CHAPTER

5
UNDERSTANDING CASH
FLOW STATEMENTS

SOLUTIONS
1. The three major classifications of activities in a cash flow statement are:
A . inflows, outflows, and net flows.
B . operating, investing, and financing.
C . revenues, expenses, and net income.

B is correct. Operating, investing, and financing are the three major classifications of
activities in a cash flow statement. Revenues, expenses, and net income are elements of the
income statement. Inflows, outflows, and net flows are items of information in the statement
of cash flows.

2. The sale of a building for cash would be classified as what type of activity on the
cash flow statement?
A . Operating.
B . Investing.
C . Financing.

B is correct. Purchases and sales of long-term assets are considered investing activities.
Note that if the transaction had involved the exchange of a building for other than cash (for
example, for another building, common stock of another company, or a long-term note
receivable), it would have been considered a significant non-cash activity.

3. Under which section of a manufacturing company's cash flow statement are the
following activities reported?
Item 1: Purchases of securities held for trading
Item 2: Sales of securities considered cash equivalents
A . Both items are investing activities.
B . Both items are operating activities.
C . Only Item 1 is an investing activity.

B is correct. The purchase and sale of securities considered cash equivalents and securities
held for trading are considered operating activities even for companies in which this activ-
ity is not a primary business activity.
 4. Which of the following is an example of a financing activity on the cash flow
statement under US GAAP?
A . Payment of interest.
B . Receipt of dividends.
C . Payment of dividends.

C is correct. Payment of dividends is a financing activity under US GAAP. Payment of

interest and receipt of dividends are included in operating cash flows under US GAAP. Note
that IFRS allow companies to include receipt of interest and dividends as either op- erating
or investing cash flows and to include payment of interest and dividends as either operating
or financing cash flows.

5. A conversion of a face value $1 million convertible bond for $1 million of common

stock would most likely be:
A . reported as a $1 million investing cash inflow and outflow.
B . reported as a $1 million financing cash outflow and inflow.
C . reported as supplementary information to the cash flow statement.

C is correct. Non-cash transactions, if significant, are reported as supplementary informa-

tion, not in the investing or financing sections of the cash flow statement.

6. A company recently engaged in a non-cash transaction that significantly affected its

property, plant, and equipment. The transaction is:
A . reported under the investing section of the cash flow statement.
B . reported differently in cash flow from operations under the direct and indirect
methods.
C . disclosed as a separate note or in a supplementary schedule to the cash flow
statement

C is correct. Because no cash is involved in non-cash transactions, these transactions are

not incorporated in the cash flow statement. However, non-cash transactions that signifi-
cantly affect capital or asset structures are required to be disclosed either in a separate note
or a supplementary schedule to the cash flow statement.

7. y
C is correct. Interest expense is always classified as an operating cash flow under US
GAAP but may be classified as either an operating or financing cash flow under IFRS.

8. y
C is correct. Taxes on income are required to be separately disclosed under IFRS and US
GAAP. The disclosure may be in the cash flow statement or elsewhere.

147
 148 Solutions

9. A is correct. The operating section may be prepared under the indirect method. The
other sections are always prepared under the direct method.
10. A is correct. Under the indirect method, the operating section would begin with net
in- come and adjust it to arrive at operating cash flow. The other two items would
appear in the operating section under the direct method.
11. C is correct. The primary argument in favor of the direct method is that it provides
in- formation on the specific sources of operating cash receipts and payments.
Arguments for the indirect method include that it mirrors a forecasting approach and
it is easier and less costly
12. C is correct. The amount of cash collected from customers during the quarter is equal
to beginning accounts receivable plus revenues minus ending accounts
receivable:
$66 million + $72 million − $55 million = $83 million. A reduction in accounts
receivable indicates that cash collected during the quarter was greater than revenue
on an accrual basis.
13. B is correct. An addition to net income is made when there is a loss on the retirement
of debt, which is a non-operating loss. A gain on the sale of an asset and a decrease
in deferred tax liability are both subtracted from net income.
14. A is correct. Revenues of $100 million minus the increase in accounts receivable
of
$10 million equal $90 million cash received from customers. The increase in
accounts receivable means that the company received less in cash than it reported as
revenue.
15. A is correct.
Operating cash flows = Cash received from customers − (Cash paid to suppliers +
Cash paid to employees + Cash paid for other operating expenses + Cash paid for
interest + Cash paid for income taxes)
Cash received from customers = Revenue + Decrease in accounts receivable
= $37 + $3 = $40 million
Cash paid to suppliers = Cost of goods sold + Increase in inventory + Decrease in
accounts payable
= $16 + $4 + $2 = $22 million
Therefore, the company’s operating cash flow = $40 − $22 − Cash paid for salaries −
Cash paid for interest − Cash paid for taxes = $40 − $22 − $6 − $2 − $4 = $6 million.
16. C is correct. Cost of goods sold of $80 million plus the increase in inventory
of
$5 million equals purchases from suppliers of $85 million. The increase in accounts
pay- able of $2 million means that the company paid $83 million in cash ($85
million minus
$2 million) to its suppliers.
17. A is correct. Cost of goods sold of $75 million less the decrease in inventory of $6
million equals purchases from suppliers of $69 million. The increase in accounts
payable of
$2 million means that the company paid $67 million in cash ($69 million minus $2
million).
18. C is correct. Beginning salaries payable of $3 million plus salaries expense of $20
million minus ending salaries payable of $1 million equals $22 million.
Alternatively, the expense of $20 million plus the $2 million decrease in salaries
payable equals $22 million.
19. C is correct. Cash received from customers = Sales + Decrease in accounts
receivable =
254.6 + 4.9 = 259.5. Cash paid to suppliers = Cost of goods sold + Increase in inventory
– Increase in accounts payable = 175.9 + 8.8 − 2.6 = 182.1.
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