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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

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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: Why is it desirable to use a worksheet when preparing a statement of cash flows? Is a worksheet required to prepare a statement of cash flows?

Question: GROUPWORK (Analysis of Transactions’ Effect on SCF) Each of the following items must be considered in preparing a statement of cash flows for Cruz Fashions Inc. for the year ended December 31, 2017.

  1. Fixed assets that had cost \(20,000 6½ years before and were being depreciated on a 10-year basis, with no estimated scrap value, were sold for \)4,750.
  2. During the year, goodwill of \(15,000 was considered impaired and was completely written off to expense.
  3. During the year, 500 shares of common stock with a stated value of \)25 a share were issued for \(32 a share.
  4. The company sustained a net loss for the year of \)2,100. Depreciation amounted to \(2,000 and patent amortization was \)400.
  5. Uncollectible accounts receivable in the amount of \(2,000 were written off against Allowance for Doubtful Accounts.
  6. Investments (available-for-sale) that cost \)12,000 when purchased 4 years earlier were sold for \(10,600.
  7. Bonds payable with a par value of \)24,000 on which there was an unamortized bond premium of $2,000 were redeemed at 101.

Instructions

For each item, state where it is to be shown in the statement and then how you would present the necessary information, including the amount. Consider each item to be independent of the others. Assume that correct entry were made for all transactions as they took place.

Bloom Corporation had the following 2017 income statement.

Sales revenue

\(200,000

Cost of goods sold

120,000

Gross profit

80,000

Operating expenses (including depreciation of \)21,000)

50,000

Net income

\(30,000

The following accounts increased during 2017: Accounts Receivable \)12,000, Inventory \(11,000, and Accounts Payable \)13,000. Prepare the cash flows from the operating activities section of Bloom’s 2017 statement of cash flows using the direct method.

Hendrickson Corporation reported net income of \(50,000 in 2017. Depreciation expense was \)17,000. The following working capital accounts changed.

Accounts receivable $11,000 increase

Available-for-sale debt securities 16,000 increase

Inventory 7,400 increase

Nontrade note payable 15,000 decrease

Accounts payable 12,300 increase

Compute net cash provided by operating activities.
See all solutions

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