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Module 3: Statement of cash flows and case analysis

Overview
In Module 3, you learn why the statement of cash flows (SCF) is prepared and the information that it conveys.
You also become familiar with the direct and indirect presentation methods and the issues that affect
interpretation. Finally, you have an opportunity to apply these concepts in the computer activity at the end of
the module.

Test your knowledge

Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the
depth of study required.

Topic outline and learning objectives

3.1

Theoretical foundation
Describe the need for, and the usefulness of, the statement of cash flows (SCF). (Level1)

3.2

Classification of cash flows

Differentiate between operating, financing, and investing activities. (Level1)

3.3

Preparation of the statement of cash flows

Prepare a statement of cash flows using both the direct and indirect methods. (Level1)

3.4

Disclosure and special issues

Describe the manner of presentation and the required disclosure on the SCF. (Level1)

3.5

Interpretation of the statement of cash flows

Analyze and interpret data provided in the SCF to evaluate the activities of a firm during a particular
period. (Level2)

3.6

Predictive ability of the statement of cash flows: distinguishing profit and cash flow
Describe the importance of the statement of cash flows in assessing the quality of company
earnings. (Level1)

3.7

Computer illustration 3.7-1: Spreadsheet approach

Prepare an SCF using a spreadsheet. (Level1)

3.8

The CGA case analysis approach

Apply the CGA case analysis approach. (Level 1)

Module summary
Print this module

CICA Handbook Accounting, Part II Accounting Standards for Private Enterprises, section 1540 Cash Flow
Statement, governs the preparation of the statement of cash flows by private enterprises. The presentation of
the statement of cash flows under ASPE differs from IFRS in the following key areas:

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Dividends paid must be classified as a financing activity under ASPE.

Interest received and paid and dividends received included in the determination of net income
must be classified as an operating activity under ASPE.
With certain limited exceptions, cash flow per share information cannot be disclosed.

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Test your knowledge Module 3

These questions from the FA2 textbook address some of the core issues for this module. You may find it useful
to go through them before you attempt the module to help you assess the areas that you need to focus on.

Question 1
Questions Q5-1, Q5-2, Q5-3, Q5-4, Q5-5, Q5-6, and Q5-7 on page 229 of the text

Question 2
Question Q5-13 on page 230 of the text
Solutions

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Test your knowledge 3

Question 1 solutions
Q5-1

The purpose of the statement of financial position is to report the financial position (that is, assets,
liabilities, and owners equity) as of the end of the reporting period. The purpose of the statement of
comprehensive income is to report the results of operations (that is, revenues, expenses, gains, and
losses) for the reporting period. It is a change statement because it reports the detailed items that
comprise comprehensive income, which includes both net earnings and unrealized amounts. These items
cause owners' equity (retained earnings and other reserves) to change. These statements report
accrual-basis amounts. The SCF focuses on cash flow only. The statement of cash flow reports cash
flows for operating, investing, and financing activities. The SCFs primary function is to disclose
historical cash flows of the enterprise.

Q5-2

This company had accrual-based revenues of $260,000, and a cash inflow of $220,000 ($100,000 +
$40,000 + $80,000). The cash basis is reflected on the SCF, either directly or indirectly.

Q5-3

Cash includes cash on hand, plus cash in the current (bank) account. Cash also includes cash
equivalents, which are highly liquid short-term investments (original term less than three months).
Bank overdrafts are included as a (negative) component of cash, as long as the balance fluctuates
during the year. Disclosure of the cash definition is important to inform readers exactly which items
have been lumped together as cash.

Q5-4

Operating activities cash flow related to principal revenue-producing activities of the enterprise and
the related expenditures.
Investing activities - cash flows related to the asset structure of the company.
Financing activities - cash flows related to liabilities and owners equity.

Q5-5

Operating

1. Cash sales

1.

Payments to suppliers

2.

Cash from customers on account

2.

Payments for salaries and wages

3.

Advance deposits from customers

3.

Payments for rent

Inflows

Inflows

Investing 1. Cash received from sale of equipment

Q5-6

Outflows

Outflows

1. Purchase of equipment

2. Cash received from sale of debt or equity investments

2. Purchase of debt or equity securities of others

3. Cash received from collection of loan principal

3. Loans to others

Financing

1. Cash received from borrowing via bank loans

1. Payment of loans (principal)

2. Cash received from issuing bonds payable

2. Retirement of bonds payable (principal)

3. Cash received from sale of common shares

3. Cash paid to retire common shares

Operating activities
Less: gain on sale of capital asset

Inflows

Outflows

($26,000)

Investing activities

Sale of capital asset

Q5-7

$216,000

An adjustment must be made for depreciation because it is a non-cash expense originally treated as a
deduction to compute net earnings. Under the indirect method, these items must be added to net
earnings to cancel or remove their effect.

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Question 2 solution
Q5-13

Operating activities
Net earnings
Plus:
Tax expense

Tax paid ($40 - $6)

Cash from operating activties

$150

40
$190
(34)
$156

This presentation alternative is also available for dividends received, interest received, and interest paid.

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3.1 Theoretical foundation

Learning objective

Describe the need for, and the usefulness of, the statement of cash flows (SCF). (Level1)
Required reading

Chapter 5, pages 193-195 up to "Classification of Cash Flows" (Level1)

LEVEL 1

In FA1 you learned that financial statements were prepared on an accrual basis, rather than a cash basis. You
should recall that the reason for this is that the accrual method is judged to provide a better measure of a
firms economic performance.
IAS 7 p3 also recognizes the importance of cash flow to the financial reporting model:

Users of an entity's financial statements are interested in how the entity generates and uses cash and
cash equivalents. This is the case regardless of the nature of the entity's activities and irrespective of
whether cash can be viewed as the product of the entity, as may be the case with a financial institution.
Entities need cash for essentially the same reasons however different their principal revenue-producing
activities might be. They need cash to conduct their operations, to pay their obligations, and to provide
returns to their investors. Accordingly, this Standard requires all entities to present a statement of cash
flows.
Because cash is so important, accounting standards require that, in addition to an income statement, most
companies prepare a statement of cash flows. A statement of cash flows is similar to a cash-based income
statement in that it details all inflows and outflows of cash during the reporting period.
The two statements, income statement and cash flow, serve two different purposes. The income statement
measures economic performance, while the statement of cash flows speaks to the capacity of a business to
generate cash and the businesss need for cash resources. These two measures of corporate performance
should be analyzed in conjunction with each other as one cannot replace the other, and neither should be
ignored.
Managing working capital and cash flow to ensure that sufficient monies are at hand (or available through
credit lines) to pay bills when due is a critical success factor for companies. While the two topics are interrelated, this topic focuses on managing cash flow. (Module 6 discusses managing working capital.)
Cash flow is very important for one reason cash pays bills, not (accrual based) net income. This is
particularly evident in rapidly growing firms, which are profitable, but still face chronic working capital
shortages. To illustrate why this is true, consider this companys situation:
January 1, 20X9: XYZ Co. is formed. The owners contributed the initial capitalization of $500,000.
January 15, 20X9: XYZ Co. paid $200,000 cash for equipment and $300,000 cash for inventory.
January 20, 20X9: XYZ Co. sold its entire inventory for $500,000 on 30-day credit terms.

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January 31, 20X9: XYZ Co. needs to pay its rent expense of $10,000 and payroll expense of
$15,000.
According to the rules of accounting, XYZ has generated a profit of $175,000 ($500,000 $300,000 $10,000
$15,000) for the month (ignoring depreciation expense and income taxes). Unfortunately, though, XYZ has
insufficient cash available to pay its bills!
This seemingly simple example happens every day in the real world. On a small scale, the results are
predictable the employees quit, the landlord evicts the tenant, and the company goes out of business. On a
larger scale, it can have a devastating effect on the world economy. The liquidity crisis that gripped North
America and the rest of the world in the fall of 2008 was, on a very simplified basis, an example of a number
of very large institutions, including banks, having insufficient cash available to meet their obligations in a timely
manner.
Many people think that bankruptcy is the state that occurs when an entitys liabilities exceed the value of its
assets. While this may be the case, it is not necessarily so. For example, many university students who have
taken out loans to finance their education owe more than their possessions are worth, but they are not
bankrupt. Bankruptcy is the state of being unable to pay your bills when due.
It is thus vitally important that a company actively manages its cash flow to ensure that it can meet its
obligations in a timely manner. In the example above, the problem isnt that XYZ Co. did not generate sales or
that it was losing money. Rather, the underlying difficulty was that the company did not actively manage its
cash flow. Continuing with the example, if the company had prepared a cash flow budget, it would have
recognized that it was likely to run out of cash. This realization would have enabled it to make plans to deal
with the situation that may have included arranging financing for part of the equipment purchase so as to
preserve some cash, or pre-arranging for a line of credit from the bank secured by their accounts receivable
and inventory. While these options may seem obvious, many otherwise intelligent people do not act prudently
in this respect. There is also an option that is not so obvious plan to grow at a slower rate!
You will study budgeting in more depth in FN1 : Corporate Finance Fundamentals .

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3.2 Classification of cash flows

Learning objective

Differentiate between operating, financing, and investing activities. (Level1)

Required reading

Chapter 5, pages 195-196 up to "Royal Dutch Shell Statement of Cash Flow" (Level1)
LEVEL 1

To make the information provided more useful for the reader, the IASB requires that the statement of cash
flows categorize the nature of cash flows. Specifically, cash flows are designated as arising from operating,
investing, or financing activities. IAS 7 sets out the many rules that detail which cash flows are to be recorded
in which category. Exhibit 5-1 in the text summarizes the required categorization of the most common types of
transactions.
During your reading you will have noted that there are options with respect to classifying cash inflows and
outflows from dividends and interest. Also, there are alternatives for held-for-trading investments that qualify
as cash equivalents.
Note: For assignment, quiz, and examination purposes, read the question carefully and formulate your
response to reflect the options adopted by the reporting company.
Rather than trying to memorize which cash flows go where, you may find it more helpful to understand the
underlying logic of the classifications. Operating cash flows are those that arise from the normal, day-to-day
operations of the business. Picture a pizza parlour: its operating cash flows would include the cash received
from selling the pizzas, the monies paid to the delivery driver, the monies paid for supplies and rent, and so
on.
This same pizza parlours investing cash flows are the monies expended and received from the purchase and
sale of the infrastructure necessary to run the business, for example, the purchase of a pizza oven and the sale
of a delivery vehicle. For the most part, cash flows arising from the more traditional types of investing
activities, such as the purchase and sale of debt and equity securities, are also included in investing cash flows.
There are some exceptions, however, including:
cash equivalents (including qualifying held-for-trading investments, such as short term bond
investments, that the company has adopted a policy of designating as cash equivalents) that form
part of the change in cash to be reconciled; and
cash flows that arise from the purchase and sale of securities designated as held for trading that
are not designated as cash flow equivalents. These cash flows are classified as an operating
activity.
Financing cash flows encompass the inflows and outflows of monies due to creditors and owners of other
than an operating nature. Examples of financing activities include the proceeds raised from the issuance of
shares and the repayment of long-term debt.

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A cautionary note: the change in accounts payable is not classified as a financing activity. Rather, it is
considered an operating activity because a companys accounts payables arise due to its day-to-day operations
of selling pizzas. The pizza parlours accounts payable is directly related to the acquisition of the supplies
necessary to fulfil its primary goal of selling pizzas.

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3.3 Preparation of the statement of cash flows

Learning objective

Prepare a statement of cash flows using both the direct and indirect methods. (Level1)
Required reading

Chapter 5, pages 196-209 up to "Interpretation issues" (Level1)

LEVEL 1

The text provides detailed, step-by-step instructions as to how to prepare a statement of cash flows employing
both the direct and indirect layout of presentation. The direct and indirect methods of presentation are similar
in that they portray exactly the same information (the reconciliation of the observed change in cash) in a
slightly different manner. While the cash from operating activities is the same under both systems, the
disclosure as to how this total is derived is different. The investing and financing sections are exactly the same
under both methods, as is the reconciliation of the noted change in cash.
To understand the logic of the preparation of the SCF, consider the following formulas:
Assets = Liabilities + Owners' equity
Cash + Non-cash assets = Liabilities + Owners' equity
Cash = Liabilities + Owners' equity Noncash assets
Cash = Liabilities + Owners' equity Noncash assets
where = change in
The last formula implies that to explain the change in cash, one must explain the change in all the other items
on the statement of financial position. Otherwise, the change in cash from one period to the next will not be
fully explained. This formula will help you understand that all other things being equal, cash will increase when
bank loans increase and that cash will decrease when inventory increases.
The text demonstrates three methods of deriving the necessary data to prepare the SCF: ad hoc, constructing
a spreadsheet, and using T-accounts.
In your FA2 self-study questions and examinations, you will only be asked for the final product the SCF
presented using the direct or indirect method. The manner in which you make the background calculations
leading up to the SCF is left to you, although you are advised to show your work.

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3.4 Disclosure and special issues

Learning objective

Describe the manner of presentation and the required disclosure on the SCF. (Level1)
LEVEL 1

Preparation of the income statement and statement of financial position involves the use of professional
judgment; as such, two CGAs could view exactly the same set of events and record them slightly differently.
For example, they may have differing opinions on the useful life of equipment purchased, which in turn will
affect both depreciation expense and accumulated depreciation.
The SCF is a reconciliation of cash that is conducted under fairly stringent rules set out in IAS 7. As such,
professional judgment is largely restricted to the order in which the data is presented. Indeed, given the same
set of circumstances, two competent professionals should invariably produce an SCF that depicts the same cash
flow arising from operating, financing, and investing activities. 1
The text sets out the IFRS requirements for non-cash transactions, discontinued operations, and cash flows
relating to interest, dividends, and income tax. Note that separate disclosure is required with respect to interest
paid and received, dividends paid and received, and income taxes paid. Material non-cash transactions must
also be disclosed.
Paid and expensed amounts

It is important to recognize that the SCF is concerned about the interest and dividends received and paid and
income taxes paid (the actual cash inflows and outflows) rather than those recorded as income, expense, or
declared. In all instances, it is instructive to consider the underlying journal entries. Example 3.4-1 shows how
the SCF treats differences between paid and expensed amounts.

Example 3.4-1
Dividends payable, interest expense, and income tax expense

1. The company declares a dividend totalling $200,000 on December 15, 20X5, payable on January
15, 20X6. The $200,000 will flow through the 20X5 Statement of changes in equity, but the
accompanying cash flow does not take place until 20X6. In the interim, the dividends payable
account will increase $200,000.
12/15/X5

DividendsDeclared

01/15/X6

DividendsPayable

DividendsPayable
Cash

$200,000
$200,000
$200,000
$200,000

The SCF is only concerned about actual cash inflows and outflows, not accruals. As such the
dividend payment will be reported on the SCF for 20X6, not the SCF for 20X5.
2. The company previously issued a bond at a discount. Interest expense for 20X5 is $150,000,

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including the amortization of the discount.

During20X5 Interestexpense

Cash

Discount on bonds payable

$150,000
$140,000
$10,000

The SCF reports only the actual cash outflow: $140,000.

3. Income tax expense totals $85,000; the income tax payable account increased $45,000 and the
deferred income tax asset account increased $10,000.
During20X5

Income tax expense

$85,000

Deferred Income tax asset

$10,000

Income taxes payable

$45,000

Cash [$85,000 + $10,000 $45,000]

$50,000

The SCF reports only the actual cash outflow: $50,000.

The Statement of Comprehensive Income in Exhibit 5-7 of the text (second page) further illustrates the
difference between paid and expensed amounts. Note that this exhibit indicates that a provision for income tax
expense of $54,000 has been made, while the cash flow statement in Exhibit 5-9 specifies that $51,000 in tax
was paid. The difference in these two amounts can be traced to the $3,000 increase in the deferred tax liability
as set out in Exhibit 5-8.
1

While there are classification options available with respect to inflows and outflows arising from interest and
dividends, the "same set of circumstances" presumes that both preparers would be privy to the company's
policy in this respect.

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3.5 Interpretation of the statement of cash flows

Learning objective

Analyze and interpret data provided in the SCF to evaluate the activities of a firm during a
particular period. (Level2)
Required reading

Chapter 5, pages 209-229 up to Questions" (Level2)

LEVEL 2

The SCF provides a wealth of information to the interested stakeholder. The text points out some factors that
should be considered. You should also consider these areas of cash flow:

Operating
Ideally, cash flow from operations is positive and is the company's major source of cash. Remember that cash
flow from operations will be materially different from net income if there are significant non-cash charges (for
example, depreciation) or non-cash revenues, or if there are substantive changes in working capital. The latter
changes should be carefully monitored; large increases or decreases in current assets or liabilities from one
year to the next could indicate problems or perhaps only temporary fluctuations. For instance, funds from
operations may be low due to a build-up of inventory, which is often a sign of trouble. Funds from operations
may be high due to a reduction in accounts receivable, but this reduction may be only temporary. It is wise to
look at all the factors involved in cash flow from operations and consider their impact on the firms ability to
continue to manage its cash flow as discussed in Topic3.1.

Investing
Typically, enterprises have to invest in new capital assets regularly; the cash outflows appear in this section.
Major strategic decisions for example, the acquisition of new manufacturing facilities are reflected in this
section. Changes in long-term investments, another strategic area, are also highlighted.

Financing
How is the company financed? What combination of debt or equity is used? Again, major strategic decisions,
such as issuance or retirement of shares and debt issuance or redemption, are summarized in this section.

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3.6 Predictive ability of the statement of cash flows:

distinguishing profit and cash flow
Learning objective

Describe the importance of the statement of cash flows in assessing the quality of company
earnings. (Level 1)
LEVEL 1

Analysts have been using cash flow as a means of evaluating company strength for many years. The problem is
that cash flow information is often not readily available in a timely manner. It has been determined that
earnings quality is closely correlated with operating cash flow, and yet the ability to evaluate quality of earnings
could be lacking when using traditional financial statements (statement of financial position, income statement
and the statement of changes in equity). Because GAAP requires reflection of events that do not involve
immediate cash, such as the purchase of goods on credit or sales on credit, the resultant net income does not
reflect the change in wealth as measured by cash. Cash flow information is often not readily available until
months after verbal reports of profits are issued. An analysis of the statement of cash flows will help to
determine if the reported income was of low quality or high quality.
The "accrual method" is a requirement of GAAP for the production of financial statements and that is the main
area of difference between income determination and cash flow. A change in current assets can be seen in the
statement of cash flows or determined by comparing the current and prior year statement of financial position.
The role of accruals and their impact in evaluating what the changes in account balances mean in terms of
quality of earnings information will be considered by examining two accounts: accounts receivable and
inventory.
The "quality" of receivables will have an impact on the quality of earnings, but the quality of receivables cannot
be fully assessed through the financial statements. Are the receivables current? How is the allowance for bad
debts determined? Is a significant increase in accounts receivable an improvement in earnings quality or the
reverse? Management has the ability to influence the level of receivables through its policies, and the
receivables reflected in the financial statements does not disclose the quality of those receivables. If receivables
have increased substantially since the last publication, does that reflect an improvement in the value of the
company? It will depend on why the receivables have increased. Was it a change in receivable policies? It may
simply be that the receivable terms have been changed from 30 days to 60 days, but that would most likely
lower the quality of the receivables thus lowering the quality of the earnings. Was it generated by a significant
increase in sales? That may be good, but was customer quality compromised in the expansion of sales?
Quality of inventory is another major area that can be an indicator of the quality earnings. Management has
discretion as to when and how much "old" inventory should be marked down. Maybe a high inventory
represents an overstocking of items, which will necessitate mark downs in the future. These are issues that
cannot be answered through traditional statements.
There are many factors to consider, most of which are not apparent to outside interests. For that reason many
analysts rely on operating cash flow to determine the quality of the earnings. A company can report a positive
income through the use of accruals and various alternative accounting treatments, but if the company is not
generating a positive cash flow through earnings, the future may not be as bright as income figures may lead
one to believe. Generally, a shortage of cash from operations results in having to borrow to fill the gap, which
could eventually lead to failure.

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Bear in mind that there are three sections in the SCF and that while the total cash picture as reported in the
statement of cash flows could be positive, cash generated through financing or investing (or by redeeming
investments) does not add to the quality of earnings. Therefore, a positive cash flow is not always a positive
indicator; it depends how that cash flow is generated. A positive cash flow in the operations section is more
closely related to the quality of earnings than is income earned. In general, a good positive operating cash flow
would result in high earnings quality.
There is a good article by Al Rosen, "Cash Flow Myths," that speaks to the weaknesses in the statement of
cash flows that will help to indicate the complexities of the whole area of reliability on statement presentations,
which in turn relates to the "Quality of earnings" assessment.

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By Al Rosen, originally published March 12, 2007 in Canadian Business Magazine.

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Reproduced
with permission.

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3.7 Computer illustration 3.7-1: Spreadsheet approach

Learning objective

Prepare an SCF using a spreadsheet. (Level1)

LEVEL 1

This computer illustration demonstrates how to use an Excel spreadsheet to prepare a statement of cash flows
(SCF). Work through the illustration as a practice exercise.
Required

Use the data from A5-28 on pages 254-255 of the text to prepare the 20X5 SCF for Supreme Company using
both the direct and indirect presentation methods. For the indirect method, it is only necessary to complete the
operating activities and prepare the required disclosure.
In the "Analysis of Selected Accounts and Transactions" section, it is necessary to add the following:
f. Cash dividends declared and paid, $30,000.
The company makes the following elections with respect to the classification of particular cash flows:
Interest paid is classified as an operating activity

Investment income is classified as an operating activity

Dividends paid are classified as a financing activity

Remember to make the required disclosure with respect to significant non-cash transactions, and the payment
of interest and income taxes.
Procedure

1. Start Excel.
2. Open the data file FA2M3P1. There are six worksheets in this file:
IncState

contains the income statement

SFP

contains the statement of financial position and other relevant information

Dir_SCF

where you prepare the direct SCF

Ind_SCF

where you prepare the indirect SCF

Dir_SCF_soln a completed direct SCF

Ind_SCF_soln a completed indirect SCF

3. Using the SCF worksheets, create formulas that reference the relevant amounts from the IncState
and SFP worksheets to complete the SCF.

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For example, cell G9 on the Dir_SCF worksheet is where you calculate the cash collected from
customers. Sales revenue and accounts receivable amounts are needed to calculate the total cash
received. These amounts are located on the IncState and SFP worksheets respectively.
Similarly, cell G9 on the Ind_SCF worksheet is the starting point for an indirect SCF, namely net
income. This amount can be found on the IncState worksheet.
In this manner, use formulas to finish the worksheets.
The formulas in cells I16, I21, and I26 on the Dir_SCF worksheet calculate the statement of cash
flows subtotals.
Cell I29 contains the opening cash balance for the year. Then the formula in cell I30 compares
the total of the opening balance plus the changes in cash to the actual closing balance in cash. If
the numbers are the same, the formula enters the balance in cash. If the number is not the
same, #VALUE! is entered. This will let you know that the statement of cash flows is not in
balance.
4. After you have completed the statement of cash flows, click the Dir_SCF_soln and Ind_SCF_soln
sheet tabs, which contain the solution worksheets, and compare your results. If you do not obtain
the same results, correct any errors.

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3.8 The CGA case analysis approach

Learning objective

Apply the CGA case analysis approach. (Level 1)

Required reading

Analyze a case (Level 1)

LEVEL 1

As a professional accountant, you will be expected to apply what you have learned in your courses. This will
involve determining the problem to be solved, analyzing the data, generating, analyzing and evaluating
alternatives, providing a recommendation, and writing a report. You will be expected to use the case analysis
methodology as described in the required reading when answering assignment and examination questions. (You
can also find Analyze a case under the Resources tab in the course.) Self-test questions involving cases are
available for you to practice the approach. In addition, there are sample cases in that location that provide
good examples for some of the steps in the process.

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Module 3 summary
Statement of cash flows and case analysis
This module establishes why the statement of cash flows (SCF) is prepared and explains the information it
conveys. It compares and contrasts the direct and indirect presentation methods. Interpretation issues are
examined and a computer illustration is used to demonstrate the preparation of the SCF.

3.1 Describe the need for, and the usefulness of, the statement of cash
flows (SCF).
The SCF provides information about an enterprise's cash flows that supplements information
provided by the balance sheet (statement of financial position) and the income statement (results
of operations).

3.2 Differentiate between operating, financing, and investing activities.

Operating cash flows are associated with the entity's day-to-day activities.
Investing cash flows arise from the purchase and sale of long-term assets and investments.
Financing cash flows arise from borrowing and repaying debt, and issuing and repurchasing stock.

There are options with respect to classifying cash inflows and outflows from dividends and
interest under IFRS. Also, there are alternatives for held-for-trading investments that qualify as
cash equivalents.

3.3 Prepare a statement of cash flows using both the direct and indirect
methods.
If the indirect method is used to present cash flow from operations, the operations section
reconciles net income to cash flow from operations.
If the direct method is used, cash flow from customers and cash paid to suppliers is recorded
directly.
The investing and financing sections of the SCF are identical under the direct and indirect
approaches for ASPE.

3.4 Describe the manner of presentation and the required disclosure on the
SCF.
The SCF separately presents cash flows arising from operating, investing, and financing activities.
Separate disclosure is required with respect to interest paid and received, dividends paid and
received, and income taxes paid. Material non-cash transactions must also be disclosed.

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3.5 Analyze and interpret data provided in the SCF to evaluate the activities
of a firm during a particular period.
Analysis of the SCF permits a look at cash generated by operating activities and the strategic
investing and financing decisions that the enterprise has made.

3.6 Describe the importance of the statement of cash flows in assessing the
quality of company earnings.
The operating section more closely reflects the economic growth of the company than the
Earnings statement.
Cash may be a positive inflow, but may not be from activities of a continuing nature.
Generating cash through such means as selling off equipment may prove disastrous in the long
run.

3.8 Apply the CGA case analysis approach.

Consistent use of this approach ensures that your responses to case questions are complete and
organized.
Ensure you are familiar with the approach and use the self test questions to practice.

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Module 3 self-test
Question 1
Computer question
Statement of cash flows, indirect method (optional spreadsheet)
Shown below are the income statement, a comparative statement of financial position, and additional
information useful in preparing the 20X5 SCF for Sells Company.
SELLS COMPANY
Income Statement
For the year ended 31 December 20X5
Net sales

$300,000

Cost of goods sold

80,000

Gross margin

220,000

Depreciation expense

45,000

Amortization of intangibles

2,000

Other expenses

44,000

Interest expense

3,000

Income tax expense

65,000

Net income

$ 61,000

Comparative Statement of Financial Position

As of 31 December

Cash
Accounts receivable
Other receivables

20X5

20X4

$ 32,000

$ 16,000

47,000

50,000

2,000

3,000

Inventory

32,000

30,000

Equipment

77,000

80,000

Accumulated depreciation

(5,000)

(6,000)

Intangibles, net

53,000

55,000

$238,000

$228,000

Accounts payable

60,000

50,000

Income taxes payable

50,000

70,000

1,000

2,000

Bonds payable

32,000

Discount on bonds payable

(2,000)

80,000

70,000

Total assets

Interest payable

Common shares
Retained earnings

Total liabilities and owners equity

47,000

6,000

$238,000

$228,000

Additional information:
a. Dividends of 20,000 were declared and paid in 20X5.
b. Equipment costing $66,000 with a book value of $20,000 was sold at book value. New equipment
was also purchased; common shares were issued in partial payment.
c. The bonds were retired at net book value; $500 of bond discount had been amortized in 20X5.

d. Sells elects to classify interest paid as an operating expense and dividends paid as a financing
expense.

Required
Using the Excel spreadsheet stest03Q01.xls, prepare the 20X5 statement of cash flows for Sells Company using
the indirect method. You should review Computer illustration 3.7-1 in Topic 3.7 before attempting this
question.
Source: Adapted from Beechy and Conrod, Intermediate Accounting, 2nd edition, 2002, page 241. Reproduced
with permission.
Solution

Question 2
Multiple choice
a. Which of the following is included in the direct method of presenting the statement of cash
flows?
1. Calculating the operating activities section by identifying the individual items that
were involved in changes to cash
2. Deducting the non-cash expenses from the net income
3. Treating the impact of changes in statement of financial position accounts such as
accounts receivable as a separate reporting item
4. Including any gain or loss on sale of operating assets as part of the operating
activities section of the SCF
b. Which of the following results in an adjustment to net income when determining net cash flow
from operating activities under the indirect method?
1.
2.
3.
4.

Increase in long-term investment

Increase in bonds payable
Decrease in inventory
Issuance of common shares

c. The indirect method of presentation of cash flow starts with the reported net income but is
subject to adjustments. Which of the following would not be an adjustment to net income?
1.
2.
3.
4.

The depreciation of property, plant and equipment

Bond discount amortization
Insurance expense
Loss on long-term investments

d. Which of the following statements best describes the treatment of dividends declared but not
paid in presenting the statement of cash flows?
1. The dividends declared are reported as part of the operating activities section in a
manner similar to interest expense.
2. The dividends declared are reported as part of the financing activities section.
3. The dividends declared are reported in the financing activities with an offsetting
amount of dividends payable.
4. The dividends declared are not reported on the statement of cash flows.
e. The cash balance from operating activities will not be affected by changes in which of the
following accounts?

1.
2.
3.
4.

Prepaid insurance
Ordinary shares
Inventory
Accounts receivable

f. If the sales reported on the income statement were $350,000, and the accounts receivable
changed from $85,000 at the beginning of the year to $60,000 at the end of the year, the cash
received from customers would amount to which of the following?
1.
2.
3.
4.

$265,000
$350,000
$375,000
$410,000

g. The purchase of assets with an issue of bonds would be reported on the statement of cash flows
in which of the following?
1.
2.
3.
4.

The operating activities section

The financing section
The investment section
Not reported on the SCF

h. Using the indirect method, a decrease in the inventory account would be reported on the SCF as
which of the following?
1. An addition to the net income in the computation of cash flows from operating
activities
2. A reduction in the investing activities section
3. A deduction from net income in the computation of cash flows from operating
activities
4. An adjustment to the cash paid to suppliers
i. Which of the following events must be reported as part of the SCF?
1. Converting bonds to shares
2. Incurring capital lease obligations in exchange for leased assets
3. Acquiring shares in another company in exchange for shares of the reporting
company
4. Acquiring a capital asset by making a down payment and signing a note payable for
the balance
Questions j. and k. are based on the following data:
The company income statement reported a net income of $380,000. Included in the calculations
was interest expense of $40,000. The bond discount amortization in the amount of $2,000 debit
was included in the expense. The accrued interest payable on the statement of financial position
rose from $3,000 to $12,000. Income tax expense reported on the income statement was
$240,000 with an increase in deferred tax liability of $32,000.
j. Which of the following should be reported as interest paid?
1.
2.
3.
4.

$29,000
$31,000
$47,000
$51,000

k. Which of the following should be reported as income tax paid?

1.
2.
3.
4.

$208,000
$240,000
$272,000
$300,000

l. The statement of financial position reported an increase in inventories of $66,000 and a decrease
in accounts payable of $40,000. The figure reported on the income statement for cost of goods
sold was $1,460,000. The cash paid to suppliers would be reported in the operating activities
section of the SCF under the direct method at which of the following?
1.
2.
3.
4.

$1,354,000
$1,434,000
$1,486,000
$1,566,000

Questions m. and n. are based on the following data:

The income reported in the income statement included a gain on sale of assets in the amount of
$22,000 and depreciation expense of $144,000. The opening balance of net assets was $845,000
and the closing balance was $901,000. The net book value of the sold asset was $54,000.
m. The amount to be reported in the investing section of the SCF for assets acquired is which of the
following?

1.
2.
3.
4.

$56,000
$120,000
$200,000
$254,000

n. The amount to be reported as cash received for sale of asset is which of the following?
1.
2.
3.
4.

$22,000
$54,000
$56,000
$76,000

Solution

Question 3
Using the information in Question 1, use the direct presentation method to prepare the 20X5 statement of cash
flows instead of the indirect method.
Solution

Question 4
A5-1 on pages 235-236
Solution

Question 5
A5-23 on pages 249-250. Dividends paid are included in the financing activities section.
Solution

Question 6
Compuco Limited
You have just started work with a firm of public accountants. Youve been given a partially completed set of
financial statements for a client, Compuco Limited. You have been asked to prepare an SCF for Compuco
Limited, using the statement of financial position provided in Exhibit 1, the income statement and retained
earnings provided in Exhibit 2, and the selected notes provided in Exhibit 3. Use indirect disclosure for the
operating activities section. (Include separate disclosure of cash paid/received in regards to interest and tax in
the disclosure notes.) Based on your SCF, youve also been asked to draft an analysis of the strategic
operating, financing, and investing strategies of the company that are apparent from the SCF. Note: Amounts
from interest received and paid are classified as operating activities.
Exhibit 1
COMPUCO LIMITED
Extracts from Consolidated Statement of Financial Position
(in $ thousands)
As at 31 December

20X5

20X4

Assets

Current

Cash and term deposits

3,265

3,739

Accounts receivable

23,744

18,399

Inventories

26,083

21,561

145

1,402

1,613

Income taxes recoverable

Prepaid expenses
Loans receivable (Note 1)
Property, plant and equipment (Note 2)
Deferred income taxes

5,960

6,962

37,332

45,700

4,875

2,245

12,737

4,391

1,911

$ 107,197

$ 114,867

Liabilities

Current

Bank overdraft

6,844

6,280

Accounts payable

3,243

4,712

1,800

1,200

11,887

12,192

14,900

14,500

Goodwill
Development costs (Note 3)

Current portion of long-term debt (Note 4)

Long-term debt (Note 4)

Shareholders equity
Share capital

79,257

62,965

Retained earnings

1,153

25,210

80,410

88,175

$ 107,197

$ 114,867

Exhibit 2
COMPUCO LIMITED
Extracts from the Consolidated Income Statement and Statement of Retained Earnings
(in $ thousands)

20X5

For the years ended 31 December

Revenue

Operating
Interest and other

Expenses

20X4

$ 89,821

$ 68,820

1,310

446

91,131

69,266

Operating

76,766

62,355

General and administrative

13,039

12,482

Depreciation

10,220

11,709

Goodwill write-off

12,737

Interest

1,288

1,521

394

Loss before writedown and income taxes

114,445

88,067

(23,314)

(18,801)

(2,518)

Loss on sale of property, plant and equipment

Writedown of loans receivable torecoverable amounts

(Note 1)
Loss before income taxes
Income taxes
Net loss
Retained earnings, beginning of year

(25,832)

(18,801)

2,775

5,161

(23,057)

(13,640)

25,210

38,850

2,153

25,210

Stock dividend

(1,000)

Retained earnings, end of year

$ 1,153

$ 25,210

Exhibit 3
COMPUCO LIMITED
Extracts from Selected Notes to Financial Statements
1. Loans receivable
For the year ended 31 December
The companys loans receivable at 31 December are due from related parties. Amounts as follows:

($ in thousands)
20X5

20X4

XYZ Inc.

$5,962

$5,962

Writedown to recoverable amount

(2,518)

3,444

5,962

Other investments

2,516

1,000

$5,960

$6,962

2. Property, plant and equipment

Additions for the current year amounted to $2,290 and proceeds from the disposal amounted to $250.
3. Development costs
Development costs for a product are amortized once the product is ready for market. The rate depends on the
expected life of the product. In 20X5, $206 of depreciation was expensed.
4. Long-term debt

Debentures

($ in thousands)
20X5

20X4

$12,500

$12,500

Bank term loans, due 31 December 20X2;

Principal repayable $150 a month
(20X4, $100 a month)

Current maturities

4,200

3,200

16,700

15,700

(1,800)

(1,200)

$14,900

$14,500

Debentures bear interest at 12% per annum and are due in 20X8. Bank term loans bear interest at 8% and the
bank advanced $2.2 million during the year.
Source: Case 5-3, pages 241244, Intermediate Accounting, Volume I, 4th edition, 2004 by T.H. Beechy and
J. Conrod. Reproduced and adapted with permission.
Solution

Question 7
A5-7 on page 238. Dividends paid are included in the financing activities section.
Solution

Question 8
A5-9 on pages 239-240. Interest paid is reported as an operating activity. Dividends paid are included in the
financing activities section.
Solution

Question 9
A5-27 on pages 253-254. Interest paid is reported as an operating activity. Dividends paid are included in the
financing activities section.
Solution

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Self-test 3

Question 1 solution

Note 1 Income tax paid for the year amounted to $85,000.

FA2 - Module 3

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Note 2 Interest paid for the year amounted to $3,500. [Interest expense $3,000 + decrease in interest payable
$1,000 decrease in discount on bonds payable $500 = $3,500]
Source: Beechy & Conrod, Solutions Manual to Accompany Intermediate Accounting, 2nd edition, 2002, pages
179-180. Reproduced with permission.

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Self-test 3

Question 2 solution
Multiple choice
a. 1)
For example, interestpaid is considered an operating cash flow but is reported separately from
ongoing operations so that the cost of financing is evident.
b. 3)
The other items relate to the financing and investment section of the SCF.
c. 3)
Insurance expense would not be added back to the net income. Any difference between the
insurance expense in the income statement and the cash paid for insurance will be reflected in
the change in the current asset prepaid insurance. The other three items will result in an
adjustment to the net income. Items 1 and 2 are non-cash items, and number 4 will be removed
from the operating section and included in the investment section with the proceeds from the
sale of investments.
d. 4)
This is a non-cash transaction at this time.
e. 2)
Changes in ordinary shares would be the result of issuing more shares or redeeming some of the
shares. These transactions do not have an impact on the operations section but rather the
financing section.
f. 3)
$350,000 + 85,000 60,000
g. 4)
This is a non-cash transaction that is not reported directly on the SCF. If material, it is separately
disclosed.
h. 1)
A decrease in inventory indicates that some previously purchased inventory has been turned into
cash during the current year, so it would increase the cash flows from operating activities.
i. 4)
This transaction involves some cash, whereas the others are all non-cash transactions.
j. 1)
$40,000 2,000 (12,000 3,000).
k. 1)
$240,000 32,000
l. 4)

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$1,460,000 + 66,000 + 40,000

m. 4)
$845,000 54,000 144,000 = 647,000. $901,000 647,000 = $254,000.
n. 4)
Book value of the sold asset plus gain on sale of the asset = $54,000 + $22,000

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Self-test 3

Question 3 solution
SELLS COMPANY
Statement of cash flows
for the year ended December 31, 20X5
Operating activities:

Cash from customers

$ 304,000

Cash paid for goods and expenses

(116,000)

Cash paid for interest

(3,500)

Cash paid for income taxes

(85,000)

Investing activities:

Proceeds from sale of equipment

20,000

Purchase of equipment

(53,000)

Financing activities:

$ 99,500

(33,000)

Retirement of bonds payable

(30,500)

Dividends paid

(20,000)

(50,500)

Net cash increase

16,000

Cash balance, beginning of year

16,000

Cash balance, end of year

$ 32,000

Source: Adapted from Beechy and Conrod, Solutions Manual to Accompany Intermediate Accounting, 2nd
edition, 2002, pages 179180. Used with permission.

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Self-test 3

Question 4 solution
(A5-1)

Requirements 1 and 2
a)

Investing activities cash paid for capital asset

b)

Financing activities borrowed money

c)

None; non-cash transaction

d)

Financing activities repaid note payable

(18,000)
46,000

(200,000)

Cash flow for interest ($7,800) should be represented by interest expense and is separately disclosed
as a cash outflow as part of operating activties, unless the company has decided it is a financing flow.

e)

Operating activities decrease in wages payable

f)

Operating activities decrease in accounts receivable

$76,000

g)

Financing activities paid dividend

(97,000)

(8,000)

Note: this cash outflow may also be classified in operating activtiies if the company wishes.
h)

Operating activities add back depreciation

i)

Operating activities deduct gain on sale

67,000
(3,000)

Investing activities sold capital asset

13,000

Requirement 3
a)

Investing activities cash paid for capital asset (no

change from above)

b)

Financing activities borrowed money (no change from

above)

c)

None; non-cash transaction (no change from above)

d)

Financing activities repaid note payable (no change

from above)
Operating activities paid interest (may also be in
financing activitiesif the company chooses)

(18,000)
46,000

(200,000)
(7,800)

e)

Operating activities cash paid to employees

(243,000)

f)

Operating activities collected cash from customers

1,071,000

g)

Financing activities paid dividend (no change from

above)

(97,000)

h)

None excluded from SCF

i)

Investing activities sold capital asset (no change from

above)

13,000

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Self-test 3

Question 5 solution
(A5-23)
Part a - Indirect Method
LAURENT COMPANY
Statement of cash flows
for the year ended 31 December 20X8
Operations

Net income

Plus (less) non-cash items

Depreciation

$156,000

12,000
168,000

Plus (less) changes to working capital

Decrease in accounts receivable

Increase in inventory

Increase in accounts payable

(15,000)
18,000

Cash from operations

3,000

Financing activities

$174,000

Increase in short-term bank loan

3,000

Issued common shares for cash*

66,000

Paid cash dividend ($24,000 + $156,000) vs. $72,000

Investing activities

Sold long-term investment

Paid cash for capital assets

Net change in cash

(108,000)

(39,000)

9,000
(27,000)

(18,000)

117,000

Opening cash

( 15,000)

Closing cash

$102,000

* $24,000 non-cash issuance to retire long-term debt is not shown on the SCF.

$150,000 + $24,000 = $174,000 vs. $240,000

Part b - Direct Method (operating activities section only)

LAURENT COMPANY
Statement of cash flows
for the year ended 31 December 20X8
Operations

Cash collected from customers ($900,000 + $3,000)

Cash paid to suppliers ($540,000 + $15,000 - $18,000)

(537,000)

Cash paid for other expenses

(192,000)

Cash from operations

FA2 - Module 3

$903,000

$174,000

Page 37 of 47

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Self-test 3

Question 6 solution
COMPUCO LTD.
Statement of cash flows
For the year ended 31 December 20X5 (in thousands of dollars)

Operating activities:

Net Loss

$(23,057)

Plus (less) non-operating items

Loss on sale of capital items

$394

Loss on writedown of loans receivable

Depreciation

10,220

2,518

Deferred (future) income tax

(2,630)

Goodwill writeoff

Operating cash flow before working capital changes

182

Change in other working capital items (Note 1)

(11,270)

Cash used in operating activities

23,239

12,737

(11,088)

Investing activities:

Purchase of property, plant and equipment

(2,290)

Disposal of property, plant and equipment

250

Development cost (Note 2)

(2,686)

Change in loans receivable

(1,516)

Cash used for investment activities

(6,242)

Financing activities:

Issue of shares

Increase in long-term debt

2,200

Payments on long-term debt

(1,200)

Cash generated from financing activities

15,292

16,292

Net decrease in cash and cash equivalents

(1,038)

Net bank indebtedness, beginning of year

(2,541)

Net bank indebtedness, end of year

$(3,579)

Net bank indebtedness includes

Cash

Bank indebtedness (overdraft)

Total

20X5

20X4

$3,265

$3,739

(6,844)

(6,280)

$(3,579)

$(2,541)

Supplementary disclosure:

Interest received

1,310

Interest paid

(1,289)

Notes:
1. Change in non-cash working capital items related to operations (may be included on the SCF):

Accounts receivable
Inventories
Income tax recoverable
Prepaid expenses

$(5,345)
(4,522)
(145)
211

Accounts payable
Change in non-cash working capital

(1,469)
$(11,270)

2. Development costs:

Investment in development costs:

Closing balance

Less: opening balance

Add back:amortization of development costs

Increase in development costs

$(4,391)
(1,911)
206
$(2,686)

Commentary:

Compuco has incurred material losses for the second consecutive year. The 20X5 loss of $23,057 is significantly
larger than the 20X4 loss of $13,640. Cash used by operations in 20X5 ($11,088) was lower than the net loss.
This was because the loss includes significant non-cash charges of depreciation, and goodwill writeoff, although
this latter writeoff indicates that previously acquired intangibles were overvalued. Loans receivable had to be
written down to market value, again a non-cash charge to earnings, but hardly good news for the company. In
the year, there were increases to accounts receivable and inventory balances, and decreases to accounts
payable, again stretching cash resources.
The company spent approximately $6.2 million on investing activities primarily property, plant and
equipment, and development costs.
Cash from financing activities was raised by the sale of shares and a modest increase in long-term debt. This
indicates that shareholders have faith in the company. However, overall short-term cash (debt) increased by
approximately $1,000,000. Retained earnings have been almost completely eroded by operating losses. The
continued survival of the company will be contingent on improved operating cash flow, or a further infusion of
equity or debt financing. Both may perhaps be needed. The company should have plans to address the survival
factor over the next year.
Source: Solution to Case 5-3, Solutions Manual for Intermediate Accounting , Volume I, 4th edition, 2004 by
T.H. Beechy and J. Conrod. Reproduced and adapted with permission.

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Question 7 solution
RANGLER PAPER COMPANY
Statement of Cash Flow
Year Ended 31 December 20X5
(in 000s)
Net cash inflows (outflows) from operating activities:

Net earnings

$103

Adjustments

20

Depreciation
Net increase in working capital
Net cash inflow (outflow) from operating activities
Cash inflows (outflows) from investing activities:
Cash invested in restricted construction fund
Disposal of operational asset for cash (at book value)

( 3)*

$120

(60)

12

Net cash inflow (outflow) from investing activities

(48)

Cash inflows (outflows) from financing activities:

Paid cash dividend
Borrowed on long-term note
Payment of bonds payable

(10)

25

(97)

Net cash inflow (outflow) from financing activities

(82)

Net increase (decrease) in cash

(10)

Beginning cash balance, 1 January 20x5

62

Ending cash balance, 31 December 20x5

$52

*Changes in current items:

Assets
Increase in Inventory
Increase in Prepaids

Liabilities
$-14 Increase in Accounts payable

$+5

-3

Decrease in Receivables

+7

Decrease in Rent receivable

+2

Net

$-8

Overall (-8 + (+5))

$-3

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Self-test 3

Question 8 solution
Requirement 1
HKL COMPANY
Statement of Cash Flow
Year ended 31 December 20X8
Operating activities
Net earnings paid
Adjustments for non-cash items:
Depreciation
Loss on sale of capital assets
Changes in current assets and current liabilities:
Increase in accounts receivable
Increase in inventory
Decrease in prepaid insurance
Increase in accounts payable
Decrease in wages payable
Increase in rent payable ends
Net cash provided by operations
Investing activities
Sale of equipment (NBV of $6,000; loss of $2,000)
Purchase of land
Financing activities
Issued long-term note ends
Issued common shares ends
Cash dividends paid ($24,000 + $1,000 vs. $23,000)
Net increase (decrease) in cash
Cash balance, beginning of the year
Cash balance, end of the year

$ 1,000

10,000
2,000

(3,000 )
(5,000 )
1,000
3,000
(3,000 )
6,000

4,000
(20,000 )

10,000
22,000
(2,000 )

$ 1,000

10,000
2,000
2,000
3,000

(3,000 )
(5,000 )
1,000
3,000

$ 12,000

(16,000 )

30,000
26,000
35,000
$ 61,000

Requirement 2
HKL COMPANY
Statement of Cash Flow
Year ended 31 December 20X8
Operating activities
Net earnings
Adjustments :
Depreciation
Loss on sale of capital assets
Interest expense
Income tax expense
Changes in current assets and current liabilities:
Increase in accounts receivable
Increase in inventory
Decrease in prepaid insurance
Increase in accounts payable

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Decrease in wages payable

Increase in rent payable ends
Cash paid for interest
Cash paid for income tax
Net cash provided by operations
Investing activities
Sale of equipment (NBV of $6,000; loss of $2,000)
Purchase of land
Financing activities
Issued long-term note ends
Issued common shares ends
Cash dividends paid ($24,000 + $1,000 vs. $23,000)
Net increase (decrease) in cash
Cash balance, beginning of the year
Cash balance, end of the year

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(3,000 )
6,000
(2,000 )
(3,000 )

4,000
(20,000 )

10,000
22,000
(2,000 )

$ 12,000

(16,000 )

30,000
26,000
35,000
$ 61,000

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Course Schedule

Course Modules

Review and Practice

Exam Preparation

Resources

Self-test 3

Question 9 (A5-27) solution

BUFFALO INC.
Statement of Cash Flow
For the year ended 31 December 20X3
Cash for operating activities:

Net earnings (loss)

Plus/minus:
Gain on sale of land

(71,000)

(22,000)

27,000

115,000

Income tax recovery

(54,000)

Depreciation ($110,000 + $75,000)

185,000

180,000

Loss on sale of machine

Interest expense

Changes in working capital

Receivables

(40,000)

Inventory

(99,000)

Current liabilities

(75,000)

(115,000)

Cash paid for interest

Cash received for income tax
Cash for operating activities

54,000

(95,000)

Cash from financing:

Issued preferred shares, for cash

205,000

Dividendspreferred

(50,000)

Dividendscommon (plug) ($311-$71-$50-$148)

(42,000)

Purchase of common shares

Cash from financing

(55,000)

58,000

Cash from investing:

Sale of marketable securities

40,000

Sale of building

60,000

Sale of machine (Given: book value of $67 and cost of

$135)

40,000

Sale of land ($80 + $22)

Purchase of machine ($875 + $120 - $135) versus
$1,080.

102,000

(220,000) *

Cash from investing

(22,000)

Decrease in cash

(15,000)

Opening balance.

20,000

Closing balance

5,000

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*1) The sale price of the machinery is $40,000 as noted in point 3 of additional information.
2) The net book value of the equipment sold is $67,000; Proceeds from the sale plus the loss on sale ($40,000
+ $27,000).
3) Machinery acquired in exchange for shares is valued at $120,000. As noted in point 5 of additional
information, $55,000 of common shares were retired yet the common share account increased by $65,000
($565,000 - $500,000); $55,000 + $65,000 = $120,000.
4) Depreciation of equipment for the year was $75,000 and the accumulated depreciation machinery account
increased from $212,000 to $219,000, which means that the equipment sold had accumulated depreciation of
$68,000 [$212,000 + $75,000 - $219,000 = $68,000]. As such the cost of the machinery sold is $135,000
($67,000 net book value + $68,000 accumulated depreciation).
5) The increase in machinery $1,080,000 [new balance] - $875,000 [old balance] = $205,000 + cost of
machine sold $135,000 cost of machinery acquired by shares $120,000 = $220,000.

Recent assignment question

A requirement of FA2 is to ensure that students are able to make judgment calls, apply research skills, and
effectively communicate their recommendations to others. For this reason, you will see previous assignment
questions in certain modules to provide you with practice in these competencies. Be aware that these skills will
also be assessed on the examination as well as more quantitative skills. Please note that the solutions to these
questions are based on Part V of the CICA Handbook Accounting , which was in effect at the time the
questions were written.

Analysis of Statement of Cash Flows (30 marks)

a. Analyze the attached Consolidated Statements of Cash Flow for Bombardier Inc. for the year
ending January 31, 2008, and give a brief summary of the major activities that appear to have
taken place during the year. (4 marks)

b. What does the line "net change in non-cash balances related to operations" refer to? Explain.
(4marks)

c. Identify possible future problems based on this statement. (4 marks)

Note: Because of the nature of the business, large amounts are paid by customers as advances
and progress billings on long-term contracts, which represent billings allowed under the terms of
the various contracts but for which the work has not yet been done. Consequently, those
amounts represent a current liability.
d. How are cash flow and net income related? How do they differ? (4 marks)
e. Why does the Handbook require that we prepare both an income statement and a statement of
cash flows? (4 marks)

f. Which of the two statements is normally the better indicator of the sustainability of a firms
operations? Why? (4 marks)

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g. Assess the adequacy of Bombardiers cash position from the perspective of creditors. (6 marks)
Marker Guidelines
Analysis of a Statement of Cash Flows (30 marks)

a. (4 marks)

The operations have provided a significant amount of cash ($2.333 billion) and much of that
($1.076 billion) was used to pay off long-term debt. Did that debt mature during the year and
have to be paid or was it management policy to pay off that debt?
It appears that they have continued the policy of asset replacement, but have not incurred any
new long-term debt. Neither have they issued any more shares to generate funds.
The dividend policy does not appear to have changed. There is a significant positive increase in
the "Net change in non-cash balances related to operations," which would normally mean that
the liabilities are growing because the bills are not being paid or the receivables are being
reduced, thus providing more cash.
b. (4 marks)
A major portion of the positive operating cash flow consisted of "net change in non-cash balances
related to operations." This has added to the cash flow from operations. There are several
possible reasons for a significant increase in this figure compared to the previous year.
a.
b.
c.
d.

They could have improved their collection of receivables.

Reduced inventories.
Delayed payments to their suppliers.
Received funds in advance on long-term contracts, which become a liability until the
work is completed.

Without a breakdown of that change, it is impossible to analyze the exact cause of the significant
increase over the previous year 2007, an increase of more than $1billion.
c. (4 marks)
One possible danger is that the contract work that has been billed for already may not reach
conclusion because of future financial constraints or political changes and general change in
economic conditions. These are long-term contracts and if the contracts are not fulfilled, then the
cash already paid may have to be returned.
Inventories have dropped by $451 million, which may be a result of cleaning out old inventories
or keeping fewer items in stock. If the latter, then this may become a problem if this policy is
carried too far. Exchange rates result in a positive difference of $264 million at this time. Will this
continue? Should some hedging be considered?
d. (4 marks)
At a very basic level, net income and cash flow are related because using the indirect method,
net income is the starting point for determining cash flow from operations. Obviously, the more

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profitable the firm is, the more cash inflow from operations that it will receive over time. Net
income and cash flows are also related in that almost all cash inflows and outflows arising from
operations are at some point recorded on the income statement as revenues or expenses.
Cash flow and income differ in many ways. The most obvious of these is that net income is an
accrual based construct that has little to do with how much cash was received or paid out during
the period. For example, we recognize revenue when the risks and rewards of ownership are
transferred, not when we receive the cash. Similarly, the cash received from a bank loan is never
recorded on the income statement nor are the dividends paid out to shareholders.
e. (4 marks)
The Handbook requires that we prepare the two statements because they provide different
information and are used for different purposes. For example, shareholders use net income to
assess managements stewardship of the resources entrusted to them. Creditors, however, are
more interested in the net cash flow of the operation as, ultimately, cash pays bills, not accrualbased net income.
f. (4 marks)
The statement of cash flows, or more specifically the operating section of the statement of cash
flows, is the better indicator of the sustainability of a firms operations. There are two forms of
insolvency the first is when the value of your liabilities exceeds the value of your assets.
Neither the statement of cash flows nor income statement speaks to this matter. The second is
when you are unable to meet your commitments when due. While net income is a well
understood figure and is useful in many ways, it is also an artificial construct that has little to do
with the actual cash flows of the company. For example, it does not speak to cash generated
from asset sales, borrowings, or cash used to purchase capital assets or retire debt. The fact is
that rapidly growing companies usually have a great bottom line but little cash, given their
growing base of trading assets (accounts receivables and inventory). Cash flows from operations
captures this as it reflects the net cash generated by the day-to-day business activities of the
firm. It is quite possible and fairly common to report net income and yet experience a substantive
cash outflow from operations. Cash flows from operations tends to be a better indicator of the
sustainability of the firm than the statement of cash flows as a whole because it speaks to the
underlying core business. Certainly, this figure needs to be analyzed in concert with fixed charges
on this cash-flow stream, such as debt repayment and preferred dividends. While cash can
certainly be generated by borrowing or asset sales, there are obvious limits on both; for this
reason, they are not sustainable.
g. (6 marks)
Creditors are typically concerned about the liquidity and solvency of the borrower. Liquidity is a
measure of the companys ability to pay debts when due; the current ratio is widely used to
assess this aspect. Solvency is a measure of a companys ability to meet its long-term obligations;
a firms long-term debt-to-equity ratio can be used to evaluate a companys solvency. Creditors
can also use the statement of cash flows as an indicator as to the companys ability to repay its
debts.
Because Bombardiers balance sheet as at January 31, 2008 is not classified (broken into current
and non-current components), it is very difficult to accurately assess the companys current ratio.
While close reading of the notes to the financial statements does provide some insight as to the
currency of Bombardiers assets and liabilities, it remains that a definitive comparison cannot be
made given the information at hand. We do know that cash and cash equivalents increased

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US$1billion from US$2.6 billion to US$3.6 billion, though, which while seemingly a positive sign,
was more than offset by the US $1.7 billion increase in advances and progress billings.
Bombardiers long-term debt-to-equity ratio declined from 1.8:1 to 1.4:1. While this decline
suggests that Bombardiers solvency is improving, the absence of a classified balance sheet
hampers this assessment as well.
Bombardiers statement of cash flows indicates that
Cash inflow from operations increased from $891 million to $2.333billion
Cash outflow from investing activities decreased from $1.419billion to $487million
Cash from financing activities declined from a net inflow of $57million to an
outflow of $1.156billion
Cash inflow from continuing operations increased from a net outflow of $337million
to a net inflow of $954million
At first glance, the foregoing appears to be extremely positive. Closer examination as to the
source of cash flows from operating activities suggests that $1.336 billion of the $2.333 billion
was generated through the net change in non-cash balances related to operations. From perusal
of the accompanying note to the financial statements, we know that this change was due
primarily to an increase in accounts payable, which is not sustainable in the long run.
When considering all of the above, from a creditors perspective, it would appear that Bombardier
is sufficiently liquid and solvent to meet its ongoing obligations in a timely manner. Given the
downturn in the global economy, though, this aspect may deteriorate and should be monitored
on an ongoing basis.
Note: Students answers will vary widely. They should be awarded marks based on the logic, clarity, and
reasonableness of their response.

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