Problem 15-18 (IAA)

Saturn Company reported that the financial statements contained the following errors:

2012 2013
Ending inventory 60,000 understated 90,000 overstated
Depreciation expense 120,000 overstated 75,000 overstated

None of the errors were detected or corrected, and that no additional errors were made in 2014.
By what amount would current assets on December 31, 2014 be overstated or understated?

a. 90,000 understated
b. 90,000 overstated
c. 30,000 overstated
d. 0

Problem 15-19 (AICPA Adapted)

Glory Company reported the following errors in the financial statements:

2013 2014
Ending inventory 200,000 under 300,000 over
Depreciation 50,000 under

An insurance premium of P150, 000 was prepaid in 2013 to cover 2013, 2014 and 2015. The
entire amount was charged to expense in 2013. On December 31, 2014, fully depreciated
machinery was sold for P250, 000 cash but the sale was not recorded until 2015. There were no
other errors during 2013 and 2014 and no corrections have been made for any of the errors.
Ignoring income tax, what is the effect of the errors on retained earnings on December 31, 2014?

a. 300,000 overstated
b. 250,000 understated
c. 50,000 overstated
d. 50,000 understated

565
Problem 15-20 (AICPA Adapted)

Shannon Company began operations on January 1, 2013. The financial statements contained the
following errors:

2013 2014
Ending inventory 16,000 understated 15,000 overstated
Depreciation expense 6,000 understated
Insurance expense 10,000 overstated 10,000 understated
Prepaid insurance 10,000 understated

On December 31, 2014, fully depreciated machinery was sold for P10, 800 cash but the sale was
not recorded until 2015. No corrections have been made for any of the errors. Ignoring income
tax, what is the total effect of the errors on

1. Net income for 2013?

a. 20,000 over
b. 20,000 under
c. 26,000 under
d. 0

2. Net income for 2014?

a. 30,200 over
b. 30,200 under
c. 41,000 over
d. 41,000 under

3. Retained earnings on December 31, 2014?

a. 10,200 over
b. 10,200 under
c. 20,000 over
d. 20,000 under

4. Working capital on December 31, 2014?

a. 4,200 over
b. 5,800 under
c. 6,000 under
d. 9,800 under

566
Problem 15-21 (IAA)

Zenson Company has determined the 2014 net income to be P5, 000,000. Revenue received in
advance in 2014 of P250, 0000 was credited to a revenue account when received. Of the total,
P50, 000 was earned in 2014, P120, 000 will be earned in 2015 and the remainder will be earned
in 2016. Loss on sale of equipment of P150, 000 in 2014 was erroneously debited to retained
earnings. What is the adjusted net income for 2014?

a. 4,650,000
b. 4,850,000
c. 4,930,000
d. 4,600,000

Problem 15-22 (IAA)

Lea Company had correctly determined the following information related to operations for 2014.

Revenue from sales 7,000,000

Expenses 4,000,000

Income before income tax 3,000,000

During 2014, the entity discovered an error in depreciation in 2013. The correction of this error,
which has not been recorded, will result in an increase in depreciation for 2013 of P200, 000.
During 2014, an inventory loss of P400, 000 was due to government ban on certain highly
flammable fabrics. This has not been recorded. What is the adjusted income before tax for 2014?

a. 2,600,000
b. 2,400,000
c. 3,000,000
d. 3,400,000

567
Problem 15-23 (PHILCPA Adapted)

Malampaya Company showed income before income tax of P6, 500,000 on December 31, 2014.
The year-end verification of the transactions revealed the following errors:

P1, 000,000 worth of merchandise was purchased in 2014 and included in the ending
inventory. However, the purchase was recorded only in 2015.

A merchandise shipment valued at P1, 500,000 was properly recorded as purchase at

year-end. Since the merchandise was still at the port area, it was inadvertently omitted
from the inventory on December 31, 2014.

Advertising for December 2014, amounting to P500, 000, was recorded when payment
was made in January, 2015.

Rent of P300, 000 on an equipment applicable for six months was received on November
1, 2014. The entire amount was reported as income upon receipt.

Insurance premium covering the period from July 1, 2014 to July 1, 2015, amounting to
P200, 000 was paid and recorded as expense on July 31, 2014. The entity did not make
any adjustment at the end of the year.

What is the corrected income before tax for 2014?

a. 6,900,000
b. 6,400,000
c. 6,500,000
d. 6,300,000

568
Problem 15-24 (IAA)

Blonde Company provided the following information for each year:

2014 2013
Sales 4,600,000 4,350,000
Cost of goods sold 2,346,000 2,305,000
Expenses 1,598,000 1,533,000
Beginning retained earnings 1,441,000 1,077,000
Dividends paid 157,000 148,000

In 2015, the entity discovered that ending inventory for 2013 was understated by P100, 000 and
the ending inventory for 2014 was overstated by P300, 000.

1. What is the corrected income for 2013?

a. 512,000
b. 612,000
c. 412,000
d. 912,000

2. What is the corrected income for 2014?

a. 856,000
b. 256,000
c. 556,000
d. 356,000

3. What is the corrected balance of retained earnings on December 31, 2014?

a. 2,240,000
b. 1,640,000
c. 2,340,000
d. 1,540,000

569
Problem 15-25 (IAA)

Mariot Company reported income before tax of P3, 700,000 for 2013 and P5, 200,000 for 2014.
An audit produced the following information:

The ending inventory for 2013 included 5, 000 units erroneously priced at P59 per unit.
The correct cost was P95 per unit.

Merchandise costing P175, 000 was shipped to Mariot Company, FOB shipping point, on
December 26, 2013. The purchase was recorded in 2013, but the merchandise was
excluded from the ending inventory because it was not received until January 4, 2014.

On December 28, 2013, merchandise costing P30, 000 was sold to Deluxe Company.
Deluxe had asked Mariot in writing to keep the merchandise until January 2, 2014. The
merchandise was included in the inventory count. The sale was correctly recorded in
December 2013.

Gray Company sold merchandise costing P15, 000 to Mariot Company. The purchase
was made on December 29, 2013 and the merchandise was shipped on December 30,
2013. Terms were FOB shipping point. Because the bookkeeper was on vacation, neither
the purchase nor the receipt of goods was recorded until January 2014?

What is the correct income before tax for 2014?

a. 4,875,000
b. 4,815,000
c. 4,890,000
d. 5,525,000

570
Problem 15-26 (IAA)

Rebecca Company is in the process of adjusting the accounts at the end of 2014. The records
revealed the following information:

The entity failed to accrue sales commissions at the end of each year as follows:

2012 220,000
2013 140,000

In each case, the sales commission were paid and expensed in January of the following
year.

Errors in ending inventories for the last three years were discovered to be as follows:

2012 400,000 understated

2013 540,000 overstated
2014 150,000 understated

The unadjusted retained earnings balance on January 1, 2014 is P12, 600,000 and the unadjusted
net income for 2014 was P3, 000,000. Dividends of P1, 750,000 were declared during 2014.

1. What is the adjusted net income for 2014?

a. 3,830,000
b. 3,150,000
c. 3,680,000
d. 3,530,000

2. What is the adjusted balance of retained earnings on December 31, 2014?

a. 14,000,000
b. 13,320,000
c. 13,850,000
d. 11,000,000

571
Problem 15-27 (IAA)

Holden Company reports on a calendar-year basis. The financial statements contained the
following errors:

2013 2014
Over (under) statement of ending inventory (100,000) 40,000
Depreciation understatement 40,000 60,000
Failure to accrue salaries at year-end 80,000 120,000

As a result of the errors, what was the effect on net income for 2014?

a. 240,000 understated
b. 240,000 overstated
c. 320,000 understated
d. 320,000 overstated

Problem 15-28 (AICPA Adapted)

During the course of an audit of the financial statements of Julie Company for the year ended
December 31, 2014, the following data are discovered:

Inventory on January 1, 2014 had been overstated by P300, 000.

Inventory on December 31, 2014 was understated by P500, 000.

An insurance policy covering three years had been purchased on January 1, 2013 for
P150, 000. The entire amount was charged as an expense in 2013.

During 2014, the entity received a P100, 000 cash advance from a customer for merchandise to
be manufactured and shipped during 2015. The amount had been credited to sales revenue. The
gross profit on sales is 50%. Net income for 2014 per book was P2, 000,000. What is the proper
net income for 2014?

a. 2,650,000
b. 2,350,000
c. 1,650,000
d. 2,050,000

572
Problem 15-29 (AICPA Adapted)

Galaxy Company provided the following financial statement information:

2015 2014
Revenue 1,350,000 1,000,000
Expenses 980,000 650,000
Net income 370,000 350,000

Total assets 1,750,000 1,050,000

Total liabilities 500,000 350,000
Total owners equity 1,070,000 700,000

The entity failed to record P120, 000 of accrued wages at the end of 2014. The wages were
recorded and paid in January 2015. The correct accruals were made on December 31, 2015.

1. What is the corrected net income for 2014?

a. 230,000
b. 350,000
c. 470,000
d. 250,000

2. What is the corrected net income for 2015?

a. 490,000
b. 370,000
c. 250,000
d. 430,000

3. What is the correct amount of total liabilities on December 31, 2014?

a. 470,000
b. 230,000
c. 400,000
d. 500,000

4. What is the correct amount of owners equity on December 31, 2015?

a. 1,070,000
b. 1,190,000
c. 1,010,000
d. 950,000

573
Problem 15-30 (AICPA Adapted)

Jenny Company reported net income of P9, 000,000 in 2014. The audit of the records revealed
that the ending inventory of 2013 was understated by P500, 000. Insurance payment of P900,
000 in 2012 was charged to expense. The insurance coverage related equally to 2012, 2013 and
2014. Revenue received in advance of P1, 000,000 in 2014 was treated as earned in 2014 but it
will actually be earned in 2015. Interest payable of P2, 000,000 at the end of 2014 was not
recorded. What is the corrected net income for 2014?

a. 5,200,000
b. 6,700,000
c. 6,000,000
d. 7,200,000

Problem 15-31 (AICPA Adapted)

Emma Company revealed the following errors in the financial statements:

December 31, 2013 inventory understated 500,000

December 31, 2014 inventory overstated 800,000
Depreciation for 2013 overstated 250,000
December 31, 2014 accrued rent income overstated 300,000
December 31, 2014 accrued salaries understated 150,000

The understatement of the 2013 ending inventory pertains to goods in transit purchased FOB
shipping point which were not recorded in 2013 but paid in 2014. On December 31, 2014, fully
depreciated machinery was sold for P100, 000 cash but the sale was not recorded until 2015.
What is the effect of the errors on retained earnings on December 31, 2014?

a. 1,150,000 understated
b. 1,150,000 overstated
c. 900,000 understated
d. 900,000 overstated

574
CHAPTER 16

STATEMENT OF CAH FLOWS

Definition

A statement of cash flows is a component of financial statements summarizing the operating,

investing and financing activities of an entity.

In simple language, the statement of cash flows provides information about the cash receipts
and cash payments of an entity during a period.

An entity shall prepare a statement of cash flows and present it as an integral part of the
financial statements for each period for which financial statements are presented.

Purpose of statement of cash flows

The primary purpose of a statement of cash flows is to provide relevant information about cash
receipts and cash payments of an entity during a period.

Cash flow information is useful in assessing the ability of the entity to generate cash and cash
equivalents.

The statement of cash flows also enhances the comparability of operating performance by
different entities.

Users of an entitys 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 entitys activities.

Entities need cash for essentially the same reasons however different in their principal revenue
producing activities might be.

Entities need cash to conduct their operations, to pay their obligations and to provide returns to
their investors.

575
Cash and cash equivalents

The statement of cash flows is designed to provide information about the change in an entitys
cash and cash equivalents.

Cash comprises cash on hand and demand deposits.

Cash equivalents are short-term highly liquid investments that are readily convertible to known
amount of cash and which are subject to an insignificant risk of change in value.

PAS 7, paragraph 7, provides that an investment normally qualifies as a cash equivalent only
when it has a short maturity of three months or less from date of acquisition.

In other words, the investment must be acquired three months or less before the date of maturity.

Examples of cash equivalents

a. Three-month BSP treasury bill

b. Three-year BSP treasury bill purchased three months before date of maturity
c. Three-month time deposit
d. Three-month money market instrument or commercial paper

Thus, a BSP treasury bill that was purchased three years ago cannot qualify as cash equivalent
even if the remaining maturity is three months or less.

Equity securities cannot qualify as cash equivalents because shares do not have a maturity date.

However, preference shares with specified redemption date and acquired three months before
the redemption date can qualify as cash equivalents.

576
Components of cash and cash equivalents

An entity shall disclose the components of cash and cash equivalents and shall present a
reconciliation of the amounts in the statement of cash flows with the equivalent items reported in
the statement of financial position.

It is also necessary to disclose the accounting policy used in deciding which items are included in
determining cash and cash equivalents.

Classification of cash flows

Cash flows are inflows and outflows of cash and cash equivalents.

The statement of cash flows shall report cash flows during the period classified as operating,
investing and financing activities.

Classification by activity provides information that allows users to assess the impact of those
activities on the financial position of the entity and the amount of its cash and cash equivalents.

Bank borrowings are generally considered as financing activities.

However, bank overdrafts which are repayable on demand form an integral part of an entitys
cash management.

In these circumstances, bank overdrafts are included as component of cash and cash equivalents.

A characteristic of such banking arrangement is that the bank balance often fluctuates from being
positive to overdrawn.

In the Philippines, bank overdrafts generally are not permitted.

577
Operating activities

Operating activities are the cash flows derived primarily from the principal revenue producing
activities of the entity.

In other words, operating activities generally result from transactions and other events that enter
into the determination of net income or loss.

Examples of cash flows from operating activities are:

a. Cash receipts from sale of goods and rendering of services

b. Cash receipts from royalties, rental, fees, commissions and other revenue
c. Cash payments to suppliers for good and services
d. Cash payments for selling, administrative and other expenses
e. Cash receipts and cash payments of an insurance enterprise for premiums and claims,
annuities and other policy benefits
f. Cash payments or refunds of income taxes unless they can be specifically identified with
financing and investing activities
g. Cash receipts and payments for securities held for dealing or trading purposes

Trading securities

PAS 7, paragraph 15, provides that cash flows arising from the purchase and sale of dealing or
trading securities are classified as operating activities.

Similarly, cash advances and loans made by a financial institution are usually classified as
operating activities since they relate to the main revenue producing activity of that entity.

Investing activities

Investing activities are the cash flows derived from the acquisition and disposal of long-term
assets and other investments not included in cash equivalent.

As a simple guide, investing activities include cash flows from transactions involving
nonoperating assets.

578
Examples of cash flows from investing activities

a. Cash payments to acquire property, plant and equipment, intangibles and other long-term
assets.

b. Cash receipts from sales of property, plant and equipment, intangibles and other long-
term assets.

c. Cash payments to acquire equity or debt instruments of other entities and interests in
joint ventures (current and long-term investments).

d. Cash receipts from sales of equity or debt instruments of other entities and interests in
joint venture.

e. Cash advances and loans to other parties (other than advances and loans made by
financial institution).

f. Cash receipts from repayment of advances and loans made to other parties.

g. Cash payments for future contract, forward contract, option contract and swap contract.

h. Cash receipts from future contract, forward contract, option contract and swap contract.

Financing activities

Financing activities are the cash flows derived from the equity capital and borrowings of the
entity.

In other words, financing activities are the cash flows that result from transactions between the
entity and its owners (equity financing) and between the entity and its creditors (debt financing).

As a simple guide, financing activities include the cash flows from transactions involving
nontrade liabilities and equity of an entity.

579
Examples of cash flows from financing activities

a. Cash receipts from issuing shares or other equity instruments (for example, issuance of
ordinary and preference shares).

b. Cash payments to owners to acquire or redeem the enterprises shares (for example,
payment for treasury stock).

c. Cash receipts from issuing debentures, loans, notes, bonds, mortgages, and other short or
long term borrowings.

d. Cash payments for amounts borrowed.

e. Cash payments by a lessee for the reduction of the outstanding liability relating to a
finance lease.

Note that cash payments to settle such obligations as trade accounts and notes payable, income
tax payable, accrued expenses and similar items are operating activities, not financing activities.

Noncash transactions

PAS 7, paragraph 43, provide that investing and financing transactions that do not require use of
cash or cash equivalents shall be excluded from the statement of cash flows.

Such transactions shall be disclosed elsewhere in the financial statements either in the notes to
financial statements or in a separate schedule or in a way that provides all relevant information
about these transactions.

The statement of cash flows is strictly a cash concept. Accordingly, the following noncash
transactions are disclosed separately:

a. Acquisition of asset either by assuming directly related liability or by means of a finance

lease.

b. Acquisition of asset by means of issuing share capital or bonds payable.

c. Conversion of debt to equity, for example conversion of bonds payable to share capital.

d. Conversion of preference share to ordinary share.

580
Interest

PAS 7, paragraph 33, provides that interest paid and interest received shall be classified as
operating cash flows because they enter into the determination of net income or loss.

Alternatively, interest paid may be classified as financing cash flow because it is a cost of
obtaining financial resources.

Alternatively, interest received may be classified as investing cash flow because it is a return on
investment.

For a financial institution, interest paid and interest received are usually classified as operating
cash flows.

Cash flows from interest paid and interest received shall be classified in a consistent manner
from period to period as either operating, investing or financing activities.

Dividends

PAS 7, paragraph 33, provides that dividend received shall be classified as operating cash flow
because it enters into the determination of net income.

Alternatively, dividend received may be classified as investing cash flow because it is a return
on investment.

PAS 7, paragraph 34, provides that dividend paid shall be classified as financing cash flow
because it is a cost of obtaining financial resources.

Alternatively, dividend paid may be classified as operating cash flow in order to assist users to
determine the ability of the entity to pay dividends out of operating cash flows.

The classification of dividend received and dividend paid as either operating, investing or
financing activity shall be made on a consistent basis from period to period.

581
Income taxes

PAS 7, paragraph 35, provides that cash flows arising from income taxes shall be separately
disclosed as cash flows from operating activities unless they can be specifically identified with
investing and financing activities.

Tax cash flows are often difficult to match to the originating underlying transaction, so most of
the time all tax cash flows are classified as arising from operating activities.

Illustration Operating activities

Simple Company reported the following comparative statement of financial position and income
statement for 2014.

Assets 2014 2013

Cash 3,000,000 2,000,000

Accounts receivable 940,000 350,000
Inventory 175,000 100,000
Prepaid insurance 15,000 20,000
Property, plant and equipment 2,000,000 2,000,000
Accumulated depreciation ( 550,000) ( 500,000)
Patent 40,000 50,000

Total assets 5,620,000 4,020,000

Liabilities and Equity

Accounts payable 170,000 150,000

Accrued salaries payable 25,000 10,000
Accrued interest payable 10,000 15,000
Income tax payable 350,000 250,000
Unearned rent income 10,000 40,000
Mortgage payable 500,000 500,000
Share capital 2,000,000 2,000,000
Retained earnings 2,555,000 1,055,000

Total liabilities and equity 5,620,000 4,020,000

582
 Income Statement
Year ended December 31, 2014

Sales 6,500,000
Cost of sales:
Inventory January 1 100,000
Purchases 3,200,000

Goods available for sale 3,300,000

Inventory December 31 ( 175,000) 3,125,000
Gross income 3,375,000
Rent income 80,000

Total income 3,455,000

Expenses:
Salaries 950,000
Insurance 40,000
Other expenses 500,000
Depreciation 50,000
Amortization of patent 10,000
Interest expense 55,000 1,605,000
Income before tax 1,850,000
Income tax 350,000

Net income 1,500,000

Direct method

PAS 7, paragraph 18, provides that an entity shall report cash flows operating activities using
either the direct method or indirect method.

The direct method shows in detail or itemizes the major classes of gross cash receipts and gross
cash payments.

The cash receipts are listed one by one, the cash payments are listed one by one, and the
difference represents the net cash flow from operating activities.

In essence, the direct method is the cash basis income statement.

Actually, the statement of cash flows is a conversion from the accrual basis to the cash basis of
accounting. Accordingly, some formulas may be necessary for determining cash receipts and
cash payments.

583
Computation of collections

Trade accounts and notes receivable beginning xx

Add: Sales (accrual basis) xx

Total xx
Less: Trade accounts and notes receivable end xx

Collection of accounts and notes receivable xx

Computation of payments to merchandise creditors

Trade accounts and notes payable beginning xx

Add: Purchases (accrual basis) xx

Total xx
Less: Trade accounts and notes payable end xx

Payment to merchandise creditors xx

Computation of payments for expenses

Expenses (accrual) xx
Add: Prepaid expense end xx
Accrued expense beginning xx

Total xx
Less: Prepaid expense beginning xx
Accrued expense end xx xx

Expenses paid xx

Computation of collection of other income

Income other than sales (accrual) xx

Add: deferred income end xx
Accrued income beginning xx

Total xx
Less: deferred income beginning xx
Accrued income end xx xx

Collection of other income xx

584
Computations under the direct method

1. Accounts receivable 2013 350,000

Add: Sales 6,500,000

Total 6,850,000
Less: Accounts receivable 2014 940,000

Collections from customers 5,910,000

2. Rent income 80,000

Add: Unearned rent income 2014 10,000

Total 90,000
Less: Unearned rent income 2013 40,000

Rent received 50,000

3. Accounts payable 2013 150,000

Add: Purchases 3,200,000

Total 3,350,000
Less: Accounts payable 2014 170,000

Payments to merchandise creditors 3,180,000

4. Salaries 950,000
Add: Accrued salaries payable 2013 10,000

Total 960,000
Less: accrued salaries payable 2014 25,000

Salaries paid 935,000

5. Insurance 40,000
Add: Prepaid insurance 2014 15,000

Total 55,000
Less: Prepaid insurance 2013 20,000

Payment for insurance 35,000

6. Other expenses paid 500,000

585
 7. Interest expense 55,000
Add: Accrued interest payable 2013 15,000

Total 70,000
Less: Accrued interest payable 2014 10,000

Interest paid 60,000

8. Income tax 350,000

Add: Income tax payable 2013 250,000

Total 600,000
Less: Income tax payable 2014 350,000

Payment for income tax 250,000

The net cash provided by operating activities under the direct method would appear as follows:

Cash received from customers 5,910,000

Rent received 50,000
Cash payments to merchandise creditors (3,180,000)
Salaries paid ( 935,000)
Insurance paid ( 35,000)
Other expense paid ( 500,000)

Cash generated from operations 1,310,000

Interest paid ( 60,000)
Income tax paid ( 250,000)

Net cash provided by operating activities 1,000,000

PAS 7, paragraph 32, provides that interest paid is disclosed separately whether it has been
recognized in profit or loss or capitalized.

Paragraph 35 provides that income tax paid is also disclosed or presented separately.

Observe that the depreciation of P500, 000 and amortization of P10, 000 do not appear in the
statement of cash flows using the direct method.

The reason is that these are noncash expenses or expenses not requiring use of cash.

PAS 7, paragraph 19, provides that entities are encouraged to report cash flows from operating
activities using the direct method.

586
Indirect method

The indirect method means that the net income or loss is adjusted for the effects of transactions
of a noncash nature, any deferrals or accruals of past or future operating cash receipts and
payments, and items of income or expense associated with investing and financing activities.

The indirect method of presenting the cash flow from operations begins with the accrual basis
net income and applies a series of adjustments to convert the income to a cash basis.

The following general guidelines are offered for the adjustments of net income to cash basis:

1. All increases in trade noncash current assets are deducted from net income.

2. All decreases in trade noncash current assets are added to net income.

3. All increases in trade current liabilities are added to net income.

4. All decreases in trade current liabilities are deducted from net income.

5. Depreciation, amortization and other noncash expenses are added back to net income to
eliminate the effect they had on net income.

6. Any gain on disposal of property or gain on early retirement of nontrade liabilities is

included in net income but it is a nonoperating item.

Thus, this is deducted from net income.

7. Any loss on disposal of property or loss on early retirement of nontrade liabilities is

deducted from net income but this is a nonoperating item.

Thus, this is added back to net income.

587
Continuing the illustration, the changes in current assets and current liabilities are summarized
as follows:

Increase
2014 2013 (Decrease)
Accounts receivable 940,000 350,000 590,000
Inventory 175,000 100,000 75,000
Prepaid insurance 15,000 20,000 ( 5,000)
Accounts payable 170,000 150,000 20,000
Accrued salaries payable 25,000 10,000 15,000
Accrued interest payable 10,000 15,000 ( 5,000)
Income tax payable 350,000 250,000 100,000
Unearned rent income 10,000 40,000 ( 30,000)

The net cash provided by operating activities using the indirect method would appear as
follows:

Net income 1,500,000

Increase in accounts receivable ( 590,000)
Increase in inventory ( 75,000)
Decrease in prepaid insurance 5,000
Increase in accounts payable 20,000
Increase in accrued salaries payable 15,000
Decrease in accrued interest payable ( 5,000)
Increase in income tax payable 100,000
Decrease in unearned rent income ( 30,000)
Depreciation 50,000
Amortization of patent 10,000

Net cash provided by operating activities 1,000,000

The direct method and indirect method are applicable only to operating activities.

PAS 7, paragraph 21, provides that an entity shall report separately major classes of gross cash
receipts and gross cash payments arising from investing and financing activities using the direct
method.

588
Comprehensive illustrations

Illustrar Company provided the following statement of financial position on December 31, 2014
and 2013 and other financial data relating to activities during 2014:

2014 2013
Cash and cash equivalents 600,000 200,000
Accounts receivable, net of allowance 1,100,000 1,040,000
Notes receivable trade 150,000 200,000
Inventory 1,200,000 1,360,000
Prepaid expenses 110,000 120,000
Investment in equity securities, at cost 300,000 500,000
Property, plant and equipment 3,400,000 2,000,000
Accumulated depreciation ( 900,000) ( 600,000)
Patent 80,000

5,690,000 4,900,000

Accounts payable 880,000 840,000

Notes payable trade 60,000 240,000
Accrued expenses 100,000 330,000
Note payable bank (short term debt) 400,000
Share capital, P100 par 3,000,000 2,400,000
Share premium 530,000 400,000
Retained earnings 990,000 790,000
Treasury shares, at cost ( 100,000)

5,690,000 4,900,000

The statement of retained earnings for the year ended December 31, 2014 showed the following:

Retained earnings January 1 790,000

Add: Net income for 2014 1,000,000

Total 1,790,000
Less: Cash dividends paid 300,000

Retained earnings December 31 990,000

589
Additional information

The entity sold an investment in equity securities for P240, 000 cash. There were no other
transactions affecting the investment in equity securities.

Land was purchased in the current year for P1, 200,000, paying P1, 000,000 cash and
issuing P200, 000 share capital at par value.

Equipment costing P200, 000 and having a carrying amount of P80, 000 was sold for
P60, 000 cash.

Equipment of P400, 000 was purchased for cash.

The entity borrowed P400, 000 from a bank to be paid on June 30, 2015.

Share capital with par value of P400, 000 was issued for cash at a premium of P100, 000.

The treasury shares were reissued for P130, 000 cash.

The patent was fully amortized.

Basic guidelines

a. Operating activities include the cash effects of transactions that enter into the
determination of net income.

b. Investing activities include the cash effects of transactions involving nonoperating

assets.

c. Financing activities include the cash effects of transactions involving nontrade

liabilities and equity.

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Introduction

In determining cash receipts and cash payments, it is necessary to analyze all accounts in the
statement of financial position, with the exception of cash and cash equivalents. The net changes
in all statement of financial position accounts are traced to their original entry.

Accordingly, the preparation of the statement of cash flows requires reconstruction of original
entries affecting the statement of financial position accounts.

The cash effects of transactions can then be properly determined from the original entries.

Retained earnings, P200, 000 increase

As a matter of procedure, it is practical and logical to analyze first the retained earnings account.

The statement of retained earnings shows a net income of P1, 000,000 and cash dividend paid of
P800, 000, resulting to a net increase of P200, 000.

The original entries are properly numbers for easy reference. With respect to the net income, the
original entry to close the same to retained earnings is:

1. Profit and loss 1,000,000

Retained earnings 1,000,000

The net income is the principal cash inflow from operations and therefore the first item under
operating activities.

With respect to the cash dividend, the payment is recorded as follows:

2. Retained earnings 800,000

Cash 800,000

The transaction affects retained earnings, a shareholders equity item. Therefore, the payment of
cash dividend is shown under financing activities as a deduction because it decreases cash.

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Accounts receivable, P600, 000 increase

The increase in accounts receivable is originally recorded as:

3. Accounts receivable 60,000

Sales 60,000

The increase in accounts receivable increased net income but did not increase cash. Thus, the
increase in accounts receivable is deducted from net income under operating activities.

Remember the basic rule that all increases in trade current assets are deducted from net income.

Note that the accounts receivable should be analyzed net of the allowance for doubtful
accounts.

Notes receivable trade, P50, 000 decrease

The decrease in notes receivable is originally recorded as follows:

4. Cash 50,000
Notes receivable 50,000

The decrease in notes receivable increased cash but did not increase net income. Thus, the
decrease in notes receivable is added to net income under operating activities.

Again, remember the basic rule under the indirect method that all decreases in trade current
assets are added to net income.

Inventory, P160, 000 decrease

The decrease in inventory is originally recorded as follows:

5. Cost of sales 160,000

Inventory 160,000

The decrease in inventory increased cost of sales and consequently decreased net income but did
not decrease cash.

Thus, the decrease in inventory is added back to net income under operating activities.

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Prepaid expenses, P10, 000 decrease

The decrease in prepaid expenses is originally recorded as follows:

6. Expenses 10,000
Prepaid expenses 10,000

The decrease in prepaid expenses increased expenses and consequently decreased net income but
did not decrease cash.

Thus, the decrease in prepaid expenses is added back to net income under operating activities.

Investment in equity securities, P200, 000 decrease

The decrease represents sale of securities for P240, 000, or a gain of P40, 000. The original entry
is

7. Cash 240,000
Investment in equity securities 200,000
Gain on sale of investment 40,000

The transaction involves a nonoperating asset.

Therefore, the cash received from sale of the investment shown under investing activities as an
addition because it increases cash.

The gain on sale of investment is previously included in the determination of net income but this
is a nonoperating item.

Therefore, the gain is deducted from net income under operating activities.

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