March 1, 2021, land was purchased for expansion purposes. On July 12, 2021, another section of land with a carrying value of $111,800 was sold for $150,000 cash.

    3. On June 15, 2021, notes payable of $160,000 were retired in exchange for the issuance of common shares. On December 31, 2021, notes payable of $10,500 were issued for additional cash flow.

    4. Available for sale investments (OCI) were purchased during 2021 for $20,000 cash. By year-end, the fair value of this portfolio dropped to $81,900. No investments from this portfolio were sold in 2021.

    5. At year-end, plant assets originally costing $53,000 were sold for $27,300 since they were no longer contributing to profits. At the date of the sale, the accumulated depreciation for the assets sold was $15,600.

    6. Cash dividends were declared and a portion were paid in 2021. These dividends are reported under the financing section.

    7. Goodwill impairment loss was recorded in 2021 to reflect an impairment of the cash-generating unit (CGU), including goodwill.

    8. The company's policy is to classify interest received and paid, and dividends received in operating activities, and dividends paid in financing activities.

    9. Changes in other statement of financial position accounts resulted from usual transactions and events.

    Required:

    1. Prepare a statement of cash flows in good form, including all required disclosures identified in the chapter material. The company uses the indirect method to prepare the statement.

    2. Analyze and comment on the results reported in the statement.

    EXERCISE 20–6

    Below are unclassified financial statements for Bognar Ltd. at December 31, 2020, and selected additional information taken from the accounting records:

    Bognar Ltd.
    Comparative Statement of Financial Position
    December 31, 2020
      2020 2019
    Cash $5,500 $21,000
    Accounts receivable, net 297,000 189,000
    Investments – held for trading 209,000 241,500
    Inventory 809,600 663,600
    Land 363,000 430,500
    Building 1,144,000 1,176,000
     
    Accumulated depreciation, building
     (517,000) (399,000)
    Machinery 1,188,000 918,750
     
    Accumulated depreciation, machinery
     (240,900) (222,600)
    Goodwill 49,500 115,500
     $3,307,700 $3,134,250
      
    Accounts payable $57,200 $94,500
    Bonds payable, due 2031 (net) 1,089,000 1,034,250
    Deferred tax payable (non-current) 26,400 69,300
    Preferred shares 1,152,800 885,150
    Common shares 305,500 199,500
    Common stock conversion rights 525,000 525,000
    Retained earnings 151,800 326,550
     $3,307,700 $3,134,250
    Statement of Income
    For the Year Ended December 31, 2020
    Sales $1,852,400
    Cost of goods sold 1,213,300
    Gross profit 639,100
    Depreciation, building 121,000
    Depreciation, machinery 82,500
    Goodwill impairment 66,000
    Interest expense 126,500
    Other operating expenses 342,100
    Loss in held for trading investment 32,500
    Gain on sale of land (24,200)
    Loss on sale of machine 10,800
    Loss before income tax (118,100)
    Income tax, recovery 59,400
    Net loss $(58,700)

    Additional information:

    1. No held for trading investments were purchased or sold. These investments are not cash equivalents.

    2. A partially depreciated building was sold for an amount equal to its carrying value.

    3. Cash of $50,000 was received on the sale of a machine that originally cost $125,000. Additionally, other machinery was purchased during 2020.

    4. Bonds payable are convertible to common shares at the rate of 15 common shares for every $1,000 bond after August 1, 2022. No new bond issuances occurred in 2020.

    5. Preferred shares were issued for cash on May 1, 2020. Dividends of $40,000 were paid on these shares in 2020.

    6. In 2020, 25,000 common shares were purchased and retired. The shares had an average issue price of $60,000 and were repurchased for $65,000. Also in 2020, 50,000 common shares were issued in exchange for machinery.

    7. The company's policy is to classify interest received and paid, and dividends received in operating activities, and dividends paid in financing activities.

    8. Changes in other statement of financial position accounts resulted from usual transactions and events.

    Required:

    1. Prepare the statement of cash flows three-step worksheet for Bognar Ltd. for the year ended December 31, 2020 using the direct method. Include supplemental disclosures, if any.

    2. Using the information from part (a), prepare the statement of cash flows operating activities section.

    3. Prepare the operating activities section of the statement of cash flows for Bognar Ltd. for the year ended December 31, 2020 using the indirect method. Include supplemental disclosures, if any.

    EXERCISE 20–7

    The following are a list of transactions for an ASPE company, Verdon Ltd., for 2020:

    1. Land asset account increased by $98,000 over the year. In terms of activity during the year, land that originally cost $80,000 was exchanged, along with a cash payment of $5,000, for five acres of undeveloped land appraised at $100,000. Three months later, additional land was acquired for cash.

    2. Equipment asset account had an opening balance of $70,000 at the beginning of the year, and $60,000 closing balance at year-end. Accumulated depreciation opening balance was $20,000 and its closing balance was $6,600. Equipment which originally cost $15,000 (and was fully depreciated) was sold during the year for $2,000. There was also equipment that originally cost $4,000, with a carrying value of $1,200, that was discarded. During the year, there was new equipment purchased for cash.

    3. Half way through the current year, the company entered into a six year capital lease for some equipment. The lease term called for six annual payments of $20,000, to be paid at the beginning of each year. Upon signing the lease agreement, the first payment was made. The equipment will revert back to the lessor at the end of the lease term. The implicit rate for the lease was 8%, which was known to the lessee.

    Required:

    1. Prepare the journal entries for Verdon Ltd. that relate to each of the changes in each asset account for 2020. Include entries for current year cash payments, depreciation, and interest, if any.

    2. Identify and classify the cash flows for each of the transactions identified in part (a).

    3. Prepare a partial SCF: operating activities, using the indirect method, including supplemental disclosures, if any. Assume no other transactions occurred in the current year for this company other than those identified in this question.

    EXERCISE 20–8

    Below are unclassified financial statements for Aegean Anchors Ltd. at December 31, 2020, and selected additional information taken from the accounting records.

    Aegean Anchors Ltd.
    Comparative Statement of Financial Position
    December 31, 2020
      2020 2019 Increase
        (Decrease)
    Cash $33,960 $53,280 $(19,320)
    Accounts receivable, net 1,015,680 920,040 95,640
    Inventory 861,120 810,000 51,120
    Equipment 3,679,680 3,439,680 240,000
     
    Accumulated depreciation, equipment
     (1,398,000) (1,212,000) 186,000
    Investment in Vogeller Ltd., at equity 345,600 319,200 26,400
    Note receivable 301,800 0 301,800
     $4,839,840 $4,330,200 
       
    Bank overdraft $171,120 $87,480 $83,640
    Accounts payable 904,320 977,520 (73,200)
    Income tax payable 44,400 55,200 (10,800)
    Dividends payable 78,000 102,000 (24,000)
    Obligations under lease 324,000 0 324,000
    Common shares 1,080,000 1,080,000 0
    Retained earnings 2,238,000 2,028,000 210,000
     $4,839,840 $4,330,200 

    Additional information:

    1. Net income for 2020 was $288,000. The income taxes paid were $181,000.

    2. The amount of interest paid during the year was $18,000, and the amount of interest received was $11,300.

    3. On January 2, 2020, Aegean Anchors Ltd. sold equipment which cost $84,000 (with a carrying amount of $53,000) for $50,000 cash.

    4. On December 31, 2019, Aegean Anchors Ltd. acquired 25% of Vogeller Ltd.'s common shares for $319,200. On that date, the carrying value of Vogeller Ltd.'s assets and liabilities were $1,276,800, which approximated their fair values. Vogeller Ltd. reported net income of $105,600 for the year ended December 31, 2020, and no dividend was paid on their common shares during 2020.

    5. On January 2, 2020, Aegean Anchors Ltd. loaned $350,000 to Vancorp Ltd. (the company is not related to Aegean Anchors Ltd.). Vancorp Ltd. made the first semi-annual principal repayment of $48,200, plus interest at seven percent, on December 31, 2020.

    6. The bank overdraft identified in the comparative statement of financial position is a line of credit, payable on demand.

    7. On December 31, 2020, Aegean Anchors Ltd. entered into a finance lease for equipment. The present value of the annual lease payments is $324,000, which equals the equipment's fair value. Aegean made the first payment of $57,000 on January 2, 2021 when it was due.

    8. Aegean Anchors Ltd. declared and paid dividends in 2019 and 2020. In 2019, a dividend for $102,000 was declared to the shareholders on record at December 15, 2019. This dividend was paid on January 10, 2020. In 2020, a dividend for $78,000 was declared on December 15, 2020 and was paid on January 10, 2021.

    9. The company's policy is to classify interest received and paid, and dividends received in operating activities, and to classify dividends paid in financing activities.

    10. Changes in other statement of financial position accounts resulted from usual transactions and events.

    Required: Prepare a statement of cash flows for Aegean Anchors Ltd. for the year ended December 31, 2020, using the indirect method. Include supplemental disclosures, if any.