CHAPTER F6
Financial Reporting: The Statement of Cash Flows


QUESTIONS

6-1   The income statement provides information a...
208                                                                    Chapter F6


       cash collections from customers...
Financial Reporting: The Statement of Cash Flows                                209


6-11   GAAP require that the issuanc...
210                                                                     Chapter F6


       3 year period is very worrisom...
Financial Reporting: The Statement of Cash Flows                                  211



       c.   Net cash flow from in...
212                                                                   Chapter F6


6-5   a. $16,000;   Cash received from ...
Financial Reporting: The Statement of Cash Flows                              213


6-8
                                  ...
214                                                                      Chapter F6


6-10   Net income ($15,000 − $8,000)...
Financial Reporting: The Statement of Cash Flows                           215


6-12   a. Net cash flow from operations  ...
216                                                                      Chapter F6


6-13

            Account Balance   ...
Financial Reporting: The Statement of Cash Flows                              217


6-14   Cash flow from operating activi...
218                                                                      Chapter F6


         receivable. Other adjustmen...
Financial Reporting: The Statement of Cash Flows                              219


       b. Cash flow associated with in...
220                                                                             Chapter F6


6-20

           Account and ...
Financial Reporting: The Statement of Cash Flows                               221


PROBLEMS

P6-1
                      ...
222                                                                         Chapter F6


              Purchase of land   ...
Financial Reporting: The Statement of Cash Flows                                        223


                            ...
224                                                                          Chapter F6


P6-4                            ...
Financial Reporting: The Statement of Cash Flows                                  225


   D.                         Plan...
226                                                                        Chapter F6


P6-6
       A. In 1998, Rowe’s pri...
Financial Reporting: The Statement of Cash Flows                           227


           is more than the amount of ren...
228                                                                    Chapter F6


      Original                        ...
Financial Reporting: The Statement of Cash Flows                            229


      were as follows. Depreciation (a n...
230                                                                        Chapter F6


        or equity. Issuances in fi...
Financial Reporting: The Statement of Cash Flows                               231




P6-12
        A. Sara Lee’s cash ac...
232                                                                          Chapter F6


           substantial dividend ...
Financial Reporting: The Statement of Cash Flows                               233


         term assets, which caused ca...
234                                                                                        Chapter F6


              stoc...
Financial Reporting: The Statement of Cash Flows                                  235


        manager must closely monit...
236                                                                    Chapter F6


                       future. Cash fr...
Financial Reporting: The Statement of Cash Flows                           237


       3. Prepaid advertising: The increa...
238                                                                          Chapter F6


P6-21

A.                       ...
Financial Reporting: The Statement of Cash Flows                                  239



Pro-forma Balance Sheet          ...
240                                                                                       Chapter F6


P6-23

            ...
Financial Reporting: The Statement of Cash Flows                                      241


CASES

C6-1
       A. General ...
242                                                                     Chapter F6


       G. The company’s most importan...
Financial Reporting: The Statement of Cash Flows                              243


C6-3
   A. The statements are similar ...
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Chapter 6

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Chapter 6

  1. 1. CHAPTER F6 Financial Reporting: The Statement of Cash Flows QUESTIONS 6-1 The income statement provides information about how well a company has performed during a period based on the operating activities for that period. These activities may affect cash flows of prior or future periods. The effects are captured in the income statement regardless of when the cash flows occur. Because some of the effects may occur in future periods or cannot be measured precisely, the income statement provides an estimate of what these effects are expected to be. The income state- ment helps decision makers assess the long-run success of a company. The statement of cash flows describes the cash flows that resulted from current period operating activities. It provides information about a company’s ability to pay current obligations. A company must generate sufficient cash to pay creditors, suppliers, employees, and other pro- viders of goods and services. Profitability, as reported on the income statement, does not ensure short-run survival of a company.   6-2 Concerning operating activities, where did cash come from and where did cash go? 6-3 To grow significantly, a company usually must expand its set of operating assets such as land, buildings, and machinery. The acquisition of these long-term assets generally requires the outlay of cash which causes cash flow from investing activities to be negative. 6-4 First, a company that does not have profitable opportunities in which to reinvest its earnings has little opportunity but to distribute those earnings to stockholders via dividends. Second, if the businesses’ activities are declining, the firm will not need as much financing and will pay back its loans (perhaps ahead of time). Third, a company may begin to buy back its own stock. All three situations lead to negative cash flow from financing activities. 6-5 What caused net income for the period to be different from net cash flow? The indirect method is a reconciliation of net income to cash flow. Certain items of revenue and expense have different effects on net income during a period than they have on cash flow. For example, when sales are made on credit they affect net income (through sales revenue) but have no effect on cash flow. Therefore, when sales on credit exceed 207
  2. 2. 208 Chapter F6 cash collections from customers, the difference must be deducted from net income to arrive at cash flow. 6-6 The indirect format is a reconciliation of revenues and expenses measured by accrual accounting (net income) and revenues and expenses measured using cash basis accounting (cash flow from operations). The approach is to start with accrual basis net income and adjust for revenues and expenses that had different cash flow consequences than accrual consequences. Depreciation expense and amortization expense are examples of this situation. Both reduce net income, but neither reduces cash flow. That is, these expenses have zero cash flow consequences. Therefore, concerning these two items, net income understates the amount of cash flow. To obtain cash flow, these amounts must be added back to net income. 6-7 When the balance in accounts receivable increases during a fiscal period, it means that new sales on credit have exceeded the amount of cash collected from receivables. Therefore, the amount of revenue recognized on the income statement is greater than the amount of cash collected from customers. To reconcile net income to cash from operations, the increase in accounts receivable must be subtracted. 6-8 The usual presentation of investing activity and financing activity information on a statement of cash flows is consistent with the direct format that is occasionally used in the operating activities section. 6-9 Interest is included as an operating activity because interest expense is included on the income statement. The FASB decided that cash paid for interest should be an operating item for consistency. One could argue that interest is logically a financing activity. Nevertheless, GAAP requires that it be included as an operating activity. 6-10 The acquisition of machinery typically involves cash. Nevertheless, the acquisition of machinery is always an investing activity. How it was paid for makes no difference. Long-term notes payable are generally issued in exchange for cash. Nevertheless, the issuance of a note payable is always a financing activity. What the firm got in return makes no difference. Clearly, then, the direct exchange of a note payable for machinery is both a financing activity and an investing activity at the same time.
  3. 3. Financial Reporting: The Statement of Cash Flows 209 6-11 GAAP require that the issuance of either debt or equity in exchange for long-term assets be disclosed, but not necessarily on the statement of cash flows. Even though no cash is involved, most companies report this information at the bottom of the statement of cash flows as an addendum. Companies also have the option of reporting this information in a separate schedule. Regardless of the disclosure method chosen, the requirement is that a user of the financial statements be able to identify all material financing and investing activities of the fiscal period. 6-12 Operations consist of the primary activities that the company was set up to perform. If the firm’s primary operations consume cash, rather than generate it, the company cannot survive in the long-run. Another way of looking at it is to ask the question “If you can’t generate cash from operations, why are you in this business?” Over a relatively short period of time (perhaps during the startup period or during a period of major strategy or market changes) a company might be able to endure a cash outflow from operations. In the long-run, however, creditors will not lend money to a firm that does not generate cash from its primary activities. Similarly, investors will not invest in such a firm. 6-13 When cash flow from investing activities is positive it means that the company is dis-investing. That is, it is selling off its long-term assets and reducing its productive capacity. A company that has a profitable and successful future typically is buying new long-term assets rather than selling off the ones they already have. In most cases, positive cash flow from investing activities is not a positive sign. 6-14 The most frequent uses of cash generated by operations are as follows: a. payment of dividends b. repayment of debt c. repurchase of the company’s own stock (treasury stock) d. expansion—acquisition of new productive assets such as plant and equipment e. expansion—investments in, or acquisitions of, other companies 6-15 There are two possibilities. First, the company may be so profitable that it can finance all growth out of operating cash flow and still have cash left over to reduce debt and buy back equity. Second, the company may have few profitable new investment opportunities and therefore no need for the cash. In this case, cash is being returned to those who loaned it to the firm and to those who purchased stock in the firm (in the form of dividends and/or by repurchasing its own stock). 6-16 It suggests that this company is in serious difficulty. To observe this situation in any one year is bad enough; to see it consistently over a
  4. 4. 210 Chapter F6 3 year period is very worrisome. First, the inability to generate cash from its primary activities is very bad news. If this can’t be turned around quickly there is no future for this firm. Second, the positive cash flow from investing activities means that the firm is selling off its long-term assets to cover the cash requirements of operations and financing. Third, the negative cash flow from financing activities, coupled with the above, implies that the firm is short of cash. There are required repayments of debt that must be repaid and the company can only do so by selling off its long-term assets. If the debt repayments were voluntary, the firm would likely postpone them rather than sell off assets. 6-17 For most corporations, two of the major differences between net income and cash flow from operating activities are depreciation and amortization. These often are large expenses on the income statement but do not reduce cash flow. Changes in working capital also can account for major differences between net income and cash flow. Thus, a company may have a net loss but have an increase in cash flow from operating activities. The cash flow may result from transactions of prior periods that produce cash flow during the current period or that reduce income without using cash during the current period. EXERCISES 6-1 Definitions of all terms are listed in the glossary. 6-2 a. Net cash flow from operating activities: Received from customers $87,500 Paid for advertising $ 300 Paid for income taxes 3,000 Paid for insurance 200 Paid for interest 450 Paid for utilities 790 Paid to employees 18,000 Paid to suppliers 39,000 Total payments (61,740) Net cash flow from operating activities $25,760 b. Net cash flow from financing activities: Received from issuing long-term debt $23,000 Paid to owners (12,000) Net cash flow from financing activities $11,000
  5. 5. Financial Reporting: The Statement of Cash Flows 211 c. Net cash flow from investing activities: Received from sale of land $ 19,500 Paid for equipment (42,000) Net cash flow from investing activities $(22,500) d. Net change in cash for the period: Net cash flow from operating activities $ 25,760 Net cash flow from financing activities 11,000 Net cash flow from investing activities (22,500) Net change in cash $ 14,260 6-3 Item Type of Activity Add or Subtract a. Purchase of plant assets Investing Subtract b. Cash paid to suppliers Operating Subtract c. Cash collected from customers Operating Add d. Payment of long-term debt Financing Subtract e. Net income Not included Not included f. Depreciation expense Not included Not included g. Payment of dividends Financing Subtract h. Issuing stock Financing Add i. Cash paid to employees Operating Subtract j. Cash paid for income taxes Operating Subtract k. Disposal of plant assets Investing Add 6-4 Cash collected from customers $ 268,000 Cash paid to suppliers (83,500) Cash paid for utilities (20,000) Cash paid for insurance (23,000) Cash paid to employees (57,500) Cash paid for interest (7,500) Net cash from operating activities $ 76,500
  6. 6. 212 Chapter F6 6-5 a. $16,000; Cash received from customers $ 185,300 Cash paid to suppliers of inventory (119,850) Cash paid to employees (31,500) Cash paid for insurance (4,800) Cash paid for interest (3,750) Cash paid for utilities (9,400) Net cash flow from operating activities $ 16,000 b. ($22,600); Cash paid for dividends c. ($27,100); Cash received from disposal of equipment $ 38,000 Cash paid for equipment (65,100) Net cash flow from investing activities $(27,100) 6-6 a. Cash flows from financing activities: Debt issued $ 13,057 Payments of debt (80,323) Net cash used for financing activities $ (67,266) b. Cash flows from investing activities: Proceeds from sales of businesses $ 30,957 Proceeds from sales of plant and equipment 1,986 Additions to plant and equipment (5,379) Net cash provided by investing activities $ 27,564 6-7 a. D b. I c. I d. I e. I f. D g. D h. B i. D j. B
  7. 7. Financial Reporting: The Statement of Cash Flows 213 6-8 Statement Statement Added or Section format subtracted? 1. Decrease in taxes payable O I – 2. Cash paid to suppliers of inventory O D – 3. Dividends declared and paid F B – 4. Depreciation expense O I + 5. Sale of stock F B + 6. Increase in accounts receivable O I – 7. Cash collected from customers O D + 8. Purchase of plant assets I B – 9. Payments on long-term debt F B – 10. Cash paid for taxes O D – 11. Increase in wages payable O I + 12. Purchase of treasury stock F B – 6-9 Type of Add or Item Activity Subtract a. Purchase of plant assets Investing Subtract b. Increase in accounts payable Operating Add c. Decrease in accounts receivable Operating Add d. Payment of long-term debt Financing Subtract e. Net income Operating Add f. Depreciation expense Operating Add g. Payment of dividends Financing Subtract h. Issuing stock Financing Add i. Increase in inventory Operating Subtract j. Decrease in taxes payable Operating Subtract k. Disposal of plant assets Investing Add
  8. 8. 214 Chapter F6 6-10 Net income ($15,000 − $8,000)* $7,000 Depreciation expense 800 Patent expense 300 Increase in accounts receivable (700) Decrease in inventory 1,000 Decrease in supplies 400 Increase in accounts payable 1,100 Decrease in wages payable (500) Net cash flow from operating activities $9,400 *The $8,000 includes depreciation and patent expenses. 6-11 a. Cash paid to suppliers $37,500 Decrease in accounts payable (3,000) Increase in inventory (3,500) Cost of goods sold $31,000 More cash was paid than the cost of goods sold because accounts payable decreased. Cash was paid to creditors. Also more cash was paid than the cost of goods sold because inventory increased. Cash was used to pay for extra inventory. b. Interest paid $ 4,000 Interest payable decreased (1,200) Interest expense $ 2,800 Expense was less than the amount paid because some of the cash was used to reduce the payable. c. Cash flow from operations $28,000 Decrease in current assets (6,000) Decrease in current liabilities 2,000 Net income $24,000 Net income is less than cash flow when current assets are consumed but are not replaced (current assets decreased). Net income is greater than cash flow when cash is used to pay off current liabilities (current liabilities decreased). d. Cash collected from customers $27,000 Increase in accounts receivable 3,000 Sales revenue $30,000 More goods were sold than cash collected because receivables increased.
  9. 9. Financial Reporting: The Statement of Cash Flows 215 6-12 a. Net cash flow from operations $ 28,000 Noncash revenues 11,000 Noncash expenses (15,500) Net income $ 23,500 Net income includes noncash revenues and noncash expenses that are not included in cash flow from operations. Revenues increase and expenses decrease net income. b. Wages expense $ 70,500 Increase in wages payable (10,500) Cash paid to employees $ 60,000 More employee labor was used than paid for when wages payable increased during a period. c. Sales revenue $241,000 Cash collected from customers (224,500) Increase in accounts receivable 16,500 Beginning accounts receivable 38,000 Ending accounts receivable $ 54,500 If sales revenue is greater than cash collected during a period, accounts receivable must have increased by the difference. The increase is added to the beginning balance. d. Net income $ 49,500 Increase in current assets (7,500) Increase in current liabilities 10,000 Cash flow from operations $ 52,000 Cash flow is less than net income when more current assets are acquired than are consumed (current assets increase). Cash flow is greater than net income when more resources are used than are paid for (current liabilities increase).
  10. 10. 216 Chapter F6 6-13 Account Balance Adjustment and Reason a. Accounts receivable Subtract $10,000 from net income because increased $10,000 cash collected from customers was $10,000 less than sales for the period. b. Accounts payable Add $7,500 to net income because inventory increased $7,500 was acquired for sale (increase in cost of goods sold and decrease in net income) but was not paid for during the period. c. Inventory decreased Add $50,000 to net income because $50,000 inventory was consumed (increase in cost of goods sold and decrease in net income) that was not paid for during the period. d. Notes payable No effect because notes payable result from increased $100,000 a financing activity, not an operating activity. e. Equipment No effect because equipment results from an decreased $80,000 investing activity, not an operating activity. f. Prepaid insurance Add $22,000 to net income because decreased $22,000 insurance was consumed (increase in expense and decrease in net income) that was not paid for during the period. g. Wages payable Subtract $8,000 from net income because decreased $8,000 wages were paid during the period that were not expenses (did not reduce net income) during the period. h. Unearned revenue Add $13,000 to net income because cash increased $13,000 was received during the period for revenues that were not earned (did not increase net income) during the period.
  11. 11. Financial Reporting: The Statement of Cash Flows 217 6-14 Cash flow from operating activities (in millions): Net earnings $ 1,120 Depreciation and amortization 1,622 Increase in accounts receivable (167) Decrease in inventories 618 Decrease in accounts payable (806) Increase in income taxes payable 145 Decrease in unearned revenues (324) Other additions to net income 159 Net cash provided by operating activities $ 1,066 6-15 (date) Martha Rosenbloom 945 Oak Lane Anytown, USA Dear Ms. Rosenbloom: A mutual friend, Mr. Arthur Doyle, has asked if I can provide you assis- tance in understanding the statement of cash flows in corporate annual reports. I am currently enrolled in an accounting course at the university, and I am pleased to respond to Mr. Doyle’s request. The cash flow from operating activities section of the statement of cash flows provides a reconciliation between accrual and cash flow results of operations. Net income is an accrual measure that recognizes revenues when earned and expenses when incurred. Not all items in- cluded on the income statement in calculating net income result in cash flows during the current fiscal period, however. Some revenues and ex- penses recognized during the current fiscal period are associated with cash received or paid in past or future fiscal periods. For example, assume a company purchases plant assets and pays cash during 2001. The assets are not expensed until they are used. Depreciation expense is recognized over the useful life of the assets. Therefore, while depreciation expense is recognized on the assets in 2002, no cash flow is associated with the expense. Thus, the amount of depreciation expense for a period is added to net income in computing cash flow from operating activities. Differences also exist between the amount of revenue or expense recognized during a period and the amount of cash flow for items such as sales. For example, customers often purchase merchandise on credit, paying for their purchases at a later time. Therefore, the amount of sales revenue recognized during a fiscal period and the amount collected from customers often differs. This difference is equal to the amount of change in accounts receivable for the period. The cash collected from customers can be determined by adjusting net income for the change in accounts
  12. 12. 218 Chapter F6 receivable. Other adjustments are made in a similar manner for differ- ences between cost of goods sold and cash paid for inventory and for other expense items such as wages, interest, and taxes. The cash flow statement provides an indirect calculation of cash from operating activities by adjusting net income for amounts on the income statement that do not affect cash. These noncash items include depreciation and amounts equal to changes in current asset and liability accounts. A more direct method would be to simply report cash received from customers, cash paid to suppliers, etc. Only a small percentage of companies report cash flows in this direct manner, however. I hope my explanations are useful. Please let me know if I can be of further assistance. Sincerely, (student’s name) 6-16 a. The additions and subtractions are caused by events in which the amount of revenue or expense generated was different from the amount of cash flow. For example, if merchandise is sold for $10,000 on credit, it generates $10,000 of revenue (and increases net income) but generates zero cash flow. b. 1. Depreciation expense is added because it decreased net income but did not affect cash. 2. If accounts receivable decreased by $2,000, this means that cash collections exceeded sales revenue by this amount. Therefore, cash flow was $2,000 greater than sales revenue and must be added to net income. 3. If inventory increased, this means that more inventory was purchased than was sold. Therefore, the amount of cash spent for inventory exceeded the cost of goods sold. The extra expenditure used cash and is subtracted. 4. A decrease in accounts payable means that the cash used to pay off creditors for goods and services rendered was greater than new obligations that arose during the period. This extra expenditure reduced cash and, therefore, is subtracted. 6-17 a. Bangle had the largest cash flow from operating activities at $14,656. Bungle had the smallest at $3,052.
  13. 13. Financial Reporting: The Statement of Cash Flows 219 b. Cash flow associated with investing activities should be negative because most companies will purchase more long-term assets than they will dispose of during a period. Only when companies are downsizing or needing cash and selling off major components would they have large cash inflows from investing activities. c. Bingle used large amounts of cash for investing activities during the year, unlike Bangle and Bungle. Cash flow from operating activities was sufficient to provide the needed cash. Bangle and Bungle used their operating cash flows to reduce debt and equity. Thus, they were shrinking, rather than expanding. 6-18 Landsdowne Company has shown a steady increase in net income over the six-year period, with the exception of year 6. Its cash flow from operating activities has steadily declined since year 2, however. The difference between net income and cash flow can be explained by the increases in current asset and liability accounts. The company has grown and expanded its investment in working capital. Perhaps the expansion has been too rapid. The company appears to be facing a cash flow problem. The increase in payables may signal an impending difficulty in meeting obligations unless receivables can be collected and inventory can be sold. Landsdowne Company is an example of an organization that has demonstrated earnings growth but may not remain viable because of cash flow problems. Failure to maintain adequate cash flows has resulted in bankruptcy for many businesses. 6-19 Sommer Company has incurred losses in its last two years of operations. Without the large amount of depreciation recorded each year, the com- pany would have had net income in each year. The company has main- tained a steady growth in cash flows from operating activities. These cash flows are much higher than the investments the company is making in plant assets. Therefore, the company has a large amount of cash flow that could be used for other purposes. Apparently, Fischer believes he can manage the company to make use of its cash flow potential. A number of takeovers have occurred in recent years in situations similar to the one illustrated in this exercise. Cash flows may be a better signal of a company’s potential value than net income, under certain cir- cumstances. Much depends on whether the cash flows have to be rein- vested in a company to maintain it or whether the cash flows can be used for discretionary purposes.
  14. 14. 220 Chapter F6 6-20 Account and balance Anticipated future event and cash flow a. Accounts receivable, $12,000 of cash should be received from $12,000 customers during the next fiscal year. Operating activities section. b. Prepaid insurance, $22,000 Insurance coverage costing $22,000 is expected to be used up within the coming fiscal year. No cash flow expected. c. Merchandise, $50,000 Merchandise that cost the company $50,000 is available to be sold during the next fiscal year. Operating activities section. d. Treasury stock, $33,000 The company has repurchased some of its own shares at a cost of $33,000. The shares might be resold sometime in the future, maybe not. If sold, it would be reported in the financing activities section. e. Accounts payable, $6,500 Currently, $6,500 is owed to short-term creditors that will be repaid during the next fiscal year. Operating section. f. Machinery, $92,000 Machinery with an original cost of $92,000 is available for use by the firm in the future. No cash flow expected from machinery until it is sold. The depreciation expense, a noncash item, would appear in the operating section under the indirect format. g. Notes payable, long-term, The company borrowed $88,000 in the past $88,000 and is expected to repay it sometime after the next fiscal year. A financing activity. (Any interest paid on the borrowing appears in the operating section.) h. Unearned revenue, $10,000 The company has received $10,000 for goods and services that it should provide during the next fiscal period. No further cash flow expected. i. Taxes payable, $7,800 Currently the company owes $7,800 to the government which it expects to pay during the next fiscal period. An operating activity. j. Retained earnings, $56,000 The firm’s undistributed profits total $56,000. If any portion of this is distributed in the future it will be a financing activity.
  15. 15. Financial Reporting: The Statement of Cash Flows 221 PROBLEMS P6-1 San Garza Properties Statement of Cash Flows (direct format) For the month of January 2002 Cash flow from operating activities: Receipts: Collections from customers $ 8,100 Payments: To suppliers of inventory $ (7,000) For interest (135) For advertising (2,200) For rent (3,000) Total cash payments (12,335) Net cash flow for operating activities (4,235) Cash flow from investing activities: Purchase of office furniture (5,500) Purchase of computer equipment (4,800) Net cash flow for investing activities (10,300) Cash flow from financing activities: Proceeds from bank loan 18,000 Proceeds from sale of stock 10,000 Payment of dividends (2,000) Payment on bank loan (5,000) Net cash flow from financing activities 21,000 Net increase in cash $ 6,465 Cash balance, December 31, 2001 9,121 Cash balance, January 31, 2002 $ 15,586 P6-2 A. 1. $134,850 ($135,800 Sales – $950 increase in Accounts Receivable) 2. $55,800 ($54,300 Cost of goods sold + $1,500 increase in Inventories) 3. $4,900 ($4,800 Insurance expense + $100 increase in Prepaid Insurance) 4. $14,505 ($14,255 Rent expense + $250 decrease in Rent Payable) 5. $0 (Depreciation does not consume cash.) 6. $33,050 ($33,400 Wages expense – $350 increase in Wages Payable) B. Purchase of property, plant and equipment $(5,015)
  16. 16. 222 Chapter F6 Purchase of land (1,000) C. Addition to loan payable $4,000 Sale of common stock 1,000 Purchase of treasury stock (3,000) Payment of dividends (1,000) D. Planet Accessories Company Statement of Cash Flows (direct format) Year Ended December 31, 2002 Operating activities: Cash collections from customers $134,8501 Cash paid to suppliers of inventory (55,800)2 Cash paid for advertising (17,029) Cash paid for insurance (4,900)3 Cash paid for rent (14,505)4 Cash paid for wages (33,050)5 Cash paid for interest (650) Cash paid for taxes (3,628) Cash flow from operating activities $5,288 Investing Activities: Purchase of property, plant and equipment $(5,015)6 Purchase of land (1,000)7 Cash flow from investing activities (6,015) Financing Activities: Addition to loan payable $4,0008 Sale of common stock 1,0009 Purchase of treasury stock (3,000)10 Payment of dividends (1,000)11 Cash flow from financing activities 1,000 Net increase in cash during the year 273 1 proof given in part a 2 proof given in part a 3 proof given in part a 4 proof given in part a 5 proof given in part a 6 (Increase in Property, plant and equipment account = $5,015) 7 (Increase in Land account = $1,000) 8 (Increase in Loan payable account = $4,000) 9 (Increase in Common stock account = $1,000) 10 (Increase in Treasury stock account = $3,000) 11 (Payment of dividends shown at bottom of income statement = $1,000) P6-3 A. 1. Net income = $44,750 Sales ($307,400 + $88,250) $ 395,650
  17. 17. Financial Reporting: The Statement of Cash Flows 223 CGS ($200,000 + $57,400) 257,400 Gross profit 138,250 Operating expenses 93,500 Net income $ 44,750 2. Cash flow from operations = ($25,950) Cash received from customers: Cash sales $ 88,250 Collections on account 321,000 $409,250 Cash paid to suppliers: Cash purchases $ 48,100 Payments on account 293,600 (341,700) Cash paid for operating expenses (93,500) Cash flow from operating activities ($ 25,950) B. 1. Decrease in accounts Credit sales to customers $ 307,400 receivable = $13,600 Collections from customers on account 321,000 Net decrease in accounts receivable $ 13,600 2. Increase in merchandise Purchases ($233,700 + $48,100) $ 281,800 inventory = $24,400 CGS ($200,000 + $57,400) 257,400 Net increase in inventory $ 24,400 3. Decrease in accounts Purchases on credit $ 233,700 payable = $59,900 Cash payments on accounts payable 293,600 Net decrease in accounts payable ($ 59,900) C. Dollar Sine Enterprises Statement of Cash Flow (operating activities only – indirect method) For the year just ended Net income $ 44,750 Add (deduct): Decrease in accounts receivable $ 13,600 Increase in merchandise inventory (24,400) Decrease in accounts payable (59,900) (70,700) Cash flow for operating activities ($ 25,950)
  18. 18. 224 Chapter F6 P6-4 Reuben Corporation Statement of Cash Flows (indirect format) For the Year Ended December 31, 2001 Operating activities: Net income $ 7,000 Add (deduct): Adjustments to convert net income to cash flow from operating activities: Depreciation expense $ 1,000 Decrease in accounts receivable 1,200 Increase in inventory (1,600) Decrease in prepaid advertising 300 Increase in rent payable 200 Decrease in taxes payable (400) Increase in wages payable 1,100 1,800 Cash provided by operating activities $ 8,800 Investing activities: Purchase of land (4,000) Cash used by investing activities (4,000) Financing activities: Repayment on loan (8,250) Sale of common stock 6,000 Payment of dividends (1,700) Cash used by financing activities (3,950) Net increase in cash $ 850 P6-5 A. 1. $6,738 (from the income statement) 2. $1,000 (from the income statement) 3. $(950) (subtract increase in accounts receivable) 4. $(1,500) (subtract increase in inventories) 5. $(100) (subtract increase in prepaid insurance) 6. $(250) (subtract decrease in rent payable) 7. $350 (add increase in wages payable) B. Purchase of property, plant and equipment $(5,015) Purchase of land (1,000) C. Addition to loan payable $4,000 Sale of common stock 1,000 Purchase of treasury stock (3,000) Payment of dividends (1,000)
  19. 19. Financial Reporting: The Statement of Cash Flows 225 D. Planet Accessories Company Statement of Cash Flows (indirect format) Year Ended December 31, 2002 Operating activities: Net income $6,738 Add/deduct items to reconcile net income to cash flow from operating activities: Depreciation 1,000 1 Increase in accounts receivable (950) 2 Increase in inventories (1,500) 3 Increase in prepaid insurance (100) 4 Decrease in rent payable (250) 5 Increase in wages payable 350 6 1,450 Cash flow from operating activities 5,288 Investing Activities: Purchase of property, plant and equipment $(5,015)7 Purchase of land (1,000)8 Cash flow for investing activities (6,015) Financing Activities: Addition to loan payable $4,000 9 Sale of common stock 1,000 10 Purchase of treasury stock (3,000) 11 Payment of dividends (1,000) 12 Cash flow from financing activities 1,000 Net increase in cash during the year $ 273 1 proof given in part a 2 proof given in part a 3 proof given in part a 4 proof given in part a 5 proof given in part a 6 proof given in part a 7 (Increase in Property, plant and equipment account = $5,015) 8 (Increase in Land account = $1,000) 9 (Increase in Loan payable account = $4,000) 10 (Increase in Common stock account = $1,000) 11 (Increase in Treasury stock account = $3,000) 12 (Payment of dividends shown at bottom of income statement = $1,000)
  20. 20. 226 Chapter F6 P6-6 A. In 1998, Rowe’s primary sources of cash were collections from sales to customers of $189.4 million and the issuance of long-term debt totaling $25 million. The primary source in prior years was cash collections from customers only. There was no significant financing in those years nor any other material cash inflows. B. The primary uses of cash included payments to suppliers and employees, income taxes, capital expenditures, acquisitions and investments, and the purchase of treasury stock. The big differences in 1998 were the acquisitions and investment…there were no similar actions in the prior years shown. In addition, capital expenditures were about double the amount in prior years. C. The most significant cause of the decrease in cash flow from operating activities was that the cash paid to suppliers and employees increased more rapidly than the cash collected from customers. Cash paid was up 41% [($180,372 – $128,135) ÷ $128,135] while cash received was up only 33% [($189,437 – $142,136) ÷ $142,136]. Other primary causes were that income taxes paid and interest paid doubled from the previous year. D. For 1996 and 1997, Rowe was largely able to finance its other activities with cash from operations. This was not true of 1998, however. In that year, the company had to issue long-term debt ($25 million) in order to finance its acquisition and investment expenditures. E. Cash flow from operations in 1998 was radically different from net income largely because of increases in accounts receivable and inventories and because of decreases in accounts payable and accrued expenditures. Depreciation and amortization narrowed the difference, but the items mentioned were the major items that widened it. F. This section is an indirect format presentation of cash from operating activities. In effect, if a company chooses the direct format, it must also prepare and report the indirect format. It is not surprising that most companies find it simpler just to report using the indirect format. P6-7 A. 1. Cash received from customers is incorrect. It has been reported as the accrual basis sum of revenues ($73,000 + $42,100 = $115,100). But, Accounts Receivable increased by $1,500 ($5,800 – $4,300) meaning that collections were $1,500 less than accrual basis sales. Therefore, collections should have been reported at $113,600 ($115,100 – $1,500 = $113,600). 2. Cash paid for rent is incorrect. Accrual basis rent expense of $24,000 apparently was adjusted for the $400 decrease in Rent Payable. But, the $400 decrease should have been added to $24,000, not subtracted. When Rent Payable decreases, this means that the cash paid for rent
  21. 21. Financial Reporting: The Statement of Cash Flows 227 is more than the amount of rent expense. Therefore, the correct amount of cash paid for rent is $24,400 ($24,000 + $400). 3. Cash paid for taxes is incorrect. The accrual basis Tax Expense was $12,000. Because there was no change in Taxes Payable, the $12,000 amount is also the amount of cash that was paid. The amounts reported as cash payments for advertising and wages are correct. B. Starkovich Architects, Inc. Operating Activities (direct format) Year ending 12/31/2002 Operating Activities: Cash received from customers ($73,000 + $42,100 – $1,500) $ 113,600 Cash paid for advertising (OK as reported) (13,400) Cash paid for rent ($24,000 + $400) (24,400) Cash paid for wages (OK as reported) (40,450) Cash paid for taxes ($12,000 + $0) (12,000) Cash provided by operating activities $ 23,350 P6-8 A. Indirect format B. The colleague’s thinking is incorrect. Using a depreciation method that reports a higher amount of depreciation will have no effect on cash flow. However, there can be a positive effect on cash flow if the increased depreciation is used to decrease income tax expense. C. A simple example based on the data provided in the problem will prove the point as shown below. In the first column is the problem data. In the second column is the problem data assuming that depreciation expense for the period had been twice as high as reported. Cash flow from operating activities is the same under either option.
  22. 22. 228 Chapter F6 Original Adjusted Data Data Operating activities: Net income $ 84,597 $ 74,0961 Add: Depreciation expense 10,501 21,0022 Decrease in accounts receivable 4,157 4,157 Increase in wages payable 2,924 2,924 Cash provided by operating activities $102,179 $102,179 1 If depreciation expense had been twice as high ($10,501 higher), net income would have been $10,501 lower ($84,597 – $10,501 = $74, 096). 2 $10,501 times 2 = $21,002. P6-9 A. Avnet uses the indirect format. B. Over the last three years, the sales trend is steadily up, the net income trend is steadily down, and the cash flow from operating activities trend is mixed. Sales are up 13.6% [($5,916,267 – $5,207,797) ÷ $5,207,797] over the three years but profits are down 19.6% [($188,256 – $151,424) ÷ $188,256]. This is not an encouraging relationship. The company is selling more and more but making less and less. This cannot continue indefinitely. Unless this trend is halted or reversed, the company is headed for serious financial difficulty. C. The trend in cash flow from operations does not match up with either the trend of sales or the trend of net income. Cash flow from operations is small one year, huge the next year, and then small again the third. D. Cash: increased (see the bottom of the cash flow statement) Receivables: increased (increases are subtracted from net income) Inventory: increased (increases are subtracted from net income) Payables: increased (increases are added to net income) E. While there were changes in all of the non-cash and reconciling items shown, the three items causing the most fluctuation were changes in receivables, inventory, and payables. (The net effects of Depreciation and Amortization, Deferred Taxes and Other were pretty much a wash over each of the three years.) Overall, receivables, inventory, and payables each increased during each of the three years. But, it was the size of the increases that fluctuated greatly. For example, receivables were up by $23 million in fiscal 1997, but up by almost $114 million in fiscal 1998. Similarly, inventory was up by about $171.6 million in fiscal 1996, but only up by about half that much in fiscal 1997 and fiscal 1998. Payables were up by about $67 million in fiscal 1997 but only up by $4.7 million in fiscal 1998. Overall, these items explain most of the fluctuation in cash flow from operations during the three years reported. F. Net income was $151 million for fiscal 1998 while cash flow from operations was only $6 million. The three major causes of the difference
  23. 23. Financial Reporting: The Statement of Cash Flows 229 were as follows. Depreciation (a non-cash expense) added $50.1 million back to net income, but the increase in Receivables meant about $114 million less cash and the increase in Inventories consumed another $94 million of cash. G. Overall, cash flows from financing activities were positive three years ago but were negative in the two most recent years. In general, two major events have been occurring. First, large amounts of commercial paper and bank debt have been issued over the three year period ($188 million + $29 million + $299 million = $516 million). Second, most of this cash has been used to repurchase common stock ( $0 + $142 million + $308 million = $450 million). By comparison, the other three categories of financing cash flows have been minimal in impact. The major story, then, is that the company has substituted a significant amount of debt financing for equity financing over the three year period. H. Overall, cash flows from investing activities have gone from being negative $152 million three years ago to negative $39 million two years ago to positive $48 million in the most recent year. This is caused by a modest shrinkage of investments in new plant and equipment over the three years coupled with purchase of a subsidiary three years ago and the sale of a subsidiary in the most recent year. The amount of new assets acquired is roughly equal to the amount of depreciation and amortization. This suggests the company is not growing its long-term asset base very aggressively. P6-10 A. The trend in net income is down and the trend in cash provided by operations is up. B. The single biggest reason that cash provided by operations was negative in fiscal 1996 is the HUGE increase in inventory, prepaid expenses, and other current assets ($291 million). Other factors that helped make the result negative overall were the decrease in deferred revenue and other current liabilities and the increase in accounts receivable. C. First, net income was positive. Second, depreciation of $116 million did not use any cash. Third, the adjustment for increases in accounts payable, accrued expenses, and other current liabilities ($63 million) was helpful. D. The company’s long-term asset base appears to have expanded significantly during the three years shown. In each year, the purchase of property and equipment comfortably exceeds the sum of depreciation expense and sales of property and equipment. Over the three years shown, the excess of long-term asset purchases exceeds depreciation and disposals by $472 million ($588 + $542 + $518 –$297 – $333 – $251 – $116 – $99 – $80 = $472). E. The major reason that cash provided by financing activities dropped during fiscal 1998 was that the company all but stopped issuing new debt
  24. 24. 230 Chapter F6 or equity. Issuances in fiscal 1996 totaled $332 million ( $92 + $222 + $18). Issuances in fiscal 1997 totaled $460 million ( $33 + $15 + $412). During fiscal 1998, issuances dropped to $30 million ($6 + $22 + $2). The probable reason for the dropoff in issuances of debt and equity is probably that it wasn’t needed. In fiscal 1998, cash flow from operations generated almost $195 million that was used to finance investing activities. To finance the rest, the company drew down its cash balance from the previous year by $86 million. P6-11 Office Decor Company Statement of Cash Flows For the Year Ended December 31, 2001 (in thousands) Operating activities: Net income $ 2,000 Increase in accounts receivable (2,400) Increase in inventories (4,400) Increase in accounts payable 1,200 Cash flow for operating activities $(3,600) Financing activities: Increase in notes payable 4,000 Payment of dividends (1,000) Cash flow from financing activities 3,000 Decrease in cash $ (600) Office Decor reported net income of $2,000,000 for 2001. The company’s cash flow from operating activities was a cash outflow of $3,600,000, however. Thus, though the company appears to be profitable, it may be facing some major cash flow and operating problems in the near future. Accounts receivable and inventories increased substantially during the year. These increases suggest that customers are not paying for their purchases on a timely basis. The company appears to be building a large inventory that it is not able to sell. It has financed these activities by issuing additional debt. This financing might support the company’s operations in the short run but will not ensure long-run survival. The company’s problems may be caused by overinvestment in develop- ment during a period of economic decline or a period of overbuilding. The increase in accounts receivable may reflect pressure to sell inventory, even when prospective buyers are poor credit risks. The company may be granting very favorable payment terms to buyers, resulting in a slowdown of cash receipts. The payment of dividends during this period is questionable, unless management believes the cash flow problems are temporary.
  25. 25. Financial Reporting: The Statement of Cash Flows 231 P6-12 A. Sara Lee’s cash account increased by $1 million during 1998. B. The primary sources of cash for the company were operating activi- ties ($1,935 million), long-term debt ($594 million), dispositions of businesses ($451 million), sales of property ($140 million), short term borrowings ($113 million), and sale of common stock ($86 million). C. The primary uses of cash were for purchases of common stock ($1,500 million), purchases of property and equipment ($474 million), payment of dividends ($447 million), acquisitions of businesses ($393 million), and repayment of long-term debt ($296 million). D. Depreciation and amortization were added to net income to compute cash flow from operating activities because these expenses were subtracted from revenues in computing net income but did not reduce cash flow. Therefore, cash flow from operating activities is greater than net income by the amount of these expenses, in addition to other adjustments. E. The increase in inventories was subtracted because less expense was recognized for cost of goods sold than the amount of cash paid for inventories during 1998. Inventories increase when they are purchased and decrease when they are sold. If more inventories are purchased than sold, less expense is included in computing net income than cash used to buy inventories. The increase in accounts payable is added to cash flow because the amount of expenses associated with these items was greater than the cash paid during the year. The decrease in receivables was added to net income in computing cash flow from operating activities because the decrease was associated with collections in 1998 being greater than sales for 1998. An increase of collections over sales will increase cash but have no effect on accrual-basis revenue. F. Purchases of property and equipment are listed as investing activi- ties because cash was used to purchase long-term (capital) assets. These assets were not purchased for resale and, therefore, were not directly part of operating activities. Sales of property occur when a company disposes of long-term assets. Because these assets are not held for resale, their disposal is not an operating activity. Acquisi- tions of other companies result in additional long-term assets. These purchases are similar to capital expenditures. G. Short-term debt increased during the year by $113 million. H. The company issued $594 million of new long-term debt during the year. It paid off $296 million of old long-term debt. I. The company does not appear to be facing an immediate cash flow problem. Although cash only increased slightly in 1998, the company’s cash flows from operating activities were adequate. It was able to meet its operating and debt needs with little problem. It paid a
  26. 26. 232 Chapter F6 substantial dividend and made purchases of capital assets. These payments could be reduced or eliminated if a potential cash flow problem arose. Note that the restucturing charge, which appears as an addition of $2,040 on the statement of cash flows and would not be expected to appear in subsequent years, is a significant reason for the net loss that year. P6-13 There are three primary factors that have caused the rapid decrease in cash provided by operating activities. First, the company’s profits have fallen about 16% [($467 – $391) ÷ $467] over the three years. Second, despite decreased profits, the firm’s accounts receivable are increasing rapidly. (One might ask “why?”) An increase in receivables reduces the amount of cash flowing in to the firm. Third, there has been a large increase in inventories over the three years. (Again, one might ask “why?”) Building up inventory holdings is a drain on cash when the purchases are paid for. The firm’s accounts payable have fluctuated some but are quite stable. Therefore, the buildup of inventory has consumed large amounts of cash. The other items reported have had little material impact on cash. P6-14 Items from the income statement (IS) and statement of cash flows (CF) can be used to answer each question (in millions): A. Revenues (IS) $ 8,358.2 Increase in receivables (CF) (16.1) Cash collected from customers $ 8,342.1 B. Cost of goods sold (IS) $ (7,026.1) Decrease in inventory (CF) 71.3 Increase in accounts payable (CF) 239.3 Cash paid for inventory $ (6,715.5) C. Selling, general, & administrative expenses (IS) (1,145.3) Increase in other assets (CF) (19.9) Increase in accrued expenses (CF) 101.8 Depreciation and amortization expense 68.3 Cash paid for selling, general, & administrative expenses $ (995.1) P6-15 Both Intel and Apple were profitable during 1998, although Intel’s profits were almost twenty times larger than Apple’s. Both companies experienced a decrease in inventories and other assets and an increase in receivables. Intel showed a decrease in payables, while Apple showed an increase in payables. Both Intel and Apple’s operating activities generated more cash than net income. Both companies invested in additional long-
  27. 27. Financial Reporting: The Statement of Cash Flows 233 term assets, which caused cash from investing activities to be negative. The firms differed significantly in cash provided by financing activities. Because Intel’s cash from operations was so high, it apparently used some of this cash for dividends, repayment of debt, or repurchase of out- standing stock. Overall, Intel significantly decreased its cash balance during the year, whereas Apple carried an increase in cash. Compared to net income, Intel’s decreased cash balance was pretty significant in size. Apple’s cash increase, on the other hand, was slightly less than its net income, indicating some present stability. P6-16. A. False. Depreciation expense is added to net income because depre- ciation reduces net income but not cash flow. Therefore, to determine cash flow from operating activities, depreciation must be added back to net income. The two accounts affected by recording depreciation are Depreciation Expense and Accumulated Depreciation. Notice, therefore, that neither the cash account nor cash flow are affected by the recording of depreciation expense. B. True. An increase in accounts receivable means that a company collected less cash from customers than the amount of sales revenue. Therefore, cash flow would be less than operating revenue by the amount of increase in accounts receivable. If $20 of goods were sold but only $18 was collected so far, Accounts Receivable would have increased by $2. So, cash flow ($18) would be less than sales ($20) by $2. C. False. An increase in accounts payable indicates that some of the goods purchased have not yet been paid for. When Accounts Payable increases, cash has been conserved (not paid out). Therefore, an increase in accounts payable should be added back to net income. The adjustment would be to add $3 million rather than to subtract it. D. True. An increase in merchandise inventory indicates that a company purchased more inventory than it sold during a period. Therefore, Delta must have purchased $8 million more in inventory than the $27 of inventory it sold. This totals $35 and was all paid to suppliers in cash. E. True. Gamma’s operating activities are generating a negative cash flow. Thus, it is not generating enough cash to cover expenses, meet debt requirements, pay dividends, or replace assets. To meet its cash requirements, the company is selling assets and issuing debt (or
  28. 28. 234 Chapter F6 stock). Its ability to continue is in serious doubt unless it can create positive cash flows from operating activities. P6-17 A. and B. Event Type Effect on Effect on of activity March’s March’s net income cash flow 1. Sold $18,000 of goods on credit to customers. Received a 25% down payment with the balance on operating +$18,000 +$4,500 account. 2. Purchased $500 of office supplies for cash that will be used during April. operating 0 –$500 3. Received $3,000 from a customer in full payment of her account balance. operating 0 +$3,000 4. Borrowed $80,000 from a local bank to be repaid in monthly installments plus interest starting in April. financing 0 +$80,000 5. Paid rent on the office space ($1,200 per month) for the months of February, March, and April. operating –$1,200 –$3,600 6. Distributed monthly paychecks to employees totaling $13,300. 30% was for work performed in February and the balance for work performed in March. operating –$9,310 –$13,300 7. Purchased new Internet server equipment at a cost of $50,000. investing 0 –$50,000 8. Purchased a 3-year fire insurance policy at a total cost of $10,800. Its coverage began on March 1. operating –$300 –$10,800 9. Purchased merchandise from suppliers on credit at a cost of $70,000. operating 0 0 10. Collected $22,000 from customers in payment of their accounts. 80% of this amount was from sales recorded in February and the balance from March operating 0 +$22,000 sales.* 11. Collected four months rent in advance (at $700 per month) from a tenant who will move in on April 1. operating 0 +$2,800 12. Paid $45,000 to suppliers in partial payment of goods purchased in #9 above. operating 0 –$45,000 13. Sold $33,000 of merchandise to customers on credit. operating +$33,000 0 14. Sold an investment in stocks and bonds for $28,000; the same amount that had been paid for it. A 3-year, 9% note receivable was accepted in full payment. investing 0 0 Totals for March $40,190 –$10,900 * March sales are indicated in event 1. Event 10 is indicating collection of some of the receivables from those sales. C. Student responses will vary. One possible response is as follows. It is foolish to try to manage an organization with accrual-basis accounting information only. As illustrated by this problem, a company can be profitable on the accrual basis but be running a deficit in cash. A
  29. 29. Financial Reporting: The Statement of Cash Flows 235 manager must closely monitor both profits and cash flow. Failure to manage cash flow will result in an inability to pay obligations as scheduled. Neither suppliers, employees, nor government tax authorities will long put up with a failure to receive cash when it is due. P6-18 Sheik Company: Sheik’s cash flow information is characterized by steady and reliable cash flow from operations over the past five years. Profits are probably relatively steady also. The firm is not using the cash flow from operations to finance growth. Very few new long-term assets are being acquired. Maybe not even enough new assets to replace equipment when it wears out. The firm is not growing its operations, and it may even be shrinking. The cash flow from operations is being used to “di-finance” the company. It appears that the company does not have attractive growth opportunities in which to invest its profits. So, the company is paying off debt, buying back stock, or paying large dividends to stockholders. Speer Company: Speer’s cash flow information is not encouraging. First, cash flow from operations has swung from quite favorable 5 years ago to quite unfavorable today. Every day the company opens its doors for business, some of its cash leaks out. If this situation can’t be corrected rather quickly, the company is headed for disaster. Because of the deteriorating operating cash flow situation, the company has had to abandon its expansion and reinvestment plans. Five years ago, it was expanding rapidly and using its operating cash flow and cash from financing activities to pay for it. Now, the company is selling off long-term assets just to pay the bills. In addition, any monies raised by financing activities are being used to cover operating cash flow deficits. The situation does not look encouraging. Love Company: Love’s cash flow from operations is growing rapidly. While smaller than the other two firms, it is growing the most rapidly. Further, the company appears to plan on even more expansion as the investment in new long-term assets continues to rise. Because the cash flow from operations is not yet large enough to finance all the expansion plans, the firm is raising cash through financing activities such as selling stock or borrowing. Of the three firms, this one appears to have the brightest
  30. 30. 236 Chapter F6 future. Cash from operations is growing rapidly, investment in long-term assets continues to grow, and the company appears able to attract continued financing. P6-19 A. The primary source of cash inflow was $1,014 provided by an increase in long-term debt. Operating activities provided $278 and the sale of investments provided $206. B. A large contributor to the net loss was depreciation and amortization expense of $592. This expense did not consume any cash. C. The primary uses of cash were for the repurchase of common stock ($740), for the purchase of investments and acquisitions ($424), and for dividends paid ($402). D. Receivables decreased; the cash inflow from customers was greater than the amount of sales revenue. Inventories decreased; the amount of cash paid for inventories was less than the cost of goods sold. Accounts payable increased; the amount paid for inventory was less than the amount of inventory purchased and sold. E. Revenues $3,960 Decrease in accounts receivable 172 Cash collected from customers $4,132 P6-20 A. 1. Net income: The purpose of the operating activities section under the indirect format is to show why cash flow differed from net income. Therefore, the starting point is net income. Items or events that generated (or consumed) a different amount of cash than revenue (or expense) are added to (or deducted from) net income to obtain cash flow from operations. 2. Depreciation expense: Depreciation expense consumes zero cash. Therefore, the entire amount of depreciation expense is added back to net income in the determination of cash flow from operations. B. 1. Accounts receivable: The increase in accounts receivable balance is deducted from net income because some of the sales revenues were not collected in cash. 2. Inventory: The decrease in inventory is added to net income because some of the inventory that was sold was not replaced. Hence, the cash that was expended to replenish inventory was less than the expense recorded as cost of goods sold.
  31. 31. Financial Reporting: The Statement of Cash Flows 237 3. Prepaid advertising: The increase in prepaid advertising is deducted from net income because more advertising was purchased and paid for than was consumed. 4. Rent payable: The decrease in rent payable is deducted from net income because cash payments for rent exceeded the amount of rent expense. In effect, all of the current period’s rent expense was paid plus a portion of rent payable from the previous period was also paid. 5. Wages payable: The increase in wages payable is added to net income because not all wages (expense) consumed cash. Some wages were not paid in cash. They are still payable. C. No income statement items or events will appear under investing activities on the statement of cash flow. D. 1. Buildings and equipment: The increase in account balance during the year indicates that additional buildings and equipment were purchased. Most likely, cash was involved. A smaller amount of buildings or equipment could also have been sold, but we cannot tell. 2. Land: The increase in the account balance indicates that additional land was purchased. Most likely, cash was involved. 3. Investments, long-term: The decrease in the account balance indicates that a portion of investments were sold. Most likely cash was received. E. No income statement items or events will appear under financing activities on the statement of cash flow. F. 1. Notes payable, long-term: The increase in the account balance indicates that additional financing was obtained in exchange for a note payable. Most likely, cash was obtained. 2. Common stock: The increase in the account balance indicates that additional financing was obtained by selling common stock. Most likely, cash was obtained.
  32. 32. 238 Chapter F6 P6-21 A. Beltway Distributors, Inc. Statement of Cash Flows For the Year Ended January 30, 2002 (in thousands) Operating activities: Net income $ 5,300 Add/Deduct: Depreciation expense 2,900 Decrease in accounts receivable 4,800 Decrease in inventories 3,600 Decrease in accounts payable (200) Cash flow from operating activities 16,400 Financing activities: Decrease in bank loan payable (11,300) Payment of dividends (5,000) Cash flow for financing activities (16,300) Increase in cash $ 100 B. It appears that the company is slowly decreasing the size of its operations. No new investment in long-term assets is occurring. Cash flows are being used to pay dividends and reduce debt. It may be that the firm is in a declining industry that does not have significant growth opportunities. So far, operations are still profitable but the company is reducing its investment in receivables and inventories and using the cash to liquidate debt. P6-22 A. Pro-forma Income Statement First Month Second Third Month Month Sales revenues $22,500 $22,500 $22,500 Cost of good sold (12,000) (12,000) (12,000) Gross profit 10,500 10,500 10,500 Depreciation 600 600 600 Other operating expenses 3,500 3,500 3,500 Income from operations 6,400 6,400 6,400 Interest expense 425 425 425 Net income $5,975 $5,975 $5,975
  33. 33. Financial Reporting: The Statement of Cash Flows 239 Pro-forma Balance Sheet First Month Second Third Month (at end of) Month Cash $15,075 $15,150 $18,225 Accounts receivable 7,500 7,500 7,500 Inventory 3,000 3,000 3,000 Plant assets, net of depreciation 66,900 66,300 65,700 Total assets $92,475 $ 91,950 $94,425 Accounts payable 15,000 12,000 12,000 Notes payable 44,500 44,000 43,500 Investment by owner 30,000 30,000 30,000 Retained earnings 2,975 5,950 8,925 Total liabilities & owners’ equity $92,475 $ 91,950 $94,425 Pro-forma Cash Flow Statement First Month Second Third Month Month Cash collected from customers $15,000 $22,500 $22,500 Cash paid to suppliers 0 (15,000) (12,000) Cash paid for operating expenses (3,500) (3,500) (3,500) Cash paid for interest (425) (425) (425) Cash paid for plant assets (67,500) 0 0 Cash received from bank 45,000 0 0 Cash received from owner 30,000 0 0 Cash paid to repay loan (500) (500) (500) Cash paid to owner (3,000) (3,000) (3,000) Net change in cash $15,075 $ 75 $3,075 B. Assuming that Hal is a person of character who will repay the loan if able, the bank should probably grant the loan. The expected cash flows are more than enough to repay the loan. While the net cash flow is “skinny” in the second month ($75), it will $3,075 each month thereafter. In other words, after the second month, there will be a $3,075 cash cushion each month over and above the amount necessary to make the $500 loan payment.
  34. 34. 240 Chapter F6 P6-23 The Book Wermz Statement of Cash Flows For the Month Ended November 30, 2001 Direct Method Indirect Method Operating Cash Flow: Operating Cash Flow: From customers $ 45,003.48 Net income $ 2,447.45 For merchandise (33,243.92) Depreciation expense 817.20 For supplies (2,576.93) Decrease in accounts receivable 125.00 For wages (4,073.79) Increase in supplies (165.40) For rent (1,738.15) Increase in inventory (8,438.37) For interest (932.03) Increase in accounts payable 6,131.77 For taxes (897.45) Increase in wages payable 623.56 Net operating cash flow 1,541.21 Net operating cash flow 1,541.21 Investing Cash Flow: Investing Cash Flow: Purchase of equipment (2,000.00) Purchase of equipment (2,000.00) Financing Cash Flow: Financing Cash Flow: Payment of debt (1,122.77) Payment of debt (1,122.77) Payment of dividends (1,500.00) Payment of dividends (1,500.00) Net financing cash flow (2,622.77) Net financing cash flow (2,622.77) Net change in cash (3,081.56) Net change in cash (3,081.56) Beginning cash balance 15,389.55 Beginning cash balance 15,389.55 Ending cash balance $ 12,307.99 Ending cash balance $ 12,307.99 If net income had been $2,600 and cash received from customers had been $45,156.03, net operating cash flow would have been $1,693.76. P6-24 1 2 3 4 5 6 7 8 9 10 a a d d b d c c b b
  35. 35. Financial Reporting: The Statement of Cash Flows 241 CASES C6-1 A. General Mills’ major operating activities during 1998 included sales of goods for $6,033.0 million that cost the company an estimated $2,389.3 million. Additional activities included selling and administra- tive expenses of $2,498.6 million. The major differences between the accrual and cash flow effects of these activities were as follows: (1) depreciation and amortization reduced income by $194.9 million (before taxes) but had no effect on cash flows, (2) deferred taxes reduced cash by $29.3 million but not income, and (3) the net changes in current asset accounts and current liability accounts freed up an additional $54.5 million of cash, and (4) unusual items, but not specified, contributed $166.4 more to cash than to net income. B. 1998 1997 Return on total assets 10.9% 11.4% ($421.8 ÷ $3,861.4) ($445.4 ÷ $$3,902.4) Return on equity 221.8% 90.1% ($421.8 ÷ $190.2) ($445.4 ÷ $494.6) The return on total assets decreased slightly from 1997 to 1998. The return on equity, though, more than doubled over this time because stockholders’ equity was cut by more than half. C. Your 1998 claim on the company’s earnings (10,000 shares) would be $26,700 (10,000 × $2.67 earnings per share $26,700). The 1997 claim on company earnings (10,000 shares) would be $28,200 ($10,000 × $2.82 earnings per share = $28,200). Your 1998 claim is smaller. D. The company’s major source of cash for 1998 was its operating activities (net cash inflow of $769.5 million). In general, the company used this cash to make investments and to pay back financing. E. The major cash inflows from financing activities in 1998 were issuance of notes payable, long-term debt and common stock ($63.9 million, $286.6 million, and $92.5 million, respectively). In addition, the major cash outflows from financing activities were from paying off long-term debt, purchasing treasury stock, and paying dividends ($151.6 million, $524.9 million, and $336.3 million, respectively). Over the three years shown, the firm has been “de-financing” as revealed by the negative cash flows from financing activities in all three years. F. The major investing activity was the purchase of property, plant, and equipment ($183.6 million of cash) and purchase of investments ($9.5 million and $10.6 million).
  36. 36. 242 Chapter F6 G. The company’s most important reported assets were accounts receivable ($395.1 million); inventories ($389.7 million); and land, buildings, and equipment ($1,186.3 million). Assets that may be important to the company but that are not reported on its balance sheet include investment in employee and management skills, investment in research and development, and the company’s brand names. C6-2 A. General Mills’ statement of cash flows reveals that its net earnings were $421.8 million in 1998. Its cash flow from operating activities was $769.5 million. The difference between these two measures results from noncash expenses, such as depreciation and amorti- zation; the difference between income tax expense and income tax owed (deferred income taxes); and an increase in working capital (current assets minus current liabilities). B. Inventory and deferred income taxes increased. In addition to cash, accounts receivable and prepaid expenses decreased. Because accounts receivable decreased by $24 million during the period, we know that the amount of cash collected from customers was $24 million greater than the amount of sales made during the period. (If sales equaled cash inflow from customers during the period, there would be no change in accounts receivable.) Since sales were $6,033.0, we know that cash collected from customers totaled $6,057.0 ($6,033.0 + $24.0). C. The trend in net income has been downward for the last three years while cash from operations has trended both down and up. In all years, cash flow from operating activities was higher than net income in all three years. Generally, this difference is explainable largely by noncash charges on the income statement for depreciation and amortization (in all three years) and unusual expenses in 1997 and 1998. These noncash charges reduced net income but not cash flow from operations. This was offset somewhat by growth in working capital (current assets minus current liabilities) in 1996 and 1997. D. General Mills’ profit performance deteriorated between 1996 and 1998. Sales were up by $617 million, but costs and expenses were up by $709 million. Net income decreased between during this period by $54.6 million and earnings per share was down by 11%. Operating cash flow was down (or flat) over the three years when the unusual items of 1997 and 1998 are removed from the analysis. Overall, the company has had a tough three years.
  37. 37. Financial Reporting: The Statement of Cash Flows 243 C6-3 A. The statements are similar in that both report: 1. exactly the same totals for cash flow from operating activities, investing activities, and financing activities. 2. identical investing activity and financing activity information. 3. identical information about the net change in cash, beginning cash balance, and ending cash balance. B. The statements are dissimilar in two ways. 1. The information presented in the operating activity section. 2. The reconciliation of net income to cash flow provided by operating activities that appears at the bottom of the direct-format statement. C. The reconciliation of net income to cash flow provided by operating activities looks an awful lot like the indirect format of the operating activities section. In fact, it provides exactly the same information as found on the indirect format statement of cash flows. This is a required disclosure when a direct format statement is prepared. Therefore, it is true that when a company reports using the direct format, it actually must report operating activities in both the direct format and the indirect format. D. Because the only information that differs between the two statement formats is in the operating activities section, only questions related to operating activities might differ. Further, since the direct format also includes the indirect format (as a required disclosure), there are no questions that can be answered by an indirect format statement that cannot be answered by referring to a direct format statement. Questions that can be answered by a direct format statement that cannot be answered by an indirect format statement include: 1. What amount of cash was collected from customers? 2. What amount of cash was paid to suppliers of inventory and employees? 3. What amount of cash was received from debtors paying interest? 4. What amount of cash was paid out for interest? 5. What amount of cash was paid for income taxes? E. Student responses will differ. Most will probably argue in favor of the direct format information because the operating activity section is inherently easier to understand than the complexities of the indirect format. F. Student responses will differ. Most will probably express a preference for the direct format because they found the operating activity information easier to understand. Also, some students will probably point out that with the direct format you actually get the indirect format information too. Therefore, why not get two sets information for the price of one?

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