CH04 Solutions DEP

©Cambridge Business Publishers, 2011

Solutions Manual, Chapter 4 4-1

Chapter 4

Reporting and Analyzing Cash Flows

Learning Objectives – coverage by question

Mini-exercises Exercises Problems Cases

LO1 – Explain the purpose of the statement of cash flows and how it complements the income statement and balance sheet.

21, 22, 24, 25 34, 36, 38, 39 44, 47, 51, 55 57, 58, 59

LO2 – Construct and explain the statement of cash flows.

21, 22, 23, 24,

25, 26, 27, 28,

29, 30, 31

34, 35, 36, 37,

38, 39, 40, 41,

42, 43

44, 45, 46, 47,

48, 49, 50, 51,

52, 53, 54, 55,

56

57, 58

LO3 – Compute and interpret ratios that reflect a company’s liquidity and solvency.

32, 33, 35, 43 46, 48, 50, 52,

56 59

LO4 – Appendix 4A: Use a spreadsheet to construct the statement of cash flows.

56


Financial Accounting, 3rd Edition

4-2

QUESTIONS Q4-1 Cash equivalents are short-term, highly liquid investments that firms acquire

with temporarily idle cash to earn interest on these excess funds. To qualify as a cash equivalent, an investment must (1) be easily convertible into a known cash amount and (2) be close enough to maturity so that its market value is not sensitive to interest rate changes (generally, investments with initial maturities of three months or less). Three examples of cash equivalents are Treasury bills, commercial paper, and money market funds.

Q4-2 Cash equivalents are included with cash in a statement of cash flows

because the purchase and sale of such investments are considered to be part of a firm's overall management of cash rather than a source or use of cash. Similarly, as statement users evaluate cash flows, it may matter very little to them whether the cash is on hand, deposited in a bank account, or invested in cash equivalents.

Q4-3 Operating activities Inflow: Cash received from customers Outflow: Cash paid to suppliers

Investing activities Inflow: Sale of equipment Outflow: Purchase of stocks and bonds

Financing activities Inflow: Issuance of common stock Outflow: Payment of dividends Q4-4 a. Investing; outflow. b. Investing; inflow. c. Financing; outflow. d. Operating (direct method, not shown separately under indirect method);

inflow. e. Financing; inflow. f. Operating (direct method, not shown separately under indirect method);

inflow. g. Operating (direct method, not shown separately under indirect method);

outflow. h. Operating (direct method, not shown separately under indirect method);

inflow. Q4-5 This is a noncash investing and financing event. It must be reported in a

supplementary schedule to the statement of cash flows.



Q4-6 Noncash investing and financing transactions are disclosed as supplemental information to a statement of cash flows because a secondary objective of cash flow reporting is to present information about investing and financing activities. Noncash investing and financing transactions, generally, affect future cash flows. Issuing bonds payable to acquire equipment, for example, requires future cash payments for interest and principal on the bonds. On the other hand, converting bonds payable into common stock eliminates future cash payments related to the bonds. Knowledge of these types of events, therefore, should be helpful to users of cash flow data who wish to assess a firm's future cash flows.

Q4-7 A statement of cash flows helps external users assess the amount, timing,

and uncertainty of future cash flows to the enterprise. These assessments help users evaluate their own future cash receipts from their investments in, or loans to, the firm. A statement of cash flows shows the periodic cash effects of a firm's operating, investing, and financing activities. Distinguishing among these different categories of cash flows helps users compare, evaluate, and predict cash flows. With cash flow information, creditors and investors are better able to assess a firm's ability to settle its liabilities and pay its dividends. Over time, the statement of cash flows permits users to observe and analyze management's investing and financing policies. A statement of cash flows also provides information useful in evaluating a firm's financial flexibility (which is its ability to generate cash to respond to unanticipated needs and opportunities).

Q4-8 The direct method presents the net cash flow from operating activities by

showing the major categories of operating cash receipts and cash payments (such as cash received from customers, cash paid to employees and suppliers, cash paid for interest, and cash paid for income taxes). The indirect (or reconciliation) method, in contrast, presents the net cash flow from operating activities by applying a series of adjustments to the accrual net income to convert it to a cash basis.

Q4-9 Under the indirect method, depreciation is added to net income because, as

a noncash expense, it was deducted in computing net income. Adding depreciation to net income, therefore, eliminates it from the cash-basis income amount. Amortization and depletion expenses are handled the same way.

Q4-10 Under the indirect method, the $98,000 cash received from the sale of the

land will appear in the cash flows from investing activities section of the statement of cash flows. In addition, the $28,000 gain from the sale will be deducted from net income as one of the adjustments made to determine the net cash flow from operating activities.



4-4

Q4-11 Net income $ 88,000 Add (deduct) items to convert net income to cash basis Depreciation 6,000 Accounts receivable decrease 13,000 Inventory increase (9,000) Accounts payable decrease (3,500) Income tax payable increase 1,500 Net cash provided by operating activities $ 96,000 Q4-12 The separate disclosures required for a company using the indirect method

in the statement of cash flows are (1) cash paid during the year for interest (net of amount capitalized) and for income taxes, (2) all noncash investing and financing transactions, and (3) the policy for determining which highly liquid, short-term investments are treated as cash equivalents.

Q4-13 The statement of cash flows will show a positive net cash flow from

operating activities if operating cash receipts exceed operating cash payments. This could happen, for example, if noncash expenses (such as depreciation and amortization) exceed the net loss. It would also happen if operating cash receipts exceed sales by more than the loss or if operating cash payments are less than accrual expenses by more than the loss (or some combination of these events).

Q4-14 Sales $925,000 + Accounts receivable decrease 14,000 = Cash received from customers $939,000

Q4-15 Wages expense $ 86,000 + Wages payable decrease 1,100 = Cash paid to employees $ 87,100

Q4-16 Advertising expense $ 43,000 + Prepaid advertising increase 1,600 = Cash paid for advertising $ 44,600

Q4-17 Under the direct method, the $5,100 cash received from the sale of equipment will appear in the cash flows from investing activities section of the statement of cash flows.

Q4-18 The separate disclosures required for a company using the direct method in

the statement of cash flows are (1) a reconciliation of net income to net cash flow from operating activities, (2) all noncash investing and financing transactions, and (3) the policy for determining which highly liquid, short-term investments are treated as cash equivalents.



Q4-19 The operating-cash-flow-to-current-liabilities ratio is calculated by dividing net cash flow from operating activities by average current liabilities. This ratio is a measure of a firm's ability to liquidate its current liabilities.

Q4-20 The operating-cash-flow-to-capital-expenditures ratio is calculated by

dividing a firm's cash flow from operating activities by its annual capital expenditures. A ratio below 1.00 means that the firm's current operating activities are not providing enough cash to cover the capital expenditures. A ratio above 1.0 is normally considered a sign of financial strength.



4-6

MINI EXERCISES M4-21 (5 minutes) a. __+__$823 increase in accounts payable b. __+__$319 increase in accrued liabilities c. __+__$853 decrease in inventory d. __+__$448 decrease in accounts receivable e. __+__$1,259 increase in depreciation and amortization M4-22 (10 minutes) a. Cash flow from an operating activity. b. Cash flow from an investing activity. c. Cash flow from an investing activity. d. Cash flow from an operating activity. e. Cash flow from a financing activity. f. Cash flow from a financing activity. g. Cash flow from an investing activity. M4-23 (15 minutes)

Dole Food Company, Inc.

Selected Items from the Cash Flow Statement

1 Cash dividends paid Financing

2 Change in inventories Operating

3 Depreciation and amortization Operating

4 Long-term debt repayments Financing

5 Change in accounts payable and accrued liabilities Operating

6 Net income Operating

7 Proceeds from sales of assets Investing

8 Change in provision for deferred income taxes Operating

9 Change in prepaid expenses and other assets Operating

10 Short-term debt borrowings Financing

11 Capital additions Investing



M4-24 (10 minutes) a. Cash flow from a financing activity. b. Cash flow from an operating activity. c. Noncash investing and financing activity. d. Cash flow from an operating activity. e. Cash flow from an operating activity. f. None of the above (a change in the composition of cash and cash equivalents). M4-25 (15 minutes)

Pacific Sunwear of California, Inc.

Selected Items from the Cash Flow Statement

1 Depreciation and amortization Operating

2 Proceeds from sale of common stock and exercise of stock options

Financing

3 Loss on disposal of equipment Operating

4 Change in accrued liabilities Operating

5 Repayments of long-term debt obligations Financing

6 Changes in income taxes payable and deferred income taxes

Operating

7 Change in accounts receivable Operating

8 Purchases of property and equipment Investing

9 Repurchase and retirement of common stock Financing

10 Purchases of short-term investments Investing

M4-26 (15 minutes –INDIRECT METHOD) Net income $ 45,000 Add (deduct) items to convert net income to cash basis Depreciation 8,000 Gain on sale of investments (9,000) Accounts receivable increase (9,000) Inventory increase (6,000) Prepaid rent decrease 2,000 Accounts payable increase 4,000 Income tax payable decrease (2,000) Net cash provided by operating activities $ 33,000



4-8

M4-27 (20 minutes)

A “+” indicates that the amount is added and a “-“ indicates that it is subtracted when preparing the cash flow statement using the indirect method.

Ethan Allen Interiors Inc. And Subsidiaries

Consolidated Statements of Cash Flows – Selected Items

1 Purchases of short-term investments Investing - 2 Payment of cash dividends Financing - 3 Depreciation and amortization Operating + 4 Increase in deferred income tax liability Operating + 5 Decrease in customer deposits Operating - 6 Capital expenditures Investing - 7 Increase in income taxes and accounts payable Operating + 8 Payments on long-term debt and capital leases Financing - 9 Gain on disposal of property, plant and equipment Operating - 10 Increase in prepaid and other current assets Operating - 11 Net proceeds from issuance of common stock Financing + 12 Proceeds from the disposal of property, plant and

equipment Investing + 13 Net income Operating + 14 Decrease in inventories Operating + 15 Borrowings on revolving credit facility Financing +

M4-28 (15 minutes—INDIRECT METHOD) Net loss $(21,000) Add (deduct) items to convert net loss to cash basis Depreciation 8,600 Accounts receivable decrease 9,000 Inventory decrease 3,000 Prepaid expenses decrease 3,000 Accounts payable increase 4,000 Accrued liabilities decrease (2,600) Net cash provided by operating activities $ 4,000 Cairo Company's 2010 operating activities provided $4,000 cash.



M4-29 (20 minutes) A “+” indicates that the amount is added and a “-“ indicates that it is subtracted when preparing the cash flow statement using the indirect method.

Nordstrom, Inc. Consolidated Statement of Cash Flows – Selected Items

1 Increase in accounts receivable Operating - 2 Capital expenditures Investing - 3 Purchases of short-term investments Investing - 4 Increase in deferred income tax liability Operating + 5 Principal payments on long-term debt Financing - 6 Increase in merchandise inventories Operating - 7 Decrease in income taxes payable Operating - 8 Proceeds from employee stock purchase plan Financing + 9 Increase in accounts payable Operating + 10 Net earnings Operating + 11 Repurchase of common stock Financing - 12 Increase in accrued salaries, wages and related

benefits Operating + 13 Proceeds from sale of assets Investing + 14 Cash dividends paid Financing - 15 Depreciation and amortization of buildings and

equipment Operating + M4-30 (15 minutes—DIRECT METHOD) a. Rent expense $ 60,000 – Prepaid rent decrease (2,000) = Cash paid for rent $ 58,000 b. Interest income $ 16,000 – Interest receivable increase (700) = Cash received as interest $ 15,300 c. Cost of goods sold $ 98,000 + Inventory increase 3,000 + Accounts payable decrease 4,000 = Cash paid for merchandise purchased $105,000



4-10

M 4-31 (15 minutes—DIRECT METHOD)

Sales $825,000 – Accounts receivable increase (11,000) = Cash received from customers $814,000 Cost of goods sold $550,000 + Inventory increase 13,000 + Accounts payable decrease 6,000 = Cash paid for merchandise purchased $569,000



EXERCISES E4-32 (20 minutes)

a. Merck: $3,364/$5,618 = 0.60

Pfizer: $18,238/$24,422 = 0.75

Abbot Labs: $6,995/$10,347 = 0.68 b. Merck: $3,364 – ($747 – $44) = $2,661

Pfizer: $18,238 – ($1,701 – $0) = $16,537

Abbott Labs: $6,995 – ($1,288 – $0) = $5,707

c. None of the firms has sufficient cash flow to cover their current liabilities although none of the ratios is of major concern. Pfizer is the largest of these three companies and has relatively more cash left over after capital expenditures to consider using on other activities that could strengthen the firm’s operating or financial position. Given that these firms are of different sizes and have different research program success, it is difficult to generalize further.

E4-33 (20 minutes)

a. Wal-Mart: $23,147/$56,934 = 0.41

General Electric: $48,601/$246,925 = 0.20

Exxon: $59,725/$53,706 = 1.11 b. Wal-Mart: $23,147 – ($11,499 – $714) = $12,362

General Electric: $48,601 – ($16,010 – $10,975) = $43,566

Exxon: $59,725 – ($19,318 – $5,985) = $46,392

c. General Electric reports substantial current liabilities and its operating cash flow produces only 20% of what is needed to cover its obligations. Exxon appears to be in the best position, with a substantial amount of its operational cash flows available for dividends, expansion, and other business pursuits. The situation has improved as Exxon’s profits have increased substantially with higher oil prices. Extra cash does not earn any return, which provides Exxon a problem or, better, an opportunity. Because the firm is so large, it is unlikely that an acquirer may look with interest at the large cash position of the company.



4-12

E4-34 (30 minutes) (a) Items from the table have been grouped into operating, investing, and financing categories in (b) the cash flow statement below. (c) The cash balance at the end of the period is $864 million.

Target Corporation

Consolidated Statement Of Cash Flows

($ millions)

Net earnings ……………………………………………………………. $2,214

Loss on disposal of property and equipment ……………………. 33

Depreciation and amortization ……………………………………… 1,826

Deferred income taxes ……………………………………………….. 91

Stock based compensation …………………………………………. 72

Decrease in accounts receivable, net ……………………….…….. 793

Decrease in inventory ………………………………………………… 77

Decrease in accounts payable ……………………………………… (389)

Decrease in accrued liabilities ……………………………………… (230)

Other operating cash flow adjustments …………………………… (57)

Total cash flow from operating activities …………………………. 4,430

Expenditures for property and equipment ……………………….. (3,547)

Other investments …………………………………………………….. (865)

Proceeds from disposals of property and equipment ………….. 39

Cash flow used for investing activities ……………………………. (4,373)

Additions to long-term debt …………………………………………. 3,557

Reductions of long-term debt ………………………………………. (1,455)

Reduction of short-term debt ………………………………………. (500)

Stock issued and other ………………………………………………. 35

Repurchase of common stock ……………………………………… (2,815)

Dividends paid …………………………………………………………. (465)

Cash flow used for financing activities ……………………………. (1,643)

Net change in cash …………………………………………………….. (1,586)

Cash balance, beginning of the period …………………………….. 2,450

Cash balance, end of the period …………………………………….. $ 864



E 4-35 (15 minutes—INDIRECT METHOD) a. Net income $113,000 Add (deduct) items to convert net income to cash basis Accounts receivable increase (5,000) Inventory decrease 6,000 Prepaid insurance increase (1,000) Accounts payable increase 4,000 Wages payable decrease (2,000) Net cash provided by operating activities $115,000 b. $115,000/[($31,000 + $29,000)/2] =3.83 E4-36 (30 minutes) (a) Items from the table have been grouped into operating, investing, and

financing categories in (b) the cash flow statement below. (c) The cash balance at the end of the period is $31,313,000. (d) It is not unusual for companies like Oakley to borrow money from banks for

short periods of time. For example, these borrowings may be needed to finance seasonal fluctuations in working capital. In many cases, cash might be borrowed and then repaid before the end of the accounting period, and consequently, never be reported on the year-end balance sheet. By presenting the amount borrowed and the amount repaid in the cash flow statement (rather than merely the net increase or decrease), the financial statements provide investors and creditors with potentially useful information about Oakley’s short-term financing needs. The net change in bank borrowings is an increase of $22,538,000 ($254,211,000 - $231,673,000).



4-14

E4-36—continued.

Oakley, Inc. And Subsidiaries Consolidated Statements Of Cash Flows

($ thousands)

Net income ……………………………………………………………… $44,788 Depreciation and amortization ……………………………………… 37,571 Loss on sale of equipment ………………………………………….. 460 Loss on investment …………………………………………………… 4,329 Noncash compensation ……………………………………………… 3,081 Deferred income taxes ……………………………………………….. (11,222) Increase in accounts receivable ……………………………………. (1,611) Increase in inventories ………………………………………………. (23,177) Increase in prepaid expenses and other current assets ………. (2,268) Increase in accounts payable ………………………………………. 10,135 Increase in accrued expenses and other current liabilities........ 14,886 Increase in accrued income taxes ………………………………… 4,937

Cash flow from operating activities ……………………………….. 81,909 Purchases of property and equipment ……………………………. (52,527) Proceeds from sale of property and equipment …………………. 221 Acquisitions of other businesses ………………………………….. (86,751) Purchase of investments …………………………………………….. (705)

Cash used for investing activities ………………………………….. (139,762) Proceeds from bank borrowings ……………………………………. 254,211 Repayments of bank borrowings …………………………………… (231,673) Stock issued and other ………………………………………………. 5,774 Repurchase of common stock ……………………………………… (10,351) Payment of cash dividends …………………………………………. (10,952)

Cash provided by financing activities ……………………………... 7,009 Net increase in cash …………………………………………………… (50,844) Cash and cash equivalents, beginning ……………………………. 82,157

Cash and cash equivalents, end …………………………………….. $31,313



E4-37 (30 minutes—INDIRECT METHOD)

LUND CORPORATION STATEMENT OF CASH FLOWS

FOR YEAR ENDED DECEMBER 31, 2010

Net Cash Flow from Operating Activities Net Income $76,000 Add (Deduct) Items to Convert Net Income to Cash Basis Depreciation 29,000 Amortization 6,000 Gain on Sale of Equipment (4,000) Accounts Receivable Increase (4,000) Inventory Decrease 13,000 Prepaid Expenses Increase (2,000) Accounts Payable Increase 9,000 Accrued Liabilities Decrease (3,000) Net Cash Provided by Operating Activities …………….. $120,000 Cash Flows from Investing Activities Sale of Equipment 17,000 Purchase of Land (90,000) Net Cash Used by Investing Activities …………………... (73,000) Cash Flows from Financing Activities Issuance of Common Stock 35,000 Retirement of Bonds Payable (60,000) Payment of Dividends (29,000) Net Cash Used by Financing Activities (54,000) Net Decrease in Cash (7,000) Cash at Beginning of Year 22,000 Cash at End of Year $ 15,000



4-16

E4-38 (30 minutes)

a.

Merchandise inventories, 2008 ……………… $ 8,209

less Merchandise inventories, 2007 ……….. (7,611)

Increase in merchandise inventories ………. 598 Cost of merchandise sold ……………………. 31,729

Inventory purchases …………………………... 32,327 Accounts payable, 2007 ………………………. 3,713

less Accounts payable, 2008 ………………… (4,109)

Cash paid for inventory ………………………. $31,931

b. Property, net of depreciation, 2008 …………. $22,722

Less, Property, net of depreciation, 2007 …. (21,361)

Net increase in property ……………………… 1,361 Depreciation expense …………………………. 1,539

Net property acquired ………………………… $ 2,900

c. Retained earnings, 2007 ……………………… $ 15,345 Net income ……………………………………… 2,195 Less Retained earnings, 2008 ………………. (17,049)

Dividends paid …………………………………. $ 491

E4-39 (15 minutes) a. Cash flows from investing activities will show:

Purchase of stock investments $ (80,000)

Sale of stock investments 59,000 b. Cash flows from financing activities will show:

Issuance of bonds $130,000

Retirement of bonds (131,000)



E4-40 (30 minutes)

a. Merchandise inventories, 2008 …………………………………… $ 915.2

Less merchandise inventories, 2007 …………………………… (1,242.0)

Decrease in merchandise inventories …………………………… (326.8) Cost of merchandise sold ………………………………………… 2,484.8

Inventory purchases ………………………………………………… 2,158.0 Trade accounts payable, 2007 …………………………………… 511.9 Less trade accounts payable, 2008 ……………………………… (350.0)

Cash paid for merchandise inventory …………………………… $ 2,319.9

b. Property and equipment, 2007 …………………………………… $ 592.8

Expenditures for property and equipment ……………………… 79.9 Less depreciation expense ………………………………………… (107.1)

Less property and equipment, 2008 ……………………………… (494.2)

Book value of property and equipment sold in 2008 ………… 71.4 Loss on sale of property and equipment ……………………… (57.1)

Cash proceeds from the sale of property and equipment …. $ 14.3

c. Retained earnings, 2007 …………………………………………… $ 250.5 Less net loss ………………………………………………………… (186.7) Less retained earnings, 2008 …………………………………… (63.8)

Dividends paid ……………………………………………………… $ 0

d. Merchandise inventory (+A) ………………………..….. 2,158.0

Trade accounts payable )+L)…………………… 2,158.0

Trade accounts payable (-L) …………………………… 2,319.9

Cash (-A) …………………………………………… 2,319.9

Cash (-A) …..………………………………………….…… 14.3

Loss on sale of property and equipment (+E, -SE) … 57.1 Property and equipment, net (-A) …………….. 71.4



4-18

E4-41 (20 minutes—DIRECT METHOD) a. Advertising expense $ 62,000 + Prepaid advertising increase 4,000 = Cash paid for advertising $ 66,000 b. Income tax expense $ 29,000 + Income tax payable decrease 2,200 = Cash paid for income taxes $ 31,200 c. Cost of goods sold $180,000 – Inventory decrease (5,000) – Accounts payable increase (2,000) = Cash paid for merchandise purchased $173,000 E4-42 (30 minutes—DIRECT METHOD)

MASON CORPORATION STATEMENT OF CASH FLOWS


Cash flows from operating activities Cash received from customers $194,000 Cash received as interest 6,000 $200,000 Cash paid to employees and suppliers 148,000 Cash paid as income taxes 11,000 (159,000) Net cash provided by operating activities 41,000 Cash flows from investing activities Sale of land 40,000 Purchase of equipment (89,000) Net cash used by investing activities (49,000) Cash flows from financing activities Issuance of bonds payable 30,000 Acquisition of treasury stock (10,000) Payment of dividends (16,000) Net cash provided by financing activities 4,000 Net decrease in cash (4,000) Cash at beginning of year 16,000 Cash at end of year $ 12,000



E4-43 (30 minutes—DIRECT METHOD) a. Sales $750,000 – Accounts Receivable Increase (5,000) = Cash Received from Customers $745,000 Cost of Goods Sold $470,000 – Inventory Decrease (6,000) – Accounts Payable Increase (4,000) = Cash Paid for Merchandise Purchased $460,000 Wages Expense $110,000 + Wages Payable Decrease 2,000 = Cash Paid to Employees $112,000 Insurance Expense $ 15,000 + Prepaid Insurance Increase 1,000 = Cash Paid for Insurance $ 16,000 Cash Flows from Operating Activities Cash Received from Customers $745,000 Cash Paid for Merchandise Purchased $460,000 Cash Paid to Employees 112,000 Cash Paid for Rent 42,000 Cash Paid for Insurance 16,000 630,000 Net Cash Provided by Operating Activities $115,000 b. $115,000/[($31,000 + $29,000)/2] =3.83 E4-44 (15 minutes)

1. True ---

2. False $25

3. False $10

4. False $0



4-20

PROBLEMS P4-45 (20 minutes)

Cash flows from operating activities

Net income .......................................................................................... $135,000

Adjustments to reconcile net income to operating cash flows

Depreciation .................................................................................. $25,000

Accounts receivable increase ..................................................... (10,000)

Prepaid expenses decrease ......................................................... 3,000

Accounts payable increase ......................................................... 6,000

Wages payable decrease ............................................................. (4,000)

Gain on sale of assets .................................................................. (5,000) 15,000

Net cash provided from operating activities ................................... $150,000



P4-46 (45 minutes—INDIRECT METHOD) a. Cash, December 31, 2010 ...................................................... $11,000 Cash, December 31, 2009 ...................................................... 5,000 Cash increase during 2010 .................................................... $ 6,000 b. STATEMENT OF CASH FLOWS (INDIRECT METHOD)

WOLFF COMPANY STATEMENT OF CASH FLOWS


Net Cash Flow from Operating Activities Net Income $56,000 Add (Deduct) Items to Convert Net Income to Cash Basis

Depreciation 17,000

Accounts Receivable Increase (9,000)

Inventory Increase (30,000)

Prepaid Insurance Decrease 2,000

Accounts Payable Decrease (3,000)

Wages Payable Increase 3,000

Income Tax Payable Decrease (1,000)

Net Cash Provided by Operating Activities $35,000

Cash Flows from Investing Activities

Purchase of Plant Assets (55,000)

Cash Flows from Financing Activities

Issuance of Bonds Payable 55,000

Payment of Dividends (29,000)

Net Cash Provided by Financing Activities 26,000

Net Increase in Cash 6,000

Cash at Beginning of Year 5,000

Cash at End of Year $11,000

c. (1) $35,000/(($23,000 + $24,000)/2) = 1.49

(2) $35,000/$55,000 = 0.64

Wolff’s cash flow ratios indicate that, while the company has sufficient cash flow to cover its current obligations, it must rely on external financing to pay for capital expenditures.



4-22

P4-47 (30 minutes) a.

Wolff Company Cash Flow from Operations – Direct Method

Revenue or Expense

Adjustments Operating Cash Flow

Revenues/Cash Receipts: Sales revenue …………………………… $635,000 - Increase in accounts receivable …… ($9,000) Cash received from customers ……… $626,000

Less Expenses/Cash Payments: Cost of goods sold …………………….. 430,000 + Increase in inventory ……………… 30,000 + Decrease in accounts payable ……… 3,000 Cash paid for merchandise …………… 463,000 Wages expense ……………………… 86,000 - Increase in wages payable ………… (3,000) Cash paid for wages ………………… 83,000 Insurance expense …………………… 8,000 - Decrease in prepaid insurance …… (2,000) Cash paid for insurance ……………… 6,000

Interest expense ……………………… 9,000 Cash paid for interest ………………… 9,000 Depreciation expense ………………… 17,000 - Depreciation expense ……………… (17,000) Cash paid for deprecation …………… 0

Income tax expense …………………… 29,000 + Decrease in income tax payable …… 1,000 Cash paid for income taxes ………… 30,000 Net income …………………………… $56,000 Total adjustments ……………………… ($ 21,000) Cash flow from operating activities $35,000

b. Computing cash flows from operating activities using the direct method provides additional detail about the specific cash flows that occurred during the period. For example, the indirect method does not reveal that Wolff paid $463,000 for merchandise during 2010, or $83,000 for wages. Because this detail is missing, the FASB requires supplemental disclosure of two specific (and important) cash payments – interest and taxes – if the indirect method is used.



P4-48 (45 minutes—INDIRECT METHOD) a. Cash, December 31, 2010 $49,000 Cash, December 31, 2009 28,000 Cash increase during 2010 $21,000 b. STATEMENT OF CASH FLOWS (INDIRECT METHOD)

ARCTIC COMPANY STATEMENT OF CASH FLOWS


Net Cash Flow from Operating Activities Net Loss $ (42,000) Add (Deduct) Items to Convert Net Loss to Cash Basis Depreciation 22,000 Gain on Sale of Land (25,000) Accounts Receivable Decrease 8,000 Inventory Decrease 6,000 Prepaid Advertising Decrease 3,000 Accounts Payable Decrease (14,000) Interest Payable Increase 6,000 Net Cash Used by Operating Activities $ (36,000) Cash Flows from Investing Activities Sale of Land 70,000 Purchase of Equipment (183,000)* Net Cash Used by Investing Activities (113,000) Cash Flows from Financing Activities Issuance of Bonds Payable 200,000 Purchase of Treasury Stock (30,000) Net Cash Provided by Financing Activities 170,000 Net Increase in Cash 21,000 Cash at Beginning of Year 28,000 Cash at End of Year $ 49,000

* The sum of the increase in PPE assets account ($138,000) and the book value of the land sold ($45,000). c. -$36,000/(($23,000 + $31,000)/2) = -1.33

-$36,000/$183,000 = -0.20

Arctic’s operating cash flows are negative, primarily because the firm reported a net loss for the year. As a consequence, its cash flow ratios indicate insufficient cash flows to fund operations and capital expenditures.



4-24

P4-49 (30 minutes) a.

Arctic Company Cash Flow from Operations – Direct Method

Revenue or Expense

Adjustments Operating Cash Flow

Revenues/Cash Receipts: Sales revenue …………………………………….. $728,000 + Decrease in accounts receivable ……………. 8,000 Cash received from customers ………………… $736,000

Gain on sale of land ……………………………… 25,000 - Gain on sale of land ……………………………. (25,000) Cash flow from gain ……………………………… 0 753,000 (17,000) 736,000

Less Expenses/Cash Payments: Cost of goods sold ………………………………. 534,000 - Decrease in inventory ………………………… (6,000) + Decrease in accounts payable ………………. 14,000 Cash paid for merchandise …………………….. 542,000 Wages expense …………………………………… 190,000 Cash paid for wages ……………………………… 190,000 Advertising expense …………………………….. 31,000 - Decrease in prepaid insurance ………………. (3,000) Cash paid for advertising ………………………. 28,000

Interest expense …………………………………. 18,000 - Increase in interest payable …….................... (6,000) Cash paid for interest …………………………… 12,000 Depreciation expense …………………………… 22,000 - Depreciation expense …………………………. (22,000) Cash paid for deprecation …………………….. 0 795,000 (23,000) 772,000

Net loss ……………………………………………. ($42,000) Total adjustments ……………………………….. $ 6,000 Cash flow from operating activities ………….. ($36,000)

b. Computing cash flows from operating activities using the direct method

provides additional detail about the specific cash flows that occurred during the period. For example, the indirect method does not reveal that Arctic paid $542,000 for merchandise during 2010, or $28,000 for advertising. Because this detail is missing, the FASB requires supplemental disclosure of two specific (and important) cash payments – interest and taxes – if the indirect method is used.



P4-50 (50 minutes—INDIRECT METHOD) a. Cash, December 31, 2010 .............................................. $27,000 Cash, December 31, 2009 .............................................. 18,000 Cash increase during 2010 ............................................ $ 9,000 b. STATEMENT OF CASH FLOWS (INDIRECT METHOD)

DAIR COMPANY STATEMENT OF CASH FLOWS


Net Cash Flow from Operating Activities Net Income $ 85,000 Add (deduct) items to convert net income to cash basis Depreciation 22,000

Amortization of intangible assets 7,000

Loss on bond retirement 5,000

Accounts receivable increase (5,000)

Inventory decrease 6,000

Prepaid expenses increase (2,000)

Accounts payable increase 6,000

Interest payable decrease (3,000)

Income tax payable decrease (2,000)

Net cash provided by operating activities $119,000

Cash flows from investing activities

Sale of equipment 17,000

Cash flows from financing activities

Retirement of bonds payable (125,000)

Issuance of common stock 24,000

Payment of dividends (26,000)

Net cash used by financing activities (127,000)

Net increase in cash 9,000

Cash at beginning of year 18,000

Cash at end of year $ 27,000



4-26

P4-50—continued c. (1) Supplemental cash flow disclosures Cash paid for interest ......................................................................... $ 13,000* Cash paid for income taxes ............................................................... $ 38,000†

* Interest expense $10,000 + Interest payable decrease 3,000 Cash paid for interest $13,000 † Income tax expense $36,000 + Income tax payable decrease 2,000 Cash paid for income taxes $38,000

(2) Schedule of noncash investing and financing activities Issuance of bonds payable to acquire equipment .......................... $ 60,000 d. (1) $119,000/[($42,000 + $41,000)/2] = 2.87. (2) The firm did not spend any cash on capital investments. The firm did issue

debt for equipment, but this is not a capital expenditure. (3) $119,000 + $17,000 = $136,000



P4-51 (45 minutes) a. Depreciation is a noncash expense that is deducted in the computation of net

income. The depreciation add-back zeros this expense out of the income statement to focus on cash profitability. The positive amount for depreciation does not mean that the company is generating cash from depreciation, a common misconception. It is merely an adjustment to remove that expense from the computation of profit.

b. The positive amount relating to merchandise inventories indicates that the dollar

amount of inventories on hand has declined during the period. This is positive if decline is the result of the elimination of excess inventories, but is worrisome if the company is reducing inventories below the level necessary to maintain its competitive position in an effort to temporarily boost its operating cash flow.

c. The $4.7 billion outflow for investing activities relates to the purchase of

property, plant and equipment (PPE) and short-term investments. The company is growing its infrastructure and building liquidity, both of which are positive (provided that its PPE purchases are for new stores in good locations).

d. Staples operates businesses in 26 countries outside of the U.S. including

businesses in Europe, Asia, South America, Australia, and Canada. This means that some of its cash transactions occur in currencies other than the U.S. dollar. This fact requires the company to hold cash in other currencies that may be revalued relative to the dollar from one period to the next. When foreign cash balances are revalued in foreign exchange markets relative to the U.S. dollar, the dollar value of the company’s cash balance changes even though there was no actual cash flow. Hence, this exchange rate effect is listed in the cash flow statement to explain the change in the cash balance.

e. Although net cash decreased during the period, Staples presents a “healthy”

cash flow picture for the year. It generated almost $1.7 billion of operating cash flow and raised $2.5 billion through financing transactions but spent $4.7 billion to grow its infrastructure.



4-28

P4-52 (50 minutes—INDIRECT METHOD) a. Cash and cash equivalents, December 31, 2010 ........................ $19,000 Cash and cash equivalents, December 31, 2009 ........................ 25,000 Cash and cash equivalents decrease during 2010 .................... $ 6,000

b. See the cash flow statement provided on the following page.

c. (1) Supplemental Cash Flow Disclosures Cash paid for interest $ 12,000* Cash paid for income taxes $ 46,000† * Interest expense $13,000 - Interest payable increase (1,000) Cash paid for interest $12,000

† Income tax expense $44,000 + Income tax payable decrease 2,000

Cash paid for income taxes $46,000 (2) Schedule of noncash investing and financing activities Issuance of preferred stock to acquire patent $ 25,000 d. (1) $101,000/[($34,000 + $31,000)/2] = 3.11.

(2) $101,000/($185,000) = 0.55.

(3): $101,000 – ($90,000 + $95,000 - $14,000) = -$70,000



P4-52—continued b.

RAINBOW COMPANY STATEMENT OF CASH FLOWS


Net cash flow from operating activities Net income $ 90,000 Add (deduct) items to convert net income to cash basis Depreciation 39,000 Patent amortization 7,000 Loss on sale of equipment 5,000 Gain on sale of investments (3,000) Accounts receivable increase (10,000) Inventory increase (26,000) Prepaid expenses increase (4,000) Accounts payable increase 4,000 Interest payable increase 1,000 Income tax payable decrease (2,000) Net cash provided by operating activities ……… $101,000 Cash flows from investing activities Sale of investments 60,000 Purchase of land (90,000) Improvements to building (95,000) Sale of equipment 14,000 Net cash used by investing activities (111,000) Cash flows from financing activities Issuance of bonds payable 30,000 Issuance of common stock 24,000 Payment of dividends (50,000) Net cash provided by financing activities ……… 4,000 Net decrease in cash and cash equivalents (6,000) Cash and cash equivalents at beginning of year …. 25,000 Cash and cash equivalents at end of year $ 19,000



4-30

P4-53 (35 minutes) a. Cash and cash equivalents, December 31, 2010 ……….. $19,000 Cash and cash equivalents, December 31, 2009 ……….. 25,000 Cash and cash equivalents decrease during 2010 …….. $ 6,000 b.

RAINBOW COMPANY STATEMENT OF CASH FLOWS (DIRECT METHOD)


Cash flows from operating activities Cash received from customers ………………………… $740,000 Cash received as dividends …………………………….. 15,000 $755,000 Cash paid for merchandise purchased ……………….. 462,000 Cash paid for wages and other operating expenses … 134,000 Cash paid for interest …………………………………….. 12,000 Cash paid for income taxes ……………………………… 46,000 (654,000) Net cash provided by operating activities …………….. 101,000 Cash flows from investing activities Sale of investments ……………………………………….. 60,000 Purchase of land …………………………………………… (90,000) Improvements to building ………………………………… (95,000) Sale of equipment ………………………………………….. 14,000 Net cash used by investing activities …………………... (111,000) Cash flows from financing activities Issuance of bonds payable ………………………………. 30,000 Issuance of common stock ………………………………. 24,000 Payment of dividends ……………………………………… (50,000) Net cash provided by financing activities ……………… 4,000 Net decrease in cash and cash equivalents ……………….. (6,000) Cash and cash equivalents at beginning of year …………. 25,000 Cash and cash equivalents at end of year …………………. $ 19,000



P4-53—continued. c. (1) Reconciliation of net income to net cash flow from operating activities Net income $ 90,000 Add (deduct) items to convert net income to cash basis Depreciation 39,000 Patent amortization 7,000 Loss on sale of equipment 5,000 Gain on sale of investments (3,000) Accounts receivable increase (10,000) Inventory increase (26,000) Prepaid expenses increase (4,000) Accounts payable increase 4,000 Interest payable increase 1,000 Income tax payable decrease (2,000) Net cash provided by operating activities $101,000 (2) Schedule of noncash investing and financing activities Issuance of preferred stock to acquire patent $ 25,000



4-32

P4-54 (30 minutes) ($ millions)

a.

Net sales ………………………………………………………………… $36,537

- Increase in accounts receivable …………………………………… (939)

Cash collected from customers …………………………………….. $35,598

b.

Cost of goods sold ……………………………………………………. $23,397

- Decrease in inventories …………………………………………….. (54)

Purchases ………………………………………………………………. 23,343

- Increase in accounts payable ……………………………………… (92)

Cash paid for purchases of inventories …………………………… $23,251

c.

Property, plant and equipment, ending balance …………………. $2,954

- Purchases of property, plant and equipment …………………… (1,144)

+ Book value of PPE assets sold ($42 + 26) ………………………. 68

+ Depreciation of property, plant and equipment ………………… 577

Property, plant and equipment, beginning balance ……………… $2,455

d. Stock-based compensation expense is deducted when calculating net income similar to cash compensation. The only difference is that the compensation is paid in shares of stock (or stock options) instead of cash. Because stock-based compensation does not require the payment of cash, it is treated as a noncash expense, much like depreciation, and added back to net income when the indirect method is used in the cash flow statement. Generally speaking, compensation cost is classified as part of operating activities whether or not the compensation is paid in cash.



P4-55 (60 minutes) ($ millions)

a.

Sales revenue ……………………………………………………………… $71,288

+ Decrease in accounts receivable …………………………………….. 287

- Decrease in deferred revenue …………………………………………. (309)

Cash collected from customers ………………………………………… $71,266

b.

Cost of sales ………………………………………………………………. $47,298

- Decrease in merchandise inventories ($11,731-$10,673) ……........ (1,058)

Purchases …………………………………………………………………. 46,240

+ Decrease in accounts payable ($5,732-$4,822) ………………........ 910

Cash paid for purchases of merchandise inventory ………………… $47,150

c.

Property and equipment, at cost, beginning balance ………………. $36,412

+ Purchases of property and equipment ……………………………… 1,884

- Property and equipment, at cost, ending balance …………………. (36,477)

Original cost of property and equipment sold ……………………….. $ 1,819

d. Property and equipment (+A) ………………………….. 37 Long-term debt (+L) ……………………………….. 37

e.

Long-term debt, including current maturities, beginning balance ($11,383+$300) ………………………………………………………….

$11,683

+ Increase from purchase of property and equipment ……………….. 37

- Long-term debt, including current maturities, ending balance ($9,667+$1,767) …………………………………………………….......

(11,434)

Long-term debt repaid …………………………………………………….. $ 286



4-34

P4-55 (continued)

f.

Provision for income taxes (income tax expense) …………………….. $ 1,278

- Increase in income taxes payable ($289-$60) ………………………… (229)

+ Decrease in deferred income taxes ($688-$369) …………………….. 319

Income taxes paid ………………………………………………………….. $ 1,368

g.

Retained earnings, beginning balance ………………………………… $11,388

+ Net income ……………………………………………………………….. 2,260

- Retained earnings, ending balance …………………………………… (12,093)

Dividends declared and paid ……………………………………………. $ 1,555



P4-56 (60 minutes) a. Home Depot cash flow spreadsheet:

A B C D E F G H

Assets: 2010 2009 Change Effect of change on cash flow No effect

on cash Operating Investing Financing

Cash & equivalents 519 445 74

S.T. investments 6 12 (6) (168)

S.T. invest. sold 174

Accounts receivable 972 1,259 (287) 287

Merchandise inventory

10,673 11,731 (1,058) 1,058

Other current assets 1,192 1,227 (35) 35

Property & equipment, net

26,234 27,476 (1,242)

Depreciation 1,785

Prop. & equip. purchased

(1,847) (37)

Prop. & equip. sold: 580 761

Goodwill and other 1,568 2,174 (606) 606

Liabilities:

Current installments of L.T. debt

1,767 300 1,467 1,467

S.T. debt 0 1,747 (1,747) (1,747)

Accounts payable 4,822 5,732 (910) (910)

Accrued salaries and related expenses

1,129 1,094 35 35

Deferred revenue 1,165 1,474 (309) (309)

Sales taxes payable 337 445 (108) (108)

Income tax payable 289 60 229 229

Other accrued expenses

1,644 1,854 (210) (210)

L.T. debt 9,667 11,383 (1,716) (1,753) 37

Other L.T liabilities 2,198 1,833 365 365

Deferred income taxes 369 688 (319) (319)

Equity:

Common stock 6,133 5,885 248 176 72

Treasury stock (372) (314) (58) (58)

Retained earnings 12,093 11,388 705

Net income 2,260

Dividends (1,555)

Accumulated other comprehensive inc.

(77) 755 (832) (832)

Totals 4,728 (1,080) (3,574) 0



4-36

P4-56 (continued) b.

The Home Depot, Inc. and Subsidiaries Consolidated Statement of Cash Flows

Year ended February 1, 2009 ($ millions)

Operating activities:

Net income ……………………………………………………………………… $ 2,260

Depreciation ……………………………………………………………………. 1,785

Loss on property and equipment …………………………………………… 580

Deferred income taxes ……………………………………………………….. (319)

Stock-based compensation …………………………………………………. 176

Changes in assets and liabilities affecting operations:

Accounts receivable …………………………………………………….. 287

Merchandise inventory …………………………………………………. 1,058

Other current assets ……………………………………………………. 35

Goodwill and other assets ……………………………………………… 606

Accounts payable ………………………………………………………… (910)

Accrued salaries and related expenses ……………………………… 35

Deferred revenue ………………………………………………………… (309)

Sales taxes payable ……………………………………………………… (108)

Income tax payable ………………………………………………………. 229

Other accrued expenses ……………………………………………….. (210)

Other long-term liabilities ………………………………………………. 365

Accumulated other comprehensive income ………………………… (832)

Cash flow from operating activities …………………………………… 4,728

Investing activities:

Purchase of short-term investments ………………………………………. (168)

Proceeds from the sale of short-term investments ……………………… 174

Purchases of property and equipment …………………………………….. (1,847)

Proceeds from the sale of property and equipment ……………………… 761

Cash flow used for investing activities ……………………………….. (1,080)

Financing activities:

Short-term debt repaid ……………………………………………………….. (1,747)

Long-term debt repaid (includes current installments) …………………. (286)

Issuance of common stock ………………………………………………….. 72

Purchases of treasury stock ………………………………………………… (58)

Dividends paid …………………………………………………………………. (1,555)

Cash used for financing activities ……………………………………… (3,574)

Net increase in cash …………………………………………………………… 74

Cash balance, beginning of period ………………………………………….. 445

Cash balance, end of period …………………………………………………. $ 519



P4-56 (continued) c. Operating cash flow to current liabilities ($ millions): $4,728 / [($11,153 + $12,706) / 2] = 0.396 Operating cash flow to capital expenditures ($ millions): $4,728 / $1,847 = 2.56



4-38

CASES AND PROJECTS C4-57 (30 minutes) The required debt to equity ratio allows for total liabilities to be up to $477 million. That is $477 / ($125+$148) =1.747 < 1.75. This implies total short-term borrowing of $107 million and an ending cash balance of $70 million.

Lambert Co. Statement of Cash Flows (projected)

Cash from operations

Net income …………………………………………………… $ 18

Depreciation expense ……………………………………… 120

Increase in accounts receivable …………………………. (40)

Decrease in inventory ……………………………………… 20

Increase accounts payable ……………………………….. 30

Decrease in income taxes payable ………………………. (10)

Cash provided by (used in) operations ……………….. $ 138

Cash from investing

Acquisitions of property, plant and equipment ………… (225)

Disposal proceeds ………………………………………….. 75

Cash provided by (used in) investing …………………. (150)

Cash from financing

Issue long-term debt ……………………………………….. 80

Repay long-term debt ……………………………………….. (100)

Common stock issue ……………………………………….. 25

Shareholder dividends ……………………………………… (30)

Increase (decrease) in short-term borrowing …………… 57

Cash provided by (used in) financing ………………….. 32

Net change in cash …………………………………………….. 20

Beginning cash balance ………………………………………. 50

Ending cash balance ………………………………………….. $ 70



C4-58 (45 minutes)

a. 1 Accounts receivable (+A) …………………………… 3,800 Sales revenue (+R,+SE)………………………… 3,800 2 Cash (+A) ……………………………………………… 3,500 Accounts receivable (-A) ……………………… 3,500 3 Cost of goods sold (+E,-SE) ………………………… 1,800 Inventory (-A) ……………………………………. 1,800 4 Inventory (+A) ………………………………………… 1,200 Accounts payable (+L) …………..…………….. 1,200 5 Accounts payable (-L) …..…………………………… 1,100 Cash (-A) …….………………………………….. 1,100 6 Salaries and wages expense (+E,-SE) ……………. 700 Salaries and wages payable (+L) ……………. 700 7 Salaries and wages payable (-L) …………………… 730 Cash (-A) ……..………………………………….. 730 8 Rent expense (+E,-SE)……………………….……… 200 Prepaid rent (-A) ……………………………….. 200 9 Prepaid rent (+A) ……………………..……………… 600 Cash (-A) …….………………………………….. 600 10 Depreciation expense (+E,-SE) ……………………. 150 Accumulated depreciation (+XA,-A) …………. 150 11 Cash (+A) ………………………………………………. 10 Accumulated depreciation (-XA,+A) ………………… 70 Fixtures and equipment (-A) …………………… 80 12 Fixtures and equipment (+A) ……………………….. 800 Cash (-A) ………………………………………….. 800 13 Interest expense (+E,-SE) …..……………………….. 16 Cash (-A) ………………………………………….. 16 14 Bank loan payable (-L) ……….……………………….. 1,600 Cash (-A) ………………………………………….. 1,600 15 Cash (+A) ……………………………………………….. 2,000 Long-term loan payable (+L) …………………… 2,000



4-40

C4-58 (continued) 16 Income tax expense (+E,-SE) …………………………. 374 Taxes payable (+L) ……………………………….. 374 17 Retained earnings (-SE) ………………………………. 80 Cash (-A) …………………………………………… 80 18 Revenue (-R) ……………………………………………. 3,800 Cost of goods sold (-E) …………………………. 1,800 Salaries and wages expense (-E) ……………… 700 Rent expense (-E) ………………………………… 200 Depreciation expense (-E) ……………………… 150 Interest expense (-E) …………………………….. 16 Income tax expense (-E) ………………………… 374 Retained earnings (+SE) ………………………… 560 Entry 18 closes revenue and expense accounts to retained earnings.



b. + Cash (A) - - Accounts Payable (L) + - Common Stock (SE) +

600 3,000 4,600

2 3,500 5 1,100 1,200 4 4,600 Bal

1,100 5 3,100 Bal 730 7 600 9 - Retained Earnings (SE)+

11 10 - Salaries and Wages + 1,300 800 12 Payable (L) 17 80 560 18

16 13 100 1,780 Bal

1,600 14 7 730 700 6

15 2,000 70 Bal

80 17 - Revenue (R) + Bal 1,184 3,800 1

- Taxes Payable (L) + 18 3,800

0 0 Bal

374 16

+ Accounts Rec. (A) - 374 Bal + Cost of Goods Sold (E) -

6,500 3 1,800 1 3,800 3,500 2 - Bank Loan Payable (L) + 1,800 18

Bal 6,800 1,600 Bal 0 14 1,600

0 Bal + Salaries & Wages (E) -

+ Inventory (A) - 6 700

2,400 - Long-term Loan (L) + 700 18

4 1,200 1,800 3 0 Bal 0 Bal 1,800 2,000 15

2,000 Bal + Rent Expense (E) -

8 200 + Prepaid Rent (A) - 200 18

0 Bal 0 9 600 200 8

Bal 400 + Depreciation Exp. (E) -

10 150 150 18

+ Fixtures and - Bal 0 Equipment (A)

1,900 + Interest Expense (E) -

12 800 80 11 13 16 Bal 2,620 16 18

Bal 0

- Accum. Deprec. (XA) + + Income Tax Exp (E) -

800 16 374 11 70 150 10 374 18

880 Bal Bal 0



4-42

C4-59 (30 minutes) a. Depreciation is a noncash expense that is deducted in the computation of net

income. The depreciation add-back zeros this expense out of the income statement to focus on operating cash flow. The positive amount for depreciation does not mean that the company is generating cash from depreciation, a common misconception. It is merely an adjustment to remove that expense from net income to convert profit to cash flow.

b. Share based compensation expense is deducted when calculating net income similar to cash compensation. The only difference is that the compensation is paid in shares of stock (or stock options) instead of cash. Because share based compensation does not require the payment of cash, it is treated as a noncash expense, much like depreciation, and added back to net income when the indirect method is used in the cash flow statement. Generally speaking, compensation cost is classified as part of operating activities whether or not the compensation is paid in cash.

c. In a sale-leaseback transaction, a long-term asset is sold and then immediately leased (or rented) from the party it was sold to. The transaction is considered to be a financing transaction, so the proceeds from the sale are listed as financing cash flows. This is because there is no net change in assets (the original asset is replaced with a capital lease asset) but long-term liabilities (in the form of capital lease obligations) are increased. Any gain recognized in the income statement on a sale-leaseback transaction is noncash and nonoperating and must be deducted when calculating cash flow from operating activities. (Gains on the sale of the asset are normally deferred and amortized over the term of the lease.)

d. Free cash flow ($ millions): –$1,521 – $923 = -$2,444.

Southwest’s operating cash flow is negative, as is its free cash flow.

e. Southwest’s cash flow from operating activities is negative, as is its cash flow from investing activities. It generated a positive cash flow of $1,654 million from financing activities. As a result, the net decrease in cash was $845 million. Southwest appears to be strong enough to withstand a reduction in cash of this magnitude, especially given that it has a record (in 2007 and 2006) of reporting positive cash flows from operations.

To be thorough in analyzing Southwest’s liquidity and solvency, one would want to ask why operating cash flows were negative. The cash flow statement is useful here. The largest negative adjustment is for a decrease in accounts payable and accrued liabilities. This adjustment is considerably larger than others listed, and to better understand what it represents, one would need to search the notes to find an explanation. As it turns out, a substantial portion of this adjustment was to pay amounts owed to counterparties for fuel derivatives. Hence, we suspect that this is a nonrecurring cash outflow.

In its 2009 cash flow statement (released after the text was completed), Southwest reported positive cash flow from operating activities of $985 million.

CH04 Solutions DEP

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