Weygandt Chot 18 Statement of Cash Flows

The s t a t e m e nt of
c a s h f lows
18
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CONCEPTS FOR REVIEW

Before studying this chapter, you should know or, if necessary, review:
■ the difference between the accrual basis and the cash basis of accounting
(ch. 3, p. 96)
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■ the major items included in an entity’s statement of financial position
(ch. 17, pp. 699–700)
■ the major items included in an entity’s income statement.
(ch. 15, p. 628)
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
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1. indicate the usefulness of the statement of cash flows
2. distinguish among operating, investing and financing activities
3. prepare a statement of cash flows using the direct method
4. prepare a statement of cash flows using the indirect method
5. understand the concept of free cash flow
6. explain the guidelines and procedural steps in using a worksheet to prepare
the statement of cash flows using the indirect method.
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714 Principles of financial accounting
‘Cash is king.’
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his quote sums up the importance of ensuring that an entity’s cash flow is properly managed. Cash is fundamental to the
operation of a business. It is vital for entities to develop, monitor and update cash flow projections regularly. Current
estimates indicate that about 90% of business failures are the result of poor cash flow and the ‘global credit crisis will
create a cash crunch for many Australian small businesses’.
The lag between delivering a product or service and receiving payment can create a significant burden for business, particu-
larly if the business has slow paying customers. ‘Bad payers considerably reduce business cash flow, draining the funds required
for day-to-day operations.’ According to Dun & Bradstreet, business-to-business trade payments are at their highest level since
2001. Firms are now waiting 55.8 days, on average, to receive payment from customers. That means businesses are being denied
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access to their own funds for almost 4 weeks longer than the standard term.
For internal reporting purposes, an effective cash flow process requires cash flow projections to be prepared quarterly at a
minimum, if not more frequently. Accurate cash flow projections alert managers to trouble before it occurs. Entities also need a
process for continuous monitoring to keep inflows and outflows in check. A positive forecast cannot keep a business viable if the
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cash flow is burdened by serious funding shortfalls. Having an accurate insight into customers’ financial health and debt paying
behaviour is also critical to the business’s viability.
CPA Australia’s Small Business Survey, covering 500 small businesses with up to 20 staff each, and 200 CPA Australia
members with small businesses as clients, found many small firms are experiencing troubles with their cash flows and this is
affecting profit margins. It found that 41% of respondents never prepare cash flow forecasts and 25% never chase late payments.
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Other survey findings included 39% of small firms do not know the interest rates on their borrowings and 36% borrowed in the
past year to survive, but 66% of businesses are confident about their growth in the next few years.
Cash flow information is fundamental for management. It is also important for investors. Information about the cash inflows
and outflows of an entity provides users of financial statements with a basis to assess the ability of the entity to generate cash and
the needs of the entity to utilise those cash flows. Users are interested in evaluating the ability of an entity to generate cash
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and the timing and certainty of this cash generation. A statement of cash flows provides information on an entity’s cash inflows
and outflows.
Source: C. Christian, ‘Cash flow the lifeblood of every business’, The Sydney Morning Herald, 5 July 2008, p. 50; ‘Cash flow is king as minnows navigate global credit crunch’,
The Australian, 30 August 2008, p. 41.
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CHAPTER 18 The statement of cash flows 715
PREVIEW OF CHAPTER 18
As the scene setter indicates, cash flow is an important indicator of an entity’s health, and it is important for entities
to have cash reserves or access to cash resources. Entities cannot continue operating without cash to pay bills as
they fall due. The statement of financial position, income statement and statement of changes in equity do not always
show the whole picture of the financial condition of an entity. In fact, looking at the financial statements of some
well-known companies, a thoughtful investor might ask questions like these: How did Harvey World Travel finance
dividends in 2008 of $3.2 million in a year in which it earned only $2.5 million? How could Fairfax Media Ltd have
net investing activities of $699 million cash outflow in a year in which it reported a net cash flow from operating
activities of $420 million? Answers to these and similar questions can be found in this chapter, which presents the
statement of cash flows.
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The content and organisation of this chapter are as follows.

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STATEMENT OF CASH FLOWS
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OR
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Statement of cash flows: Section 1 Section 2 The concept of free

usefulness and format direct method indirect method cash flow
• Usefulness of the statement • Step 1: Operating activities • Step 1: Operating activities • Free cash flow
of cash flows • Step 2: Investing and financing • Step 2: Investing and
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• Classification of cash flows activities financing activities
• Significant non-cash activities • Step 3: Net change in cash • Step 3: Net change in cash
• Format of the statement of
cash flows
• Preparing the statement of
cash flows
• Direct and indirect methods
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Statement of cash flows: usefulness and
format
The basic financial statements we have presented so far provide only limited information about an
entity’s cash flows (cash receipts and cash payments). For example, a comparative statement of
financial position shows the increase in property, plant and equipment (PPE) during the year, but
does not show how the additions were financed or paid for. The income statement shows profit,
but it does not indicate the amount of cash generated by operating activities. The statement of
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changes in equity shows cash dividends declared, but not the cash dividends paid during the year.
None of these statements presents a detailed summary of where cash came from and how it was
used.
Usefulness of the statement of cash flows LEARNING

The statement of cash flows reports the cash receipts, cash payments and net change in cash OBJECTIVE 1
resulting from operating, investing and financing activities during a period. The information in a
statement of cash flows should help investors, creditors and others assess: Indicate the usefulness
1. the entity’s ability to generate future cash flows. By examining relationships between items in of the statement of
the statement of cash flows, investors and others can make predictions of the amounts, timing cash flows.
and uncertainty of future cash flows better than they can from accrual-based data.
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2. the entity’s ability to pay dividends and meet obligations. If an entity does not have adequate
E T H I C S N OT E cash, it cannot pay employees, settle debts or pay dividends. Employees, creditors and share-
holders should be particularly interested in this statement, because it alone shows the flows of
Many believe that cash cash in an entity.
flow is less susceptible 3. the reasons for the difference between profit and net cash provided (used) by operating activi-
to management
ties. Profit provides information on the success or failure of an entity. However, some are
manipulation than
critical of accrual-based profit because it requires many estimates. As a result, the reliability
traditional accounting
of the number may be challenged. Such is not the case with cash. Many readers of the state-
measures such as profit.
ment of cash flows want to know the reasons for the difference between profit and net cash
Though we would
from operating activities. Then they can assess for themselves the reliability of the profit
discourage reliance
number.
on cash flows to the
4. the cash investing and financing transactions during the period. By examining an entity’s
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exclusion of accrual
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accounting, comparing investing and financing transactions, a financial statement user can better understand why
cash from operations assets and liabilities changed during the period.
to profit can reveal
Classification of cash flows
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important information
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about the ‘quality’ of The statement of cash flows classifies cash receipts and cash payments as operating, investing and
reported profit. Such a financing activities. Transactions and other characteristics of each kind of activity are described
comparison can reveal in the list below.
the extent to which 1. Operating activities include the cash effects of transactions that create income and expenses.
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profit provides a good
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They thus enter into the determination of profit.

measure of actual 2. Investing activities include (a) acquiring and disposing of investments and property, plant and
performance.
equipment and (b) lending money and collecting the loans.
3. Financing activities include (a) obtaining cash from issuing debt and repaying the amounts
borrowed and (b) obtaining cash from shareholders and providing them with a return on their
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LEARNING investment.
OBJECTIVE 2
The category of operating activities is very important. As noted above, it shows the cash
provided by the entity’s operations. This source of cash is generally considered to be the best
Distinguish among measure of an entity’s ability to generate sufficient cash to continue as a going concern.
operating, investing and
Figure 18.1 lists typical cash receipts and cash payments within each of the three classi-
financing activities.
fications. Study the list carefully. It will prove very useful in solving assigned exercises and
problems.
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Figure 18.1 Typical receipts
and payments classified by Types of cash inflows and outflows
business activity and shown in
the statement of cash flows Operating activities — Income statement items
Cash inflows:
from customers from sale of goods or rendering of services
from returns on loans (interest received) and on equity securities (dividends received)
from royalties, fees, commissions and other income.
Cash outflows:
to suppliers for goods and services
to employees for services
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to government for taxes

to lenders for interest
Operating activities to others for expenses.
Investing activities — Changes in investments and non-current assets

Cash inflows:
from sale of PPE and other non-current assets
JAVA JAVA
TIME TIME from sale of debt or equity securities of other entities
from collection of principal on loans to other entities.
Cash outflows:
to purchase PPE and other non-current assets
to purchase debt or equity securities of other entities
Investing activities to make loans to other entities.
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Financing activities — Changes in non-current liabilities and shareholders’ equity Figure 18.1 Continued
Cash inflows:
from issue of ordinary or preference shares
from issue of debt (bonds and notes). SHARE
BOND
Cash outflows:
to shareholders as dividends
to redeem non-current debt or repurchase shares.
Note the following general guidelines: (1) operating activities involve income statement items;
(2) investing activities involve cash flows resulting from changes in investments and non-current Financing activities
asset items; (3) financing activities involve cash flows resulting from changes in non-current
liability and shareholders’ equity items. HELPFUL HINT
Entities are required to separately disclose cash flows from interest and dividends received and
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paid. Dividends paid are classified as a financing cash flow. There is discretion as to the classifi- The accounting
cation of interest received and paid, and dividends received. They may be classified as operating standard on statements
activities or, alternatively, interest paid may be regarded as a financing activity, and interest and of cash flows is IAS 7
dividends received as investing activities. The important factor is that entities are consistent in
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Statement of Cash Flows.

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their classification from period to period.
Significant non-cash activities

Not all of an entity’s significant activities involve cash. Examples of significant non-cash activi-
ties are:
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1. Issue of shares to purchase assets.

2. Conversion of bonds into shares.
3. Issue of debt to purchase assets. HELPFUL HINT
4. Exchanges of PPE assets.
Material financing and investing activities that do not affect cash are not reported in the body of
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Do not include
the statement of cash flows. Investing and financing transactions that do not require the use of cash non-cash investing
are disclosed elsewhere in the financial statements so as to provide relevant information to users. and financing activities
The reporting of these non-cash activities elsewhere in the financial statements satisfies the in the body of the
full disclosure principle. In solving assigned exercises and problems you should present material statement of cash flows.
non-cash investing and financing activities in a separate schedule at the bottom of the statement
of cash flows. (See lower section of figure 18.2 on the next page for an example.)
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ACCOUNTING IN ACTION
BUSINESS INSIGHT
Profit is not the same as net cash provided by operating activities. The differences are
illustrated by the following results from the annual reports for 2007 or 2008 of various companies.
Note the wide disparity among these companies that operate in different industries.
Cash flows provided by

Profit operating activities
Company ($m) ($m)
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Virgin Blue Holdings Ltd 98 294

CSR Ltd 177 326
Wesfarmers Ltd 1 050 1 451
MYOB Ltd 19 41
New Zealand Oil & Gas 77 122
PSA Peugeot 826 5 081
Format of the statement of cash flows

The general format of the statement of cash flows presents the results of the three activities dis-
cussed previously — operating, investing and financing. A widely used format for the statement
of cash flows is shown in figure 18.2 on the next page.
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Figure 18.2 Format of

statement of cash flows C O M PA N Y N A M E
Statement of Cash Flows
Period Covered
Cash flows from operating activities

(List of individual items) XX
Net cash from (used by) operating activities XXX
Cash flows from investing activities
(List of individual inflows and outflows) XX
Net cash from (used by) investing activities XXX
Cash flows from financing activities
(List of individual inflows and outflows) XX
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Net cash from (used by) financing activities XXX

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Net increase (decrease) in cash XXX
Cash at beginning of period XXX
Cash at end of period XXX
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Listed elsewhere in the financial report
Material non-cash investing and financing activities
(List of individual non-cash transactions) XXX
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The cash flows from operating activities section always appears first. It is followed by the
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investing activities and the financing activities sections.
B E F O R E YO U G O O N
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>> Review it
1. What is the primary purpose of a statement of cash flows?
2. Why is the statement of cash flows useful?
3. What are the major classifications of cash flows on the statement of cash flows?
4. Locate the most recent financial statements for Billabong International from the website www.
billabongcorporate.com. What amounts are reported by Billabong for (1) net cash provided/
used in operating activities, (2) net cash used in investing activities and (3) net cash used in
financing activities? The answer to this question is provided on page 761.
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5. What are some examples of material non-cash activities?
6. What is the general format of the statement of cash flows? In what sequence are the three
types of cash flow activities presented?
>> Do it
During its first week, Home Hardware Ltd had these transactions.
1. Issued 100 000 shares for $800 000 cash.
2. Borrowed $200 000 from Bigger Bank, signing a 5-year bond bearing 8% interest.
3. Purchased two semi-trailer trucks for $170 000 cash.
4. Paid employees $12 000 for salaries and wages.
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5. Collected $20 000 cash for services rendered.

Classify each of these transactions by type of cash flow activity.
Action Plan
• Identify the three types of activities used to report all cash inflows and outflows.
• Report as operating activities the cash effects of transactions that create income and expenses
and enter into the determination of profit.
• Report as investing activities transactions that (a) acquire and dispose of investments and
property, plant and equipment and (b) lend money and collect loans.
• Report as financing activities transactions that (a) obtain cash from issuing debt and repay the
amounts borrowed and (b) obtain cash from shareholders and pay them dividends.
5_60_19251_POFA_2E_ch18.indd 718 7/25/09 10:13:19 AM

Solution
1. Financing activity 4. Operating activity
2. Financing activity 5. Operating activity
3. Investing activity
Related exercise material: BE18.3, BE18.5, E18.1 and E18.6.
Preparing the statement of cash flows

The statement of cash flows is prepared differently from the other financial statements. First, it
is not prepared from an adjusted trial balance. The statement requires detailed information con-
cerning the changes in account balances that occurred between two points in time. An adjusted
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trial balance will not provide the necessary data. Second, the statement of cash flows deals with
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cash receipts and payments. As a result, the effects of the use of accrual accounting must be
adjusted to determine cash flows.
The information to prepare this statement usually comes from three sources:
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• Comparative statement of financial position. Information in the comparative statement of

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financial position indicates the amount of the changes in assets, liabilities and shareholders’
equity from the beginning to the end of the period.
• Current income statement. Information in this statement helps determine the amount of cash
provided or used by operations during the period.
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• Additional information. Such information includes transaction data that are needed to deter-
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mine how cash was provided or used during the period.

Preparing the statement of cash flows from these data sources involves three major steps,
explained in figure 18.3.
Figure 18.3 Three major
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steps in preparing the
Step 1: Determine net cash from (used by) operating activities by converting statement of cash flows
profit from an accrual basis to a cash basis.
This step involves analysing not only

Buying and selling
goods
the current year's income statement
but also the comparative statement of
financial position and selected additional data.
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Step 2: Analyse changes in non-current asset and liability accounts and record as
investing and financing activities, or as significant non-cash transactions.
This step involves analysing comparative

statement of financial position data and
Inve g selected additional information for their
stin
g ncin
Fina effects on cash.
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Step 3: Compare the net change in cash on the statement of cash flows with the
change in the cash account reported on the statement of financial position
to make sure the amounts agree.
The difference between the beginning

+ or – and ending cash balances can be easily
calculated from the comparative statement of
financial position.
For the purpose of preparing the statement of cash flows, entities determine what to include in
‘cash’. The international accounting standard requires a statement of cash flows to provide infor-
mation about cash and cash equivalents. Cash is defined as cash on hand and demand deposits.
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Cash equivalents are short-term, highly liquid investments that can be readily converted to cash.
For example, an entity may include cash on hand, cash in transit, cash on short-term deposit and
bank overdrafts in its cash and cash equivalents. Entities must disclose the components included
as cash, and present a reconciliation of the cash at the start and end of the period in the statement
of cash flows with that in the statement of financial position. Further, any cash that is held by the
entity and has restrictions on its availability for use must be disclosed.
Direct and indirect methods

In order to perform step 1, profit must be converted from an accrual basis to a cash basis. This
conversion may be done by either of two methods: (1) the direct method or (2) the indirect
method. Both methods arrive at the same total amount for ‘Net cash from operating activities’.
They differ in how they arrive at the amount.
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What is the difference between the direct and indirect method? The direct method provides
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information about major classes of gross cash receipts and gross cash payments. These amounts
are determined from the accounting records of the entity or by adjusting sales, cost of sales and
other items in the income statement for:
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• changes during the period in inventories and operating receivables and payables
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• other non-cash items, and
• other items for which the cash effects are investing or financing cash flows.
Applying the indirect method, the net cash from operating activities is determined by adjusting
profit for the effects of:
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• changes during the period in inventories and operating receivables and payables
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• non-cash items such as depreciation, provisions, deferred taxes, unrealised foreign currency
gains and losses, undistributed profits of associates, and minority interests, and
• all other items for which the cash effects are investing or financing cash flows.
Alternatively, the net cash from operating activities may be presented under the indirect method
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by showing the revenues and expenses disclosed in the income statement and the changes during
the period in inventories and operating receivables and payables.
The international accounting standard on the statement of cash flows allows entities to choose
between reporting net cash from operating activities using either the direct or indirect method.
Entities are encouraged to report net cash from operating activities using the direct method. If an
Australian entity chooses the direct method, a reconciliation of net cash from operating activities
to profit must be disclosed in the notes to the financial statements.
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>> Review it
1. What is the primary difference between the indirect and direct approaches to the statement of
cash flows? Which method is prescribed?
2. What are the three major steps in the preparation of a statement of cash flows?
BUSINESS INSIGHT
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Chapter 4 of the Australian Securities Exchange’s listing rules deal with periodic disclosure.
Quarterly cash flow reporting is required for companies admitted under the ‘commitments test’.
Under Listing Rule 1.3.2(b), new companies are allowed to seek admission to the official list if they
have net tangible assets of at least $2 million or a market capitalisation of at least $10 million. Further,
such ‘initially cash-rich companies’ must have commitments consistent with their business plan to
spend at least half of their cash (or assets readily convertible to cash).
The quarterly cash flows must be lodged within one month of the end of each quarter of an
entity’s financial year for a period of 2 years after admission. The ASX has discretion to apply the
quarterly reporting regime to other entities and for varying time periods.
Source: ‘ASX announcement — new companies quarterly reporting’, ASX Limited, 1 May 2000, www.asx.com.au.
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On the following pages, in two separate sections, we describe the use of the two methods.
Section 1 illustrates the direct method. Section 2 illustrates the indirect method. These sections
are independent of each other. Only one or the other need be covered in order to understand
and prepare the statement of cash flows. When you have finished the section assigned by your
lecturer, turn to ‘The concept of free cash flow’ on page 738.
SECTION 1 STATEMENT OF CASH FLOWS — LEARNING

OBJECTIVE 3
DIRECT METHOD
To explain and illustrate the direct method, we will use the transactions of Gold Ltd for 2011 to Prepare a statement
prepare an annual statement of cash flows. Figure 18.4 presents information related to 2011 for of cash flows using the
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direct method.
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Gold Ltd.
Figure 18.4 Comparative

GOLD LTD statement of financial position,
Statement of Financial Position
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income statement and

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as at 30 June additional information for
Change Gold Ltd
Assets 2011 2010 Increase/Decrease
Cash $ 191 000 $ 159 000 $ 32 000 Increase
Accounts receivable 12 000 15 000 3 000 Decrease
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Inventory 170 000 160 000 10 000 Increase

Prepaid expenses 6 000 8 000 2 000 Decrease
Land 140 000 80 000 60 000 Increase
Equipment 160 000 0 160 000 Increase
Accumulated depreciation — equipment (16 000) 0 16 000 Increase
Total assets $ 663 000 $ 422 000
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Liabilities and Shareholders’ equity
Accounts payable $ 52 000 $ 60 000 $ 8 000 Decrease
Accrued expenses payable 15 000 20 000 5 000 Decrease
Income taxes payable 12 000 0 12 000 Increase
Bonds payable 130 000 0 130 000 Increase
Share capital 360 000 300 000 60 000 Increase
Retained earnings 94 000 42 000 52 000 Increase
Total liabilities and shareholders’ equity $663 000 $422 000
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GOLD LTD
Income Statement
for the year ended 30 June 2011
Sales revenue $ 975 000
Cost of sales $ 660 000
Expenses (excluding depreciation) 176 000
Depreciation expense 18 000
Loss on sale of store equipment 1 000 855 000
Profit before income taxes 120 000
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Income tax expense 36 000

Profit $ 84 000
Additional information
1. In 2011, the company declared and paid a $32 000 cash dividend.
2. Bonds were issued for $130 000 in cash.
3. Equipment costing $180 000 was purchased for cash.
4. Equipment costing $20 000 was sold for $17 000 cash when the carrying amount of the equipment
was $18 000.
5. Ordinary shares of $60 000 were issued to acquire land.
To prepare a statement of cash flows under the direct approach, we will apply the three steps
outlined in figure 18.3 (page 719).
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Step 1: Operating activities

DETERMINE NET CASH FROM (USED BY) OPERATING ACTIVITIES BY
CONVERTING PROFIT FROM AN ACCRUAL BASIS TO A CASH BASIS
Under the direct method, net cash from (used by) operating activities is calculated by adjusting
each item in the income statement from the accrual basis to the cash basis. To simplify and
condense the operating activities section, only major classes of operating cash receipts and cash
payments are reported. For these major classes, the difference between cash receipts and cash
payments is the net cash from (used by) operating activities. These relationships are as shown in
figure 18.5.
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Cash receipts – Cash payments = Net cash from (used by)
operating activities
To suppliers
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From sales of
goods and services To employees
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to customers
Net cash
Gold Ltd
For expenses from (used by)
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For interest
From receipts
of interest and
dividends on loans
and investments
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For taxes
Figure 18.5 Major classes of

cash receipts and payments for An efficient way to apply the direct method is to analyse the items reported in the income
operating activities statement in the order in which they are listed. Cash receipts and cash payments related to these
income and expenses are then determined. The direct method adjustments for Gold Ltd in 2011 to
determine net cash from (used by) operating activities are presented on the following pages.
CASH RECEIPTS FROM CUSTOMERS

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The income statement for Gold Ltd reported sales revenue from customers of $975 000. How
much of that was cash receipts? To answer that, it is necessary to consider the change in
accounts receivable during the year. When accounts receivable increases during the year, sales
revenue on an accrual basis is higher than cash receipts from customers. Operations led to
sales revenue, but not all of this revenue resulted in cash receipts. To determine the amount of
cash receipts, the increase in accounts receivable is deducted from sales revenue. On the other
hand, there may be a decrease in accounts receivable. That would occur if cash receipts from
customers exceeded sales revenue. In that case, the decrease in accounts receivable is added to
sales revenue.
For Gold Ltd, accounts receivable decreased $3000. Thus, cash receipts from customers were
$978 000, calculated as shown in figure 18.6.
5_60_19251_POFA_2E_ch18.indd 722 7/25/09 10:13:21 AM

Figure 18.6 Calculation of

Sales revenue from sales $ 975 000 cash receipts from customers
Add: Decrease in accounts receivable 3 000
Cash receipts from customers $ 978 000
Cash receipts from customers may also be determined from an analysis of the Accounts Receiv-
able account, as shown in figure 18.7.
Figure 18.7 Analysis of
Accounts Receivable accounts receivable
1/7/10 Balance 15 000 Receipts from customers 978 000
Sales revenue 975 000 HELPFUL HINT
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30/6/11 Balance 12 000 The T account shows
that sales revenue plus
The relationships among cash receipts from customers, sales revenue, and changes in accounts decrease in receivables
equals cash receipts.
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receivable are shown in figure 18.8.

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⎭⎪ Figure 18.8 Formula to
Cash receipts + Decrease in accounts receivable calculate cash receipts from
Sales ⎬
from = ⎪⎫ or customers — direct method
revenue
customers − Increase in accounts receivable
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CASH PAYMENTS TO SUPPLIERS

Gold Ltd reported cost of sales of $660 000 on its income statement. How much of that was
cash payments to suppliers? To answer that, it is first necessary to find purchases for the year.
To find purchases, cost of sales is adjusted for the change in inventory. When inventory increases
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during the year, more inventory was purchased than sold. As a result, to determine the amount
of purchases, the increase in inventory is added to cost of sales. On the other hand, there may
be a decrease in inventory. That would occur if more inventory was sold in the year than was
purchased. Thus, the decrease in inventory is deducted from the cost of sales.
In 2011, Gold Ltd’s inventory increased $10 000. Purchases are calculated as shown in
figure 18.9.
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Cost of sales $ 660 000 purchases
Add: Increase in inventory 10 000
Purchases $670 000
After purchases are calculated, cash payments to suppliers can be determined. This is done by
adjusting purchases for the change in accounts payable. When accounts payable increase during
the year, purchases on an accrual basis are higher than they are on a cash basis. As a result, to
determine cash payments to suppliers, an increase in accounts payable is deducted from pur-
chases. On the other hand, there may be a decrease in accounts payable. That would occur if cash
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payments to suppliers exceed purchases. In that case, the decrease in accounts payable is added
to purchases.
For Gold Ltd, cash payments to suppliers were $678 000, calculated as shown in figure 18.10.

Purchases $ 670 000 cash payments to suppliers
Add: Decrease in accounts payable 8 000
Cash payments to suppliers $678 000
Cash payments to suppliers may also be determined from an analysis of the Accounts Payable
account as shown in figure 18.11 on the next page.
5_60_19251_POFA_2E_ch18.indd 723 7/25/09 10:13:21 AM


accounts payable Accounts Payable
Payments to suppliers 678 000 1/7/10 Balance 60 000
HELPFUL HINT Purchases 670 000
30/6/11 Balance 52 000
The T account shows
that purchases plus
decrease in accounts The relationships among cash payments to suppliers, cost of sales, changes in inventory and
payable equals changes in accounts payable are shown in the formula in figure 18.12.
payments to suppliers.
⎭⎪ ⎭⎪
Cash + Increase in inventory + Decrease in accounts payable
Cost of ⎬ ⎬
Figure 18.12 Formula to payments = or or
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sales ⎫⎪ ⎫⎪
− Decrease in inventory − Increase in accounts payable
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calculate cash payments to to suppliers
suppliers — direct method
CASH PAYMENTS FOR EXPENSES

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Expenses of $176 000 were reported on Gold’s income statement. How much of that amount
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was cash paid for expenses? To answer that, we need to adjust this amount for any changes
in prepaid expenses and accrued expenses payable. For example, if prepaid expenses increased
during the year, cash paid for expenses is higher than expenses reported on the income statement.
To convert expenses to cash payments for expenses, the increase must be added to expenses. On
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the other hand, if prepaid expenses decrease during the year, the decrease must be deducted from
expenses.
Expenses must also be adjusted for changes in accrued expenses payable. When accrued
expenses payable increase during the year, expenses on an accrual basis are higher than they are
on a cash basis. As a result, to determine cash payments for expenses, an increase in accrued
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expenses payable is deducted from expenses. On the other hand, a decrease in accrued expenses
payable is added to expenses because cash payments exceed expenses.
Gold Ltd’s cash payments for expenses were $179 000, calculated as shown in figure 18.13.

cash payments for expenses Expenses $176 000
Deduct: Decrease in prepaid expenses (2 000)
Add: Decrease in accrued expenses payable 5 000
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Cash payments for expenses $179 000
The relationships among cash payments for expenses, changes in prepaid expenses and changes
in accrued expenses payable are shown in the formula in figure 18.14.
Figure 18.14 Formula to ⎭ ⎭

calculate cash payments for + Increase in prepaid + Decrease in accrued
Cash ⎪ ⎪
expenses — direct method ⎬ expenses ⎬ expenses payable
payments for
= Expenses ⎪ or ⎪ or
expenses
− Decrease in prepaid − Increase in accrued
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⎫ ⎫
expenses expenses payable
DEPRECIATION EXPENSE AND LOSS ON SALE OF EQUIPMENT

Expenses are shown exclusive of depreciation. Depreciation expense in 2011 was $18 000. Depre-
ciation expense is not shown on a statement of cash flows because it is a non-cash expense. If the
amount for expenses includes depreciation expense, expenses must be reduced by the amount of
depreciation to determine cash payments for expenses.
The loss on sale of equipment of $1000 is also a non-cash expense. The loss on sale of equip-
ment reduces profit, but it does not reduce cash. Thus, the loss on sale of equipment is not reported
on a statement of cash flows.
5_60_19251_POFA_2E_ch18.indd 724 7/25/09 10:13:22 AM

Other expenses that do not require the use of cash, such as the amortisation of intangible assets
and impairment losses, are treated in the same manner as depreciation.
CASH PAYMENTS FOR INCOME TAXES

Income tax expense reported on the income statement was $36 000. Income taxes payable, how-
ever, increased $12 000. This increase means that $12 000 of the income taxes have not been paid.
As a result, income taxes paid were less than income taxes reported in the income statement.
Cash payments for income taxes were, therefore, $24 000, as shown in figure 18.15.
Figure 18.15 Calculation

Income tax expense $ 36 000 of cash payments for income
Deduct: Increase in income taxes payable 12 000 taxes
Cash payments for income taxes $ 24 000
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The relationships among cash payments for income taxes, income tax expense, and changes in
income taxes payable are shown in the formula in figure 18.16.
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⎭⎪ Figure 18.16 Formula
Cash Income tax ⎬ + Decrease in income taxes payable to calculate cash payments
payments for = expense ⎪⎫ or for income taxes — direct
income taxes − Increase in income taxes payable method
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The results of the previous analysis are presented in the operating activities section of the state-
ment of cash flows of Gold Ltd in figure 18.17.
Figure 18.17 Operating

activities section of the
FO TI
Cash receipts from customers $ 978 000 statement of cash flows
Cash payments:
To suppliers $ 678 000
For expenses 179 000
For income taxes 24 000 881 000
Net cash from operating activities $ 97 000
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Step 2: Investing and financing activities
ANALYSE CHANGES IN NON-CURRENT ASSET AND LIABILITY ACCOUNTS AND
RECORD AS INVESTING AND FINANCING ACTIVITIES, OR AS SIGNIFICANT
NON-CASH TRANSACTIONS
INCREASE IN LAND
Land increased $60 000. The additional information section indicates that ordinary shares were
issued to purchase the land. The issue of ordinary shares for land has no effect on cash. But it is
a significant non-cash investing and financing transaction. This transaction requires disclosure in
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a separate section of the financial statements.
INCREASE IN EQUIPMENT
The comparative statement of financial position shows that equipment increased $160 000 in
2011. The additional information in figure 18.4 (page 721) indicates that the increase resulted
from two investing transactions: (1) equipment costing $180 000 was purchased for cash and
(2) equipment costing $20 000 was sold for $17 000 cash when its carrying amount was $18 000.
The relevant data for the statement of cash flows are the cash paid for the purchase and the cash
proceeds from the sale. For Gold Ltd, the investing activities section will show the following: the
$180 000 purchase of equipment as an outflow of cash, and the $17 000 sale of equipment as an
inflow of cash. The two amounts should not be netted. Both individual outflows and inflows of
cash should be shown.
5_60_19251_POFA_2E_ch18.indd 725 7/25/09 10:13:22 AM

The analysis of the changes in equipment should include the related Accumulated Depreciation
account. These two accounts for Gold Ltd are shown in figure 18.18.
Figure 18.18 Analysis

of equipment and related Equipment
accumulated depreciation 1/7/10 Balance 0 Cost of equipment sold 20 000
Cash purchase 180 000
30/6/11 Balance 160 000
Accumulated Depreciation — Equipment

Sale of equipment 2 000 1/7/10 Balance 0
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30/6/11 Balance 16 000

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INCREASE IN BONDS PAYABLE
Bonds Payable increased $130 000. The additional information in figure 18.4 (page 721) indicated
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that bonds were issued for $130 000 cash. The issue of bonds is a financing activity. For Gold
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Ltd, there is an inflow of cash of $130 000 from the issue of bonds.
INCREASE IN ORDINARY SHARES

The Ordinary Share Capital account increased $60 000. The additional information indicated that
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land was acquired from the issue of ordinary shares. This transaction is a significant non-cash
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investing and financing transaction that should be reported separately in the financial statements.
INCREASE IN RETAINED EARNINGS

The $52 000 net increase in Retained Earnings resulted from profit of $84 000 and the declaration
and payment of a cash dividend of $32 000. Profit is not reported in the statement of cash flows
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under the direct method. Cash dividends paid of $32 000 are reported in the financing activities
section as an outflow of cash.
Statement of cash flows — 2011

The statement of cash flows for Gold Ltd is shown in figure 18.19.
Figure 18.19 Statement of

cash flows, 2011 — direct GOLD LTD
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method Statement of Cash Flows — Direct Method

Cash receipts from customers $ 978 000
Cash payments:
To suppliers $ 678 000
For expenses 179 000
For income taxes 24 000 881 000
Net cash from operating activities 97 000
Purchase of equipment (180 000)
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Sale of equipment 17 000

Net cash used by investing activities (163 000)
Issue of bonds 130 000
Payment of cash dividends (32 000)
Net cash from financing activities 98 000
Net increase in cash 32 000
Cash at beginning of period 159 000
Cash at end of period $ 191 000
Non-cash investing and financing activities
Issue of ordinary shares to purchase land $ 60 000
5_60_19251_POFA_2E_ch18.indd 726 7/25/09 10:13:22 AM

Step 3: Net change in cash

COMPARE THE NET CHANGE IN CASH ON THE STATEMENT OF CASH FLOWS
WITH THE CHANGE IN THE CASH ACCOUNT REPORTED ON THE STATEMENT
OF FINANCIAL POSITION TO MAKE SURE THE AMOUNTS AGREE
Figure 18.19 indicates that the net change in cash during the period was an increase of $32 000.
This agrees with the change in balances in the cash account reported on the statement of financial
position in figure 18.4 (page 721).
>> Review it
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1. What is the format of the operating activities section of the statement of cash flows using the
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direct method?
2. Where is depreciation expense shown on a statement of cash flows using the direct method?
3. Where are material non-cash investing and financing activities shown on a statement of cash
flows? Give some examples of material non-cash investing and financing activities.
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>> Do it
Presented below is information related to Silver Ltd. Use it to prepare a statement of cash flows
using the direct method.
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S I LV E R L T D
as at 30 June
Change
FO TI
Cash $ 54 000 $ 37 000 $ 17 000 Increase
Accounts receivable 68 000 26 000 42 000 Increase
Inventory 54 000 0 54 000 Increase
Land 45 000 70 000 25 000 Decrease
Buildings 200 000 200 000 0
Accumulated depreciation — buildings (21 000) (11 000) 10 000 Increase
Equipment 193 000 68 000 125 000 Increase
Accumulated depreciation — equipment (28 000) (10 000) 18 000 Increase
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Total assets $569 000 $ 386 000

Accrued expenses payable 10 000 0 10 000 Increase
Bonds payable 110 000 150 000 40 000 Decrease
Total liabilities and shareholders’ equity $ 569 000 $ 386 000
S I LV E R L T D
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Income Statement
Sales revenue $890 000
Expenses 221 000
Interest expense 12 000
Loss on sale of equipment 2 000 700 000
Profit $125 000
(continued)
5_60_19251_POFA_2E_ch18.indd 727 7/25/09 10:13:23 AM

1. Expenses include depreciation expense of $33 000 and charges from prepaid expenses of $2 000.
2. Land was sold at its carrying amount for cash.
3. Cash dividends of $55 000 were declared and paid in 2011.
4. Interest expense of $12 000 was paid in cash.
5. Equipment with a cost of $166 000 was purchased for cash. Equipment with a cost of $41 000 and a
carrying amount of $36 000 was sold for $34 000 cash.
6. Bonds of $10 000 were redeemed at their carrying amounts for cash. Bonds of $30 000 were
converted into ordinary shares.
7. Ordinary shares were issued for $130 000 cash.
8. Accounts payable pertain to inventory suppliers.
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Action Plan
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• Determine net cash from (used by) operating activities by adjusting each item in the income
statement from the accrual basis to the cash basis.
• Determine net cash from (used by) investing activities.
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• Determine net cash from (used by) financing activities.

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• Determine the net increase/decrease in cash.
Solution
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HELPFUL HINT S I LV E R L T D
Statement of Cash Flows — Direct Method
1. Determine net for the year ended 30 June 2011
cash from (used by)
operating activities,
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Cash receipts from customers $ 848 000 a
recognising that Cash payments:
each item in the To suppliers $ 536 000b
income statement For other expenses 179 000 c
For interest expense 12 000
must be adjusted to For income taxes 65 000 789 000
the cash basis.
2. Determine net Cash flows from investing activities
cash from (used by) Sale of land 25 000
investing activities, Sale of equipment 34 000
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recognising that
investing activities Net cash used by investing activities (107 000)
generally relate to Cash flows from financing activities
Redemption of bonds (10 000)
changes in non-
Issue of ordinary shares 130 000
current assets. Payment of dividends (55 000)
3. Determine net Net cash from financing activities 65 000
cash from (used by)
financing activities, Cash at beginning of period 37 000
recognising that Cash at end of period $ 54 000
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financing activities
Non-cash investing and financing activities
generally relate to Conversion of bonds into ordinary shares $ 30 000
changes in non-
Calculations:
current liabilities and a
$848 000 = $890 000 − $42 000
shareholders’ equity b
$536 000 = $465 000 + $54 000 + $17 000
accounts. c
$176 000 = $221 000 − $33 000 − $2 000 − $10 000
An additional schedule reconciling profit to net cash provided in operating activities should be presented
as part of the statement of cash flows when using the direct method as shown on pages 731–4.
Related exercise material: BE18.6, BE18.7, BE18.8, E18.7, E18.8, E18.9 and E18.10.
5_60_19251_POFA_2E_ch18.indd 728 7/25/09 10:13:23 AM

Note: This concludes Section 1 on preparation of the statement of cash flows using the direct
method. Unless your lecturer assigns section 2, turn to the concluding section of the chapter, ‘The
concept of free cash flow’ on page 738.
BUSINESS INSIGHT
The Qantas Group’s cash flow statement (another name for the statement of cash flows)
is presented below. Net cash flows from operating activities, prepared under both the direct and
indirect method are shown. Under the international accounting standard either the direct or indirect
method can be presented in a statement of cash flows. Note that the direct and indirect methods
arrive at the same cash from operating activities figure. Under Australian Accounting Standards, which
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are equivalent to IFRSs, companies preparing a statement of cash flows using the direct method must
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disclose the reconciliation of profit to net cash provided in operating activities (the indirect method)
in the notes to the financial statements.
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C A S H F L OW S TAT E M E N T S
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Qantas Group
2008 2007
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Cash Flows from Operating Activities Notes $M $M
T
Cash receipts in the course of operations1 16 628.3 15 707.3

Cash payments in the course of operations (14 077.7) (12 956.3)
Interest received 264.6 230.2
Interest paid (419.3) (425.1)
Dividends received 22.3 34.4
FO TI
Income taxes paid (289.8) (166.4)
Net cash from operating activities 26 2 128.4 2 424.1
Cash Flows from Investing Activities

Payments for property, plant and equipment and
intangible assets (1 424.0) (1 282.1)
Proceeds from disposal of property, plant and equipment 43.7 47.3
Proceeds from disposal of investment 106.2 3.2
Payments for investments (35.3) (2.2)
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Payments for controlled entities, net of cash acquired 26 (13.2) (32.1)
Advances of investment loans — (0.5)
Net cash used in investing activities (1 322.6) (1 266.4)
Cash Flows from Financing Activities

Payments under share buy-back2 (505.7) —
Repurchase of own shares (69.2) (24.5)
Repayment of borrowings (784.9) (356.2)
Proceeds from swaps 342.3 96.2
Net receipts from aircraft security deposits 85.8 2.4
Dividends paid3 (638.0) (414.7)
Net cash used in financing activities (1 569.7) (696.8)
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Net (decrease)/increase in cash and cash

equivalents held (763.9) 460.9
Cash and cash equivalents held at the beginning of the year 3 362.9 2 902.0
Cash and cash equivalents at the end of the year 10 2 599.0 3 362.9
1 Prior
year cash receipts in the course of operations included $188.1 million on the sale of expendable and recoverable
spares.
2
The number of shares bought back during the year was 91.1 million.
3
The Dividend Reinvestment Plan (DRP) was suspended after the payment of the 2006 final dividend but has been re-
instated for the payment of dividends commencing with the 2008 final dividend. During the year, nil (2007: 28,991,867)
shares were issued under the DRP. Dividends settled in shares rather than cash during the year totalled nil (2007:
$99.0 million).
(continued)
5_60_19251_POFA_2E_ch18.indd 729 7/25/09 10:13:23 AM

26. Notes to the Cash Flow Statements

Qantas Group
Reconciliation of profit for the year to net cash from 2008 2007
operating activities $M $M
Profit for the year attributable to members of Qantas 969.0 672.6
Add: depreciation and amortisation 1 469.3 1 362.7
Less: net gain on disposal of investment — (30.6)
Less: net gain on disposal of property, plant and equipment (17.3) (12.9)
Less: gain on disposal of intangible assets — (3.2)
Less: capitalised interest (100.7) (83.3)
Add: writedown of property, plant and equipment 18.6 —
Add: writedown of investments — 14.5
Less: share of net profit of associates and jointly controlled entities (27.6) (46.5)
Add: dividends received from associates and jointly controlled entities 22.3 28.4
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Less: discount on acquisition of controlled entity — (8.8)

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Add: share-based payments 61.6 17.2
(Less)/add: transfer from hedge reserve to Income Statement (208.8) 9.7
Add(less): changes in fair value of financial instruments 71.0 (9.2)
(Less)/add: other items (33.4) 52.3
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Movements in operating assets and liabilities:

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(Increase)/decrease in receivables (410.3) (165.2)
Increase in receivables from controlled entities — —
(Increase)/decrease in inventories (39.3) 167.4
Increase in other assets (144.0) (16.1)
(Increase)/decrease in deferred tax assets (0.3) 2.8
Increase/(decrease) in payables 168.7 16.1
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Increase in revenue received in advance 250.7 304.9

(Decrease)/increase in provisions (41.0) 65.7
(Decrease)/increase in current tax liabilities (40.5) 80.6
Decrease in deferred lease benefits (28.6) (37.5)
Increase in deferred tax liabilities 189.0 42.5
Net cash from operating activities 2 128.4 2 424.1
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Source: Qantas Airways Ltd, Annual report 2008, pp. 78, 119.
LEARNING SECTION 2 STATEMENT OF CASH FLOWS —

OBJECTIVE 4
INDIRECT METHOD
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Prepare a statement To explain how to prepare a statement of cash flows using the indirect method, we use financial
of cash flows using the information from Bronze Ltd. Figure 18.20 presents Bronze Ltd’s current and previous year’s state-
indirect method. ment of financial position, its current year income statement and related financial information.
Figure 18.20 Comparative

statement of financial position, B RO N Z E L T D
income statement and Statement of Financial Position
additional information for as at 30 June
Bronze Ltd
Change in
account balance
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Current assets
Cash $ 55 000 $ 33 000 $ 22 000 Increase
Prepaid expenses 5 000 1 000 4 000 Increase
Property, plant and equipment
Land 130 000 20 000 110 000 Increase
Building 160 000 40 000 120 000 Increase
Accumulated depreciation — building (11 000) (5 000) 6 000 Increase
Total assets $398 000 $ 138 000
5_60_19251_POFA_2E_ch18.indd 730 7/25/09 10:13:24 AM


Current liabilities
Accounts payable $ 28 000 $ 12 000 $ 16 000 Increase
Income tax payable 6 000 8 000 2 000 Decrease
Non-current liabilities
Bonds payable 130 000 20 000 110 000 Increase
Shareholders’ equity
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B RO N Z E L T D
Income Statement
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Depreciation 9 000
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Profit $ 145 000
FO TI
Additional information for 2011
1. The company declared and paid a $29 000 cash dividend.
2. Issued $110 000 of non-current bonds in exchange for land.
3. A building costing $120 000 was purchased for cash. Equipment costing $25 000 was also purchased
for cash.
4. The company sold equipment with a carrying amount of $7 000 (cost $8 000, less accumulated
depreciation $1 000) for $4 000 cash.
5. Issued ordinary shares for $20 000 cash.
6. Depreciation expense comprised $6 000 for building and $3 000 for equipment.
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We will now apply the three steps to the information provided for Bronze Ltd. The indirect
method is essentially a reconciliation of profit to net cash from operating activities.
HELPFUL HINT
Step 1: Operating activities
DETERMINE NET CASH FROM (USED BY) OPERATING ACTIVITIES BY Converting profit from
CONVERTING PROFIT FROM AN ACCRUAL BASIS TO A CASH BASIS an accrual basis to a
cash basis is akin to the
To determine net cash from (used by) operating activities under the indirect method, profit is
reconciliation of cash
adjusted in numerous ways. A useful starting point is to understand why profit must be converted
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flows from operating

to net cash from (used by) operating activities.
activities to profit or
Under generally accepted accounting principles, most entities use the accrual basis of
loss for the period.
accounting. As you have learned, this basis requires that revenue be recorded when earned and AASB 107 requires
that expenses be recorded when incurred. Earned revenue may include credit sales that have not such a reconciliation
yet been collected in cash. Expenses incurred may include some items that have not been paid in to be disclosed in the
cash. Thus, under the accrual basis of accounting, profit is not the same as net cash from (used notes to the financial
by) operating activities. Therefore, under the indirect method, profit must be adjusted to convert statements if an entity
certain items to the cash basis. The indirect method (or reconciliation method) starts with profit prepares its statement
and converts it to net cash from (used by) operating activities. Figure 18.21 on the next page lists of cash flows using the
the three types of adjustments to profit. direct method.
The three types of adjustments are explained in the next three sections.
5_60_19251_POFA_2E_ch18.indd 731 7/25/09 10:13:25 AM

Figure 18.21 Three types of

adjustments to convert profit Profit +/− Adjustments = Net cash from (used by)
to net cash from (used by) operating activities
operating activities • Add back non-cash expenses, such as
depreciation and amortisation expense.
• Deduct gains and add losses that resulted
from investing and financing activities.
• Analyse changes to non-cash current
asset and current liability accounts.
HELPFUL HINT
Depreciation expense
Depreciation is similar to Bronze Ltd’s income statement reports depreciation expense of $9000. Although depreciation
any other expense in that expense reduces profit, it does not reduce cash. In other words, depreciation expense is a non-cash
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it reduces profit. It differs charge. It is added back to profit to arrive at net cash from (used by) operating activities. Depre-
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in that it does not involve ciation expense is reported in the statement of cash flows as shown in figure 18.22.
a current cash outflow;
that is why it must be
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added back to profit to Profit $ 145 000

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arrive at cash from (used Adjustments to reconcile profit to net cash
by) operations. from (used by) operating activities:
Figure 18.22 Adjustment for Net cash from operating activities $154 000
depreciation
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Depreciation and similar non-cash charges such as amortisation of intangible assets are frequently
listed in the statement of cash flows as the first adjustment to profit.
Loss on sale of equipment

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Bronze’s income statement reports a $3000 loss on the sale of equipment (carrying amount $7000,
less cash received from sale of equipment $4000). Figure 18.1 (page 716) states that cash received
from the sale of PPE assets should be reported in the investing activities section. Because of this,
all gains and losses must be eliminated from profit to arrive at cash from operating activities. In
our example, Bronze Ltd’s loss of $3000 should not be included in the operating activities section
of the statement of cash flows. Figure 18.23 shows that the $3000 loss is eliminated by adding
$3000 back to profit to arrive at net cash from operating activities.
Figure 18.23 Adjustment for
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loss on sale of equipment Cash flows from operating activities
Profit $145 000
Adjustments to reconcile profit to net cash
from (used by) operating activities:
Depreciation expense $ 9 000
Net cash from operating activities $157 000
If a gain on sale occurs, the gain is deducted from profit to determine net cash from operating
activities. In the case of either a gain or a loss, the actual amount of cash received from the sale is
reported as a source of cash in the investing activities section of the statement of cash flows.
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Changes to non-cash current asset and liability accounts

A final adjustment in reconciling profit to net cash from operating activities involves examining
all changes in current asset and current liability accounts. The accrual accounting process records
income in the period benefits are received and expenses in the period benefits are consumed. For
example, Accounts Receivable is used to record amounts owed to the entity for sales that have
been made and cash collections that have not yet been received. The Prepaid Insurance account
is used to reflect insurance that has been paid for, but which has not yet expired, and therefore
has not been expensed. Similarly, the Salaries Payable account reflects salaries expense that has
been incurred by the entity but has not been paid. As a result, we need to adjust profit for these
accruals and prepayments to determine net cash from (used by) operating activities. Thus, we
5_60_19251_POFA_2E_ch18.indd 732 7/25/09 10:13:25 AM

must analyse the change in each current asset and current liability account to determine its impact
on profit and cash.
Changes in non-cash current assets

The adjustments required for changes in non-cash current asset accounts are as follows: increases
in current asset accounts are deducted from profit, and decreases in current asset accounts are
added to profit to arrive at net cash from (used by) operating activities. We can observe these
relationships by analysing the accounts of Bronze Ltd.
DECREASE IN ACCOUNTS RECEIVABLE

Bronze Ltd’s accounts receivable decreases by $10 000 (from $30 000 to $20 000) during the
period. For Bronze Ltd this means that cash receipts were $10 000 higher than sales revenue.
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Figure 18.24 shows that Bronze Ltd had $507 000 in sales revenue (as reported on the income
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statement), but it collected $517 000 in cash. As shown in figure 18.25 below, to adjust profit to
net cash from (used by) operating activities, the decrease of $10 000 in accounts receivable is
added to profit.
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Accounts Receivable accounts receivable
1/7/10 Balance 30 000 Receipts from customers 517 000
Sales revenue 507 000
30/6/11 Balance 20 000
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When the Accounts Receivable balance increases, cash receipts from credit sales are lower
than sales revenue under the accrual basis. Therefore, the amount of the increase in accounts
receivable is deducted from profit to arrive at net cash from operating activities.
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INCREASE IN INVENTORY
Bronze Ltd’s Inventory balance increases $5000 (from $10 000 to $15 000) during the period.
The Inventory account reflects the difference between the amount of inventory that has been
purchased and the amount which has been sold. For Bronze Ltd this means that the cost of
inventory purchased exceeded the cost of sales by $5000. As a result, cost of sales does not reflect
$5000 of cash payments made for inventory. This inventory increase of $5000 during the period
is deducted from profit to arrive at net cash from (used by) operating activities (see figure 18.25).
If inventory decreases, the amount of the change is added to profit to arrive at net cash from (used
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by) operating activities.
INCREASE IN PREPAID EXPENSES

Prepaid expenses increased during the period by $4000. This means that cash paid for expenses is
higher than expenses reported on an accrual basis. Cash payments have been made in the current
period, but expenses (as charges to the income statement) have been deferred to future periods.
To adjust profit to net cash from (used by) operating activities, the $4000 increase in prepaid
expenses is deducted from profit (see figure 18.25).
If prepaid expenses decrease, reported expenses are higher than the expenses paid. Therefore,
the decrease in prepaid expense is added to profit to arrive at net cash from (used by) operating
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activities.
Figure 18.25 Adjustments
Cash flows from operating activities for changes in current asset
Profit $ 145 000 accounts
Loss on sale of equipment 3 000
Decrease in accounts receivable 10 000
Increase in inventory (5 000)
Increase in prepaid expenses (4 000) 13 000
5_60_19251_POFA_2E_ch18.indd 733 7/25/09 10:13:26 AM

Changes in current liabilities

The adjustments required for changes in current liability accounts are as follows: increases in cur-
rent liability accounts are added to profit and decreases in current liability accounts are deducted
from profit to arrive at net cash from (used by) operating activities.
INCREASE IN ACCOUNTS PAYABLE

For Bronze Ltd, accounts payable increased by $16 000 during the period. That means the com-
pany received $16 000 more in goods than it actually paid for. As shown in figure 18.26, to adjust
profit to determine net cash from (used by) operating activities, the $16 000 increase in accounts
payable is added to profit.
DECREASE IN INCOME TAXES PAYABLE

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When a company incurs income tax expense but has not yet paid its taxes, it records income tax
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payable. A change in the Income Tax Payable account reflects the difference between income
tax expense incurred and income tax actually paid. Bronze Ltd’s Income Tax Payable account
decreased by $2000. That means the $47 000 of income tax expense reported on the income
IS
statement was $2000 less than the amount of taxes paid during the period of $49 000. As shown
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in figure 18.26, to adjust profit to a cash basis, profit must be reduced by $2000.
for changes in current liability Cash flows from operating activities
accounts Profit $ 145 000
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FO TI
Increase in prepaid expenses (4 000)
Increase in accounts payable 16 000
Decrease in income tax payable (2 000) 27 000
Figure 18.26 shows that, after starting with profit of $145 000, the sum of all of the adjustments
to profit was $27 000. This resulted in net cash from operating activities of $172 000.
Summary of conversion to net cash from (used by)

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operating activities — indirect method
As shown in the previous illustrations, the statement of cash flows prepared by the indirect
method starts with profit. It then adds or deducts items to arrive at net cash from (used by)
operating activities. The required adjustments are of three types: (1) non-cash charges such as
depreciation and amortisation; (2) gains and losses on the sale of PPE assets; and (3) changes in
non-cash current asset and current liability accounts. A summary of these changes is provided in
figure 18.27.
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required to convert profit Adjustment required to

to net cash from (used by) convert profit to net
operating activities cash from (used by)
⎭
Non-cash ⎬ Depreciation expense Add
⎫
charges Amortisation expense Add
⎭
⎬ Loss on sale of PPE asset Add
Gains and losses ⎫
Gain on sale of PPE asset Deduct
⎭
⎪ Increase in current asset account Deduct
Changes in current ⎪
⎬ Decrease in current asset account Add
assets and current ⎪
⎪ Increase in current liability account Add
liabilities ⎫
Decrease in current liability account Deduct
5_60_19251_POFA_2E_ch18.indd 734 7/25/09 10:13:26 AM

Step 2: Investing and financing activities

ANALYSE CHANGES IN NON-CURRENT ASSET AND LIABILITY ACCOUNTS
AND RECORD AS INVESTING AND FINANCING ACTIVITIES, OR AS MATERIAL HELPFUL HINT
NON-CASH INVESTING AND FINANCING ACTIVITIES
The investing and
INCREASE IN LAND financing activities are
As indicated from the change in the Land account and the additional information, land of measured and reported
$110 000 was purchased through the issue of non-current bonds. The issue of bonds payable the same under both
for land has no effect on cash. But it is a material non-cash investing and financing activity that the direct and indirect
merits disclosure in the financial statements. methods.
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INCREASE IN BUILDING
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As the additional data indicate, an office building was acquired for $120 000 cash. This is a cash
outflow reported in the investing section.
IS
INCREASE IN EQUIPMENT
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The Equipment account increased $17 000. The additional information explains that this was a
net increase that resulted from two transactions: (1) a purchase of equipment of $25 000 and
(2) the sale for $4000 of equipment costing $8000. These transactions are classified as investing
activities. Each transaction should be reported separately. Thus the purchase of equipment should
T U
be reported as an outflow of cash for $25 000. The sale should be reported as an inflow of cash
T
for $4000. The T account in figure 18.28 shows the reasons for the change in this account during
the year.

Equipment equipment
FO TI
1/7/10 Balance 10 000 Cost of equipment sold 8 000
Purchase of equipment 25 000
30/6/11 Balance 27 000
The following entry shows the details of the equipment sale transaction.
A = L + E
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Cash 4 000 + 4 000 −3 000 Exp
Accumulated Depreciation 1 000 + 1 000
Loss on Sale of Equipment 3 000 − 8 000
Equipment 8 000
Cash flows
+4 000
INCREASE IN BONDS PAYABLE
The Bonds Payable account increased $110 000. As indicated in the additional information, land
was acquired from the issue of these bonds. This non-cash transaction is reported separately in
the financial statements.
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INCREASE IN ORDINARY SHARES

The statement of financial position reports an increase in Share Capital of $20 000. The additional
HELPFUL HINT
information section notes that this increase resulted from the issue of new shares. This is a cash
inflow reported in the financing section.
When shares or bonds
are issued for cash,
INCREASE IN RETAINED EARNINGS
the actual proceeds
Retained earnings increased $116 000 during the year. This increase can be explained by two
will appear in the
factors: (1) profit of $145 000 increased retained earnings; (2) dividends of $29 000 decreased
statement of cash flows
retained earnings. Profit is adjusted to net cash from (used by) operating activities in the oper-
as a financing inflow.
ating activities section. Payment of the dividends is a cash outflow that is reported as a financing
activity.
5_60_19251_POFA_2E_ch18.indd 735 7/25/09 10:13:26 AM

Statement of cash flows — 2011

Using the previous information, we can now prepare a statement of cash flows for 2011 for
Bronze Ltd as shown in figure 18.29.
Figure 18.29 Statement of

cash flows 2011— indirect B RO N Z E L T D
method Statement of Cash Flows — Indirect Method

Profit $ 145 000
Adjustments to reconcile net profit to net cash
D

N R
Increase in prepaid expenses (4 000)
IS
Increase in accounts payable 16 000

O IB
Decrease in income tax payable (2 000) 27 000
Purchase of building (120 000)
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HELPFUL HINT
T
Sale of equipment 4 000

Note that in the Cash flows from financing activities
investing and financing
activities sections,
Net cash used by financing activities (9 000)
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positive numbers
indicate cash inflows
(receipts) and negative
numbers indicate cash
Material non-cash investing and financing activities
outflows (payments).
Issue of bonds payable to purchase land $ 110 000
Step 3: Net change in cash

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COMPARE THE NET CHANGE IN CASH ON THE STATEMENT OF CASH FLOWS
WITH THE CHANGE IN THE CASH ACCOUNT REPORTED ON THE STATEMENT
OF FINANCIAL POSITION TO MAKE SURE THE AMOUNTS AGREE
Figure 18.29 indicates that the net change in cash during the period was an increase of $22 000.
This agrees with the change in Cash account reported on the statement of financial position in
figure 18.20 (page 730).
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>> Review it
1. What is the format of the operating activities section of the statement of cash flows using the
indirect method?
2. Where is depreciation expense shown on a statement of cash flows using the indirect
method?
3. Where are material non-cash investing and financing activities shown in a statement of cash
flows? Give some examples.
>> Do it
Presented below is information related to Platinum Ltd. Use it to prepare a statement of cash
flows using the indirect method.
5_60_19251_POFA_2E_ch18.indd 736 7/25/09 10:13:27 AM

P L AT I N U M L T D
as at 30 June
Change
Cash $ 54 000 $ 37 000 $ 17 000 Increase
Accounts receivable 68 000 26 000 42 000 Increase
Inventory 54 000 0 54 000 Increase
Land 45 000 70 000 25 000 Decrease
Buildings 200 000 200 000 0
Accumulated depreciation — buildings (21 000) (11 000) 10 000 Increase
D
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Total assets $ 569 000 $ 386 000
IS

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Accrued expenses payable 10 000 0 10 000 Increase
Bonds payable 110 000 50 000 40 000 Decrease
T U
T
FO TI
Income Statement

Expenses 221 000
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Profit $ 125 000
1. Expenses include depreciation expense of $33 000 and charges from prepaid expenses of $2 000.
2. Land was sold at its carrying amount for cash.
3. Cash dividends of $55 000 were declared and paid in 2011.
4. Interest expense of $12 000 was paid in cash.
5. Equipment with a cost of $166 000 was purchased for cash. Equipment with a cost of $41 000 and a
carrying amount of $36 000 was sold for $34 000 cash.
6. Bonds of $10 000 were redeemed at their carrying amount for cash. Bonds of $30 000 were converted
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into ordinary shares.

8. Accounts payable pertain to inventory suppliers.
Action Plan
• Determine net cash from (used by) operating activities by adjusting profit for items that did not
affect cash.
• Determine net cash from (used by) investing activities and financing activities.
• Determine the net increase/decrease in cash.
(continued)
5_60_19251_POFA_2E_ch18.indd 737 7/25/09 10:13:27 AM

Solution
HELPFUL HINT
1. Determine net Statement of Cash Flows — Indirect Method
cash from (used by) for the year ended 30 June 2011
operating activities, Cash flows from operating activities
recognising that Profit $ 125 000
operating activities Adjustments to reconcile profit to net cash
generally relate to from (used by) operating activities:
changes in current Loss on sale of equipment 2 000
assets and current Increase in accounts receivable (42 000)
liabilities. Increase in inventories (54 000)
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Decrease in prepaid expenses 2 000

2. Determine net
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Decrease in accounts payable (17 000)
cash from (used by) Increase in accrued expenses payable 10 000 (66 000)
investing activities, Net cash from operating activities 59 000
recognising that Cash flows from investing activities
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investing activities Sale of land 25 000

O IB
generally Sale of equipment 34 000
relate to changes in
non-current assets.
3. Determine net Cash flows from financing activities
Redemption of bonds (10 000)
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cash from (used by)
T

financing activities, Payment of dividends (55 000)
recognising that Net cash from financing activities 65 000
financing activities Net increase in cash 17 000
generally relate to Cash at beginning of period 37 000
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changes in non- Cash at end of period $ 54 000
current liabilities and Non-cash investing and financing activities
shareholders’ equity Conversion of notes into ordinary shares $ 30 000
accounts.
Related exercise material: BE18.1, BE18.2, BE18.4, E18.2, E18.3, E18.4 and E18.5.
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Note: This concludes section 2 on preparation of the statement of cash flows using the indirect
method. You should now proceed to the ‘The concept of free cash flow’ section below.
LEARNING The concept of free cash flow

OBJECTIVE 5 In chapter 19 we introduce a number of ratios used by investors, analysts and creditors in
assessing the financial position and performance of an entity. Traditionally, ratios have been
Understand the concept based on profit. We will see in chapter 19 that, for some profitability ratios, net cash from oper-
of free cash flow. ating activities can be substituted for profit. Further, figures from the statement of cash flows
can also be used to assess an entity’s liquidity and solvency. In this section we introduce a cash
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flow concept — free cash flow. This concept provides additional insight into an entity’s cash-
generating capacity.
Free cash flow

In the statement of cash flows, net cash from (used by) operating activities is intended to indicate
the cash-generating capability of the entity. Analysts have noted, however, that net cash from
operating activities fails to take into account that an entity must invest in new fixed assets just
to maintain its current level of operations. Companies also must at least maintain dividends at
current levels to satisfy investors. A measurement to provide additional insight regarding an
entity’s cash-generating ability is free cash flow. Free cash flow describes the cash remaining
from operations after adjustment for capital expenditures and dividends.
5_60_19251_POFA_2E_ch18.indd 738 7/25/09 10:13:27 AM

Consider the following example: suppose that MPC produced and sold 10 000 personal com-
puters this year. It reported $100 000 net cash from operating activities. In order to maintain
production at 10 000 computers, MPC invested $15 000 in equipment. It chose to pay $5000 in
dividends. Its free cash flow was $80 000 ($100 000 − $15 000 − $5000). The company could use
this $80 000 either to purchase new assets to expand the business or to pay an $80 000 dividend
and continue to produce 10 000 computers. In practice, free cash flow is often calculated with the
formula in figure 18.30. Alternative definitions also exist.
Figure 18.30 Free cash flow
Free cash Net cash from Capital Cash
= − −
flow operations expenditures dividends
D
Microsoft’s annual reports are available at www.microsoft.com. From the cash flow statement,
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Microsoft’s net cash from operating activities was $21 612 million and $17 796 million in 2008
and 2007 respectively. In these years, Microsoft expended $3182 million and $2264 million on
property, plant and equipment. Microsoft paid dividends of $4015 million and $3805 million
IS
in 2008 and 2007 respectively. Figure 18.31 calculates Microsoft’s free cash flow in 2008 and
O IB
2007.
Figure 18.31 Calculation
2008 2007 of Microsoft’s 2008 and 2007
free cash flow ($ in millions)
Net cash from operating activities $21 612 $17 796
T U
T
Less: Expenditures on property, plant and equipment 3 182 2 264

Less: Dividends paid 4 015 3 805
Free cash flow 14 412 11 727
This free cash flow of $14 412 million in 2008 is a tremendous amount of cash generated in a single year
and highlights Microsoft’s cash-generating capacity. It is available for the acquisition of new assets, the
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retirement of debt or repurchase of shares.
BUSINESS INSIGHT
A freeze on dividends is set to hit parts of corporate Australia, as pressure is placed
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on company earnings and cash flows. The chairman of corporate advisory and insolvency firm
McGrathNicol, Tony McGrath, said that so far few public companies had cut dividends but the situa-
tion would soon change. ‘We will see that because earnings will decline but, more importantly, cash
flow will be under pressure,’ he said. ‘With the challenge of managing your debt load, why do you
want to leak some of your cash flow to your dividends at this moment?’
As debt funding matures, boards are focusing on the options of paying a dividend versus debt retire-
ment, versus the dangers of undertaking capital raisings. However, some companies have maintained
dividend payments. Suncorp experienced a severe drop in profit in 2008. Despite this, it opted to
maintain its dividend per share at $1.07. If all of its shareholders opted for the final dividend distribu-
tion rather than electing to use the dividend to acquire more shares via the dividend reinvestment
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plan, Suncorp would have to find as much as $525 million from it retained earnings.
Source: K. Jimenez, ‘Dividends to be frozen as earnings decline’, The Australian, 18 December 2008, www.the australian.news.com.
au; D. John, ‘Suncorp raids kitty to pay dividend, The Sydney Morning Herald, 2 August 2008, p. 39.
>> Review it
1. What is the difference between cash from operating activities and free cash flow?
2. What does it mean if an entity has negative free cash flow?
5_60_19251_POFA_2E_ch18.indd 739 7/25/09 10:13:28 AM

D E M O N S T R AT I O N P R O B L E M
The income statement for the year ended 30 June 2011 for Gee Electronics Ltd contains the
following condensed information.
G E E E L E C T RO N I C S L T D
Income Statement for the month ended 30 June 2011
Sales revenue $6 583 000

Expenses (excluding depreciation) $ 4 920 000
Depreciation expense 880 000 5 800 000
D
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Profit $ 430 000
Included in expenses is a $24 000 loss resulting from the sale of machinery for $270 000
cash. Machinery was purchased at a cost of $750 000.
IS
O IB
The following balances are reported on Gee Electronics’s comparative statement of finan-
cial position as at 30 June.
G E E E L E C T RO N I C S L T D
Statement of Financial Position (partial)
T U
T
2011 2010
Cash $672 000 $130 000
Accounts receivable 775 000 610 000
Inventory 834 000 867 000
Accounts payable 521 000 501 000
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Income tax expense of $353 000 represents the amount paid during the year. Dividends
declared and paid during the year totalled $200 000.
Instructions
(a) Prepare the statement of cash flows using the direct method.
OR
(b) Prepare the statement of cash flows using the indirect method.
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ACTION PLAN
■ Apply the same data Solution to demonstration problem

to the preparation of a
statement of cash flows (a) G E E E L E C T RO N I C S L T D
under both the direct and Statement of Cash Flows — Direct Method
indirect methods. for the year ended 30 June 2011
■ Note the similarities of
the two methods: both Cash flows from operating activities $ 6 418 000 *
Cash receipts from customers
methods report the same Cash payments:
information in the investing For expenses $ 4 843 000 * *
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and financing sections. For income taxes 353 000 5 196 000
■ Note the differences Net cash from operating activities 1 222 000
between the two Cash flows from investing activities
Sale of machinery 270 000
methods: the cash flows
Purchase of machinery (750 000)
from operating activities
sections report different Cash flows from financing activities
information (but the Payment of cash dividends (200 000)
amount of net cash from Net increase in cash 542 000
(used by) operating Cash at beginning of period 130 000
activities is the same for Cash at end of period $ 672 000
both methods).
5_60_19251_POFA_2E_ch18.indd 740 7/25/09 10:13:29 AM

Direct method calculations:

* Calculation of cash receipts from customers:
Sales revenue per the income statement $ 6 583 000
Less increase in accounts receivable 165 000
Cash receipts from customers $ 6 418 000
* * Calculation of cash payments for expenses:
Expenses per the income statement $ 4 920 000
Deduct loss from sale of machinery (24 000)
Deduct decrease in inventory (33 000)
Deduct increase in accounts payable (20 000)
Cash payments for expenses $ 4 843 000
D
N R
(b) G E E E L E C T RO N I C S L T D
Statement of Cash Flows — Indirect Method
IS
O IB
Profit $ 430 000
T U
Loss on sale of machinery 24 000
T
Increase in accounts receivable (165 000)

Decrease in inventory 33 000
Increase in accounts payable 20 000 792 000
Net cash from operating activities 1 222 000
FO TI
Sale of machinery 270 000
Purchase of machinery (750 000)
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SUMMARY OF LEARNING OBJECTIVES
1. Indicate the usefulness of the statement of cash flows involves three major steps: (1) determine net cash
flows. The statement of cash flows provides informa- from (used by) operating activities by adjusting each
tion about the cash receipts and cash payments during a item in the income statement from the accrual basis to the
period categorised by operating, investing and financing cash basis (2) analyse changes in non-current asset and
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activities. liability accounts and record as investing and financing

2. Distinguish among operating, investing and financ- activities or as significant non-cash transactions; (3) com-
ing activities. Operating activities include the cash ef- pare the net change in cash on the statement of cash
fects of transactions that enter into the determination of flows with the change in the cash account reported on the
profit. Investing activities involve cash flows resulting statement of financial position to make sure the amounts
from changes in investments and non-current asset items. agree.
Financing activities involve cash flows resulting from 4. Prepare a statement of cash flows using the indirect
changes in non-current liability and shareholders’ equity method. The preparation of a statement of cash flows
items. involves three major steps: (1) determine net cash from
3. Prepare a statement of cash flows using the di- (used by) operating activities, by adjusting profit for items
rect method. The preparation of the statement of cash that do not affect cash (2) analyse changes in non-current
5_60_19251_POFA_2E_ch18.indd 741 7/25/09 10:13:29 AM

asset and liability accounts and record as investing and 5. Understand the concept of free cash flow. The statement
financing activities or as significant non-cash transactions; of cash flows can be used for cash-based ratio analysis.
(3) compare the net change in cash on the statement of cash Free cash flow provides information about an entity’s
flows with the change in the cash account reported on the cash-generating capabilities. It is calculated as cash from
statement of financial position to make sure the amounts operating activities less capital expenditures and cash
agree. dividends.
KEY TERMS
Cash (p. 719) Indirect method (p. 730)
Cash equivalents (p. 719) Investing activities (p. 716)
D
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Direct method (p. 722) Operating activities (p. 716)
Financing activities (p. 716) Statement of cash flows (p. 715)
Free cash flow (p. 738)
IS
O IB
LEARNING APPENDIX — USING A WORKSHEET TO
OBJECTIVE 6
PREPARE THE STATEMENT OF CASH
T U
T
Explain the guidelines

and procedural steps in FLOWS — INDIRECT METHOD
using a worksheet to When preparing a statement of cash flows, numerous adjustments to profit may be necessary. In
prepare the statement such cases, a worksheet is often used to assemble and classify the data that will appear on the
of cash flows using the statement. The worksheet is merely an aid in the preparation of the statement. Its use is optional.
FO TI
indirect method. The skeleton format of the worksheet for preparation of the statement of cash flows is shown in
figure 18A.1.
Figure 18A.1 Format of

worksheet XYZ L T D
Worksheet
for the year ended . . .
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End of Reconciling items End of
last year current year
Statement of financial position accounts balance Debits Credits balance
Debit balance accounts XX XX XX XX
XX XX XX XX
Totals XXX XXX
Credit balance accounts XX XX XX XX
XX XX XX XX
Totals XXX XXX
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Statement of cash flows effects

Operating activities
Profit XX
Adjustments to profit XX XX
Investing activities
Receipts and payments XX XX
Financing activities
Receipts and payments XX XX
Totals XXX XXX
Increase (decrease) in cash (XX) XX
Totals XXX XXX
5_60_19251_POFA_2E_ch18.indd 742 7/25/09 10:13:29 AM

The following guidelines are important in using a worksheet.

1. In the statement of financial position accounts section, accounts with debit balances are listed
separately from those with credit balances. This means, for example, that Accumulated Depre-
ciation is listed under credit balances and not as a contra account under debit balances. The
beginning and ending balances of each account are entered in the appropriate columns. The
transactions that caused the change in the account balance during the year are entered as rec-
onciling items in the two middle columns.
After all reconciling items have been entered, each line pertaining to a statement of financial
position account should ‘foot across’. That is, the beginning balance plus or minus the recon-
ciling item(s) must equal the ending balance. When this agreement exists for all statement of
financial position accounts, all changes in account balances have been reconciled.
2. The bottom portion of the worksheet consists of the operating, investing and financing activi-
D
ties sections. It provides the information necessary to prepare the formal statement of cash
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flows. Inflows of cash are entered as debits in the reconciling columns. Outflows of cash are
entered as credits in the reconciling columns. Thus, in this section, the sale of equipment for
cash at carrying amount is entered as a debit under investing activities. Similarly, the purchase
IS
of land for cash is entered as a credit under investing activities.

O IB
3. The reconciling items shown in the worksheet are not entered in any journal or posted to any
account. They do not represent either adjustments or corrections of the statement of financial
position accounts. They are used only to facilitate the preparation of the statement of cash flows.
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Preparing the worksheet
T
As in the case of worksheets illustrated in earlier chapters, the preparation of a worksheet involves
a series of prescribed steps. The steps in this case are:
1. Enter in the statement of financial position accounts section the statement of financial position
accounts and their beginning and ending balances.
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2. Enter in the reconciling columns of the worksheet the data that explain the changes in the
statement of financial position accounts other than cash and their effects on the statement of
cash flows.
3. Enter on the cash line and at the bottom of the worksheet the increase or decrease in cash. This
entry should enable the totals of the reconciling columns to be in agreement.
To illustrate the preparation of a worksheet, we will use the 2011 data for Bronze Ltd. Your
familiarity with these data should help you understand the use of a worksheet. For ease of refer-
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ence, the comparative statement of financial position, income statement and selected data for
2011 are presented in figure 18A.2 below and on the next page.
Figure 18A.2 Comparative

B RO N Z E L T D statement of financial position,
Statement of Financial Position income statement and
as at 30 June additional information for
Bronze Ltd
Change in
account balance
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Current assets
Cash $ 55 000 $ 33 000 $ 22 000 Increase
Prepaid expenses 5 000 1 000 4 000 Increase
Property, plant and equipment
Land 130 000 20 000 110 000 Increase
Building 160 000 40 000 120 000 Increase
Accumulated depreciation — building (11 000 ) (5 000 ) 6 000 Increase
Accumulated depreciation — equipment (3 000 ) (1 000 ) 2 000 Increase
Total assets $ 398 000 $ 138 000
(continued)
5_60_19251_POFA_2E_ch18.indd 743 7/25/09 10:13:30 AM

Figure 18A.2 Continued

Current liabilities
Accounts payable $ 28 000 $ 12 000 $ 16 000 Increase
Income tax payable 6 000 8 000 2 000 Decrease
Non-current liabilities
Bonds payable 130 000 20 000 110 000 Increase
Shareholders’ equity
B RO N Z E L T D
D
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Income Statement

IS

O IB
T U
T
Profit $145 000
Additional information for 2011:

1. The company declared and paid a $29 000 cash dividend.
2. The company obtained land through the issue of $110 000 of non-current bonds to the seller of the
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land.
3. A building costing $120 000 was purchased for cash. Equipment costing $25 000 was also purchased for
cash.
4. The company sold equipment with a carrying amount of $7 000 (cost $8 000, less accumulated
depreciation $1 000) for $4 000 cash.
5. Issued ordinary shares for $20 000 cash.
6. Depreciation expense comprised $6 000 for building and $3 000 for equipment.
Determining the reconciling items

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Several approaches may be used to determine the reconciling items. For example, the changes
affecting net cash from (used by) operating activities can be completed first, and then the effects
of financing and investing transactions can be determined. Or, the statement of financial position
accounts can be analysed in the order in which they are listed on the worksheet. We will follow
this latter approach for Bronze Ltd, except for cash. As indicated above, cash is handled last.
Accounts receivable
The decrease of $10 000 in accounts receivable means that cash collections from sales revenue
are higher than the sales revenue reported in the income statement. To convert profit to net cash
from (used by) operating activities, the decrease of $10 000 is added to profit. The entry in the
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reconciling columns of the worksheet is:
(a) Operating — Decrease in Accounts Receivable 10 000

Accounts Receivable 10 000
Inventory
Bronze Ltd’s Inventory balance increases $5000 during the period. The Inventory account reflects
the difference between the amount of inventory that has been purchased and the amount that
has been sold. For Bronze Ltd this means that the cost of inventory purchased exceeds the cost
of sales by $5000. As a result, cost of sales does not reflect $5000 of cash payments made for
5_60_19251_POFA_2E_ch18.indd 744 7/25/09 10:13:30 AM

inventory. This inventory increase of $5000 during the period is deducted from profit to arrive at
net cash from (used by) operating activities. The worksheet entry is shown below.
(b) Inventory 5 000

Operating — Increase in Inventory 5 000
Prepaid expenses
An increase of $4000 in prepaid expenses means that expenses deducted in determining profit are
less than expenses that were paid in cash. The increase of $4000 must be deducted from profit in
determining net cash from (used by) operating activities. The worksheet entry is:
D
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(c) Prepaid Expenses 4 000
Operating — Increase in Prepaid Expenses 4 000
Land
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HELPFUL HINT
O IB
The increase in land of $110 000 resulted from a purchase through the issue of non-current bonds.
This transaction should be reported as a material non-cash investing and financing activity. The
These amounts are
worksheet entry is:
asterisked in the
worksheet to indicate
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(d) Land 110 000
T
that they result from

Bonds Payable 110 000
a material non-cash
transaction.
Building
The cash purchase of a building for $120 000 is an investing activity cash outflow. The entry in
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the reconciling columns of the worksheet is:
(e) Building 120 000

Investing — Purchase of Building 120 000
Equipment
The increase in equipment of $17 000 resulted from a cash purchase of $25 000 and the sale of
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equipment costing $8000. The carrying amount of the equipment was $7000, the cash proceeds
were $4000 and a loss of $3000 was recorded. The worksheet entries are:
(f) Equipment 25 000

Investing — Purchase of Equipment 25 000
(g) Investing — Sale of Equipment 4 000
Operating — Loss on Sale of Equipment 3 000
Accumulated Depreciation — Equipment 1 000
Equipment 8 000
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Accounts payable
The increase of $16 000 in accounts payable must be added to profit to determine net cash from
(used by) operating activities. The following worksheet entry is made.
(h) Operating — Increase in Accounts Payable 16 000

Accounts Payable 16 000
Income taxes payable

When a company incurs income tax expense but has not yet paid its taxes, it records income tax
payable. A change in the Income Tax Payable account reflects the difference between income
5_60_19251_POFA_2E_ch18.indd 745 7/25/09 10:13:30 AM

tax expense incurred and income tax actually paid. Bronze Ltd’s Income Tax Payable account
decreases by $2000. That means the $47 000 of income tax expense reported on the income state-
ment was $2000 less than the amount of taxes paid during the period of $49 000. To adjust profit
to a cash basis, profit must be reduced by $2000. The worksheet entry is:
(i) Income Taxes Payable 2 000

Operating — Decrease in Income Taxes Payable 2 000
Bonds payable
The increase of $110 000 in this account resulted from the issue of bonds for land. This is a
material non-cash investing and financing activity. Worksheet entry (d) on page 745 is the only
D
entry necessary.
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Share capital
The statement of financial position reports an increase in share capital of $20 000. The additional
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information section notes that this increase resulted from the issue of new shares. This is a cash
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inflow reported in the financing section. The worksheet entry is:
(j) Financing — Issue of Ordinary Shares 20 000

Ordinary Share Capital 20 000
T U
T
Accumulated depreciation — building, and accumulated

depreciation — equipment
Increases in these accounts of $6000 and $3000, respectively, resulted from depreciation expense.
Depreciation expense is a non-cash charge that must be added to profit to determine net cash
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from (used by) operating activities. The worksheet entries are:
(k) Operating — Depreciation Expense — Building 6 000

Accumulated Depreciation — Building 6 000
(l) Operating — Depreciation Expense — Equipment 3 000
Accumulated Depreciation — Equipment 3 000
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Retained earnings
The $116 000 increase in retained earnings resulted from profit of $145 000 and the declaration
and payment of a $29 000 cash dividend. Profit is included in net cash from (used by) operating
activities, and the dividends are a financing activity cash outflow. The entries in the reconciling
columns of the worksheet are:
(m) Operating — Profit 145 000

Retained Earnings 145 000
(n) Retained Earnings 29 000
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Financing — Payment of Dividends 29 000
Change in cash
The company’s cash increased $22 000 in 2011. The final entry on the worksheet, therefore, is:
(o) Cash 22 000

Increase in Cash 22 000
As shown in the worksheet, the increase in cash is entered in the reconciling credit column as a
balancing amount. This entry should complete the reconciliation of the changes in the statement
of financial position accounts. Also, it should permit the totals of the reconciling columns to be
5_60_19251_POFA_2E_ch18.indd 746 7/25/09 10:13:31 AM

in agreement. When all changes have been explained and the reconciling columns are in agree-
ment, the reconciling columns are ruled to complete the worksheet. The completed worksheet for
Bronze Ltd is shown in figure 18A.3.
Figure 18A.3 Completed

B RO N Z E L T D worksheet — indirect method
Worksheet
Reconciling items
Statement of financial Balance Balance
position accounts 30/6/10 Debits Credits 30/6/11
Debits
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Cash 33 000 (o) 22 000 55 000
Accounts Receivable 30 000 (a) 10 000 20 000
Inventory 10 000 (b) 5 000 15 000
Prepaid Expenses 1 000 (c) 4 000 5 000
Land 20 000 (d) 110 000 * 130 000
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Building 40 000 (e) 120 000 160 000
Equipment 10 000 (f) 25 000 (g) 8 000 27 000
Totals 144 000 412 000
Credits
Accounts Payable 12 000 (h) 16 000 28 000
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Income Taxes Payable 8 000 (i) 2 000 6 000

Bonds Payable 20 000 (d) 110 000* 130 000
Accumulated Depreciation —
Building 5 000 (k) 6 000 11 000
Accumulated Depreciation —
Equipment 1 000 (g) 1 000 (l) 3 000 3 000
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Share Capital 50 000 (j) 20 000 70 000
Retained Earnings 48 000 (n) 29 000 (m) 145 000 164 000
Totals 144 000 412 000
Statement of cash flows effects

Operating activities
Profit (m) 145 000
Decrease in accounts receivable (a) 10 000
Increase in inventory (b) 5 000
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Increase in prepaid expenses (c) 4 000
Increase in accounts payable (h) 16 000
Decrease in income taxes payable (i) 2 000
Depreciation expense — building (k) 6 000
Depreciation expense — equipment (l) 3 000
Loss on sale of equipment (g) 3 000
Investing activities
Purchase of building (e) 120 000
Purchase of equipment (f) 25 000
Sale of equipment (g) 4 000
Financing activities
Issue of ordinary shares (j) 20 000
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Payment of dividends (n) 29 000

Totals 525 000 503 000
Increase in cash (o) 22 000
Totals 525 000 525 000
*Material non-cash investing and financing activity.
Preparing the statement

The statement of cash flows is prepared primarily from the data that appear in the worksheet
under ‘statement of cash flows effects’. The reconciling columns should also be scanned for any
asterisked items that designate material non-cash activities. The formal statement was shown in
figure 18.29 (page 736).
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SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX

6. Explain the guidelines and procedural steps in using credits; (3) do not enter reconciling items in any journal
a worksheet to prepare the statement of cash flows or account, but use them only to help prepare the cash flow
using the indirect method. When there are numerous statement.
adjustments, a worksheet can be a helpful tool in prepar- The steps in preparing the worksheet are (1) enter begin-
ing the statement of cash flows. Key guidelines for using ning and ending balances of statement of financial posi-
a worksheet are: (1) list accounts with debit balances tion accounts; (2) enter debits and credits in reconciling
separately from those with credit balances; (2) in the columns; (3) enter the increase or decrease in cash in two
reconciling columns in the bottom portion of the work- places as a balancing amount.
sheet, show cash inflows as debits and cash outflows as
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* Note: All asterisked questions, exercises and problems relate to material
SELF-STUDY QUESTIONS in the appendixes to the chapter.
Answers are at the end of the chapter. 7. Which of the following about the statement of cash flows is (LO 2)
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(LO 1) 1. Which of the following is incorrect about the statement of incorrect?
cash flows? (a) The direct method may be used to report cash from
(a) It is a financial statement. operations.
(b) It provides information about cash receipts and cash (b) The statement shows the cash used (by) in three
payments of an entity during a period. categories of activity.
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(c) The operating section is the last section of the statement
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(c) It reconciles the ending cash account balance to the

balance per the bank statement. presented.
(d) It provides information about the operating, investing (d) The indirect method may be used to report cash provided
and financing activities of the entity. in operations.
(LO 2) 2. The statement of cash flows classifies cash receipts and cash Questions 8 and 9 apply only to the indirect method.
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payments by the following activities: 8. Profit is $264 000. During the year, accounts payable (LO 4)
(a) operating and non-operating. increased $20 000, inventory decreased $12 000, and
(b) investing, financing and operating. accounts receivable increased $24 000. Under the
(c) financing, operating and non-operating. indirect method, net cash from operating
(d) investing, financing and non-operating. activities is:
(a) $248 000.
(LO 2) 3. An example of a cash flow from an operating
(b) $204 000.
activity is:
(c) $272 000.
(a) payment of cash to lenders for interest.
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(d) $224 000.
(b) receipt of cash from the sale of shares.
(c) payment of cash dividends to the company’s 9. Non-cash charges that are added back to profit in (LO 4)
shareholders. determining cash provided in operating activities under the
(d) None of the above. indirect method do not include:
(a) depreciation expense.
(LO 2) 4. An example of a cash flow from an investing activity is: (b) an increase in inventory.
(a) receipt of cash from the issue of bonds payable. (c) amortisation expense.
(b) payment of cash to repurchase issued shares. (d) loss on sale of equipment.
(c) receipt of cash from the sale of equipment.
Questions 10 and 11 apply only to the direct method.
(d) payment of cash to suppliers for inventory.
10. The beginning balance in accounts receivable is $88 000. (LO 3)
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(LO 2) 5. Cash dividends paid to shareholders are classified on the The ending balance is $84 000. Sales during the period are
statement of cash flows as: $258 000. Cash receipts from customers are:
(a) operating activities. (a) $254 000.
(b) investing activities. (b) $258 000.
(c) a combination of the above. (c) $262 000.
(d) financing activities. (d) $282 000.
(LO 2) 6. An example of a cash flow from a financing 11. Which of the following items is reported on a statement of (LO 3)
activity is: cash flows prepared by the direct method?
(a) receipt of cash from sale of land. (a) Loss on sale of building
(b) issue of debt for cash. (b) Increase in accounts receivable
(c) purchase of equipment for cash. (c) Depreciation expense
(d) None of the above. (d) Cash payments to suppliers
5_60_19251_POFA_2E_ch18.indd 748 7/25/09 10:13:31 AM

(LO 1) 12. The statement of cash flows should not be used to evaluate (b) Australian equivalents to IFRSs require entities to
an entity’s ability to: present cash from operating activities using the direct
(a) earn profit. method.
(b) generate future cash flows. (c) Australian equivalents to IFRSs require entities to
(c) pay dividends. present cash from operating activities on the statement
(d) meet obligations. of cash flows using the indirect method.
(LO 6) *13. In a worksheet for the statement of cash flows, a decrease (d) International Financial Reporting Standards (IFRSs)
in accounts receivable is entered in the reconciling require entities to present cash from operating
columns as a credit to Accounts Receivable and a debit activities on the statement of cash flows using the
in the: direct method.
(a) investing activities section. 15. Ting Computers reported $150 000 cash provided in (LO 5)
(b) operating activities section. operating activities. The company paid a dividend of
(c) financing activities section.
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$30 000. In order to maintain operating capacity, the

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(d) None of the above. company invested $50 000 in computer equipment. What
(LO 3,4) 14. Which of the following statements is correct? is Ting’s free cash flow?
(a) International Financial Reporting Standards (IFRSs) (a) $150 000
allow entities to present cash from operating activities (b) $200 000
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on the statement of cash flows using either the direct or (c) $170 000
indirect method. (d) $70 000
QUESTIONS
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1. What is the statement of cash flows? 14. Identify five items that are adjustments to reconcile profit
2. Omar Morena maintains that the statement of cash flows is to net cash from (used by) operating activities under the
an optional financial statement. Do you agree? Explain. indirect method.
3. Why is the statement of cash flows useful? 15. Why and how is depreciation expense reported in a
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statement of cash flows prepared using the indirect
4. Distinguish among the three types of activities reported in method?
the statement of cash flows.
16. Identify two non-cash charges other than depreciation
5. Would a cash deposit with a maturity of 6 months be expense that are treated like depreciation expense in a
regarded as a cash equivalent? statement of cash flows.
6. What are the major sources (inflows) of cash in a statement 17. During 2010, Omar Khan Ltd converted $800 000 of its total
of cash flows? What are the major uses (outflows) of cash? $ 1000 000 of bonds payable into ordinary shares. Indicate
7. Why is it important to disclose certain non-cash how the transaction would be reported on a statement of
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transactions? How should they be disclosed? cash flows, if at all.
8. George Burns and Gracie Allen were discussing the 18. Describe the direct method for determining net cash from
presentation format of the statement of cash flows of Classic (used by) operating activities.
Comedy Ltd. At the bottom of Classic Comedy’s statement of 19. Give the formulas under the direct method for computing
cash flows was a separate section entitled ‘Non-cash investing (a) cash receipts from customers and (b) cash payments to
and financing activities’. Give three examples of significant suppliers.
non-cash transactions that would be reported in this section.
20. George Dong Ltd reported sales of $6 million for 2010.
9. Why is it necessary to use a comparative statement of Accounts receivable decreased $1.2 million and accounts
financial position, a current income statement and certain payable increased $325 000. Calculate cash receipts from
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transaction data in preparing a statement of cash flows? customers, assuming that the receivable and payable
10. When the total cash inflows exceed the total cash outflows, transactions related to operations.
how and where is this excess identified? 21. Why is depreciation expense not reported in the direct-
11. Describe the indirect method for determining net cash from method net cash flow from operating activities section?
(used by) operating activities. 22. What does free cash flow indicate, and how is it calculated?
12. Why is it necessary to convert accrual-based profit to 23. A Company sold PPE for $500 000 and acquired new PPE
cash-based profit when preparing a statement of cash flows? for $800 000 during the year. Can the company report cash
13. The CEO of Ming Ltd is puzzled. During the year, the outflows for PPE of $300 000 in the statement of cash flows?
company incurred loss of $800 000, yet its cash increased *24. Why is it advantageous to use a worksheet when preparing a
$300 000 during the same period. Explain to the CEO how statement of cash flows? Is a worksheet required to prepare a
this situation could occur. statement of cash flows?
5_60_19251_POFA_2E_ch18.indd 749 7/25/09 10:13:32 AM

BRIEF EXERCISES
Calculate net cash from (used BE18.1 Reliance Ltd reported profit of $5 million in 2010. Depreciation for the year was $180 000,
by) operating activities — accounts receivable decreased $700 000, and accounts payable decreased $155 000. Calculate
indirect method. net cash from (used by) operating activities using the indirect approach.
(LO 4)
Calculate net cash from (used BE18.2 The profit for Karen Chung for 2010 was $140 000. For 2010, depreciation on PPE assets was
by) operating activities — $30 000, and the company incurred a loss on sale of PPE assets of $5000. Calculate net cash
indirect method. from (used by) operating activities under the indirect method.
(LO 4)
Indicate statement presentation BE18.3 Each of the following items must be considered in preparing a statement of cash flows for
of selected transactions. Catherine Ho Ltd for the year ended 31 December 2010. For each item, state how it should
(LO 2) be shown in the statement of cash flows for 2010.
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(a) Issued bonds for $300 000 cash.

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(b) Purchased equipment for $140 000 cash.
(c) Sold land costing $20 000 for $20 000 cash.
(d) Declared and paid a $50 000 cash dividend.
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Calculate net cash from (used BE18.4 The statement of financial position for Mogilny Ltd shows the following changes in non-
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by) operating activities using cash current asset accounts: accounts receivable decrease $75 000, prepaid expenses increase
indirect method. $16 000 and inventories increase $30 000. Calculate net cash from (used by) operating activi-
(LO 4) ties using the indirect method, assuming that profit is $250 000.
Classify items by activities. BE18.5 Classify the following items as an operating, investing, or financing activity. Assume all items
(LO 2) involve cash unless there is information to the contrary.
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(a) Payments to suppliers.

(b) Cash receipts from commissions.
(c) Share buy back.
(d) Acquisition of property.
(e) Depreciation.
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(f) Repayment of loan.
Calculate receipts from BE18.6 Taza Ltd has accounts receivable of $28 000 as at 1 July 2010 and $42 000 as at 30 June 2011.
customers using direct method. Sales revenue for 2011 was $470 000. What is the amount of cash receipts from customers in
(LO 3) 2011?
Calculate cash payments for BE18.7 Pelican Ltd reported income taxes of $87 000 in its 2011 income statement and income taxes
income taxes using direct payable of $14 000 as at 30 June 2010 and $9000 as at 30 June 2011. What amount of cash
method. payments was made for income taxes during 2011?
(LO 3)
Calculate cash payments for BE18.8 Willis Ltd reports expenses of $200 000 excluding depreciation expense of $30 000 for 2011.
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expenses using direct method. During the year prepaid expenses decreased $15 000, and accrued expenses payable increased
(LO 3) $4500. Calculate the cash payments for expenses in 2011.
Calculate cash and cash BE18.9 ABD Ltd has cash $20 000, Deposits 30 Days $100 000, Deposits 180 Days $250 000, Share
equivalents. Investments $50 000 and Bank Overdraft $30 000. Calculate ABD’s cash and cash equivalents.
(LO 3, 4)
Determine cash received in sale BE18.10 The T accounts for Equipment and the related Accumulated Depreciation for Wanda Fish Ltd
of equipment. at the end of 2011 are as follows.
(LO 3, 4) Equipment Accumulated Depreciation
Beg. bal. 80 000 Disposals 22 000 Disposals 5 500 Beg. bal. 44 500
Acquisitions 41 600 Depr. 12 000
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End. bal. 99 600 End. bal. 51 000

Wanda Fish Ltd’s income statement reported a loss on the sale of equipment of $4100. What
amount was reported on the statement of cash flows as ‘Cash flow from sale of equipment’?
Identify financing activity BE18.11 The following T account is a summary of the cash account of Boger Ltd.
transactions. Cash (summary form)
(LO 2)
Balance, 1/7/10 8 000 Payments for goods 200 000
Receipts from customers 364 000 Payments for expenses 140 000
Dividends on share investments 6 000 Interest paid 10 000
Proceeds from sale of equipment 36 000 Taxes paid 8 000
Proceeds from issue of bonds Dividends paid 41 000
payable 200 000
Balance, 30/6/11 215 000
5_60_19251_POFA_2E_ch18.indd 750 7/25/09 10:13:32 AM

For Boger Ltd what amount of net cash from financing activities should be reported in the
statement of cash flows?
BE18.12 Matt Mathers Ltd reported cash from operations of $450 000, cash expenditure on capital Calculate free cash flow.
assets of $110 000 and $40 000 of dividends paid. Calculate the free cash flow. (LO 5)
EXERCISES
E18.1 Amy Leung Ltd had the following transactions during 2011. Classify transactions by type of
1. Issued $50 000 ordinary shares for cash. activity.
2. Collected $11 000 of accounts receivable. (LO 2)
3. Declared and paid a cash dividend of $25 000.
4. Sold a non-current investment with a cost of $15 000 for $15 000 cash.
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5. Issued $200 000 ordinary shares upon conversion of bonds with a value of $200 000.
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6. Paid $14 000 on accounts payable.
7. Purchased a machine for $30 000 giving a non-current note in exchange.
Instructions
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Analyse the transactions above and indicate whether each transaction resulted in a cash flow
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from (used by) (a) operating activities, (b) investing activities, (c) financing activities or
(d) non-cash investing and financing activities.
E18.2 Bombay Ltd reported profit of $117 000 for 2011. Bombay also reported depreciation expense Prepare the operating activities
of $15 000 and a loss of $3000 on the sale of equipment. The statement of financial position section — indirect method.
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shows an increase in accounts receivable of $9000 for the year, a $4800 increase in accounts (LO 4)
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payable and a decrease in prepaid expenses of $4200.

Instructions
Prepare the operating activities section of the statement of cash flows for 2011 using the
indirect method.
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E18.3 The current sections of Backpacker Hostel Ltd’s statement of financial position as at 30 June Prepare the operating activities
2011 and 2010 are presented below. section — indirect method.
(LO 4)
B AC K PAC K E R H O S T E L L T D
Statement of Financial Position (partial)
as at 30 June
2011 2010
Current assets
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Cash $ 105 000 $ 99 000
Inventory 171 000 186 000
Prepaid expenses 27 000 32 000
Total current assets $ 413 000 $ 402 000
Current liabilities
Accrued expenses payable $ 15 000 $ 5 000
Total current liabilities $ 103 000 $ 97 000
Backpacker Hostel’s profit for 2011 was $163 000. Depreciation expense was $30 000.
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Instructions
Prepare the net cash from (used by) operating activities section of Backpacker Traveller’s
statement of cash flows for the year ended 30 June 2011 using the indirect method.
E18.4 Presented below are three accounts that appear in the general ledger of Karen Weller Ltd Prepare a partial statement of
during the reporting period. cash flows — indirect method.
Equipment (LO 4)
Date Debit Credit Balance
Jan. 1 Balance 192 000
July 31 Purchase of equipment 84 000 276 000
Sept. 2 Cost of equipment constructed 63 600 339 600
Nov. 10 Cost of equipment sold 54 000 285 600
(continued)
5_60_19251_POFA_2E_ch18.indd 751 7/25/09 10:13:32 AM

Accumulated Depreciation — Equipment

Nov. 10 Accumulated depreciation on
equipment sold 42 000 43 200
Dec. 31 Depreciation for year 28 800 72 000
Retained Earnings
Aug. 23 Dividends (cash) 16 800 109 200
Dec. 31 Profit 73 200 182 400
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Instructions
From the postings in the accounts above, indicate how the information is reported on a
statement of cash flows by preparing a partial statement of cash flows using the indirect
method. The loss on sale of equipment was $7200.
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Statements of financial position for Luc Nguyen Ltd are presented below.
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Prepare a statement of cash E18.5
flows — indirect method.
(LO 4, 5)
LUC NGUYEN LTD
as at 31 December
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Assets 2011 2010

Cash $ 116 000 $ 44 000
Inventory 360 000 378 000
Land 160 000 200 000
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Equipment 520 000 400 000
Accumulated depreciation (132 000 ) (84 000 )
Total assets $1194 000 $1090 000

Accounts payable $ 68 000 $ 94 000
Bonds payable 300 000 400 000
Share capital 388 000 328 000
Retained earnings 438 000 268 000
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Total liabilities and shareholders’ equity $1194 000 $1090 000
Additional information:
1. Profit for 2011 was $125 000.
2. Cash dividends of $80 000 were declared and paid.
3. Bonds payable amounting to $100 000 were redeemed for cash $100 000.
5. Depreciation expense was $48 000.
6. Sales for the year were $195 600.
Instructions
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(a) Prepare a statement of cash flows for 2011 using the indirect method.
(b) Calculate free cash flow.
Classify transactions by type of E18.6 An analysis of the comparative statement of financial position, the current year’s income
activity. statement and the general ledger accounts of Homer Winslow Ltd uncovered the following
(LO 2) items. Assume all items involve cash unless there is information to the contrary.
1. Issue of ordinary shares. 8. Purchase of land.
2. Amortisation of patent. 9. Payment of dividends.
3. Issue of bonds for land. 10. Sale of building at carrying amount.
4. Payment of interest on bonds payable. 11. Exchange of land for patent.
5. Conversion of bonds into ordinary shares. 12. Depreciation.
6. Sale of land at a loss. 13. Redemption of bonds.
7. Receipt of dividends on investment in shares. 14. Receipt of interest on bonds receivable.
5_60_19251_POFA_2E_ch18.indd 752 7/25/09 10:13:33 AM

Instructions
Indicate how the above items should be classified in the statement of cash flows using the
following four major classifications: operating activity (indirect method), investing activity,
financing activity, and significant non-cash investing and financing activity.
E18.7 Kuman Ltd has just completed its first year of operations on 31 December 2011. Its initial Calculate net cash from
income statement showed that the company had sales revenue of $137 000 and expenses operating activities — direct
of $81 000. Accounts receivable at year-end were $42 000. Accounts payable at year-end method.
were $37 000. Assume that accounts payable related to utility expenses. Ignore income (LO 3)
taxes.
Instructions
Calculate net cash from (used by) operating activities using the direct method.
E18.8 The income statement for Alatorre Ltd shows cost of sales $317 000 and expenses Calculate cash payments —
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(excluding depreciation) $250 000. The comparative statement of financial position for the direct method.
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year shows that inventory increased $6000, prepaid expenses decreased $6000, accounts (LO 3)
payable (inventory suppliers) decreased $8000 and accrued expenses payable increased
$8000.
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Instructions
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Using the direct method, calculate (a) cash payments to suppliers and (b) cash payments for
expenses.
E18.9 The current reporting period accounting records of Malay Ltd reveal the following transac- Calculate net cash flow from
tions and events. operating activities — direct
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method.
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Payment of interest $ 4 000 Collection of accounts receivable $ 170 000 (LO 2, 3)

Cash sales 38 000 Payment of salaries and wages 65 000
Receipt of dividend revenue 14 000 Depreciation expense 24 000
Payment of income taxes 15 000 Proceeds from sale of aircraft 812 000
Profit 38 000 Purchase of equipment for cash 22 000
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Payment of accounts payable Loss on sale of aircraft 3 000
for inventory 90 000 Payment of dividends 14 000
Payment for land 74 000 Payment of expenses 20 000
Instructions
Prepare the cash flows from operating activities section using the direct method. (Not all of
the above items will be used.)
E18.10 The following information is taken from the 2011 general ledger of Ed Bradley Ltd. Calculate cash flows — direct
method.
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Rent Rent expense $ 33 000 (LO 3)
Prepaid rent, 1 January 7 900
Prepaid rent, 31 December 3 000
Salaries Salaries expense $ 54 000
Salaries payable, 1 January 3 000
Salaries payable, 31 December 9 000
Sales Revenue from sales $ 180 000
Accounts receivable, 1 January 12 000
Accounts receivable, 31 December 7 000
Instructions
In each of the above cases, calculate the amount that should be reported in the operating
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activities section of the statement of cash flows using the direct method.
E18.11 Presented here is information for two companies in the same industry: Ying Ltd and Yang Ltd. Compare two companies by
using cash-based ratios.
Ying Ltd Yang Ltd (LO 5)
Cash from operations $300 000 $ 300 000
Capital expenditures 50 000 150 000
Cash dividends 80 000 100 000
Profit 200 000 200 000
Sales 400 000 800 000
Instructions
Calculate the free cash flow for each company. Comment on the ability of each to generate cash.
5_60_19251_POFA_2E_ch18.indd 753 7/25/09 10:13:33 AM

Calculate net cash f low. E18.12 According to a study by a Deutsche Bank analyst, shares with high defensive qualities —
(LO 5) high free cash flow yield and a low prospective price earnings ratio — include Telstra, James
Hardie, Aristocrat Leisure, Ansell and Harvey Norman.
Access the most recent financial statements for one of these companies. For each of
the years, calculate the company’s net cash flow from operating activities and free cash
flows.
Prepare a worksheet. *E18.13 Information for Luc Nguyen Ltd is presented in E18.5.
(LO 6) Instructions
Use the data in E18.5 to prepare a worksheet for a statement of cash flows for
2011. Enter the reconciling items directly on the worksheet, presenting the entries
alphabetically.
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PROBLEMS
Prepare the operating activities P18.1 The income statement of Good Pets is shown below.
section — indirect method.
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(LO 4) GOOD PETS
Income Statement
for the year ended 30 November 2011
Sales revenue $ 6 800 000
Cost of sales
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Beginning inventory $ 2 000 000

Purchases 4 300 000
Goods available for sale 6 300 000
Ending inventory 1 400 000
Cost of sales 4 900 000
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Gross profit 1 900 000
Expenses
Selling expenses 450 000
Administrative expenses 600 000 1 050 000
Profit $ 850 000
1. Accounts receivable decreased $230 000 during the year.
2. Prepaid expenses increased $150 000 during the year.
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3. Accounts payable to suppliers of inventory decreased $200 000 during the year.
4. Accrued expenses payable decreased $100 000 during the year.
5. Administrative expenses include depreciation expense of $90 000.
Instructions
Net cash from operating Prepare the operating activities section of the statement of cash flows for the year ended 30
activities $1 320 000 November 2011 for Good Pets using the indirect method.
Prepare the operating activities P18.2 Data for Good Pets are presented in P18.1.
section — direct method. Instructions
(LO 3)
Net cash from operating Prepare the operating activities section of the statement of cash flows using the direct
activities $1 320 000 method.
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Prepare the operating activities P18.3 Ana Alicia Ltd’s income statement for the year ended 31 December 2011 contained the fol-
section — direct method. lowing condensed information.
(LO 3)
Fee revenue $ 1 260 000
Expenses (excluding depreciation) $ 873 600
Profit $ 196 000
Alicia’s statement of financial position contained the following comparative data as at

31 December.
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chapter 18 The statement of cash flows 755
2011 2010
Accounts receivable $47 000 $57 000
Income taxes payable 4 000 7 000
(Accounts payable pertains to expenses.)
Instructions
Prepare the operating activities section of the statement of cash flows using the direct Net cash from operating
method. activities $314 400
p18.4 Data for Ana Alicia Ltd are presented in P18.3. Prepare the operating activities
section indirect method.
Instructions
(LO 4)
Prepare the operating activities section of the statement of cash flows for Ana Alicia Ltd Net cash from operating
using the indirect method. activities $314 400
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p18.5 The financial statements of Louis Zimmer Ltd appear below:

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Prepare a statement of cash
flows indirect method, and
Louis Zimmer Ltd perform analysis.
Statement of Financial Position (LO 4, 5)
as at 31 December
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Assets 2011 2010
Cash $ 31 000 $ 13 000
Inventory 25 000 35 000
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Property, plant and equipment 60 000 78 000
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Accumulated depreciation (22 000) (24 000)

Total assets $122 000 $116 000
Liabilities and Shareholders equity

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Total $122 000 $116 000
Louis Zimmer Ltd

Income Statement
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for the year ended 31 December 2011
Cost of sales 180 000
Gross profit 40 000
Selling expenses $14 000
Administrative expenses 8 000 22 000
Net profit $ 13 000
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1. Dividends declared and paid were $4000.
2. During the year equipment was sold for $8500 cash. This equipment cost $18 000
originally and had a carrying amount of $8500 at the time of sale.
3. All depreciation expense is in the selling expense category.
(a) Net cash from operating
4. All sales and purchases are on account. activities $17 500
Instructions Prepare a statement of cash
(a) Prepare a statement of cash flows using the indirect method. flows direct method, and
(b) Calculate free cash flow. perform analysis.
p18.6 Data for Louis Zimmer Ltd are presented in P18.5. Further analysis reveals the following. (LO 3, 5)
1. Accounts payable relate to inventory suppliers.

2. All expenses except for depreciation were paid in cash.
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Instructions
(a) Cash receipts from (a) Prepare a statement of cash flows for Louis Zimmer Ltd using the direct method.
customers $206 000 (b) Calculate free cash flow.
Prepare a statement of cash P18.7 The financial statements of Ernest Banks Ltd appear below.
flows — indirect method.
(LO 4) ERNEST BANKS LTD
as at 31 December
Assets 2011 2010

Cash $ 11 500 $ 6 500
Inventory 10 000 13 500
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Land 20 000 20 000
Property, plant and equipment 100 000 112 500
Less: Accumulated depreciation (25 000 ) (33 750)
Total assets $ 138 500 $ 141 750
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Accrued expenses payable 4 750 3 750
Interest payable 500 750
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ERNEST BANKS LTD
Income Statement
for the year ended 31 December 2011
Income
Gain on sale of PPE assets 1 250 $301 250
Less: Expenses
Cost of sales 250 000
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Other expenses (excluding depreciation) 30 000
Income tax expense 4 500 290 750
Profit $ 10 500
1. PPE assets were sold at a sales price of $31 250.
2. Additional equipment was purchased at a cost of $30 000.
3. Dividends of $4250 were paid.
4. All sales and purchases were on account.
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5. Bonds were redeemed at face value.

6. Additional shares were issued for cash.
Net cash from operating Instructions
activities $14 000; Investing Prepare a statement of cash flows for Ernest Banks Ltd for the year ended 31 December
activities $1250
2011 using the indirect method.
Prepare a statement of cash P18.8 Data for Ernest Banks Ltd is presented in P18.7. Further analysis reveals the following.
flows — direct method. 1. Accounts payable relates to inventory creditors.
(LO 3) 2. All expenses, except depreciation expense, were paid in cash.
Instructions
Net cash from operating
activities $14 000; Investing Prepare a statement of cash flows for Ernest Banks Ltd for the year ended 31 December
activities $1250 2011 using the direct method.
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P18.9 Presented below is the statement of financial position for Green Watch Ltd as at 30 June. Prepare a statement of cash
flows — indirect method, and
G R E E N W AT C H L T D perform analysis.
Statement of Financial Position (LO 4, 5)
as at 30 June
Assets 2011 2010

Cash $ 38 000 $ 45 000
Inventory 153 450 142 000
Land 100 000 130 000
Equipment 228 000 155 000
Accumulated depreciation — equipment (45 000 ) (35 000 )
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Building 200 000 200 000
Accumulated depreciation — building (60 000 ) (40 000 )
$ 679 730 $ 670 000

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$ 679 730 $ 670 000
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1. Expenses include depreciation expense of $42 000.
2. Land was sold for cash at carrying amount.
3. Cash dividends of $24 000 were paid.
4. Profit for 2011 was $38 000.
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5. Equipment was purchased for $95 000 cash. In addition, equipment costing $22 000 with
a carrying amount of $10 000 was sold for $8100 cash.
6. Bonds were converted at face value by issuing 50 000 ordinary shares at $1.
7. Net sales for 2011 totalled $420 000.
Instructions
(a) Prepare a statement of cash flows for the year ended 30 June 2011 using the indirect (a) Net cash from operating
method. activities $73 900
(b) Calculate free cash flow for 2011.
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*P18.10 Data for Ernest Banks Ltd are presented in P18.7. Prepare a worksheet.
Instructions (LO 6)
Prepare a worksheet for a statement of cash flows for 2011. Enter the reconciling entries Total reconciling items
directly on the worksheet, presenting the entries alphabetically. $139 250
B RO A D E N I N G YO U R P E R S P E C T I V E
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Financial reporting and analysis
■ FINANCIAL REPORTING PROBLEM: John Fairfax Holdings
BYP18.1 Refer to the most recent financial statements of the Qantas Group, accessible via the website
www.qantas.com.au, and answer the following questions.
(a) What was the amount of net cash from operating activities for the latest year-end? For
the previous year-end?
(b) What was the amount of increase or decrease in cash and cash equivalents for the latest
year-end? For the previous year-end?
(c) Which method of calculating net cash from operating activities does the Qantas Group use?
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(d) From your analysis of the latest statement of cash flows, did the change in accounts
and notes receivable require or provide cash? Did the change in inventories require or
provide cash? Did the change in accounts payable and other current liabilities require or
provide cash?
(e) What was the net outflow or inflow of cash in investing activities for the latest year?
(f) What was the amount of interest paid in the latest year? What was the amount of income
taxes paid in the latest year?
(g) What does Qantas include in its definition of ‘cash’ for the purpose of preparing the
statement of cash flows? Can you reconcile the opening and closing cash and cash
equivalents figures in the statement of cash flows with the cash figures in the statement
of financial position.
■
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FINANCIAL REPORTING PROBLEM: Fortescue Metals Group

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BYP18.2 The following is an extract from an article by Matt Chambers in The Australian on
20 December 2008.
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Andrew Forrest’s Fortescue Metals Group has taken the unusual step of issuing shares to pay
contractor bills in a move that raises questions about the strength of the company’s cash position.
Yesterday, Fortescue said it had issued 1.55 million ordinary shares to raise $3.65 million.
A spokesman said the shares were issued to a contractor in lieu of a cash payment and that
the company might do similar deals in an effort to preserve cash.
The notice came on the same day the company revealed that a US court had frozen close to
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$US1.5 million ($2.19 million) of its cash in relation to claims lodged by ship owners seeking
more than $US130 million in damages for suspended contracts.
Paying bills by issuing shares is not unheard of but in the financial sector it is usually done with
success fees.
…
Fortescue shares fell 20c, or 8.5 per cent, to $2.16 yesterday.
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The issued shares were sold to the contractor, whom Fortescue refused to name, at $2.36 a
share, the previous day’s closing price.
It was unclear whether the contractor immediately sold the shares, which would have weighed
on the price yesterday, or chose to stay on as an investor. Any further deals might need to be
mindful of the dilution effect the issuing of new shares would have for existing shareholders.
Fortescue would not say how much available cash it had, and pointed to the $624 million figure
it previously gave at the end of the third quarter. One analyst said available cash was probably
lower than this due to funds Fortescue needed to keep in an account to service debt.
Fortescue, however, said all the cash was available.
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In another effort to preserve cash, the spokesman said, Fortescue had put on 180-day terms of
credit contractors that had been working on a now-suspended expansion.
Other contractors remained on normal terms of trade, he said.
The moves to preserve cash come amid a collapse in Chinese iron ore demand and still-frozen
global credit markets.
…
Source: M. Chambers, ‘Fortescue share issue to pay contractor begs question of cash position’, The Australian,
20 December 2008, p. 25.
Instructions
(a) How would the transaction involving the issue of shares to the contractor be recorded in
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the statement of cash flows?

(b) Locate the financial statements for Fortescue for the last 3 years. Calculate the free cash
flow for each year.
(c) Calculate and comment on the cash debt coverage and cash return on sales ratios.
(d) Fortescue was being sued by the Greek Shipping Giant the Angelicoussis Group. What
was the outcome of this lawsuit?
(e) Has the financial performance and position of Fortescue improved in recent years?
■ FINANCIAL REPORTING PROBLEM: Qantas
BYP18.3 The Qantas Group’s cash flow statement for the 2008 reporting period was presented on
pp. 729–30.
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Instructions
You are working as an assistant to the chief financial officer of Qantas. Prepare a discussion
on the cash performance of Qantas during 2008 for inclusion in the management discussion
and analysis section of the annual report.
■ INTERPRETING FINANCIAL STATEMENTS: A Global Focus
BYP18.4 The free cash flow for Microsoft was provided in figure 18.31 (page 739). Visit the website
www.microsoft.com to complete the following activities.
(a) Write a brief report commenting on the change in Microsoft’s cash position from the
current year to 2 years prior (e.g. 2010 to 2008) and the reasons for the change.
(b) Locate the Management Discussion and Analysis section and summarise the particular
transactions that Microsoft attributes to its change in cash position in each of these
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years.
■ EXPLORING THE WEB

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BYP18.5 StockDiagnostics.com monitors the ‘Operational-cashflow Per Share (‘OPS’)’ of public
companies and assigns an ‘OPS Ranking’. According to StockDiagnostics.com, ‘OPS
Rankings measure the long term risk associated with a company’s ability to remain in
business. They were discovered from in-depth research conducted by StockDiagnostics.
com on operational cash flow. These studies revealed that a company’s ‘OPS’ (Operational-
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cashflow Per Share) logically falls into a mathematical sequence that ranks it into one of
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eight distinctive ‘risk’ categories. Each of the categories is based on a company’s operating
cash flow for each of its last 4 quarters and its cumulative operating cash flow for its most
recent 12 months’.
Address: www.stockdiagnostics.com
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Instructions
(a) What is StockDiagnostics.com’s definition of OPS?
(b) What is an ‘OPS Ranking’?
(c) How are OPS Rankings calculated?
(d) StockDiagnostics.com reports that the best way to evaluate earnings quality is to
compare operating cash flow per share (OPS) to reported EPS (earnings per share).
What is meant by the term ‘earnings quality’? What would a comparison of OPS and
EPS reveal about earnings quality?
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Critical thinking
■ GROUP DECISION CASE
BYP18.6 Kirby Garok and Jana Kingston are examining the following statement of cash flows for
Poquito Trading Ltd for the year ended 31 January 2011.
P O Q U I TO T R A D I N G L T D
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for the year ended 31 January 2011
Sources of cash
From sales of inventory $ 390 000
From issue of shares 420 000
From sale of investment (purchased below) 80 000
From depreciation 55 000
From issue of bond for truck 25 000
From interest on investments 6 000
Total sources of cash 976 000
(continued)
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Uses of cash
For purchase of property, plant and equipment 320 000
For inventory purchased for resale (all sold) 258 000
For expenses (including depreciation) 160 000
For purchase of investment 75 000
For purchase of truck by issue of bond 25 000
For purchase of notes 10 000
For interest on bond payable 3 000
Total uses of cash 851 000
Net increase in cash $ 125 000
Kirby claims that Poquito’s statement of cash flows is an excellent example of a superb first
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year, with cash increasing $125 000. Jana replies that it was not a superb first year — but
rather, that the year was an operating failure. She says that the statement was incorrectly
presented and that $125 000 is not the actual increase in cash. The cash balance at the
beginning of the year was $140 000.
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Instructions
With the class divided into groups, answer the following.
(a) With whom do you agree, Kirby or Jana? Explain your position.
(b) Using the data provided, prepare a statement of cash flows using the indirect method.
The only non-cash items in the income statement are depreciation and the gain from the
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sale of the investment.
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■ RESEARCH IN ACTION
BYP18.7 The following is an extract from an abstract of an article appearing in an academic

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accounting journal.
This multi-method study reports the results of two complementary experiments investigating the
relevance of cash flow and accrual information. A behavioural field experiment investigated
differences in the accuracy of solvency assessments between commercial lending managers using
cash flow information and those using accrual information. Results indicated . . .
Source: D. Sharma and E. Iselin 2003, ‘The relative relevance of cash flow and accrual information for
solvency assessments: a multi-method approach’, Journal of Business Finance & Accounting, Vol. 30, Iss. 7/8,
pp. 1115–41.
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Instructions
Access your library databases to locate the article and answer the following questions.
(a) What research question are the authors are addressing?
(b) What was the research methodology they used to investigate the research question?
(c) Summarise the research findings.
(d) What are the implications of the research findings?
■ ETHICS CASE
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BYP18.8 Auto Supplies is a medium-sized wholesaler of motor vehicle parts. It has 10 shareholders,
who have been paid a total of $1 million in cash dividends for eight consecutive years.
The policy of the Board of Directors requires that in order for this dividend to be declared,
net cash from operating activities as reported in Auto Supplies’ current year’s statement of
cash flows must be in excess of $1 million. CEO Ray Thomas’s job is secure so long as he
produces annual operating cash flows to support the usual dividend.
At the end of the current year, financial controller Jon Lawler presents CEO Thomas with
some disappointing news: the net cash from operating activities is calculated to be only
$970 000. The CEO says to Jon, ‘We must get that amount above $1 million. Isn’t there
some way to increase operating cash flow by another $30 000?’ Jon answers, ‘These figures
were prepared by my assistant. I’ll go back to my office and see what I can do’. The CEO
replies, ‘I know you won’t let me down, Jon’.
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Upon close scrutiny of the statement of cash flows, Jon concludes that he can get the
operating cash flows above $1 million by reclassifying a $60 000, 2-year bond payable listed
in the financing activities section as ‘Proceeds from bank loan — $60 000’. He will report
the bond instead as ‘Increase in payables — $60 000’ and treat it as an adjustment of profit
in the operating activities section. He returns to the CEO saying, ‘You can tell the board
to declare their usual dividend. Our net cash flow from operating activities is $1 030 000’.
‘Good man, Jon! I knew I could count on you’, exults the CEO.
Instructions
(a) Who are the stakeholders in this situation?
(b) Was there anything unethical about the CEO’s actions? Was there anything unethical
about the financial controller’s actions?
(c) Are the board members or anyone else likely to discover the misclassification?
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Answers to self-study questions

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1. c 2. b 3. a 4. c 5. d 6. b 7. c 8. d 9. b 10. c
11. d 12. a 13. b 14. a 15. d
Answer to Billabong review it question 4, page 718
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In its 2008 cash flow statement, Billabong reported:

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(1) net cash from operating activities of $153 207 000 (net inflow)
(2) net cash used in investing activities of $146 867 000 (net outflow)
(3) net cash from financing activities of $1 862 600 (net outflow).
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Weygandt Chot 18 Statement of Cash Flows

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Weygandt Chot 18 Statement of Cash Flows

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The s t a t e m e nt of

CONCEPTS FOR REVIEW

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The content and organisation of this chapter are as follows.

Statement of cash flows: Section 1 Section 2 The concept of free

Usefulness of the statement of cash flows LEARNING

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They thus enter into the determination of proﬁt.

to government for taxes

Investing activities — Changes in investments and non-current assets

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Statement of Cash Flows.

Significant non-cash activities

1. Issue of shares to purchase assets.

Cash flows provided by

Virgin Blue Holdings Ltd 98 294

Format of the statement of cash flows

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Figure 18.2 Format of

Cash flows from operating activities

Net cash from (used by) financing activities XXX

investing activities and the ﬁnancing activities sections.

5. Collected $20 000 cash for services rendered.

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Related exercise material: BE18.3, BE18.5, E18.1 and E18.6.

Preparing the statement of cash flows

• Comparative statement of ﬁnancial position. Information in the comparative statement of

mine how cash was provided or used during the period.

This step involves analysing not only

This step involves analysing comparative

The difference between the beginning

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Direct and indirect methods

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SECTION 1 STATEMENT OF CASH FLOWS — LEARNING

Figure 18.4 Comparative

income statement and

Inventory 170 000 160 000 10 000 Increase

Income tax expense 36 000

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Step 1: Operating activities

Figure 18.5 Major classes of

CASH RECEIPTS FROM CUSTOMERS

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Figure 18.6 Calculation of

receivable are shown in ﬁgure 18.8.

CASH PAYMENTS TO SUPPLIERS

Figure 18.10 Calculation of

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Figure 18.11 Analysis of

CASH PAYMENTS FOR EXPENSES

Figure 18.13 Calculation of

Figure 18.14 Formula to ⎭ ⎭

DEPRECIATION EXPENSE AND LOSS ON SALE OF EQUIPMENT

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CASH PAYMENTS FOR INCOME TAXES

Figure 18.15 Calculation

Figure 18.17 Operating

a separate section of the ﬁnancial statements.

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Figure 18.18 Analysis

Accumulated Depreciation — Equipment