20.7 Comprehensive Example: Both Methods

The example below will incorporate some different transactions that were discussed earlier in this course, or the prerequisite courses. These include more complex transactions such as long-term investments such as Available for Sale investments, long-term liabilities such as accrued pension liabilities, deferred income taxes payable or bonds issued at a discount and equity items such as convertible securities, stock options and re-acquisition and retirement of shares.

Below are three financial statements for Ace Ltd., as on December 31, 2020.

Ace Ltd.
Statement of Income
For the Year Ended December 31, 2020
Sales $1,400,000
Cost of golds sold 630,000
Gross profit 770,000
Operating expenses
Depreciation expense $43,000
Salaries and benefits expense 120,000
Utilities expenses 50,000
Travel expenses 26,000
Operating expenses, including rent expense 80,000 319,000
Income from operations 451,000
Other (non-operating) revenue and expenses:
Investment income 3,000
Interest expense (30,000)
Gain on sale of AFS investment 3,000
Loss on sale of machinery (15,000) (39,000)
Income before taxes 412,000
Income tax expense 79,000
Deferred tax recovery (12,000) 67,000
Net income $345,000
Ace Ltd.
Statement of Comprehensive Income
For the Year Ended December 31, 2020
Net income $345,000
Other comprehensive income
Items that may be reclassified subsequently to net income or loss:
Increase in fair value, AFS investments (OCI)* 44,000
Removal of unrealized gain on sale of AFS investment* (3,000)
Actuarial loss on defined benefit pension plan* (20,000)
Comprehensive income 366,000

* In the interest of simplicity, income taxes have been ignored.

Ace Ltd.
Balance Sheet
As at December 31, 2020
2020 2019
Assets
Current assets
Cash $50,000 $30,000
Accounts receivable (net) 110,000 145,000
Inventory 175,000 200,000
Prepaid insurance expenses 6,000
Total current assets 341,000 375,000
Investments – available for sale (OCI) 150,000 80,000
Property, plant, and equipment
Land 380,000 200,000
Machinery 1,700,000 1,500,000
Accumulated depreciation (363,000) (400,000)
Total property, plant, and equipment 1,717,000 1,300,000
Goodwill 300,000 300,000
Total assets $2,508,000 $2,055,000
Liabilities and Shareholders’ Equity
Current liabilities
Accounts payable $200,000 $300,000
Salaries payable 128,000 125,000
Income taxes payable 115,000 120,000
Total current liabilities 443,000 545,000
Long-term liabilities
6%, convertible bonds payable, net 750,000
7.2% bonds payable, net 453,000
Deferred income tax payable 38,000 50,000
Accrued pension benefit liability 85,000 75,000
Total long-term liabilities 576,000 875,000
Total liabilities 1,019,000 1,420,000
Shareholders’ Equity
Paid-in capital
Common shares 1,210,000 500,000
Contributed capital, bond conversion rights 35,000
Contributed capital, stock options 62,000 50,000
Total paid-in capital 1,272,000 585,000
Retained earnings 192,000 46,000
Accumulated Other Comprehensive Income,
pension
(40,000) (20,000)
Accumulated Other Comprehensive Income,
investments
65,000 24,000
Total shareholders’ equity 1,489,000 635,000
Total liabilities and shareholders’ equity $2,508,000 $2,055,000

Additional information:

  • Issued additional 7.2%, $500,000, 10-year bonds payable for cash of $452,000.
  • Cash dividends were declared and paid.
  • An AFS investment (OCI) was sold for $50,000 cash on January 2, 2020. Its original cost was $47,000 and had a carrying value of $50,000 (fair value) at the time of the sale. All unrealized gains previously recorded to OCI/AOCI for the sold investment were reclassified to net income. AFS investments of $76,000 were purchased for cash.
  • There is a stock option plan for senior executives. In 2020, stock options with a book value of $15,000 were exchanged for common shares, along with $40,000 in cash. The remaining increase in the stock options account is due to the compensation expense included in the income statement as salaries and benefits.
  • The six percent convertible bond payable was converted into common shares at the beginning of 2020.
  • Land was acquired for cash.
  • Machinery, with an original cost of $100,000 and a net book value of $20,000, was sold at a loss of $15,000. Additional machinery for other activities was acquired in exchange for common shares.
  • Common shares with an average original issue price of $430,000 were retired for $485,000.
  • The accrued pension benefit liability was increased by $20,000, due to an actuarial revaluation, and $10,000, because of the difference between funding and the pension expense.
  • The company’s policy is to report dividends received, interest received, and interest paid as operating activities, and dividends paid as financing activities.

20.7.1. Preparing the Statement of Cash Flows: Indirect Method

Indirect Method Steps:

  1. Headings
  2. Record net income/(loss)
  3. Adjust out non-cash items from the income statement
  4. Current assets and current liabilities changes
  5. Non-current asset accounts changes
  6. Non-current liabilities and equity accounts changes
  7. Subtotal and reconcile
  8. Disclosures

Following the steps listed above, prepare a statement of cash flows using the indirect method. Details are provided below for each step, followed by the completed statement of cash flows.

Notes to the Solutions and Details About Calculations:

Step 1. Headings:

Insert headings and subheadings, leaving spaces within each section to record the relevant line items resulting from the subsequent steps.

Step 2. Record net income/(loss):

Net income (and not comprehensive income) is the starting point for a statement of cash flows with the indirect method. Comprehensive income will become relevant if any of the AFS investments are actually sold. Recall that upon sale, any unrealized gains or losses previously recorded to OCI will be realized and moved to retained earnings from AOCI.

Step 3. Adjustments:

When reviewing the income statement, non-cash items for depreciation, loss on sale of machinery, and realized gain on sale of AFS investments are reported. However, since this is a more complex example, there could be other hidden non-cash items that will become apparent when analyzing the non-current asset, liability, and equity accounts. Leave some space in this section in case other non-cash items are discovered in the accounts analysis.

Step 4. Current assets and liabilities:

Continue to use the accounting equation, A = L + E, to determine if the change amount for each non-cash working capital account is a positive number or a negative number (requiring a bracket).

Step 5. Non-current asset changes:

Analyze all the non-current asset accounts to determine the reasons for the changes in the accounts. Additional information taken from the various accounting records has been provided. Items 3, 6, and 7 pertain to non-current assets so this information will be incorporated into the step 5 analysis.

a. AFS investment (OCI):

Long-term AFS investments
80,000
50,000 sale of investment
76,000 purchase of AFS investment
X = 44,000 increase in fair value (OCI)
150,000
AOCI, investments
24,000
44,000 increase in fair value (OCI)
3,000 remove realized gain on sale
65,000

Additional information:

In note # 3 states that $50,000 of AFS investments (fair value = carrying value) was sold for $50,000 cash, so there’s no gain or loss on the actual sale. However, the original cost was $47,000, so there is an accumulated unrealized gain of $3,000 ($50,000 fair value – $47,000 original cost) for the sold investment that was reclassified from OCI/AOCI to net income. This is confirmed by reviewing the income statement. This non-cash entry has already been adjusted in operating activities in Step 3, so no further action is required.

Entry for the sale:

General Journal Example.

Entry to reclassify:

General Journal Example.

Note # 3 also states that there was also a cash paid investment of $76,000.

The T-account requires another debit for $44,000 to balance properly. This must be for fair value changes and that is confirmed by reviewing the comprehensive income statement. This non-cash entry is not included in the income statement so no further action is necessary.

Analysis result: enter the cash amounts for the sale ($50,000) and the purchase of AFS investments ($76,000) highlighted in red in the investing activities section of the statement of cash flows.

b. Land:

Land
200,000
X = 180,000 purchase of land
380,000

Additional information in note # 6 states that land was purchased for cash.

There is no other information about the land account so the balancing amount of $180,000 must be the purchase price of the land.

Entry for the purchase:

General journal example.

Analysis result: enter the cash amount for the purchase of land ($180,000) highlighted in red in the investing activities section of the statement of cash flows.

c. Machinery:

Machinery
1,500,000
100,000 sale of machinery
X = 300,000 purchase of machinery for shares
1,700,000
Accumulated depreciation
400,000
80,000 sale of machinery
43,000 X = current year depreciation
363,000

Additional information note # 7 states that there was a loss from the sale of machinery of $15,000 that originally cost $100,000. The carrying value at the time of the sale was $20,000. The cash amount for the sale would therefore be $5,000 ($20,000 carrying value – $15,000 loss). The accumulated depreciation for the sold machinery would be $80,000 ($100,000 original cost – $20,000 carrying loss).

Entry for the sale:

General journal example.
Accumulated depreciation requires another $43,000 credit to balance properly. This must be for the current year depreciation expense and that is confirmed by reviewing the income statement. This non-cash entry has already been adjusted in operating activities in Step 3, so no further action is required.

Note # 7 also stated that additional machinery was purchased in exchange for common shares. The balancing amount of $300,000 would account for this non-cash transaction which is not included in the SCF except as a supplemental disclosure required for non-cash items.

Analysis result: enter the cash amount for the sale of machinery ($5,000) highlighted in red in the investing activities section of the statement of cash flows.

Step 6. Non-current liabilities and equity changes:

Analyze all the non-current liability and equity accounts to determine the reasons for the changes in the accounts. Additional information taken from the various accounting records has been provided. Items 1, 2, 4, 5, 8, and 9 pertain to non-current liabilities and equity so this information will be incorporated into the step 6 analysis.

d. 6% bonds payable:

6% Convertible bonds payable
750,000
X = 750,000 conversion of bonds to shares

Additional information note # 5 states that these bonds were converted into common shares in 2020. The equity portion for the conversion rights of $35,000 will also be removed from the contributed surplus account.

Entry for the conversion:

General journal example.
This is a non-cash entry which is not included in the SCF except as a supplemental disclosure required for non-cash items.

Analysis result: no cash entries to record

e. 7.2% bonds payable:

7.2% Bonds payable
452,000 issuance of bonds
1,000 X = amortized discount
453,000

Additional information note # 1 states that bonds with a face value of $500,000 were issued for cash of $452,000. The discount amount would be $48,000 ($500,0000 – $452,000) which will be amortized.

Entry for the bond issuance:

General journal example.
The balancing amount of $1,000 must therefore be for amortization of the discount which will be included in net income as part of interest expense of $30,000. This $1,000 non-cash amount should be adjusted from net income in operating activities because it was not done in Step 3.

Analysis result: enter the cash amount for the bond issuance ($452,000) and adjust the $1,000 amortization expense highlighted in red in the financing activities section of the statement of cash flows.

f. Deferred income tax payable:

Deferred Income Tax Payable
50,000
X = 12,000 reduction of taxes
38,000

There is no additional information regarding this account. The balancing amount of $12,000 must be for a deferred income tax recovery which is confirmed by a review of the income statement. This non-cash entry was included in net income but not adjusted in Step 3, so it should be adjusted in the operating section now.

Analysis result: enter the non-cash amount for the deferred tax recovery ($12,000) highlighted in red in the operating activities section as an adjustment to net income.

g. Accrued pension benefit liability:

Accrued Pension Benefit Liability
75,000
20,000 actuarial revaluation
X = 10,000 funding amount greater than

pension expense

85,000
AOCI, Pension Benefits
20,000
20,000 actuarial revaluation
40,000

Additional information note #9 states that this liability was increased by $20,000 due to an actuarial revaluation. This non-cash adjusting entry to OCI/AOCI was not included in net income so it will be omitted from the SCF.

Note #9 also states that the remaining difference was due to the difference between the funding (cash paid) and the pension expense.

Entries for pension benefit:

General journal example.
The pension expense amount is not known but the funding (cash) amount is known to be greater than the pension expense by $10,000. Even though this is a non-current liability, it’s purpose is to benefit employees and not as a source of financing cash flow. For this reason, it is more appropriate to record this non-current liability reduction as an operating activity instead of a financing activity.

Analysis result: enter the cash difference amount ($10,000) highlighted in red as an operating activity item for the reduction in the pension liability.

h. Common shares:

Common shares
500,000
300,000 machinery in exchange for shares
785,000 6% bonds converted
430,000 shares repurchase
55,000 options exercise for shares
1,210,000
Contributed Surplus – Stock Options
50,000
15,000 options exercised for shares
27,000 X = compensation expense (non-cash)
62,000

Additional information note #8 states that shares with an original price of $430,000 were retired for $485,000 cash. The difference is to be debited to retained earnings.

Entry for shares repurchase:

General journal example.
Additional information note #4 states that $15,000 of stock options were exercised along with an additional $40,000 in cash for common shares. The difference in the contributed surplus account was due to compensation expense.

Entry for exercise of options:

General journal example.
Entry for compensation expense:

General journal example.
It is now evident that $27,000 of the compensation expense included in net income in salaries and benefits line item is a non-cash transaction that was not adjusted in Step 3. This amount should therefore be adjusted out of net income in operational activities now.

Analysis result: enter the cash amount for the shares repurchase ($485,000) and the cash amount for stock options ($40,000) highlighted in red in the investing activities section of the statement of cash flows. Also, enter the adjusting entry ($27,000) highlighted in red in the operating activities section of the statement of cash flows.

i. Retained earnings:

Retained earnings
46,000
345,000 net income
55,000 stock options
X = 144,000 dividends paid
192,000

Additional information note #2 states that dividends were declared and paid but no amount given. The balancing amount to retained earnings of $144,000 must therefore be the amount of the dividend.

Entry for dividends paid:

General journal example.

Analysis result: enter the dividend amount ($144,000) highlighted in red in the financing activities section of the statement of cash flows.

Step 7. Subtotal and reconcile:

Calculate subtotals for each section and also for net cash flows. Reconcile the net amount to the opening and closing cash balances from the balance sheet.

Step 8. Required disclosures:

Prepare the additional disclosures for cash paid interest and income taxes.

Below is the prepared statement of cash flows based on the steps discussed above.

steps for Statement of Cash Flow

Step 8 disclosures

Disclosures:

Cash paid for income taxes \$67,000\;+\;\$12,000\;+\;5,000)\;=\;\$84,000

Cash paid for interest charges (\$30,000\;-\;\$1,000\;amortization)\;=\;\$29,000

Machinery ($300,000) was purchased in exchange for shares.

Six percent convertible bonds ($750,000), and contributed surplus rights ($35,000), were converted to common shares.

Stock options ($15,000) and cash ($40,000) were exercised for common shares.

20.7.2. Operating Activities Section: Direct Method

We will once again use the comprehensive illustration above for Ace Ltd. to demonstrate the completion of the operating activities section using the direct method. The first example explained below demonstrates how to prepare a direct method statement on its own. The second example demonstrates a quick technique to convert an already prepared indirect statement of cash flows into a direct method format.

Direct Method Steps:

  1. Headings and categories
  2. Three additional columns
  3. Record each income statement reporting line amount to its respective direct method category under the Income Statement Accounts column. Non-cash items are shown as memo items only.
  4. Record the net change amount for each non-cash working capital account. Also record any adjustment amounts resulting from the analysis of non-current accounts from the investing or financing sections (highlighted in blue below).
  5. Calculate the net cash flow amount for each category.
  6. Calculate the subtotal for the operating activities section.

Steps 3, 4, 5, 6In this example, steps 1 and 2 are self-explanatory. Steps 3, 4, and 5 are represented by entries in each of the columns in the schedule above. Note that this example is more complex as some non-cash costs were embedded with other income statement expenses initially treated as cash items and left unadjusted. There was also a reduction in the non-current pension liability which was more appropriately reported as an operating activity. These items were discovered when the analysis of the non-current assets (investing activities), liabilities and equity (financing activities) were completed. As a result, there are four additional adjusting entries (e, f, g and h) that must be adjusted in Step 4 of the operating section above (highlighted in blue).

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