direct method.
Teaching Suggestions
Many instructors use Chapter 11 as the capstone chapter of the course. At a very minimum, students
need to be familiar with the basic format for the statement of cash flows covered in Part A. The chapter
begins with an example of the statement of cash flows that will be further developed throughout the
chapter. Classification into operating, investing, and financing activities needs to be carefully explained.
This is especially important since, as mentioned in the chapter, the FASB and IASB have proposed
extending the operating, investing, and financing classifications to the other major financial statements.
Illustration 11-4 summarizes the relationship of the income statement and balance sheet to the operating,
investing, and financing sections in the statement of cash flows.
A brief description of the differences between the indirect and direct method to report cash flows from
operating activities is provided near the end of Part A. The text proceeds to present the indirect method to
calculate net cash flows from operating activities. Illustration 11-16 provides a useful summary of the
adjustments to net income in arriving at net cash flows from operating activities under the indirect
method. The direct method is explained in the appendix to the chapter using data from the same example
company. This format offers flexibility to instructors, allowing them to focus on the indirect method used
more in practice, or to provide coverage of both the indirect and direct methods.
Investing and financing activities are discussed next. A noncash investing and financing activity, the
purchase of equipment by issuing a note payable, is included to demonstrate the proper disclosure of
noncash activities. Instructors may wish to point out the key point at the end of this section, that “most
investing activities can be explained by changes in long-term asset accounts, while most financing
activities can be explained by changes in long-term liability and stockholders’ equity accounts.” The Let’s
Review problem is also helpful for students to understand how to prepare a statement of cash flows. An
alternate Let’s Review problem, similar to the one presented in the text, is provided later in this document.
The chapter concludes with a cash flow analysis that re-examines the financial ratios introduced in
Chapter 7: return on assets, profit margin, and asset turnover, substituting operating cash flows in place of
net income. We learn that, consistent with expectations, Apple has a higher cash flow to sales ratio while
Dell has a higher asset turnover.
Assignment Charts
Assignment Charts
Questions
Learning
Objective(s) Topic
Time
(Min.)
1 LO11-1 Describe the three categories of cash flows reported in
the statement of cash flows
5
2 LO11-1 Classify changes in balance sheet accounts with
operating, investing, and financing activities
5
3 LO11-1 Explain what we mean by noncash activities and provide
an example
5
4 LO11-1 Discuss the information necessary to prepare a statement
of cash flows
5
5 LO11-1 Describe the basic format used in preparing a statement
of cash flows
5
6 LO11-1 Briefly describe the four steps outlined in the text for
preparing a statement of cash flows
5
7 LO11-1 Distinguish between the indirect method and the direct
method for reporting net cash flows from operating
activities
5
8 LO11-2 Describe the most common adjustments we use to
convert net income to net cash flows from operations
under the indirect method
5
9 LO11-2 Explain how a company can report a net loss and have
positive operating cash flows
5
10 LO11-2 Explain how we report depreciation expense using the
indirect method
5
11 LO11-2 Describe how we report a gain or loss on the sale of an
asset using the indirect method
5
12 LO11-2 Indicate the effect of changes in current assets and
current liabilities using the indirect method
5
13 LO11-2 Explain how a change in accounts receivable affects net
income and operating cash flows
5
14 LO11-3 Describe the proper reporting of noncash activities 5
15 LO11-2,11-3 Discuss how the sale of an investment affects operating,
investing, and financing activities
5
16 LO11-3 Provide examples of financing activities reported in the
statement of cash flows
5
17 LO11-4 Explain the difference in the calculation of return on
assets and cash return on assets
5
18 LO11-4 Describe the two primary strategies firms use to increase
cash return on assets
5
19 LO11-5 Identify the primary cash inflows and cash outflows
under the direct method
5
20 LO11-5 Explain why we exclude depreciation expense and the
gain or loss on sale of an asset from the operating
activities section under the direct method
5
Brief
Exercises
Learning
Objective(s) Topic
Time
(Min.)
BE11-1 LO11-1 Determine proper classification 5
BE11-2 LO11-1 Determine proper classification 5
BE11-3 LO11-2 Understand the basic format for the statement of cash
flows
5
BE11-4 LO11-2 Calculate operating activities – indirect method 5
BE11-5 LO11-2 Calculate operating activities – indirect method 5
BE11-6 LO11-2 Calculate operating activities – indirect method 5
BE11-7 LO11-2 Calculate operating activities – indirect method 5
BE11-8 LO11-3 Calculate net cash flows from investing activities 5
BE11-9 LO11-3 Calculate net cash flows from financing activities 5
BE11-10 LO11-4 Calculate the cash return on assets 10
BE11-11 LO11-4 Calculate the net cash flows from operating activities 5
BE11-12 LO11-5 Determine cash received from customers 5
BE11-13 LO11-5 Determine cash paid to suppliers 5
BE11-14 LO11-5 Determine cash paid for operating expenses 5
BE11-15 LO11-5 Determine cash paid for income taxes 5
Exercises
Learning
Objective(s) Topic
Time
(Min.)
E11-1 LO11-1 to 11-5 Match terms with their definitions 10
E11-2 LO11-1 Determine proper classification 15
E11-3 LO11-1 Determine proper classification 10
E11-4 LO11-1 Determine proper classification 10
E11-5 LO11-1 Determine proper classification 10
E11-6 LO11-1 Determine proper classification 10
E11-7 LO11-2,11-3 Prepare the basic format for the statement of cash flows 15
E11-8 LO11-2 Calculate operating activities – indirect method 15
E11-9 LO11-2 Calculate operating activities – indirect method 15
E11-10 LO11-2,11-3 Prepare a statement of cash flows – indirect method 30
E11-11 LO11-2 Calculate operating activities – indirect method 15
E11-12 LO11-4 Calculate financial ratios 20
E11-13 LO11-5 Calculate operating activities – direct method 20
E11-14 LO11-5 Calculate operating activities – direct method 20
E11-15 LO11-5 Calculate operating activities – direct method 15
Problems
Learning
Objective(s) Topic
Time
(Min.)
P11-1A LO11-1 Determine proper classification 15
P11-2A LO11-2,11-3 Basic format for the statement of cash flows 20
P11-3A LO11-2 Calculate operating activities – indirect method 20
P11-4A LO11-2,11-3 Prepare a statement of cash flows – indirect method 30
P11-5A LO11-4 Calculate and analyze ratios 30
P11-6A LO11-5 Calculate operating activities – direct method 20
P11-7A LO11-5 Calculate operating activities – direct method 20
P11-8A LO11-2,11-5 Prepare an income statement using operating cash flow
information – indirect and direct methods
25
P11-1B LO11-1 Determine proper classification 15
P11-2B LO11-2,11-3 Basic format for the statement of cash flows 20
P11-3B LO11-2 Calculate operating activities – indirect method 20
P11-4B LO11-2,11-3 Prepare a statement of cash flows – indirect method 30
P11-5B LO11-4 Calculate and analyze ratios 30
P11-6B LO11-5 Calculate operating activities – direct method 20
P11-7B LO11-5 Calculate operating activities – direct method 20
P11-8B LO11-2,11-5 Prepare an income statement using operating cash flow
information – indirect and direct methods
25
Additional
Perspectives Topic
Time
(Min.)
AP11-1 Continuing Problem: Great Adventures 30
AP11-2 Financial Analysis: American Eagle Outfitters, Inc. 20
AP11-3 Financial Analysis: The Buckle, Inc. 20
AP11-4 Comparative Analysis: American Eagle Outfitters, Inc., vs. The Buckle,
Inc.
30
AP11-5 Ethics 20
AP11-6 Internet Research 20
AP11-7 Written Communication 30
AP11-8 Earnings Management 35
Chapter Quiz Questions
The following multiple-choice questions are 10 unique quiz questions that correspond to the 10 questions
at the end of each chapter. Each question covers the same learning objective but with a little different
twist. The correct answer is highlighted in bold for each item.
LO11-1
1. The purchase of inventory for cash is classified in the statement of cash flows as a(n):
a. Operating activity.
b. Investing activity.
c. Financing activity.
d. Noncash activity.
LO11-1
2. The sale of an intangible asset for cash is classified in the statement of cash flows as a(n):
a. Operating activity.
b. Investing activity.
c. Financing activity.
d. Noncash activity.
LO11-1
3. The purchase of long-term assets by issuing debt is classified in the statement of cash flows as a(n):
a. Operating activity.
b. Investing activity.
c. Financing activity.
d. Noncash activity.
LO11-1
4. The payment of dividends is classified in the statement of cash flows as a(n):
a. Operating activity.
b. Investing activity.
c. Financing activity.
d. Noncash activity.
LO11-2
5. We can identify operating activities from income statement information and changes in
a. current asset accounts.
b. current liability accounts.
c. current asset and current liability accounts.
d. stockholders’ equity accounts.
LO11-2
6. In preparing a statement of cash flows under the indirect method, an increase in accounts payable
would be reported or included as a(n):
a. Addition to net income in the operating activities section.
b. Deduction from net income in the operating activities section.
c. Investing activity.
d. Financing activity.
LO11-3
7. Which of the following is an example of a cash outflow from an investing activity?
a. Payment of interest.
b. Purchase of an intangible asset.
c. Payment of cash dividends.
d. Purchase of treasury stock.
LO11-3
8. Which of the following is an example of a cash inflow from a financing activity?
a. Receipt of cash from the issuance of common stock.
b. Receipt of cash from the sale of equipment.
c. Receipt of cash from the collection of a note receivable.
d. Receipt of cash from the sale of inventory.
LO11-4
9. We calculate cash return on assets as
a. The change in cash divided by average total assets.
b. Net cash flows from operating activities divided by average total assets.
c. The change in cash divided by ending total assets.
d. Net cash flows from operating activities divided by ending total assets.
LO11-5
10. Which of the following items do we not report in the statement of cash flows using the direct method?
a. Depreciation expense.
b. Cash received from customers.
c. Cash paid to suppliers.
d. Cash paid for income taxes.
Alternate Let’s Review
Problem #1
Indicate whether each of the following items is classified as an operating activity, investing activity,
financing activity, or a significant noncash activity.
1. Payment of employee salaries.
2. Issuance of bonds.
3. Purchase of treasury stock.
4. Collection of notes receivable.
5. Purchase equipment by issuing long-term debt.
6. Sale of equipment for cash.
Solution:
1. Operating; 2. Financing; 3. Financing; 4. Investing; 5. Noncash; 6. Investing;
Problem #2
The income statement, balance sheets, and additional information for Surround Sound, Inc. are provided
below.
Surround Sound, Inc.
Income Statement
For the Year Ended December 31, 2015
Revenues $4,500,000
Gain on sale of land 15,000
Expenses:
Cost of goods sold 2,800,000
Operating expenses 650,000
Depreciation expense 75,000
Income tax expense 280,000
Total expenses 3,805,000
Net Income $710,000
Surround Sound, Inc.
Balance Sheets
December 31
Assets 2015 2014
Increase (I) or
Decrease (D)
Current Assets:
Cash $ 50,000 $ 30,000 $20,000 (I)
Accounts receivable 65,000 80,000 15,000 (D)
Inventory 130,000 90,000 40,000 (I)
Long-Term Assets:
Land 150,000 200,000 50,000 (D)
Equipment 650,000 440,000 210,000 (I)
Accumulated depreciation (195,000) (120,000) 75,000 (I)
Total Assets $850,000 $760,000
Liabilities and Stockholders’ Equity
Current Liabilities:
Accounts payable $37,500 $ 55,000 $17,500 (D)
Interest payable 7,500 5,000 2,500 (I)
Income tax payable 15,000 20,000 5,000 (D)
Long-Term Liabilities:
Notes payable 100,000 200,000 100,000 (D)
Stockholders’ Equity:
Common stock 280,000 280,000
Retained earnings 410,000 200,000 210,000 (I)
Total Liabilities and Equity $850,000 $760,000
Additional Information for 2015:
1. Sold land costing $50,000 for $65,000, resulting in a gain on sale of $15,000.
2. Purchased equipment for $210,000 cash.
3. Repaid $100,000 in notes payable at the beginning of the year.
4. Declared and paid a cash dividend of $500,000.
Required:
Prepare the statement of cash flows using the indirect method.
Solution:
Surround Sound, Inc.
Statement of Cash Flows
For the Year Ended December 31, 2015
Cash Flows from Operating Activities
Net income $710,000
Adjustments to reconcile net income to net
cash flows from operating activities:
Depreciation expense 75,000
Gain on sale of land (15,000)
Decrease in accounts receivable 15,000
Increase in inventory (40,000)
Decrease in accounts payable (17,500)
Increase in interest payable 2,500
Decrease in income tax payable (5,000)
Net cash flows from operating activities $725,000
Cash Flows from Investing Activities
Sale of land 65,000
Purchase of equipment (210,000)
Net cash flows from investing activities (145,000)
Cash Flows from Financing Activities
Repaid notes payable (100,000)
Payment of cash dividends (500,000)
Net cash flows from financing activities (600,000)
Net increase (decrease) in cash (20,000)
Cash at the beginning of the period 30,000
Cash at the end of the period $50,000
Key Points by Learning Objective
LO11-1 Classify cash transactions as operating, investing, or financing activities.
Operating activities relate to income statement items. Investing activities primarily involve changes in
long-term assets. Financing activities primarily involve changes in long-term liabilities and stockholders’
equity.
Companies choose between the indirect method and direct method in reporting operating activities in the
statement of cash flows. The indirect method is less costly to prepare and most companies use it. The
direct method more logically presents the cash inflows and outflows from operations. The investing and
financing sections of the statement of cash flows are identical under both methods.
LO11-2 Prepare the operating activities section of the statement of cash flows using the indirect
method.
Using the indirect method, we start with net income and adjust this number for (a) revenue and expense
items that do not affect cash, (b) gains and losses that do not affect operating income, and (c) changes in
current assets and current liabilities.
LO11-3 Prepare the investing activities section and the financing activities section of the statement
of cash flows.
Most investing activities can be explained by changes in long-term asset accounts. Most financing
activities can be explained by changes in long-term liability and stockholders’ equity accounts.
Analysis
LO11-4 Perform financial analysis using the statement of cash flows.
Cash return on assets indicates the amount of operating cash flow generated for each dollar invested in
assets. We can separate cash return on assets to two components—cash flow to sales and asset turnover—
to examine two important business strategies.
Appendix
LO11-5 Prepare the operating activities section of the statement of cash flows using the direct
method.
The indirect method and direct method differ only in the presentation of operating activities. In the
indirect method, we start with net income and adjust away the noncash effects to arrive at net cash flows
from operating activities. In the direct method, we convert each individual line item in the income
statement to its cash basis and directly list the cash inflows and cash outflows from operating activities.
The net cash flows from operating activities are the same under both methods.
Common Mistakes
Common Mistake
Students sometimes misclassify dividends in preparing the statement of cash flows. Dividends
received are included in operating activities. Dividends paid are included in financing activities.
Common Mistake
Students sometimes are unsure whether to add or subtract a loss on the sale of assets. Just
remember that a loss is like an expense–both reduce net income. Treat a loss on the sale of
assets like depreciation expense and add it back to net income. A gain on the sale of long-term
assets is the opposite of an expense, so we subtract it from net income to arrive at net cash flows
from operating activities.
Common Mistake
Some students mistakenly record a cash inflow from investing activities equal to the change in
the asset account, $10,000 in this case. Remember, though, that the statement of cash flows
reports the actual cash received or paid, which is not always the same as the change in the
balance sheet accounts.
Decision Points
Question Accounting Information Analysis & Decision
Did the company
have any significant
noncash investing
and financing
activities?
Reported either directly
after the cash flow
statement or in a note to
the financial statements
The disclosure of noncash
investing and financing
activities can be combined
with information reported on
the statement of cash flows to
provide a better overall picture
of total investing and financing
activities.
Question Accounting Information Analysis & Decision
Is a company’s
net income
supported by
strong operating
cash flows?
Operating activities
section of the statement
of cash flows using the
indirect method
The operating activities section
using the indirect method
reconciles net income to
operating cash flows. Net
income is considered to be of
higher quality when backed by
strong operating cash flows.
Question Accounting Information Analysis & Decision
Are the
company’s cash
flows based more
on selling at
higher prices or
on increasing
sales volume?
Cash flow to sales and
asset turnover ratios
Companies with high cash
flow to sales ratios obtain high
cash inflows from sales to
customers in relation to the
cash outflows to produce the
products. Companies with high
asset turnover ratios may not
make as much on each sale, but
make money through higher
sales volume.
Career Corner
Career Corner
Are you good at analysis? If so, you might consider a career as a financial analyst. A career in
this field involves understanding the operations of companies, assessing the reasonableness of
their stock price, and predicting their future performance. Analysts rely heavily on financial
statements as a source of information in predicting stock price movements. Since financial
statements, including the cash flow statement covered in this chapter, are accounting-based, it is
no surprise that a strong background in accounting is necessary for a career as a financial analyst.
A background in accounting is useful, not only in preparing accounting information, but
analyzing and interpreting that information as well.
Ethical Dilemma
Ethical Dilemma
Ebenezer is CEO of a successful small business. One day he stops by to see Tim Cratchit, the
new branch manager at First National Bank. Ebenezer and his partner Marley would like to
double the size of their loan with the bank from $500,000 to $1 million. Ebenezer explains,
“Business is booming, sales and earnings are up each of the past three years, and we could
certainly use the funds for further business expansion.” Tim Cratchit has a big heart, and
Ebenezer has been a close friend of the family. He thinks to himself this loan decision will be
easy, but he asks Ebenezer to email the past three years’ financial statements as required by bank
policy.
In looking over the financial statements sent by Ebenezer, Tim becomes concerned. Sales and
earnings have increased just as Ebenezer said. However, receivables, inventory, and accounts
payable have grown at a much faster rate than sales. Further, he notices a steady decrease in
operating cash flows over the past three years, with negative operating cash flows in each of the
past two years.
Who are the stakeholders, and what is the ethical dilemma? Do you think Tim should go
ahead and approve the loan?
Key issues
What was it in Tim’s analysis of the financial statements that caused him concern?
Should Tim go ahead and approve the loan?
Option 1: Approve the loan
The business has been successful in the past.
Ebenezer already has an established business relationship with the bank based on the
initial $500,000 loan.
Sales and earnings have increased each of the past three years.
Ebenezer is a good friend of the family.
Option 2: Deny the loan
Doubling the loan size will increase the risk of default.
Receivables, inventory, and accounts payable have grown at a much faster rate than sales,
while operating cash flows have steadily decreased over the past three years.
The increase in receivables and inventory with a corresponding decrease in cash flows
could indicate the company is inflating receivables and/or inventory to overstate income.
The increase in accounts payable may indicate the company is having difficulty paying
vendors on time and needs the loan to cover past due accounts payable.
The fact that Ebenezer is a good friend of the family should not affect the loan decision.
The chapter concludes with a cash flow analysis that re-examines the financial ratios introduced in
Chapter 7: return on assets, profit margin, and asset turnover, substituting operating cash flows in place of
net income. We learn that, consistent with expectations, Apple has a higher cash flow to sales ratio while
Dell has a higher asset turnover.
Assignment Charts
Assignment Charts
Questions
Learning
Objective(s) Topic
Time
(Min.)
1 LO11-1 Describe the three categories of cash flows reported in
the statement of cash flows
5
2 LO11-1 Classify changes in balance sheet accounts with
operating, investing, and financing activities
5
3 LO11-1 Explain what we mean by noncash activities and provide
an example
5
4 LO11-1 Discuss the information necessary to prepare a statement
of cash flows
5
5 LO11-1 Describe the basic format used in preparing a statement
of cash flows
5
6 LO11-1 Briefly describe the four steps outlined in the text for
preparing a statement of cash flows
5
7 LO11-1 Distinguish between the indirect method and the direct
method for reporting net cash flows from operating
activities
5
8 LO11-2 Describe the most common adjustments we use to
convert net income to net cash flows from operations
under the indirect method
5
9 LO11-2 Explain how a company can report a net loss and have
positive operating cash flows
5
10 LO11-2 Explain how we report depreciation expense using the
indirect method
5
11 LO11-2 Describe how we report a gain or loss on the sale of an
asset using the indirect method
5
12 LO11-2 Indicate the effect of changes in current assets and
current liabilities using the indirect method
5
13 LO11-2 Explain how a change in accounts receivable affects net
income and operating cash flows
5
14 LO11-3 Describe the proper reporting of noncash activities 5
15 LO11-2,11-3 Discuss how the sale of an investment affects operating,
investing, and financing activities
5
16 LO11-3 Provide examples of financing activities reported in the
statement of cash flows
5
17 LO11-4 Explain the difference in the calculation of return on
assets and cash return on assets
5
18 LO11-4 Describe the two primary strategies firms use to increase
cash return on assets
5
19 LO11-5 Identify the primary cash inflows and cash outflows
under the direct method
5
20 LO11-5 Explain why we exclude depreciation expense and the
gain or loss on sale of an asset from the operating
activities section under the direct method
5
Brief
Exercises
Learning
Objective(s) Topic
Time
(Min.)
BE11-1 LO11-1 Determine proper classification 5
BE11-2 LO11-1 Determine proper classification 5
BE11-3 LO11-2 Understand the basic format for the statement of cash
flows
5
BE11-4 LO11-2 Calculate operating activities – indirect method 5
BE11-5 LO11-2 Calculate operating activities – indirect method 5
BE11-6 LO11-2 Calculate operating activities – indirect method 5
BE11-7 LO11-2 Calculate operating activities – indirect method 5
BE11-8 LO11-3 Calculate net cash flows from investing activities 5
BE11-9 LO11-3 Calculate net cash flows from financing activities 5
BE11-10 LO11-4 Calculate the cash return on assets 10
BE11-11 LO11-4 Calculate the net cash flows from operating activities 5
BE11-12 LO11-5 Determine cash received from customers 5
BE11-13 LO11-5 Determine cash paid to suppliers 5
BE11-14 LO11-5 Determine cash paid for operating expenses 5
BE11-15 LO11-5 Determine cash paid for income taxes 5
Exercises
Learning
Objective(s) Topic
Time
(Min.)
E11-1 LO11-1 to 11-5 Match terms with their definitions 10
E11-2 LO11-1 Determine proper classification 15
E11-3 LO11-1 Determine proper classification 10
E11-4 LO11-1 Determine proper classification 10
E11-5 LO11-1 Determine proper classification 10
E11-6 LO11-1 Determine proper classification 10
E11-7 LO11-2,11-3 Prepare the basic format for the statement of cash flows 15
E11-8 LO11-2 Calculate operating activities – indirect method 15
E11-9 LO11-2 Calculate operating activities – indirect method 15
E11-10 LO11-2,11-3 Prepare a statement of cash flows – indirect method 30
E11-11 LO11-2 Calculate operating activities – indirect method 15
E11-12 LO11-4 Calculate financial ratios 20
E11-13 LO11-5 Calculate operating activities – direct method 20
E11-14 LO11-5 Calculate operating activities – direct method 20
E11-15 LO11-5 Calculate operating activities – direct method 15
Problems
Learning
Objective(s) Topic
Time
(Min.)
P11-1A LO11-1 Determine proper classification 15
P11-2A LO11-2,11-3 Basic format for the statement of cash flows 20
P11-3A LO11-2 Calculate operating activities – indirect method 20
P11-4A LO11-2,11-3 Prepare a statement of cash flows – indirect method 30
P11-5A LO11-4 Calculate and analyze ratios 30
P11-6A LO11-5 Calculate operating activities – direct method 20
P11-7A LO11-5 Calculate operating activities – direct method 20
P11-8A LO11-2,11-5 Prepare an income statement using operating cash flow
information – indirect and direct methods
25
P11-1B LO11-1 Determine proper classification 15
P11-2B LO11-2,11-3 Basic format for the statement of cash flows 20
P11-3B LO11-2 Calculate operating activities – indirect method 20
P11-4B LO11-2,11-3 Prepare a statement of cash flows – indirect method 30
P11-5B LO11-4 Calculate and analyze ratios 30
P11-6B LO11-5 Calculate operating activities – direct method 20
P11-7B LO11-5 Calculate operating activities – direct method 20
P11-8B LO11-2,11-5 Prepare an income statement using operating cash flow
information – indirect and direct methods
25
Additional
Perspectives Topic
Time
(Min.)
AP11-1 Continuing Problem: Great Adventures 30
AP11-2 Financial Analysis: American Eagle Outfitters, Inc. 20
AP11-3 Financial Analysis: The Buckle, Inc. 20
AP11-4 Comparative Analysis: American Eagle Outfitters, Inc., vs. The Buckle,
Inc.
30
AP11-5 Ethics 20
AP11-6 Internet Research 20
AP11-7 Written Communication 30
AP11-8 Earnings Management 35
Chapter Quiz Questions
The following multiple-choice questions are 10 unique quiz questions that correspond to the 10 questions
at the end of each chapter. Each question covers the same learning objective but with a little different
twist. The correct answer is highlighted in bold for each item.
LO11-1
1. The purchase of inventory for cash is classified in the statement of cash flows as a(n):
a. Operating activity.
b. Investing activity.
c. Financing activity.
d. Noncash activity.
LO11-1
2. The sale of an intangible asset for cash is classified in the statement of cash flows as a(n):
a. Operating activity.
b. Investing activity.
c. Financing activity.
d. Noncash activity.
LO11-1
3. The purchase of long-term assets by issuing debt is classified in the statement of cash flows as a(n):
a. Operating activity.
b. Investing activity.
c. Financing activity.
d. Noncash activity.
LO11-1
4. The payment of dividends is classified in the statement of cash flows as a(n):
a. Operating activity.
b. Investing activity.
c. Financing activity.
d. Noncash activity.
LO11-2
5. We can identify operating activities from income statement information and changes in
a. current asset accounts.
b. current liability accounts.
c. current asset and current liability accounts.
d. stockholders’ equity accounts.
LO11-2
6. In preparing a statement of cash flows under the indirect method, an increase in accounts payable
would be reported or included as a(n):
a. Addition to net income in the operating activities section.
b. Deduction from net income in the operating activities section.
c. Investing activity.
d. Financing activity.
LO11-3
7. Which of the following is an example of a cash outflow from an investing activity?
a. Payment of interest.
b. Purchase of an intangible asset.
c. Payment of cash dividends.
d. Purchase of treasury stock.
LO11-3
8. Which of the following is an example of a cash inflow from a financing activity?
a. Receipt of cash from the issuance of common stock.
b. Receipt of cash from the sale of equipment.
c. Receipt of cash from the collection of a note receivable.
d. Receipt of cash from the sale of inventory.
LO11-4
9. We calculate cash return on assets as
a. The change in cash divided by average total assets.
b. Net cash flows from operating activities divided by average total assets.
c. The change in cash divided by ending total assets.
d. Net cash flows from operating activities divided by ending total assets.
LO11-5
10. Which of the following items do we not report in the statement of cash flows using the direct method?
a. Depreciation expense.
b. Cash received from customers.
c. Cash paid to suppliers.
d. Cash paid for income taxes.
Alternate Let’s Review
Problem #1
Indicate whether each of the following items is classified as an operating activity, investing activity,
financing activity, or a significant noncash activity.
1. Payment of employee salaries.
2. Issuance of bonds.
3. Purchase of treasury stock.
4. Collection of notes receivable.
5. Purchase equipment by issuing long-term debt.
6. Sale of equipment for cash.
Solution:
1. Operating; 2. Financing; 3. Financing; 4. Investing; 5. Noncash; 6. Investing;
Problem #2
The income statement, balance sheets, and additional information for Surround Sound, Inc. are provided
below.
Surround Sound, Inc.
Income Statement
For the Year Ended December 31, 2015
Revenues $4,500,000
Gain on sale of land 15,000
Expenses:
Cost of goods sold 2,800,000
Operating expenses 650,000
Depreciation expense 75,000
Income tax expense 280,000
Total expenses 3,805,000
Net Income $710,000
Surround Sound, Inc.
Balance Sheets
December 31
Assets 2015 2014
Increase (I) or
Decrease (D)
Current Assets:
Cash $ 50,000 $ 30,000 $20,000 (I)
Accounts receivable 65,000 80,000 15,000 (D)
Inventory 130,000 90,000 40,000 (I)
Long-Term Assets:
Land 150,000 200,000 50,000 (D)
Equipment 650,000 440,000 210,000 (I)
Accumulated depreciation (195,000) (120,000) 75,000 (I)
Total Assets $850,000 $760,000
Liabilities and Stockholders’ Equity
Current Liabilities:
Accounts payable $37,500 $ 55,000 $17,500 (D)
Interest payable 7,500 5,000 2,500 (I)
Income tax payable 15,000 20,000 5,000 (D)
Long-Term Liabilities:
Notes payable 100,000 200,000 100,000 (D)
Stockholders’ Equity:
Common stock 280,000 280,000
Retained earnings 410,000 200,000 210,000 (I)
Total Liabilities and Equity $850,000 $760,000
Additional Information for 2015:
1. Sold land costing $50,000 for $65,000, resulting in a gain on sale of $15,000.
2. Purchased equipment for $210,000 cash.
3. Repaid $100,000 in notes payable at the beginning of the year.
4. Declared and paid a cash dividend of $500,000.
Required:
Prepare the statement of cash flows using the indirect method.
Solution:
Surround Sound, Inc.
Statement of Cash Flows
For the Year Ended December 31, 2015
Cash Flows from Operating Activities
Net income $710,000
Adjustments to reconcile net income to net
cash flows from operating activities:
Depreciation expense 75,000
Gain on sale of land (15,000)
Decrease in accounts receivable 15,000
Increase in inventory (40,000)
Decrease in accounts payable (17,500)
Increase in interest payable 2,500
Decrease in income tax payable (5,000)
Net cash flows from operating activities $725,000
Cash Flows from Investing Activities
Sale of land 65,000
Purchase of equipment (210,000)
Net cash flows from investing activities (145,000)
Cash Flows from Financing Activities
Repaid notes payable (100,000)
Payment of cash dividends (500,000)
Net cash flows from financing activities (600,000)
Net increase (decrease) in cash (20,000)
Cash at the beginning of the period 30,000
Cash at the end of the period $50,000
Key Points by Learning Objective
LO11-1 Classify cash transactions as operating, investing, or financing activities.
Operating activities relate to income statement items. Investing activities primarily involve changes in
long-term assets. Financing activities primarily involve changes in long-term liabilities and stockholders’
equity.
Companies choose between the indirect method and direct method in reporting operating activities in the
statement of cash flows. The indirect method is less costly to prepare and most companies use it. The
direct method more logically presents the cash inflows and outflows from operations. The investing and
financing sections of the statement of cash flows are identical under both methods.
LO11-2 Prepare the operating activities section of the statement of cash flows using the indirect
method.
Using the indirect method, we start with net income and adjust this number for (a) revenue and expense
items that do not affect cash, (b) gains and losses that do not affect operating income, and (c) changes in
current assets and current liabilities.
LO11-3 Prepare the investing activities section and the financing activities section of the statement
of cash flows.
Most investing activities can be explained by changes in long-term asset accounts. Most financing
activities can be explained by changes in long-term liability and stockholders’ equity accounts.
Analysis
LO11-4 Perform financial analysis using the statement of cash flows.
Cash return on assets indicates the amount of operating cash flow generated for each dollar invested in
assets. We can separate cash return on assets to two components—cash flow to sales and asset turnover—
to examine two important business strategies.
Appendix
LO11-5 Prepare the operating activities section of the statement of cash flows using the direct
method.
The indirect method and direct method differ only in the presentation of operating activities. In the
indirect method, we start with net income and adjust away the noncash effects to arrive at net cash flows
from operating activities. In the direct method, we convert each individual line item in the income
statement to its cash basis and directly list the cash inflows and cash outflows from operating activities.
The net cash flows from operating activities are the same under both methods.
Common Mistakes
Common Mistake
Students sometimes misclassify dividends in preparing the statement of cash flows. Dividends
received are included in operating activities. Dividends paid are included in financing activities.
Common Mistake
Students sometimes are unsure whether to add or subtract a loss on the sale of assets. Just
remember that a loss is like an expense–both reduce net income. Treat a loss on the sale of
assets like depreciation expense and add it back to net income. A gain on the sale of long-term
assets is the opposite of an expense, so we subtract it from net income to arrive at net cash flows
from operating activities.
Common Mistake
Some students mistakenly record a cash inflow from investing activities equal to the change in
the asset account, $10,000 in this case. Remember, though, that the statement of cash flows
reports the actual cash received or paid, which is not always the same as the change in the
balance sheet accounts.
Decision Points
Question Accounting Information Analysis & Decision
Did the company
have any significant
noncash investing
and financing
activities?
Reported either directly
after the cash flow
statement or in a note to
the financial statements
The disclosure of noncash
investing and financing
activities can be combined
with information reported on
the statement of cash flows to
provide a better overall picture
of total investing and financing
activities.
Question Accounting Information Analysis & Decision
Is a company’s
net income
supported by
strong operating
cash flows?
Operating activities
section of the statement
of cash flows using the
indirect method
The operating activities section
using the indirect method
reconciles net income to
operating cash flows. Net
income is considered to be of
higher quality when backed by
strong operating cash flows.
Question Accounting Information Analysis & Decision
Are the
company’s cash
flows based more
on selling at
higher prices or
on increasing
sales volume?
Cash flow to sales and
asset turnover ratios
Companies with high cash
flow to sales ratios obtain high
cash inflows from sales to
customers in relation to the
cash outflows to produce the
products. Companies with high
asset turnover ratios may not
make as much on each sale, but
make money through higher
sales volume.
Career Corner
Career Corner
Are you good at analysis? If so, you might consider a career as a financial analyst. A career in
this field involves understanding the operations of companies, assessing the reasonableness of
their stock price, and predicting their future performance. Analysts rely heavily on financial
statements as a source of information in predicting stock price movements. Since financial
statements, including the cash flow statement covered in this chapter, are accounting-based, it is
no surprise that a strong background in accounting is necessary for a career as a financial analyst.
A background in accounting is useful, not only in preparing accounting information, but
analyzing and interpreting that information as well.
Ethical Dilemma
Ethical Dilemma
Ebenezer is CEO of a successful small business. One day he stops by to see Tim Cratchit, the
new branch manager at First National Bank. Ebenezer and his partner Marley would like to
double the size of their loan with the bank from $500,000 to $1 million. Ebenezer explains,
“Business is booming, sales and earnings are up each of the past three years, and we could
certainly use the funds for further business expansion.” Tim Cratchit has a big heart, and
Ebenezer has been a close friend of the family. He thinks to himself this loan decision will be
easy, but he asks Ebenezer to email the past three years’ financial statements as required by bank
policy.
In looking over the financial statements sent by Ebenezer, Tim becomes concerned. Sales and
earnings have increased just as Ebenezer said. However, receivables, inventory, and accounts
payable have grown at a much faster rate than sales. Further, he notices a steady decrease in
operating cash flows over the past three years, with negative operating cash flows in each of the
past two years.
Who are the stakeholders, and what is the ethical dilemma? Do you think Tim should go
ahead and approve the loan?
Key issues
What was it in Tim’s analysis of the financial statements that caused him concern?
Should Tim go ahead and approve the loan?
Option 1: Approve the loan
The business has been successful in the past.
Ebenezer already has an established business relationship with the bank based on the
initial $500,000 loan.
Sales and earnings have increased each of the past three years.
Ebenezer is a good friend of the family.
Option 2: Deny the loan
Doubling the loan size will increase the risk of default.
Receivables, inventory, and accounts payable have grown at a much faster rate than sales,
while operating cash flows have steadily decreased over the past three years.
The increase in receivables and inventory with a corresponding decrease in cash flows
could indicate the company is inflating receivables and/or inventory to overstate income.
The increase in accounts payable may indicate the company is having difficulty paying
vendors on time and needs the loan to cover past due accounts payable.
The fact that Ebenezer is a good friend of the family should not affect the loan decision.