Identify the following activity pertaining to the statement of cash flows on the direct method. Acquisition of equipment by issuance of note payable A. Operating activity B. Investing activity C. Financing activity D. Noncash investing and financing activity E. Not reported on statement of cash flows
The correct answer and explanation is:
The correct answer is: D. Noncash investing and financing activity
Explanation:
When preparing the statement of cash flows using the direct method, it is important to classify transactions based on their cash flow nature. The statement of cash flows has three main sections:
- Operating activities: Cash flows related to the primary business operations (e.g., cash receipts from customers, cash paid to suppliers).
- Investing activities: Cash flows related to the purchase and sale of long-term assets (e.g., equipment, property).
- Financing activities: Cash flows related to borrowing, repaying debt, issuing stock, or paying dividends.
Acquisition of equipment by issuance of a note payable means the company obtained equipment but did not pay cash immediately. Instead, it issued a note payable (a form of debt) promising to pay in the future.
- This transaction involves acquiring a long-term asset (equipment) — which relates to investing activities.
- It also involves incurring a liability (note payable) — which relates to financing activities.
- However, no cash changed hands during this transaction, so it is neither an operating, investing, nor financing activity in terms of actual cash flows.
What happens in the statement of cash flows?
- Because no cash is exchanged, this transaction does not appear as a cash inflow or outflow in the investing or financing sections.
- Instead, it is disclosed in a separate schedule or in a footnote called noncash investing and financing activities.
- This disclosure informs financial statement users of significant noncash transactions, helping them understand changes in assets and liabilities without cash impact.
Summary:
- The acquisition of equipment by issuing a note payable is a noncash investing and financing activity.
- It does not affect cash flow directly but must be disclosed to provide a full picture of how assets and liabilities changed.
- This ensures transparency and completeness of the cash flow statement.