Financial Statements and Logical Assumptions

Metro Inc.’s 2019 financial statements showed the following:

During the year, equipment with an original cost of $90,000 was sold for cash. It had accumulated depreciation of $60,000 on the date of sale.

Prepare in good form, a Cash Flow Statement. Use the indirect form to present the operations section. Make logical assumptions regarding the nature of change in balance sheet accounts.

Explain the following:

1.Why is net income adjusted so much in the operating activities section of the cash flow statement?

2.Why is depreciation in the cash flow statement?

3. How do you decide if an item is classified in financing or investing?

4. How would the following  transaction  be reported in a cash flow statement?

Purchase of land and building for $1,000,000, with a mortgage assumed by the vendor for $800,000 of this amount.

1. Net income is included on the cash flow statement on the assumption that all revenue is cash revenue, all expenses are cash expenses, and gains and losses represent the actual cash flow (and are caused by operating activities.) To the extent that this is untrue, adjustments must be made to reconcile net income to cash flow from operating activities.

To be specific, non-cash expenses must be added back, accruals (AR, AP, Inventory, etc) must be adjusted to adjust from the accrual method to actual cash flow, and gains and losses must be eliminated to allow them to be reclassified (and to reflect cash flow from the underlying transaction).

2. Depreciation is added back in operating activities because it is an expense included in net income, but it is not a cash expense. Cash is spent up front, when the asset is purchased, not when it is depreciated.

3. Investing activities are those related to long-term assets, such as property, plant and equipment, and also investments. Financing transactions are those related to debt – new loans and repayments -  and transactions with shareholders, including dividends, issuing new common shares and retiring common shares.

4. Non- cash transactions are not included in the cash flow statement. Accordingly, the non- cash element of this transaction, $800,000 source of funds as the loan and $800,000 as the use of funds to purchase long-term assets, would both be omitted. The $200,000 actually paid in cash would be reflected in the investing section as an outflow.