Question

1. Why was the statement of cash flows created by the Financial Accounting Standards Board (FASB)?

2. Describe the three classifications of cash flows, and provide examples of activities that would appear in each classification.

3. Which section of the statement of cash flows is widely regarded as the most important? Why?

4. Briefly describe the four steps required to prepare the statement of cash flows using the indirect method.

5. Refer to the Why is the indirect method used by most companies?

6. Describe the three adjustments necessary to convert net income to a cash basis using

the indirect method. Provide an example for each adjustment.

7. Why is depreciation expense added back to net income using the indirect method of preparing the statement of cash flows?

8. Assume you are using the indirect method to prepare the operating activities section of the statement of cash flows. Describe the adjustment rules for current assets and

current liabilities, and provide one example for each rule.

9. You have just completed the statement of cash flows for a company, and the bottom of the statement shows a net increase in cash of $250,000. Describe where this

increase should be shown elsewhere in the financial statements.

10. Provide an example of a noncash investing or financing activity. Describe how these transactions are disclosed in the financial statements.

11. How is the operating cash flow ratio calculated, and what does it tell the user?

12. How is the capital expenditure ratio calculated, and what does it tell the user?

13. How is free cash flow calculated, and what does it tell the user?

14. Appendix. Describe how the indirect method differs from the direct method.

15. Appendix. Assume you are using the direct method to prepare the operating activities section of the statement of cash flows. Describe the adjustment rule used to

convert sales revenue to cash receipts from customers.

16. Appendix. Assume you are using the direct method to prepare the operating activities section of the statement of cash flows. Describe the adjustment rules used to

convert cost of goods sold to cash payments to suppliers.

17. Evaluating Cash Flows at Home Store, Inc. Refer to the dialogue at Home Store, Inc., presented at the beginning of the chapter and the follow-up dialogue after .

Required:

17a. Why was the CEO concerned about the company’s cash flow?

17b. Why did the CEO state, “We probably should have financed the equipment rather than having paid for it all at once”?

Answer 1

1. Why was the statement of cash flows created by the Financial Accounting Standards Board (FASB)?

This Statement establishes standards for cash flow reporting. It supersedes APB Opinion No. 19, Reporting Changes in Financial Position, and requires a statement of cash flows as part of a full set of financial statements for all business enterprises in place of a statement of changes in financial position.

This Statement requires that a statement of cash flows classify cash receipts and payments according to whether they stem from operating, investing, or financing activities and provides definitions of each category.

This Statement encourages enterprises to report cash flows from operating activities directly by showing major classes of operating cash receipts and payments (the direct method). Enterprises that choose not to show operating cash receipts and payments are required to report the same amount of net cash flow from operating activities indirectly by adjusting net income to reconcile it to net cash flow from operating activities (the indirect or reconciliation method) by removing the effects of (a) all deferrals of past operating cash receipts and payments and all accruals of expected future operating cash receipts and payments and (b) all items that are included in net income that do not affect operating cash receipts and payments. If the direct method is used, a reconciliation of net income and net cash flow from operating activities is required to be provided in a separate schedule.

This Statement requires that a statement of cash flows report the reporting currency equivalent of foreign currency cash flows, using the current exchange rate at the time of the cash flows. The effect of exchange rate changes on cash held in foreign currencies is reported as a separate item in the reconciliation of beginning and ending balances of cash and cash equivalents.

This Statement requires that information about investing and financing activities not resulting in cash receipts or payments in the period be provided separately.

2. Describe the three classifications of cash flows, and provide examples of activities that would appear in each classification.

Cash flows are classified as operating, investing, or financing activities on the statement of cash flows, depending on the nature of the transaction. Each of these three classifications is defined as follows.

• Operating activities include cash activities related to net income. For example, cash generated from the sale of goods (revenue) and cash paid for merchandise (expense) are operating activities because revenues and expenses are included in net income.
• Investing activities include cash activities related to noncurrent assets. Noncurrent assets include (1) long-term investments; (2) property, plant, and equipment; and (3) the principal amount of loans made to other entities. For example, cash generated from the sale of land and cash paid for an investment in another company are included in this category. (Note that interest received from loans is included in operating activities.)
• Financing activities include cash activities related to noncurrent liabilities and owners’ equity. Noncurrent liabilities and owners’ equity items include (1) the principal amount of long-term debt, (2) stock sales and repurchases, and (3) dividend payments. (Note that interest paid on long-term debt is included in operating activities.)

​3. Which section of the statement of cash flows is widely regarded as the most important? Why?

The operating activities section of the statement of cash flows is generally regarded as the most important section since it provides cash flow information related to the daily operations of the business. This section answers the question, “how much cash did we generate from the daily activities of our core business?” Owners, creditors, and managers are most interested in cash flow generated from daily activities rather than from a one-time issuance of stock or a one-time sale of land. The operating activities section allows stakeholders to assess the ongoing viability of the company.

4. Briefly describe the four steps required to prepare the statement of cash flows using the indirect method.

The operating activities section of the statement of cash flows is generally regarded as the most important section since it provides cash flow information related to the daily operations of the business. This section answers the question, “how much cash did we generate from the daily activities of our core business?” Owners, creditors, and managers are most interested in cash flow generated from daily activities rather than from a one-time issuance of stock or a one-time sale of land. The operating activities section allows stakeholders to assess the ongoing viability of the company.