The following additional information about Gould for Year 2 is available:

i. The company purchased a truck during the year at a cost of $30,000 that was financed in
full by the manufacturer.
ii. A truck with a cost of $10,000 and a net book value of $2,000 was sold during the year
for $7,000. There were no other sales of depreciable assets.
iii. Dividends paid during Year 2 are $51,000.
SOLUTION:
INDIRECT METHOD
Gould Corporation
Statement of Cash Flows [Indirect Method]
Particulars Amount Amount
[1] Cash flows from operating activities:
Net income 84,000
Add/(deduct) items to reconcile cash basis net income
(+) Depreciation and amortization 35,000
(-) Gain on sale of assets (5,000)
(-) Increase in accounts receivables (9,000)
(-) Decrease in inventory 6,000
 (+) Decrease in prepaid expenses 3,000
(-) Decrease in accounts payable (5,000)
(+) Decrease in accrued expenses 4,000
Net cash flow from operating activities 1,13,000
[2] Cash flow from investing activities:
Purchase of equipment [Working-1] (70,000)
Sale of equipment 7,000
Net cash flow from investing activities (63,000)
[3] Cash flow from financing activities
Payment for mortgage payable (1,50,000
)
Issuance of preferred stock 1,75,000
Dividends paid (51,000)
Net cash flow from financing activities (26,000)
Net increase in cash 24,000
Add: Beginning cash balance 51,000
Ending cash balance 75,000
Note-(1): Plant Assets
Ending plant assets 4,40,000
Add: Plant assets sold 10,000
4,50,000
Less: Plant asset purchased on credit 30,000
4,20,000
Less: Beginning balance 3,50,000
Plant assets purchased for cash 70,000
Note-2: If dividend is not given
Beginning retained earnings 22,000
Add: Net income 84,000
1,06,000
Less: Ending retained earnings 55,000
Dividend paid 51,000
OR
Working-(1):
Plant Assets
Dr Cr
Particulars Amount Particulars Amount
Beginning balance 3,50,000 Sale [Cash 7,000] 10,000
Purchased [by notes payable] 30,000
Purchase [cash] 70,000
Ending balance 4,40,000
4,50,000 4,50,000
Working-(2):
 Accumulated depreciation
Dr Cr
Particulars Amount Particulars Amount
Beginning balance 1,25,000

Accumulated depreciation for 8,000 Depreciation for the year 28,000

sold truck [10,000-2,000]
Ending balance 1,45,000
1,53,000 1,53,000
Procedure:
i. For indirect method, start with net income from income statement
ii. Find out the non-cash items in income statement
iii. Adjust changes in current assets and current liabilities
iv. Changes in fixed assets and loan provided
v. Changes in financing activities [ loans taken, equity, preferred shares and dividends]
DIRECT METHOD
• The direct (or inflow-outflow) method reports gross cash receipts and cash disbursements
related to operations—essentially adjusting each income statement item from accrual to
cash basis.
• A majority of respondents to the accounting Exposure Draft preceding current
requirements for reporting cash flows, especially creditors, preferred the direct method.
The direct method reports total amounts of cash flowing in and out of a company from
operating activities.
CONVERTING FROM INDIRECT TO DIRECT METHOD
• Conversion from the indirect to the direct format is portrayed in Exhibit 7.4 (next slide)
using values from Gould Corporation.
• We begin by disaggregating net income ($84,000) into total revenues ($660,000) and
total expenses ($576,000). Next, our conversion adjustments are applied to relevant
categories of revenues or expenses. From these adjustments we report the direct format of
Gould Corporation’s cash flows from operations.
• The gain from sale of equipment (transferred to investing activities) is omitted from the
direct method presentation.
Working-(1): Cash collection from sales
Sales 6,60,000
Add: Beginning accounts receivable 39,000
Total 6,99,000
Less: Ending accounts receivable 48,000
 Cash received from customers 6,51,000
Working-(2): Payment for purchases
Cost of sales 3,63,000
Beginning inventories 60,000
Add: Purchases 3,57,000
Cost of goods available for sales 4,17,000
Less: Ending inventories 54,000
Cost of sales 3,63,000
Payment for purchases
Purchases 3,57,000
Add: Beginning accounts payable 56,000
Total payable 4,13,000
Less: Ending accounts payable 51,000
Cash payments for purchases 3,62,000
Working –(3): Cash payments for operating expenses
Operating expenses 1,83,000
(+) Ending prepaid expenses 6,000
1,89,000
(-) Beginning prepaid expenses 9,000
1,80,000
(+) Beginning accrued expenses 14,000
1,94,000
Less: Ending accrued expenses 18,000
Cash paid for operating expenses 1,76,000
Gould Corporation
Statement of Cash Flows [Direct Method]
Particulars Amount Amount
[1] Cash flows from operating activities:
Cash received from customers [Working-1] 6,51,000
Cash payments for purchases [Working-2] (3,62,000
)
Cash paid for operating expenses [Working-3] (1,76,000
)
Net cash flow from operating activities 1,13,000
[2] Cash flow from investing activities:
Purchase of equipment [Working-1] (70,000)
Sale of equipment 7,000
Net cash flow from investing activities (63,000)
[3] Cash flow from financing activities
Payment for mortgage payable (1,50,000
)
Issuance of preferred stock 1,75,000
Dividends paid (51,000)
 Net cash flow from financing activities (26,000)
Net increase in cash 24,000
Add: Beginning cash balance 51,000
Ending cash balance 75,000

EXERCISE 7-2
It is important that an analyst understand the activities that comprise the statement of cash flows,
including the disclosure of their individual elements.
Required:
(i) Practice requires the classification of cash inflows and outflows into three categories. Identify
and describe those categories.
(ii) Which noncash activities are reported in the statement of cash flows and how are they
reported?
(iii) Assume First Corporation retains you to consult with them on preparation of the statement
of cash flows using the indirect method for the year ended December 31, Year 8. Advise them on
how the following separate items affect the statement of cash flows and how they are shown on
the statement:
a. Net income for the fiscal year is $950,000, including an extraordinary gain of $60,000.
b. Depreciation expense of $80,000 is included in the income statement.
c. Uncollectible accounts receivable of $50,000 are written off against the allowance for
uncollectible accounts. Bad debts expense of $24,000 is included in determining earnings
for the year, and the same $24,000 amount is added to the allowance for uncollectible
accounts.
d. Accounts receivable increase by $140,000 during the year and inventories decline by
$60,000.
e. Taxes paid to governments amount to $380,000.
f. A gain of $5,000 is realized on the sale of a machine; it originally cost $75,000 and
$25,000 is undepreciated on the date of sale.
g. On June 5, Year 8, buildings and land are purchased for $600,000; First Corp. gave in
payment $100,000 cash, $200,000 in market value of its unissued common stock, and a
$300,000 mortgage note.
h. On August 8, Year 8, First Corp. converts $700,000 face value of its 6% convertible
debentures into $140,000 par value of its common stock. The bonds are originally issued
at face value.
i. The board of directors declares a $320,000 cash dividend on October 30, Year 8, payable
on January 15, Year 9, to stockholders of record on November 15, Year 8.
j. On December 15, Year 8, First Corp. declares a 2-for-1 stock split payable on December
25, Year 8.
SOLUTION:
Req-(i):
According to the practice we can classify cash inflows and outflows into three categories, for
example, operating, investing and financing activities. Operating activities encompasses all the
earnings-related activities of the enterprise. They encompass, in addition to all the income and
expense items found in the income statement, all the net inflows and outflows of cash that
operations impose on the enterprise. Such operations include activities such as the extension of
credit to customers, investments in inventories, and obtaining credit from suppliers. This means
that operating activities relate to all items in the income statements as well as to the balance sheet
items which are related to operations- mostly working capital accounts such as accounts
receivable, inventories, prepayments, accounts payable, and accruals.
Investing activities include acquiring and selling or otherwise disposing of both securities that
are not cash equivalents and productive assets that are expected to generate revenues over the
long-term. They also include lending money and collecting on such loans.
Financing activities include obtaining resources from owners and providing them a return. They
also include obtaining resources from creditors and repaying the amounts borrowed or otherwise
setting the obligations.

Req-(ii):
It is required that all significant non-cash financing and investing activities should be disclosed.
For example, noncash transactions that include the conversion of debt to equity, the acquisition
of assets through the issuance of debt, and exchanges of assets and liabilities, should be disclosed
in a separate schedule of non-cash investing and financing activities.
Req-(iii):
(a) Net income is the starting point of the computation of cash flow from operating activities.
This is not required that the extra-ordinary items should be disclosed separately in the
statement of cash flow.
(b) Depreciation is added back as an expense not requiring cash.
(c) The write off of uncollectible receivables does not affect cash. Similarly, the bad debt
expense does not require an outlay of cash. Since, this corporation uses the indirect
method for presentation of cash flow statement, no additional adjustment is needed
beyond the adjustment for the change in the net accounts receivable, which includes the
credit to the allowance for doubtful accounts.
(d) The $1,40,000 increase in accounts receivable means that some sales have not been
collected in cash and accordingly, net income is reduced by $1,40,000 in arriving at cash
flow from operating activities. The $60,000 decline in inventories means that cost of
goods sold includes inventories paid for prior years, and did not require cash this year. As
such, net income is increased by $60,000 in arriving cash flow from operating activities.
(e) This $3,80,000 is an expense requiring cash- no adjustment is called for. This amount
also must be disclosed as part of the supplemental disclosures.
(f) Calculation of cash
Original cost 75,000
Less: Undepreciated amount 25,000
Accumulated depreciation 50,000

Undepreciated amount 25,000

Gain 5,000
Cash on sales of machine 30,000
This $30,000 increase in cash is shown as a source of cash from investing activities. The
$5,000 gain is deducted from net income so that the entire proceeds of the sale are shown
as part of investment activities.
 (g) Only the cash payments of $1,00,000 is shown in statement of cash flow as an investing
activity outflow. In a separate schedule, the purchase of buildings and land for non-cash
considerations is detailed.
(h) This is a noncash transaction that is disclosed in a separate schedule of noncash investing
and financing activities.
(i) The declaration of a cash dividend creates a current liability. During year 8, no cash
outflow occurs and there is nothing to report on the year 8 statement of cash flows.
(j) This event has no effect on cash nor need it be reported in the statement of cash flow.
EXERCISE 7-3:
The following data are taken from the records of Saro Corporation and subsidiaries for Year 1:
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000
Depreciation, depletion, and amortization . . . . . . . . . . . . . . . . . . . . . . 8,000
Disposals of property, plant, and equipment (book value) for cash . . . 1,000
Deferred income taxes for Year 1 (noncurrent) . . . . . . . . . . . . . . . . . . . 400
Undistributed earnings of unconsolidated affiliates . . . . . . . . . . . . . . 200
Amortization of discount on bonds payable . . . . . . . . . . . . . . . . . . . . . 50
Amortization of premium on bonds payable . . . . . . . . . . . . . . . . . . . . . 60
Decrease in noncurrent assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500
Cash proceeds from exercise of stock options . . . . . . . . . . . . . . . . . . . 300
Increase in accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900
Increase in accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200
Decrease in inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 850
Increase in dividends payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
Decrease in notes payable to banks . . . . . . . . . . . . . . . . . . . . . . . . . . . 400
Required:
a. Determine the amount of cash flows from operations for Year 1 (use the indirect
format).
b. For the following items, explain their meaning and implications, if any, in adjusting
net income to arrive at cash flows from operations.
(1) Issuance of treasury stock as employee compensation.
(2) Capitalization of interest incurred.
(3) Amount charged to pension expense differing from the amount funded.
SOLUTION:
Req-(a): Cash flow from operating activities:
Net income 10,000
Add/(deduct) items to convert to cash basis:
Add: Depreciation, depletion and amortization 8,000
Add: deferred income taxes 400
Less: Undistributed earnings of nonconsolidated subsidiaries and affiliates (200)
Add: Amortization of bond discount 50
Less: Amortization of premium of bonds payable (60)
Less: Increase in accounts receivable (900)
Add: Increase in accounts payable 1,200
Add: Decrease in inventories 850
Cash provided by operating activities 19,340
Req-(b):
 (1) The issuance of treasury stock for employee stock plans (as compensation) requires add
back to net income because it is an expense not using cash.
(2) The cash outflow for interest is not included in expense and must be included as cash
outflow in investing activities (as part of outlays for property).
(3) If the difference between pension and actual funding is an accrued liability, the unpaid
portion must be added back to income as an expense not required cash. If the amount
funded exceeds pension expense, then net income must be reduced by that excess
amount.
EXERCISE 7-4
SOLUTION:
Req-(a): Cash collected from sales during year 2
Net sales 19,37,000
Add: Beginning accounts receivables 3,05,000
Total potential receipts 21,42,000
Less: Ending accounts receivables 2,95,000
Cash collected from sales 18,47,000
Req-(b): Cash payments on accounts payable
Calculation of purchase
Ending inventory 5,49,000
Add: Cost of sales 11,50,000
Cost of goods available for sales 16,99,000
Less: Beginning inventory 4,31,000
Purchases during the year 12,68,000
Cash payments for purchases
Beginning accounts payable 5,63,000
Add: Purchases 12,68,000
Total probable payable 18,31,000
Less: Ending accounts payable 6,04,000
Cash payments for accounts payable 12,27,000
Req-(c) Cash receipt during year 2 not provided by operations
Issuance of capital stock [30,000+51,000) 81,000
Issuance of treasury stock 17,000
Total cash receipt from non-operating activities 98,000
Req-(d): Cash payments for non-current assets purchased during the year 2
Purchase of land 1,50,000
Purchase of plant and equipment 18,000
Total cash payments for non-current assets 1,68,000
EXERCISE 7-5:
Indicate if each transaction and event is (1) a source of cash, (2) a use of cash, and/or (3) an
adjustment leading to a source or use of cash (assume an indirect format). List also its placement
in the statement of cash flows: operations (O), financing (F), investing (I), noncash significant
(NCS), noncash nonsignificant (NCN), or no effect (NE).
SOLUTION:
Transactions Source Use Adjustment Category
Increase in accounts receivable X X O
Pay bank note X F
Issue common stock X F
Sell marketable securities X I
Retire bonds X F
Declare stock dividend NCN
Purchase equipment X I
Convert bonds to preferred stock NCS
Pay dividend X F
Increase in accounts payable X X O