Exercise-9 (Effect of transactions on statement of cash flows – indirect method)

The following is a list of independent items. Explain how each item would affect the statement of cash flows under indirect method.

1. The company sold 20,000 shares of common stock for cash during the year. The stated value of shares was $10 per share and the shares were issued at $35 per share.
2. The accounts receivable amounting to $15,000 were written-off during the year. The company uses allowance method to account for uncollectible accounts expense.
3. The company earned a net income of $37,500 for the year. A fixed asset was sold to a small firm for $15,000 which resulted in a loss of $2,500 because the book value of the asset on the date of sale was $17,500. The depreciation expense for the year was $8,500.
4. The company purchased treasury stock costing $25,000 during the year.
5. The company purchased a 3-month US Treasury Bill for $50,000.
6. The company incurred a loss of $25,000 for the year. A tract of land costing $15,000 was sold at a gain of $4,000. The depreciation expense for the year was $12,000.
7. During the year, a 50% interest in C&P Co. was acquired for $65,000. The transaction was fully settled by issuing the shares of common stock.
8. During the year, the patent amounting to $5,000 was amortized.

Solution

1. Sale of common stock:

The sale of common stock is a financing activity and the inflow of cash resulting from it would be reported in financing activities section of the statement of cash flows.

2. Write-off of accounts receivable:

The write-off of accounts receivable reduces the balances in ‘allowance for doubtful accounts account’ and ‘accounts receivable account’ but does not affect cash. Therefore, it is not reported in the statement of cash flows.

3.  Sale of plant asset at a loss and depreciation expense:

The information provided in item number 3 would affect two sections of the statement of cash flows – operating activities section and investing activities section. A brief explanation of both the effects is given below:

(a). Under indirect method, the net income, depreciation expense and loss on sale of fixed assets are reported in the operating activities section. The depreciation expense of $8,500 and loss of $2,500 on sale of plant asset both are non-cash expenses that would be added to net income to arrive at net cash provided (or used) by operating activities. The usual presentation is illustrated below:

Note: The operating activities section illustrated above is only partial. It is based on the information available in item number 3 of the exercise. The net cash provided or used by operating activities would depend on other entries in the section.

(b). The total proceeds from sale of plant asset (i.e., $15,000) would be reported in the investing activities section of the statement of cash flows as illustrated below:

4. Purchase of treasury stock:

Purchase of treasury stock is a financing activity. The out flow of cash amounting to $25,000 as a result of purchase of treasury stock would be reported in the financing activities section of the statement of cash flows.

5. Purchase of US Treasury bill:

US Treasury Bill is considered a cash equivalent instrument. It is not reported on statement of cash flows because its purchase does not change cash and cash equivalents.

6. Sale of land at a gain and depreciation expense:

The explanation of item number 6 is similar to that of item number 3.

a. The net loss, depreciation expense and gain on sale of land would be reported in operating activities section as follows:

Note: The operating activities section illustrated above is only partial. It is based on the information available in item number 6. The net cash provided or used by operating activities would depend on other entries in the section.

b. The total sale proceeds of land ($15,000 cost + $4,000 gain) would be reported in investing activities section as follows:

7. Investment in exchange of common stock:

The investment in C&P for exchange of common stock does not involve in any inflow or outflow of cash. It is a significant non-cash investing and financing activity that should be reported either at the bottom of statement of cash flows as a foot note or as a separate note to the financial statements. Reporting at the bottom of statement of cash flows is illustrated below:

Click here to read more about the disclosure of non-cash investing and financing activities.

8. Amortization of patents:

Under indirect method, the treatment of amortization is similar to that of depreciation. The amortization of patent amounting to $5,000 is a non-cash expense that must be added back to net income to arrive at net cash provided by operating activities.