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Chapter 23: Q20Q (page 1372)

Question: What are some of the arguments in favor of using the indirect (reconciliation) method as opposed to the direct method for reporting a statement of cash flows?

Short Answer

Expert verified

Answer

The indirect method is preferred over the direct method of cash flow because it does not require additional efforts for preparation; it is according to the accrual basis of accounting and also defines the difference between the net income and cash from operations.

Step by step solution

01

Definition of Cash Flow Statement

The statement prepared by the business entity providing the information regarding all the transactions that increase or decrease the cash balance is known as the cash flow statement. Such a statement is prepared in three sections.

02

Arguments in favor of using the indirect method

  1. The indirect method highlights the difference between the net income of the business entity and the cash generated from the operations.
  2. The direct method statement of cash flow confuses the financial statement's users with knowledge of only the accrual basis of accounting.
  3. Direct method cannot be justified based on cost-benefit analysis because it will require additional efforts as all other statements are prepared based on accrual accounting.

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Most popular questions from this chapter

Founded in the early 1980s, the Vermont Teddy Bear Co. designs and manufactures American-made teddy bears and markets them primarily as gifts called Bear-Grams or Teddy Bear-Grams. Bear-Grams are personalized teddy bears delivered directly to the recipient for special occasions such as birthdays and anniversaries. The Shelburne, Vermont, company’s primary markets are New York, Boston, and Chicago. Sales have jumped dramatically in recent years. Such dramatic growth has significant implications for cash flows. Provided below are the cash flow statements for two recent years for the company.

Current Year

Prior Year

Cash flows from operating activities:

Net income

\( 17,523

\) 838,955

Adjustments to reconcile net income to net cash provided by operating activities

Deferred income taxes

(69,524)

(146,590)

Depreciation and amortization

316,416

181,348

Changes in assets and liabilities:

Accounts receivable, trade

(38,267)

(25,947)

Inventories

(1,599,014)

(1,289,293)

Prepaid and other current assets

(444,794)

(113,205)

Deposits and other assets

(24,240)

(83,044)

Accounts payable

2,017,059

(284,567)

Accrued expenses

61,321

170,755

Accrued interest payable, debentures

-

(58,219)

Other

-

(8,960)

Income taxes payable

-

117,810

Net cash provided by (used for) operating activities

236,480

(700,957)

Net cash used for investing activities

(2,102,892)

(4,422,953)

Net cash (used for) provided by financing activities

(315,353)

9,685,435

Net change in cash and cash equivalents

(2,181,765)

4,561,525

Other information:

Current liabilities

\( 4,055,465

\) 1,995,600

Total liabilities

4,620,085

2,184,386

Net sales

20,560,566

17,025,856

Instructions

  1. Note that net income in the current year was only \(17,523 compared to prior-year income of \)838,955, but net cash flow from operating activities was \(236,480 in the current year and a negative \)700,957 in the prior year. Explain the causes of this apparent paradox.
  2. Evaluate Vermont Teddy Bear’s liquidity, solvency, and profitability for the current year using cash flow-based ratios.

Question: CA23-5 (Purpose and Elements of SCF) GAAP requires the statement of cash flows be presented when financial statements are prepared.

Instructions

(a) Explain the purposes of the statement of cash flows.

(b) List and describe the three categories of activities that must be reported in the statement of cash flows.

(c) Identify and describe the two methods that are allowed for reporting cash flows from operations.

(d) Describe the financial statement presentation of noncash investing and financing transactions. Include in your description an example of a noncash investing and financing transaction.

Question: (SCF—Indirect Method) Condensed financial data of Pat Metheny Company for 2017 and 2016 are presented below.

PAT METHENY COMPANY

COMPARATIVE BALANCE SHEET

AS OF DECEMBER 31, 2017 AND 2016


2017

2016

Cash

\(1,800

\)1,150

Receivables

1,750

1,300

Inventory

1,600

1,900

Plant assets

1,900

1,700

Accumulated depreciation

(1,200)

(1,170)

Long-term-investment (Held to maturity)

1,300

1,420

\(7,150

\)6,300

Account payable

\(1,200

\)900

Accrued liabilities

200

250

Bond payable

1,400

1,550

Common stock

1,900

1,700

Retained earnings

2,450

1,900

\(7,150

\)6,300

PAT METHENY COMPANY

INCOME STATEMENT

FOR THE YEAR ENDED DECEMBER 31, 2017

Sales

\(6,900

Cost of goods sold

(4,700)

Gross margin

2,200

Selling and administrative expenses

930

Income from operations

1,270

Other revenue and gains

Gains on sale of investment

80

Income before tax

1,350

Income tax expenses

540

Net income

810

Cash dividend

260

Income retained in business

\)550

Additional information:

During the year, $70 of common stock was issued in exchange for plant assets. No plant assets were sold in 2017.

Instructions

Prepare a statement of cash flows using the indirect method.

Jobim Inc. had the following condensed balance sheet at the end of operations for 2016.

JOBIM INC.

BALANCE SHEET

DECEMBER 31, 2016

Cash \( 8,500 Current liabilities \) 15,000

Current assets other than cash 29,000 Long-term notes payable 25,500

Equity investments 20,000 Bonds payable 25,000

Plant assets (net) 67,500 Common stock 75,000

Land 40,000 Retained earnings 24,500

\(165,000 \)165,000

During 2017, the following occurred.

1. A tract of land was purchased for \(9,000.

2. Bonds payable in the amount of \)15,000 were redeemed at par.

3. An additional \(10,000 in common stock was issued at par.

4. Dividends totaling \)9,375 were paid to stockholders.

5. Net income was \(35,250 after allowing depreciation of \)13,500.

6. Land was purchased through the issuance of \(22,500 in bonds.

7. Jobim Inc. sold part of its investment portfolio for \)12,875. This transaction resulted in a gain of $2,000 for the company. No unrealized gains or losses were recorded on these investments in 2017.

8. Both current assets (other than cash) and current liabilities remained at the same amount.

Instructions

(a) Prepare a statement of cash flows for 2017 using the indirect method.

(b) Prepare the condensed balance sheet for Jobim Inc. as it would appear at December 31, 2017

What is the purpose of the statement of cash flows? What

information does it provide?

See all solutions

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