04 Book.doc

CHAPTER 4Statement of Cash Flows:

Operating, Investing, and Financing Activi-ties

QUESTIONS

1. Cash is readily transferable value. It consists of currency, amounts in checking accounts, amounts on deposit in savings accounts and certificates of deposit.

2. Restricted currency is coins or paper issued by a government for use in making economic exchanges that may not be taken out of the issuing country.

3. Cash flow is the change in cash during a pe-riod.

4. Investing cash flows are changes in cash related to the acquisition and sales of assets held for or used in the production of goods or services (other than materials). Examples in-clude: cash spent by a manufacturer to ac-quire manufacturing equipment, cash spent to acquire a long term equity stake in another corporation, and cash received by a clothing retailer for the sale of land.

5. Financing cash flows are changes in cash related to obtaining resources from and re-turning resources to owners or borrowing from and repaying long-term creditors. Exam-ples include: cash raised by issuing stock, cash used to pay dividends, cash used to re-pay long-term debt.

6. Operating cash flows include all changes in cash not otherwise classified as investing or financing cash flows. Examples include: cash collected from customers, cash paid to suppli-ers of inventory, and cash paid for interest.

7. This is an accurate statement. Cash flows from operations are defined as the residual cash flow after considering the more well-de-fined cash flows from financing and investing. Investing cash flows arise from actions aimed at acquiring and disposing of assets that gen-erate a return over a long period of time, such as property, plant and equipment. Financing cash flows arise from actions aimed at obtain-ing or repaying funds that are used over a long period of time, such as issuing or repaying long-term debt. Operating cash flows arise

from activities that are neither investing nor fi-nancing activities.

8. Examples of noncash transactions include is-suing stock to compensate an employee, is-suance of preferred stock to the holder of a mortgage debt in order to settle that debt, and trading common stock for land.

9. Noncash transactions must be reported, but the chapter does not say where. In fact, there is latitude on where these transactions are re-ported.

10. Of course, both methods must come up with the same change in cash. Further, both meth-ods must show the same totals in cash flows from operations, investing and financing. The financing and investing sections of the two methods of presenting cash flows are the same. The only difference is in the presenta-tion of cash flows from operations. The direct method states each item directly, e.g., collec-tions from customers, or payments to suppli-ers. The indirect method begins with net in-come, and applies adjustments to derive cash flows from operations, e.g., add back non-cash expenses, subtract increases in ac-counts receivable, etc.

11. In a growing business, where growth is mea-sured in terms of increased sales, cash flows from operations are usually less than net in-come. As businesses grow, usually current assets such as accounts receivable, inven-tory, and prepaid expenses all grow. Some of the profit, therefore, is reflected in increases in the balances of these other assets, which leaves less for cash flow from operations.

Accounts payable usually grow too, but busi-nesses cannot typically finance all the re-quired increases in their current assets through their suppliers. There are exceptions, such as large grocers, for whom cash is col-lected from customers before cash is paid to suppliers. (The opposite of the Total Toy ex-ample in the chapter.)

108

109 Chapter 4

12. In a growing business, cash flows from fi-nancing should usually be positive. Growing businesses must acquire new assets, and of-ten seek long term financing for them.

13. In a growing business, cash flows from in-vesting should usually be negative. Growing businesses must acquire new assets, and must spend cash for them.

14. In a steady business, cash flows from opera-tions should usually be greater than net in-come. (Based on the Total Toy example in the chapter, the students will very likely say the two are equal. That is because Total Toy has only current assets.) Depreciation and amortization are deducted in computing in-come, and are not cash outflows from opera-tions. The balances in the current assets and current liabilities should be constant, so the cash and accrual amounts of items related to them will be equal.

15. Cash flows from financing should be zero, be-cause cash from operations should be suffi-cient to fund replacements of assets. These flows could be negative if we started to repay borrowed funds.

16. Cash flows from investing should be positive, because assets that are retired must be re-placed to keep the business in a steady state.

17. In a steady business, cash flows for investing should equal depreciation expense. In a steady business, depreciation expense will equal the cash required to replace retired as-sets. (Note: this answer really takes the word “steady” seriously. No changes in technology or price level, e.g., as well as steady sales.)

18. In a shrinking business, cash flows from oper-ations usually should be greater than net in-come. Not only does the income include a de-duction for depreciation, but the investment in working capital such as accounts receivable and inventory, should be getting returned.

19. In a shrinking business, cash flows from fi-nancing should be negative. That is, creditors should be getting repaid and resources should be distributed to owners.

20. In a shrinking business, cash flows from in-vesting should be zero or even positive if as-sets can be sold.

21. The cost of goods sold is exactly that: it is the cost of those items reported as sold in the in-come statement. Cash paid to suppliers is also exactly that: cash paid to entities that supply goods and services to the organiza-tion. Goods supplied may not be sold (even if they are merchandise goods) because they may remain in inventory. Goods sold may not be paid for because the company still owes the supplier for them and has an account payable (liability) to reflect this debt. Also, cash may be paid to suppliers for goods sold in a previous period.

22. Sales is the revenue recognized on the finan-cial statements, which may or may not be col-lected in cash from customers. Sales may be recorded for which the customer still owes the company. Also, cash may be collected that was generated by past sales.

23. Yes, it is reflected there, but it is reflected in-directly. Sales is a component of net income, with which the operating section begins. The adjustment for the change in accounts receiv-able is what adjusts sales to cash collected from customers.

24. Websell did NOT receive $30,000 in cash from depreciation. The $30,000 in deprecia-tion expense is added back to compensate for the fact that it was deducted in calculating net income. Adding it back just cancels out the depreciation expense in net income, and the net effect of depreciation on cash flows from operations is zero.

The amount of cash spent for equipment was deducted as a cash flow from investing when Websell bought the equipment.

25. Dividends appear in the financing section. In-terest paid appears in cash flows from opera-tions. The “reasoning” is that interest expense is deducted in computing GAAP net income, whereas dividends are not an expense. Of course, both are forms of payments to the suppliers of long-term capital, but the cash flow statement is driven by accounting con-ventions, which call for dividends to be treated differently than interest.

EXERCISES

E4-1

The data for this exercise are identical to that in Problem 3-5. The cash t-account for that problem is:

CashBB 0a 3,000 1,000 cb 20,000 20,000 df 20,500 3,000 g

50 h1,800 i

EB 17,650

Analyzing this t-account, we find that:

Operating items:

d is payments to suppliers of magazinesf is collections from customersg is payment of a salaryi is payment of interest

Investing item:

c is purchase of a bicycle

Financing items:

a is issuance of common stockb is taking out a loan from a bankh is a dividend payment

(Note: Items e and j are required to do proper accrual accounting, but do not affect cash flows.)

The direct method cash flow statement is:

Miloslav’s MagazinesStatement of Cash Flows for the Year Ended Dec. 31, 2004

Cash flows from operations:Collections from customers $ 20,500Payments to suppliers (20,000)Payment of salary (3,000)Payment of interest (1,800 )Total cash flow from (used by) operations $ (4,300 )

Cash flows used for investing: Purchase of equipment (bicycle) $ (1,000 )

Cash flows from financing:Issuance of common stock $ 3,000Loan from bank 20,000Payment of dividends (50 )Cash flow from financing $ 22,950

Change in cash $ 17,650

Statement of Cash Flows: Operating, Investing, and Financing Activities 112

E4-2

The data for this exercise are identical to that in Problem 3-6. The cash t-account for that problem is (amounts in thousands):

CashBB 0.0 a 100.0 10.0 bc 50.0 100.0 ei 30.0 20.0 fj 84.0 15.0 g

19.0 hEB 100.0


Operating items:

b is a payment for inventory itemsc is a receipt of cash for servicese is payment of wagesf is payment of rentg is partly the payment of interesti is a receipt of cash from customersj is a receipt of cash from customers

Total collections from customers: $50.0 + $30.0 + $84.0 = $164.0

Payment (g): From the answer to Problem 3-6, the entry for g is:

g. Interest Expense 9,000Notes Payable 6,000

Cash 15,000

Note: The holder would first take any interest owed off the note, then reduce the principal. The interest owed at December 31, 2004 is:

8% × $150,000 × (9/12) = 9,000.

Investing items:

None

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Financing items:

a is issuance of common stockg is partly a repayment of debth is a dividend payment

Noncash transactions:

b is partly a noncash transaction

(Note: Item d is not used.)


Ofer’s Office DesignsStatement of Cash Flows for the Year Ended Dec. 31, 2004

(amounts in thousands)

Cash flows from operations:Collections from customers $164.0Payments to suppliers (10.0)Payment of salary (100.0)Payment of rent (20.0)Payment of interest (9.0 )Total cash flow from (used by) operations $ 25.0

Cash flows used for investing: None $ 0.0

Cash flows from financing:Issuance of common stock $100.0Repayment of debt (6.0)Payment of dividends (19.0 )Cash flow from financing $ 75.0

Change in cash $100.0


E4-3

The data for this exercise are identical to that in Problem 3-7. The cash t-account for that problem is (amounts in thousands):

CashBB 0 a 100,000 60,000 bf 20,000 4,000 ci 30,000 25,000 ej 50 15,000 h

6,000 k40,050


Operating items:

c is payment of renth is a payment to suppliersi is collections from customersj is another collection from a customerk is payment of salaries and wages

Investing items:

b is purchase of equipmente is purchase of a short-term investment

Financing items:

a is issuance of common stockf is issuance of a bond

(Note: Items d, g, l and m are required to do proper accrual accounting, but do not af-fect cash flows.)

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Ralphy’s BusinessCash Flow Statement

for Nine Months Ended 12/31/04

Operations:Collections from customers $ 30,050.0 Payments to suppliers (15,000.0)Payments for salaries (6,000.0)Payments for rent (4,000.0 )Cash Flows from Operations $ 5,050.0 Investing:Investments $(25,000.0)Purchased equipment (60,000.0 )Cash Flows for Investing $(85,000.0)Financing:Issued Common Stock $100,000.0 Issued Bonds 20,000.0 Cash Flows from Financing $120,000.0 Change in Cash $ 40,050.0

Although it is not called for in the problem, you may want to either have the class do the indirect method worksheet and prepare an indirect method statement or do it in class to introduce the indirect method. What follows is the worksheet and indirect method cash flow statement.


Indirect Method WorksheetExplanation

dr cr ref dr cr ref dr crAccounts Rec. – AR 9,800.0 9,800.0 Inventories – INV 5,000.0 5,000.0 Prepaid Rent – PREPR 1,000.0 1,000.0 Investments – INVEST 25,000.0 25,000.0 Equipment – EQUIP 60,000.0 60,000.0 Acc. Depr. – 7,500.0 DEPR 7,500.0 Accounts Pay. – 15,000.0 AP 15,000.0 Salaries Pay. – 1,000.0 SALP 1,000.0 Interest Pay. – 1,500.0 INTP 1,500.0 Bonds Pay. – 20,000.0 BP 20,000.0 Common St. – 100,000.0 CS 100,000.0 Ret. Earnings – NI 4,150.0 4,150.0

– – 104,950.0 145,000.0 Beg Cash – Cash End Cash 40,050.0

– BB – 145,000.0 Operations

4,150.0 NI DEPR 7,500.0 9,800.0 AR

AP 15,000.0 5,000.0 INV SALP 1,000.0 1,000.0 PREPR INTP 1,500.0 CFO 5,050.0 –

Investing 60,000.0 EQUIP 25,000.0 INVEST

– 85,000.0 CFI

Financing BP 20,000.0

IssuedCS 100,000.0 CFF 120,000.0 –

EB 40,050.0

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Ralphy’s BusinessCash Flow Statement

for Nine Months Ended 12/31/04

Operations:Net Loss $ (4,150.00)Depreciation 7,500.00 Increase in accounts receivable (9,800.00)Increase in inventory (5,000.00)Increase in prepaid expenses (1,000.00)Increase in accounts payable 15,000.00 Increase in salaries payable 1,000.00 Increase in interest payable 1,500.00 Cash Flow from Operations $ 5,050.00

Investing:Investments $(25,000.00)Purchased equipment (60,000.00 )Cash Flow for Investing $(85,000.00)

Financing:Issued Common Stock $100,000.00 Issued Bonds 20,000.00 Cash Flow from Financing $120,000.00 Change in Cash $ 40,050.00

E4-4

The data for this exercise are identical to that in Problem 3-8. The cash T-account for that problem is (amounts in thousands):

CashBB –a 110.0 60.0 be 20.0 3.0 ch 36.0 31.0 g

16.0 i56.0


Operating items:

c is payment of rent


g is a payment to suppliersh is collections from customersi is payment of salaries and wages

Investing item:

b is purchase of equipment

Financing items:

a is issuance of common stocke is taking a loan

(Note: Items d, f, j and k are required to do proper accrual accounting, but do not af-fect cash flows.)

Rick and Stan’s BusinessCash Flow Statement

for Three Months Ended 12/31/05(in thousands)

Operations:Collections from customers $ 36.0Payments to suppliers (31.0)Payments for salaries (16.0)Payments for rent (3.0 )Cash Flows from Operations $ (14.0)

Investing:Purchased equipment $ (60.0)Cash Flows for Investing $ (60.0)

Financing:Issued Common Stock $110.0Took out a loan 20.0 Cash Flows from Financing $130.0Change in Cash $ 56.0

Although it is not called for in the problem, you may want to either have the class do the indirect method worksheet and prepare an indirect method statement or do it in class to introduce the indirect method. What follows is the worksheet and indirect method cash flow statement.

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dr cr ref dr cr ref dr crAccounts Rec. – AR 9.0 9.0 Inventories – INV 10.0 10.0 Prepaid Insurance – PREPINS 2.25 2.25 Equipment – EQUIP 60.0 60.0 Acc. Depr.—Equip. – 3.0 DEPR 3.0 Accounts Pay. – 4.0 AP 4.0 Wages Pay. – 2.0 WP 2.0 Interest Pay. – 0.6 IntP 0.6 Note Payable – 20.0 NOTE 20.0 Common St. – 110.0 CS 110.0 Ret. Earnings – 2.35 2.35

– – 83.6 139.6Beg Cash – Cash End Cash 56.0

– BB – 139.6 Operations

2.35 NI DEPR 3.0 9.0 AR

AP 4.0 10.0 INV WP 2.0 2.25 PREPINS IntP 0.6

14.0 CFO

Investing 60.0 EQUIP

60.0

Financing LOAN 20.0

CS 110.0CFF 130.0

Ch in Cash 56.0 EB 56.0


Rick and Stan’s BusinessCash Flow Statement

for Three Months Ended 12/31/05(in thousands)

Operations:Net Loss $ (2.35)Depreciation 3.00 Increase in accounts receivable (9.00)Increase in inventory (10.00)Increase in prepaid expenses (2.25)Increase in accounts payable 4.00 Increase in wages payable 2.00 Increase in interest payable 0.60 Cash Flow from Operations $ (14.00)

Investing:Purchased equipment $ (60.00)Cash Flow for Investing $ (60.00)

Financing:Issued common stock $110.00 Took out a loan 20.00 Cash Flow from Financing $130.00 Change in Cash $ 56.00

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PROBLEMSP4-1

Note: This problem does not specify whether a direct or indirect method statement should be prepared. Preparation of both is recommended.

Journal entries:

a1. Inventory 49,000Cash 49,000

a2. Cash 73,500Sales 73,500

a3. Inventory 49,000Cost of goods sold 49,000

b. Prepaid rent 4,000Cash 4,000

c. Retained earnings 2,000Cash 2,000

Implied:

d. Salaries and wages expense 11,000Cash 11,000

Adjustments:

A1. Interest expense 4,000Interest payable 4,000

10% of $40,000 = $4,000

A2. Wages expense 1,000Wages payable 1,000

A3. Rent expense 6,000Prepaid rent 6,000

$3,000 + ($4,000/8 months)*6 months = $6,000.


(The following closes all revenue and expense accounts to an account called ‘In-come Summary.’ The balance in Income Summary should be equal to Net Income as shown on the income statement, below. Income Summary is then closed to Retained Earnings. This is an alternative to closing the revenue and expense accounts di-rectly to retained earnings and provides a convenient check on the net income num-ber on the income statement.)

C1. Sales Revenue 73,500Income Summary 73,500

C2. Income Summary 49,000COGS 49,000

C3. Income Summary 6,000Rent Expense 6,000

C4. Income Summary 4,000Interest Expense 4,000

C5. Income Summary 12,000Salaries Expense 12,000

C6. Income Summary 2,500Retained Earnings 2,500

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T-accounts (in thousands)

Cash Inventory Prepaid RentBB 52.0 BB 0.0 BB 3.0 a2 73.5 49.0 a1 a1 49.0 49.0 a3 b 4.0 6.0 A3

4.0 b EB 1.02.0 c EB –

11.0 dLand Note Payable

BB 5.0 40.0 BB

EB 5.0 40.0 EB

Interest Payable Wages Payable0.0 BB

4.0 A1 1.0 A2EB 59.5 4.0 EB 1.0 EB

Common StockRetained Earnings Sales Revenue

20.0 BB 0.0 BB C1 73.5 73.5 a2c 2.0 2.5 C6 0.0 EB

20.0 EB 0.5 EB

Cost of Goods Sold

Salaries Expense Rent Expense

a3 49.0 49.0 C2 d 11.0 A3 6.0 6.0 C3EB 0.0 A2 1.0 12.0 C5

EB 0.0 EB 0.0

Interest ExpenseIncome

SummaryA1 4.0 4.0 C4 C2 49.0 73.5 C1

C3 6.0EB 0.0 C4 4.0

C5 12.0C6 2.5

0.0


To do a direct method cash flow statement, we analyze the cash T-account. We find that:

Operating items:

b is payment of renta1 is a payment to suppliersa2 is collections from customersd is payment of salaries and wages

Investing items:

none

Financing items:

c is payment of dividends


Sampson, Inc.Cash Flow Statement

for Year Ended 12/31/04(in thousands)

Operations:Collections from customers $ 73.5Payments to suppliers (49.0)Payments for salaries (11.0)Payments for rent (4 .0 )Cash Flows from Operations $ 9 .5

Investing:None Cash Flows for Investing –

Financing:Dividends $ (2 .0 )Cash Flows for Financing $ (2 .0 )Change in Cash $ 7 .5

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The indirect method cash flow worksheet is:

Indirect Method Worksheet (in thousands)Explanation

dr cr ref dr cr ref dr crPrepaid Rent 3.0 2.0 Decr in PreR 1.0Land 5.0 5.0Wages Pay. – 1.0 Incr in WP 1.0Interest Pay. – 4.0 Incr in IP 4.0Note Payable 40.0 40.0Common St. 20.0 20.0Ret. Earnings – DIV 2.0 2.5 NI 0.5

8.0 60.0 6.0 65.5Beg Cash 52.0 Cash End Cash 59.5

60.0 BB 52.0 65.5 Operations

NI 2.5 Decr PreR 2.0

Incr WP 1.0Incr IP 4.0

CFO 9.5

Investing

– CFI

Financing 2.0 DIV

2.0 CFFCh in Cash 7.5

EB 59.5


Sampson, Inc.Cash Flow Statement

for Year Ended 12/31/04(in thousands)

Operations:Net income $ 2.5Decrease in prepaid rent 2.0Increase in wages payable 1.0Increase in interest payable 4 .0 Cash Flows from Operations $ 9 .5

Investing:None Cash Flows for Investing –

Financing:Dividends $ (2 .0 )Cash Flows for Financing $ (2 .0 )Change in Cash $ 7 .5

P4-2

Journal entries (amounts in thousands)

a. Accounts receivable 3,000.0Sales 3,000.0

b. Cash 3,100.0Accounts receivable 3,100.0

c. This is information for the cost of goods sold adjustment. See T-accounts.

d. Buildings & machinery 50.0Cash 50.0

e. Cash 1.5Accumulated depreciation 8.0Loss on sale of machinery 0.5

Buildings & machinery 10.0

f. This is information for the depreciation adjustment.

g. This is information for the interest adjustment.

h. This is information for the interest adjustment.

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i. Cash 14.0Retained earnings 14.0

j. This is information for the wages adjustment.

k. Wages expense 57.0Wages payable 57.0

l. Miscellaneous expenses 50.0Cash 50.0

m. Interest payable 7.0Cash 7.0

n. Inventory 2,820.0Accounts payable 2,820.0

o. Accounts payable 2,700.0Cash 2,700.0

p. This is information for the rent adjustment.

q. Prepaid rent 25.0Cash 25.0

r. Other accrued expenses 5.0Cash 5.0

s. This is information for the accrued liabilities adjustment.

t. Tax expense 12.0Taxes payable 12.0

u. This is information for the taxes adjustment.

Adjusting entries—(calculations below)

A1. Cost of goods sold 2,800.0Inventory 2,800.0

A2. Rent expense 27.0Prepaid rent 27.0

A3. Wages payable 53.0Cash 53.0

A4. Miscellaneous expenses 9.0Other accrued liabilities 9.0

A5. Taxes payable 11.0Cash 11.0


A6. Depreciation expense 14.0Accumulated depreciation 14.0

A7. Interest expense 6.0Interest payable 6.0

A8. Interest expense 2.4Interest payable 2.4

(Closing entries.)

C1. Sales 3,000.0Income summary 3,000.0

C2. Income summary 2,800.0Cost of goods sold 2,800.0

C3. Income summary 57.0Wages expense 57.0

C4. Income summary 59.0Miscellaneous expense 59.0

C5. Income summary 27.0Rent expense 27.0

C6. Income summary 12.0Tax expense 12.0

C7. Income summary 8.4Interest expense 8.4

C8. Income summary 0.5Loss on sale of machinery 0.5

C9. Income summary 14.0Depreciation expense 14.0

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(Close the balance in income summary to retained earnings.)

C10. Income summary 22.1Retained earnings 22.1

Calculations for adjusting entries:

The inventory, unpaid wages, prepaid rent, other accrued liabilities, and unpaid taxes at the end of the year are given, and are best analyzed in the T-accounts given below.

Depreciation:

Interest:

Senior debt:

0.06 × $100,000 = $6,000.

Subordinated debt:

0.08 × $30,000 = $2,400.


1. T-accounts

Cash Accounts Rec. Inventory Prepaid RentBB 68.0 BB 340.0 BB 75.0 BB 32.0 b 3,100.0 50.0 d a 3,000.0 3,100.0 b n 2,820.0 q 25.0 e 1.5 14.0 i 2,800.0 A1 27.0 A2

50.0 l7.0 m 240.0 c 95.0 p 30.0

2,700.0 o 25.0 q

5.0 rBuildings & Machinery

AccumulatedDepreciation Land

53.0 A3 BB 100.0 25.0 BB BB 25.0 11.0 A5 d 50.0 10.0 e e 8.0 14.0 A6

140.0 31.0 25.0

Accounts Payable

Wages Payable

Interest Payable

63.0 BB 13.0 BB 3.0 BBo 2,700.0 2,820.0 n m 7.0 6.0 A7

A3 53.0 57.0 k 2.4 A8

254.5 183.0 17.0 j 4.4

Taxes PayableOther Accrued

Liabilities Senior DebtSubordinated

Debt6.0 BB 5.0 BB 100.0 BB 30.0 BB

12.0 t r 5.0 A5 11.0 9.0 A4

7.0 u 9.0 s 100.0 30.0

Common StockAdd’l Paid-in

CapitalRetained Earnings

Wages Expense

15.0 BB 115.0 BB 265.0 BB k 57.0 57.0 c3

i 14.0 22.1 c10

15.0 115.0 273.1

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SalesCost of

Goods SoldMiscellaneous

ExpenseDepreciation

Expense3,000.0 a A1 2,800.0 l 50.0 A6 14.0

2,800.0 c2 A4 9.0 c1 3,000.0 59.0 c4 14.0 c9

Interest Expense Rent Expense Tax Expense

Income Summary

A7 6.0 A2 27.0 t 12.0 3,000.0 c1A8 2.4 27.0 c5 12.0 c6 c2 2,800.0

8.4 c7 c3 57.0 c4 59.0 c5 27.0 c6 12.0

Loss on Sale of Machinery

c7 8.4

e 0.5 c8 0.5 0.5 c8 c9 14.0

c10 22.1 –


2.REVIEW Co.

Balance Sheetas of 12/31/2006

Cash $254.5 Accounts Payable $183.0 Accounts Receivable 240.0 Wages Payable 17.0 Inventory 95.0 Interest Payable 4.4 Prepaid Rent 30.0 Taxes Payable 7.0 Total Current Assets $619.5 Other Accrued Liabilities 9.0

Total Current Liabilities $220.4 Buildings & Machinery $140.0 Less: Accumulated Depreciation

(31.0 ) Senior Debt $100.0

Buildings & Machinery, net $109.0 Subordinated Debt 30.0 Land 25.0 Total Long-term Liabilities $130.0 Total Non-current Assets $134.0 Total Liabilities $350.4 Total Assets $753.5

Shareholders’ EquityCommon Stock $ 15.0 Add’l Paid-in Capital 115.0 Retained Earnings 273.1 Total Shareholders’ Equity $403.1 Total Liabilities & Shareholders’ Equity $753.5

3.

REVIEW Co.Income Statement

for Year Ended 12/31/2006

Sales $ 3,000.0 Cost of Goods Sold (2,800.0 )Gross Margin $ 200.0 Other Expenses:Wages (57.0)Depreciation (14.0)Interest (8.4)Rent (27.0)Taxes (12.0)Miscellaneous (59.0)Loss on Sale of Machine (0.5 )Net Income $ 22.1

4.REVIEW Co.

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Cash Flow Statementfor Year Ended 12/31/2006

Operations:Net Income $ 22.1

Addbacks:Depreciation 14.0 Loss on Sale of Machinery 0.5

Changes in accounts that require additions:Accounts Receivable 100.0 Prepaid Rent 2.0 Accounts Payable 120.0 Wages Payable 4.0 Interest Payable 1.4 Taxes Payable 1.0 Other Accrued Liabilities 4.0

Changes in accounts that require subtractions:Inventory (20.0 )Cash flow from operations $249.0

Investing:Sale of machinery $ 1.5 Purchase of machinery (50.0 )Cash flows for investing $ (48.5)

Financing:Payment of dividends $ (14.0)

Change in Cash $186.5

Supplemental disclosure:Cash paid for interest $ 7.0 Cash paid for taxes $ 11.0



dr cr ref dr cr ref dr crAccounts Receivable 340.0 100.0 AR 240.0 Inventory 75.0 INV 20.0 95.0 Prepaid Rent 32.0 2.0 PREPR 30.0 Buildings & Machinery 100.0 PURCH 50.0 10.0 SALE 140.0 Accumulated Depreciation 25.0 SALE 8.0 14.0 DEPR 31.0 Land 25.0 25.0 Accounts Payable 63.0 120.0 AP 183.0 Wages Payable 13.0 4.0 WP 17.0 Interest Payable 3.0 1.4 IP 4.4 Taxes Payable 6.0 1.0 TP 7.0 Other Accrued Liabilities 5.0 4.0 OAL 9.0 Senior Debt 100.0 100.0 Subordinated Debt 30.0 30.0 Common Stock 15.0 15.0 Add’l Paid-in Capital 115.0 115.0 Retained Earnings 265.0 DIV 14.0 22.1 NI 273.1

572.0 640.0 530.0 784.5Beg Cash 68.0 Cash EndCash 254.5

640.0 BB 68.0 784.5Operations

NI 22.1DEPR 14.0

LOSSSALE 0.5 20.0 INVAR 100.0

PREPs 2.0AP 120.0WP 4.0IP 1.4TP 1.0

OAL 4.0CFO 249.0

InvestingEQUIP-SALE 1.5 50.0 EQPURCH

48.5

Financing14 DIV14 CFF

ChinCash 186.5EB 254.5

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P4-3

This problem can be done by working backwards through the indirect method cash flow worksheet.


dr cr ref dr cr ref dr crAccounts Rec. 380 AR 60 440Inventories 560 INV 80 640Land 100 20 Land 80Buildings &

Equipment810 Acq B&E 260 70 Sale B&E 1,000

Other Long-term Assets

280 80 Sale OLTA 200

Accumulated Depreciation

320 Sale B&E 40 120 Depr 400

Accounts Payable 510 50 AP 560Other Current

Liabilities260 OCL 90 170

Bonds Payable 120 80 IssBonds 200Common Stock 280 120 IssCS 400Ret. Earnings 680 Div 400 400 NI 680

2,130 2,170 2,360 2,410Beg Cash 40 Cash EndCash 50

2,170 BB 40 2,410Operations

NI 400 60 ARDepr 120 80 INVAP 50 90 OCL

CFO 340Investing

Land 20 260 Acq B&ESale B&E 30

Sale OLTA 80130 CFI

FinancingIssBonds 80 400 Div

IssCS 120200 CFF

ChinCash 10EB 50


ABC Widget CompanyBalance Sheet

at December 31, 2003

Cash $ 40Accounts receivable 380Inventory 560 Total current assets $ 980

Buildings & equipment $ 810Accumulated depreciation (320 )Buildings & equipment, net $ 490Land 100Other long-term assets 280 Total long-term assets $ 870 Total assets $ 1,850

Accounts payable $ 510Other current liabilities 260 Total current liabilities $ 770

Bonds payable $ 120 Total liabilities $ 890

Common stock $ 280Retained earnings 680 Total stockholders’ equity $ 960 Total liabilities and stockholders’ equity $ 1,850

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P4-4


dr cr ref dr cr ref dr crAccounts Rec. 93.0 93.0 Inventories 151.0 151.0 Land 30.0 5.0 3 25.0 Equipment 690.0 10.0 14.0 1 730.0

EqPur 44.0 Accumulated

Depreciation460.0 1 8.0 54.0 Depr 506.0

Patents 100.0 10.0 Amort 90.0 Accounts

Payable136.0 136.0

Interest Payable 10.0 10.0 Mortgage

Payable120.0 5 10.0 110.0

Common St. 250.0 10.0 2 270.0 10.0 4

Ret. Earnings 140.0 Div 10.0 36.0 NI 166.0 1,064.0 1,116.0 1,089.0 1,198.0

Beg Cash 52.0 Cash EndCash 109.01,116.0 BB 1,198.0

OperationsNI 36.0 3.0 3

Depr 54.0 1.0 5Amort 10.0

1 2.0 4 10.0

CFO 108.0Investing

1 4.0 44.0 EqPur3 8.0

32.0 CFIFinancing

10.0 Div9.0 5

19.0 CFFChinCash 57.0

EB 109.0


Active CompanyStatement of Cash Flows (Indirect Method)

For the Year EndedDecember 31, 2004

(in thousands)

Operations:

Net Income 36.0Add: Expenses not requiring cash and lossesDepreciation expense 54.0Amortization expense 10.0Noncash compensation 10.0Loss on sale of equipment 2.0

Subtract: GainsGain on sale of land (3.0)Gain on repayment of mortgage (1 .0 )Cash Flow from Operations $ 108 .0

Investing:Sold equipment $ 4.0 Sold land 8.0Purchased equipment (44 .0 )Cash Flow for Investing $ (32 .0 )

Financing:Repaid mortgage $ (9.0) Dividends (10 .0 )Total Financing $ (19 .0 ) Change in cash $ 57 .0

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Active CompanyStatement of Cash Flows (Direct Method)

For the Year EndedDecember 31, 2001

(in thousands)

Operations:

Collections from customers $1,200.0

Payments:Suppliers (788.0)Wages (270.0)Interest (12.0)Taxes (22 .0 )Cash Flow from Operations $ 108 .0

Investing:Sold equipment $ 4.0 Sold land 8.0Purchased equipment (44 .0 )Cash Flow for Investing $ (32 .0 )

Financing:Repaid mortgage $ (9.0) Dividends (10 .0 )Total Financing $ (19 .0 ) Change in cash $ 57 .0


P4-5

a. Microsoft uses the indirect method in preparing the statement of cash flows. The indirect method shows how net income must be adjusted to get back to cash flow from operations.

b. Unearned revenue represents cash received from customers prior to the delivery of goods or performance of a service. Because the service has not been per-formed, unearned revenue is a liability. It is added back because the cash re-ceived is not reflected in net income, but represents an increase in cash for the year.

b. Recognition of unearned revenue means that the company has performed a ser-vice in the current period where the cash was received in prior periods. The per-formance of the service results in a reduction of unearned revenue and an in-crease in revenue, thereby increasing net income. However, since the cash was received in prior periods, the income appears higher than the amount of cash re-ceived for that income. Therefore, it must be deducted.

c. Answers may vary. Among the items that might be viewed positively are:

1. The company has $13.4 billion in net cash flow from operating activities.2. The company has not relied on any financing to fund operations for the year.3. The company has repurchased $6 billion of common stock, reducing the

number of shares outstanding. This is viewed positively by remaining stock-holders. Fewer shares outstanding will result in a favorable supply/demand environment and also increase earnings per share.

d. Investors may view the large purchases of investments as negative. In a growing company, investors prefer to see acquisitions of plant and equipment. Microsoft has an unusually high amount of buying and selling of investments, which is not the core business of the company. Investors would want to know the nature of such investments. The return on these investments may not be adequate to com-pensate for the risk associated with a high growth company. The implication is that Microsoft cannot find any suitable opportunities for long-term growth. Alter-natively, the additions to property and equipment were relatively small, not good news if the company is a high growth company.

Common stock investors may want to see cash dividends to offset some of the investment risk of owning common stock. Microsoft paid no common stock dividends from 1999 to 2001.

The amount of depreciation and amortization in the 2001 income statement ($1,536) exceeds the amount spent investing in property and equipment ($1,103). This suggests that Microsoft may not have spent enough in 2001 to compensate for its usage of assets.

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e. Gains on investments are deducted because the entire cash flow is considered an investing activity. Since the gain is included in net income, it must be de-ducted so that the cash flows from operations do not “double count” the gain.

Losses on investments are added because they are losses that do not repre-sent cash outflows. A loss means that the company sold the securities for less than their balance sheet carrying value. However, the transaction resulted in a positive cash flow, all of which is reflected in the investing section. The loss is added back because it did not result in the use of cash by the company even though it resulted in a reduction of net income.

f. The income statement is prepared on the accrual basis, where revenues are rec-ognized in the period earned and expenses in the period incurred, regardless of the receipt or payment of cash. It is aimed at reflecting economic performance. Therefore, the timing of cash receipts or payments may not be the same as the timing of the expense or revenue recognition. Additionally, some expenses, such as depreciation and amortization, reduce income but do not consume cash.

g. 1. The exchange of common stock for land is a significant non-cash activity. Since it is a non-cash transaction, it will not be part of the cash flows. How-ever, it must be reported separately under the caption “significant non-cash investing and financing activities.”

2. Interest paid is an operating activity. It will be part of net income. Any change in interest payable will be added to or deducted from net income to arrive at the cash provided by operating activities.

h. The accounting change represented an after-tax adjustment reducing Microsoft’s net income by $375 million. The adjustments are related to the valuations of de-rivative investments reported by Microsoft. While the adjustment resulted in a loss, it did not require the use of cash. Therefore, the adjustment is added back to net income to arrive at cash provided by operating activities.

P4-6

a. The statement of cash flows helps investors and creditors assess the amounts of cash flows from three categories of activities: operating, investing and financ-ing. The cash flow statement describes the changes in an entity’s cash over a period of time by grouping the increases and decreases to cash into one of the three categories. Investors and creditors can then use the net change in cash for the individual categories and the company as a whole to make investment and credit decisions.


b. Answers may vary. Among those items that might be of interest to a banker would be:

1. The company had positive cash provided by operations in 2000 and 2001.2. The company was able to pay off $90,000,000 of long-term debt over the two

years.3. The total cash position of the company increased in both 2000 and 2001.4. The company repaid $1,234,000 of short-term bank borrowings over the two

years.5. Cash provided by operating activities is the company’s primary source of

funds.

c. Existing creditors would be encouraged by any of the items listed in b. Also, the Management Discussion and Analysis points out that the company was in com-pliance with all loan covenants as of March 31, 2001.

d. The primary source of funds is cash provided by operations.

e. THC paid no dividends in 2000 or 2001. MD & A indicates that the company may not pay dividends or make other payments with respect to capital stock that exceed 33 percent of the Company’s cumulative consolidated net income. To avoid violating the loan covenant, it would not be wise for the company to pay a dividend at this time.

P4-7

Net income: $910,000+ Amortization expense 40,000– Increase in Accounts receivable (10,000)– Increase in inventory (2,000)– Decrease in accounts payable (20,000)+ Increase in interest payable 2,000= Cash provided by operations before depreciation adjustment $920,000+ Depreciation expense 100,000= Cash provided by operations $1,020,000

Note to Instructor: Dividends are a financing activity; the change in dividends payable is not relevant to computing the cash provided by operating activities.

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CASESC4-1 Edgar

Obviously, the instructor will have to adapt to the particular companies chosen by the students. The point of the question is to get the students to see how few compa-nies use the indirect method. We sometimes ask for a show of hands as to how many students found a direct method statement. It may be wise to examine the state-ments that some students believe are direct method, however, as many students make mistakes in this regard.

The purpose of the second question is to get the student to think about net income versus cash flows from operations. The Total Toy example in the chapter shows how a growing company can have net income in excess of cash flows from operations. Companies in more of a steady state should have cash flows from operations (plus capital expenditures) close to net income. An interesting conversation can ensue if a student has found a company with cash flow from operations more than net income. This might be because the company suffers a loss (or even takes a “big bath”), or because the company is shrinking.

Questions 2b and 2c are aimed at getting the student to think about the investing ac-tivities that firms have, and in particular to begin to think about whether investment represents growth or just replacement of assets.

Question 2d asks the student to focus on financing activities.

Questions e, f and g ask the student to find supplemental disclosures. While the company may not have any noncash transactions, the company must disclose how much was paid for taxes and interest. These disclosures may, however, be hard to find.

C4-2 Coldwater Creek’s Cash Flows

a. At this point, the students have seen,

Collections from customers = Sales – Change in Accounts receivable.

They should analyze the T-account:

Accounts receivableBB 2,342

Sales 246,697 245,020 Collections

EB 4,019

If you have a really good class, you could point out that the correct formula is:


Collections from customers = Sales – Adjustment for Accounts receivable in the cash flow statement.

Although it is not true in general (see the Appendix in Chapter 15), for Coldwater Creek’s fiscal year ended February 28, 1998, the change in Accounts receivable is equal to the adjustment for receivables listed on the cash flow statement:

Adjustment for Accounts receivable in the cash flow statement is for an increase in Accounts receivable of 1,677.

The change in Accounts receivable on the balance sheet:

Ending Accounts receivable $ 4,019Beginning Accounts receivable (2,342 )Increase in Accounts receivable $ 1,677

From Coldwater’s income statement, Net sales were $246,697; therefore, collec-tions from customers were:

Net sales $246,697Increase in Accounts receivable (1,677 )Collections from customers $ 245,020

b. We analyze the inventory account:

InventoryBB 25,279

Purch 147,898 120,126 COGS

EB 53,051

c. After determining purchases in part b, cash paid on account can be deduced from analyzing the

Accounts payable18,061 BB

Payments 138,684 147,898 Purch

27,275 EB

Again, you might point out to a really good class that:

Payments to suppliers = Cost of goods sold – Adjustment for Inventory in the cash flow statement + Adjustment for Accounts payable in the cash flow state-ment.In the case of Coldwater Creek, this approach yields a slightly different answer than the above T-account analysis:

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Payments to suppliers = 120,126 + 27,772 – 9,924= 137,974.

The difference between these two answers is $710, and might be the result of for-eign currency translations, which the students will not encounter in detail in this book.

d. The difference between net income and cash flow from operations is:

Net income $11,688Less: Cash flow for operations – (5,959)Collections from customers $17,647

The primary cause of the difference between net income and cash flow from op-erations is the increase in inventories. Of the $27,772 increase in inventories, only $9,214 (the increase in accounts payable) was financed by suppliers. The in-crease in inventories that Coldwater had to pay for was: $27,772 – $9,214 = $18,558. Therefore, only $18,558 – $17,647 = $911 comes from the combination of all other items.

C4-3 Med-Design Corporation

1. Research and development is an expense that is not listed on the balance sheet. One could say that the effects of research and development are felt in Retained earnings.

2. Zero. The change in Retained earnings (Accumulated deficit) is exactly explained by net income:

Beginning balance in Accumulated deficit $(18,967,241)Add: net income 882,889Ending balance in Accumulated deficit $( 18,084,352 )

3. Depreciation and amortization (from cash flow statement) $289,022

Less: amortization (notes) 36,602Depreciation $252,420

4. Because it is an expense related to a long term asset. Net income is the starting point in deriving cash flow from operations, but depreciation is not a cash flow and must be added back.


5. The “issuance of warrants for services” reflects an expense that did not con-sume cash. Therefore, like depreciation, it is added back in adjusting net income to cash flow from operations.

The notes reveal that the warrants were issued to directors who supplied con-sulting services to Med-Design. On January 14, 1998, warrants worth $194,000 were issued for consulting services. On September 8, 1998, warrants worth $186,802 were issued for consulting services. Their total is $380,802:

Value of warrants issued and expense recorded on January 19, 1998 $194,000

Value of warrants issued and expense recorded on September 8, 1998 186,802

Total consulting expense paid for with warrants instead of cash $380,802

6. The credit to Additional paid-in capital is deduced from examination of the stock-holders’ equity section. (Some students might think the credit should go to Other comprehensive income because they don’t know what that is.)

Wage (or Consulting) expense 194,000Additional paid-in capital 194,000

7. Increase in Prepaid expenses and other current assets $20,459Adjustment in the cash flow statement (as if there was

a decrease in Prepaid expenses and other current assets 6,545Total change in account due to warrants $27,004

8. There is no gain or loss because none is listed on the income statement and there is no adjustment for a gain or loss in the operating section of the cash flow statement.

9. Accrued expenses from income statement $ 82,335Change in Accrued expense (from cash flow statement

or balance sheet—there is $1 rounding error on the balance sheet) 36,346

Cash paid for marketing costs in 1998 $118,681

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C4-4 Blue Zone, Inc.

1. The depreciation is added back because it is an expense that decreased reported net income. But none of the expense was associated with a cash out-flow. That is, Depreciation Expense is debited and Accumulated Depreciation is credited. Since net income was the initial estimate of cash from operations,and since depreciation did not involve a cash outflow, we adjust the initial estimate by adding back depreciation expense—adjusting the estimate (net income) to get what it would have been if depreciation expense was not in it.

2. See the following table. The change number computed from the beginning and ending balances in the balance sheet agrees with the cash flow statement num-bers. It is not always true. Changes in the entity (acquisition of another com-pany or major division, or disposal,for example) or reclassification of a portion of an item’s balance (for example, reclassifying an A/R as a note receivable) will cause the balance sheet change numbers to be different from the cash flow statement numbers.

Beginning balance Ending balance Change

A/R $97,600 $221,363 $123,763 increaseWork-in-progress 70,581 0 70,581 decreasePrepaid expenses 93,204 144,767 51,563 increase

3. The prepaid expenses are a current asset that has increased. Therefore, more cash is tied up in this asset at the end of the period than at the beginning. This increase is subtracted from net income to arrive at cash flow from operations. Another way of saying this is that the cash outflow to create the prepaid asset exceeds the amount of expense created by prepaids in the income statement by the amount of the increase.

4. It is added to net income to arrive at cash provided by (used by) operating activi-ties for reasons similar to those for the depreciation adjustment. It was an ex-pense that did not consume cash. A plausible journal entry is:

Compensation expense…… 359,173APIC…………………… 359,173

5. The deferred revenue account balance decreased by $120,123 during the 2000 fiscal year. The decrease can be thought of as the following journal entry:

Deferred revenue……….. 120,123Revenue ………….. 120,123

Although revenue was recognized, the cash flow associated with the revenue was already collected in a previous period. In fiscal 1999 it was just the oppo-site. More cash was collected than revenue recognized.

6. The following excerpt from the statement explains it:


On August 1, 1997, the Company entered into an agreement to exchange services with a British Columbia television station. The Company provided website development and monthly maintenance services in exchange for daily television advertising. The Company recognized the revenues and advertising expenses from the barter transaction at the fair value of the advertisingreceived.

There was no adjustment shown in the cash flow statement, probably because the revenue was exactly equal to the expense, and neither involved a cash flow. Therefore, they cancelled out each. It might have been better to show a subtrac-tion for the revenue and an add-back for the expense in two separate lines of the cash flow from operations section of the statement. This would make it more transparent to the reader.

The company likely would not have reported the transactions in the fiscal 2000 statements because they have no historical track record on which to rely (and the new accounting pronouncement requires it).

7. The company has a net loss in all three years as well as a negative cash flow from operations in the last two years. The loss and the negative cash flow seems to be getting worse. Cash flow from financing is decreasing. Cash flow from investment is negative, indicating that the company still has to make minimal investment to sustain operations. Financing cash flow is positive, but decreasing. Overall, it looks as if the company is experiencing cash flow prob-lems because basic operations are not profitable.

8. See the following:

Fixed Assets (Gross) Accumulated Depreciation

Beg. Bal. 544,263 118,667 Beg. Balance

Increases 610,419 ? Decreases Decreases ? 197,118 Increases

End. Bal. 1,146,229 307,332 End. Balance

From the cash flow statement: fixed asset purchases were $610,419, and depre-ciation expense was $197,118.

Fixed assets………………………… 610,419Cash ………………………….. 610,419

Depreciation expense…………….. 197,118Accumulated depreciation... 197,118

After recording these two transactions in the above t-accounts, the “plug” needed to balance both of the accounts is the same, $8,453 ($544,263 + $610,419 – $1,146,229, or $118,667 + $197,118 – $307,332). Therefore, what must have

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happened is that fully depreciated assets were taken out of service. The follow-ing entry records that:

Accumulated depreciation……….. 8,453Fixed assets…………………. 8,453

You should notice that no asset sales are accounted for in the investing section of the cash flow statement.

C4-5 Bluegreen Corporation

This is an interesting case for several reasons. It shows that not every firm has a conventional balance sheet, and that the accounting and presentation is flexible enough to capture the essence of specific company transactions. The large number of supplemental cash flow statement items also shows that many material changes to assets and liabilities arise from transactions that do not go through the cash ac-count. These transactions are important and cannot be ignored.

1. There are no current asset or liability categories likely because of the nature of the business. Most of the company’s operating assets and liabilities are longer term. For example, the inventory consists of pieces of property and land, which has a longer than one-year useful life.

2. The depreciation is added back because it is an expense that decreased reported net income. But none of the expense was associated with a cash outflow. That is, Depreciation Expense is debited and Accumulated Depreciation is credited. Since net income was the initial estimate of cash from operations, and since de-preciation did not involve a cash outflow, we adjust the initial estimate by adding back depreciation expense—adjusting the estimate (net income) to get what it would have been if depreciation expense was not in it.

3. The notes receivable relate to the basic business of the company. It buys and sells property and finances it for customers. Therefore, the notes relate to operations. “Proceeds from sales of notes receivable” are the actual cash inflow from selling such notes, and “Proceeds from borrowings collateralized by notes receivable” is the cash raised by pledging the notes to get a loan. Both of these activities relate to basic operations.

4. The cash flow investing section shows proceeds from sale of property and equipment in the amount of $79. The operating section of the cash flow state-ment shows there was a loss on the sale included in net income in the amount of $45. Therefore, the book value must have been $79 + $45 = $124.

5. Some of the notes receivable were sold to a third party. The $89,786 is the de-crease resulting from normal changes in the notes account—issuing new notes and collecting on old notes from customers purchasing property from the com-pany.


6. Bluegreen did not pay any cash dividends during the year ended April 1, 2001.

Beginning RE………….. $22,654Net income…………….. 2,717Ending RE……………… $25,371

As the above shows, the change in RE is entirely explained by the amount of net income for the year.

7. The cash flow statement shows a gain on the sale of notes receivable in the amount of $3,281. It also shows that proceeds from the sale amount to $73,244. Therefore the book value must have been $73,244 – $3,281 = $69,963.

8. The journal entry to convert the debentures must have been:

Convertible debentures……………… 368Common stock…………………. 1Additional paid-in capital…….. 367

(Since we do not know the exact conversion rate, the actual entry is in the above form. The common stock has a par value of $.01; therefore, it is unlikely that more than $1 would be put in the common stock account)

9. The beginning and ending balances can be found in the balance sheet. The cash flow statement shows purchases of property and equipment for cash in the amount of $9,549. It also shows proceeds from sales of property and equipment in the amount of $79, and the operating section shows there was a loss of $45 on the sale.

Property and equipment……………. 9,549Cash…………………………….. 9,549

Cash……………………………………. 79Loss on sale…………………………... 45

Property and equipment ……. 124

From the cash flow statement we also know that depreciation expense was $4,263.

Depreciation expense………………. 4,263Accumulated depreciation…. 4,263

Now, entering the above transactions into the t-account, we have:

Property and Equipment (Net)

35,409

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4,2639,549 124

41,462

Note, however, that the beginning balance adjusted for the additions and sub-tractions would imply an ending balance of $35,409 + $9,549 – $4,263 – $124 = $40,571. But the actual ending balance is $41,462, a difference of $891. That is, we need to have added $891 in the account in addition to what we already added in order to end with $41,462. The supplemental cash flow information shows that there was an addition to property and equipment in the amount of $891, which was acquired through direct financing (not cash). The journal entry would be something like:

Property and equipment…………. 891Notes payable………………. 891

If we enter this $891 in the above t-account, the ending balance will now be com-pletely justified.

04 Book.doc

Economy & Finance

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