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Unformatted text preview: CHAPTER 5 Reporting Cash Flows THINKING BEYOND THE QUESTION How is cash flow information determined and reported to external users? A business can fail when it has insufficient cash to pay for its resource requirements and to pay principal and interest on its debt. Consequently, a profitable business that does not collect cash on a timely basis from its customers or that creates large amounts of debt can fail even though it is profitable. The primary cause of business failure for most companies is having in- adequate cash flow. Financial statements are useful for identifying a company’s sources and uses of cash and the demands on future cash flows associated with debt. QUESTIONS Q5-1 The direct format statement of cash flows answers the questions “where did cash come from?” and “where did cash go?” It lists sources and uses of cash for each of the three types of activities—operating, investing, and financing. Q5-2 The acquisition of machinery typically involves cash. Nevertheless, the acquisition of machinery is always an investing activity. How it was paid for makes no difference. Long-term notes payable are generally issued in exchange for cash. Nevertheless, the issuance of a note payable is always a financing activity. What the firm got in return makes no difference. Therefore, the direct exchange of a note payable for machinery is both a financing activity and an investing activity at the same time. Q5-3 GAAP require that the issuance of either debt or equity in exchange for long-term assets be disclosed, but not necessarily on the statement of cash flows. Even though no cash is involved, most companies report this information at the bottom of the statement of cash flows as an addendum. Companies also have the option of reporting this information in a separate schedule. Regardless of the disclosure method chosen, the requirement is that a user of the financial statements be able to identify all material financing and investing activities of the fiscal period. 131 132 Chapter 5 Q5-4 The usual presentation of investing activity and financing activity information on a statement of cash flows is consistent with the direct format that is occasionally used in the operating activities section. Q5-5 Interest is included as an operating activity because interest expense is included on the income statement. The FASB decided that cash paid for interest should be an operating item for consistency. One could argue that interest is logically a financing activity. Nevertheless, GAAP require that it be included as an operating activity. Q5-6 Q5-7 When the balance in accounts receivable increases during a fiscal period, it means that new sales on credit have exceeded the amount of cash collected from receivables. Therefore, the amount of revenue recognized on the income statement is greater than the amount of cash collected from customers. To reconcile net income to cash from operations, the increase in accounts receivable must be subtracted....
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- Spring '11