FINANCIAL REPORTING AND ANALYSIS CASES

Chapter 13Statement of Cash Flows

ANSWERS TO QUESTIONS

1. The income statement reports revenues earned and expenses incurred during a period of time. It is prepared on an accrual basis. The balance sheet reports the assets, liabilities, and equity of a business at a point in time. The statement of cash flows reports cash receipts and cash payments of a business, from three broad categories of business activities: operating, investing, and financing.

2. The statement of cash flows reports cash receipts and cash payments from three broad categories of business activities: operating, investing, and financing. While the income statement reports operating activities, it reports them on the accrual basis: revenues when earned, and expenses when incurred, regardless of the timing of the cash received or paid. The statement of cash flows reports the cash flows arising from operating activities. The balance sheet reports assets, liabilities, and equity at a point in time. The statement of cash flows and related schedules indirectly report changes in the balance sheet by reporting operating, investing, and financing activities during a period of time, which caused changes in the balance sheet from one period to the next. In this way, the statement of cash flows reports information to link together the financial statements from one period to the next, by explaining the changes in cash and other balance sheet accounts, while summarizing the information into operating, investing, and financing activities.

3. Cash equivalents are short-term, highly liquid investments that are purchased within three months of the maturity date. The statement of cash flows does not separately report the details of purchases and sales of cash equivalents because these transactions affect only the composition of total cash and cash equivalents, not the total amount. The statement of cash flows reports the change in total cash and cash equivalents from one period to the next.

4. The major categories of business activities reported on the statement of cash flows are operating, investing, and financing activities. Operating activities of a business arise from the production and sale of goods and/or services. Investing activities arise from acquiring and disposing of property, plant, and equipment and investments. Financing activities arise from transactions from investors and creditors.

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2004 Financial Accounting, 4/e 13-1

5. Cash inflows from operating activities include cash sales, collections on accounts, and notes receivable arising from sales, dividends on investments, and interest on loans and investments. Cash outflows from operating activities include payments to suppliers and employees, and payments for operating expenses, taxes, and interest.

6. Depreciation expense is added to net income to adjust for the effects of a noncash expense that was deducted in determining net income. It does not involve an inflow of cash.

7. Cash expenditures for purchases and salaries are not reported on the statement of cash flows, indirect method, because that method does not report cash inflows and outflows for each operating activity. Rather, it reports only net income, changes in accounts payable and wages payable, and net cash flow from operating activities.

8. The $50,000 increase in inventory must be used in the statement of cash flows calculations because it increases the outflow of cash all other things equal. It is used as follows:

Direct method—added to cost of goods sold, accrual basis (the other adjustment would involve accounts payable) to compute cost of goods sold, cash basis.

Indirect method—subtracted from net income as a reconciling item to obtain cash flows from operating activities.

9. The two methods of reporting cash flows from operating activities are the direct method and the indirect method. The direct method reports the gross amounts of cash receipts and cash payments arising from the revenues and expenses reported on the income statement. The indirect method reports the net amount of cash provided or used by operating activities, by reporting the adjustments to net income for the net effects of noncash revenues and expenses, and changes in accruals and deferrals. The two approaches differ in the way they report cash flows from operating activities, but are similar in that the final result, net cash provided by operating activities, is the same amount.

10. Cash inflows from investing activities include cash received from sale of operational assets, sale of investments, maturity value of bond investments, and principal collections on notes receivable. Cash outflows from investing activities include cash payments to purchase property, plant, and equipment and investments, and to make loans.

11. Cash inflows from financing activities include cash received from issuing stock, the sale of treasury stock, and borrowings. Cash outflows from financing activities include cash payments for dividends, the purchase of treasury stock, and principal payments on borrowing.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004 13-2 Solutions Manual

12. Noncash investing and financing activities are activities that would normally be classified as investing or financing activities, except no cash was received or paid. Examples of noncash investing and financing include the purchase of assets by issuing stock or bonds, the repayment of loans using noncash assets, and the conversion of bonds into stock. Noncash investing and financing activities are not reported in the statement of cash flows, because there was no cash received or cash paid; however, the activities are disclosed in a separate schedule.

13. When equipment is sold, it is considered an investing activity, and any cash received is reported as a cash inflow from investing activities. When using the direct method, the cash received from the sale of equipment is reported as an investing cash inflow. When using the indirect method, the gain on sale of equipment must be reported as a deduction from net income, because the gain was included in net income, but did not provide any cash from operating activities. The cash received is reported in the investing activities section of the statement of cash flows.

If the equipment was sold at a loss, the cash received is reported as a cash inflow from investing activities when using the direct method. When using the indirect method, the loss on sale of equipment is added to net income because the loss was included in net income but did not require an operating cash outflow. The cash received is reported as an investing cash inflow.

ANSWERS TO MULTIPLE CHOICE

1. b) 2. d) 3. d) 4. a) 5. a)6. b) 7. d) 8. a) 9. d) 10.c)


Authors' Recommended Solution Time(Time in minutes)

Mini-exercises Exercises ProblemsAlternate Problems

Cases and Projects

No. Time No. Time No. Time No. Time No. Time1 5 1 10 1 25 1 30 1 202 5 2 15 2 45 2 60 2 153 5 3 15 3 25 3 254 5 4 15 4 30 4 305 5 5 15 5 55 5 356 5 6 15 6 *7 5 7 20

8 209 10

10 1511 2012 2013 2514 2015 2516 2017 1518 1019 2020 40

* Due to the nature of these cases and projects, it is very difficult to estimate the amount of time students will need to complete the assignment. As with any open-ended project, it is possible for students to devote a large amount of time to these assignments. While students often benefit from the extra effort, we find that some become frustrated by the perceived difficulty of the task. You can reduce student frustration and anxiety by making your expectations clear. For example, when our goal is to sharpen research skills, we devote class time discussing research strategies. When we want the students to focus on a real accounting issue, we offer suggestions about possible companies or industries.

MINI–EXERCISES

M13–1.I 1. Proceeds from sale of properties.F 2. Purchase of stock. (This involves repurchase of its own stock.)O 3. Depreciation, depletion, and amortization.O 4. Accounts payable (decrease).


O 5. Inventories (decrease).F 6. Principal payment on long-term debt.

M13–2.+ 1. Depreciation, depletion, and amortization.– 2. Inventories (increase).– 3. Accounts payable (decrease).+ 4. Accounts receivable (decrease).+ 5. Accrued expenses (increase).

M13-3.F 1. Repayments of borrowings (bank debt).F 2. Dividends paid.I 3. Proceeds from sale of property, plant and equipment.O 4. Net interest paid.O 5. Receipts from customers.F 6. Payment for share buy-back.

M13–4.

Quality of income ratio = Cash flow from operations = $60,000 = 0.75 (75%)Net income $80,000

The quality of income ratio measures the portion of income that was generated in cash. The low ratio indicates a likely need for external financing.

M13–5.Investing Activities

Sale of used equipment $ 250 Purchase of short-term investments (300)

Cash used in investing activities $ (50)

M13–6.Financing Activities

Additional short-term borrowing from bank $1,000 Dividends paid (800)

Cash provided by financing activities $ 200


M13–7.Yes Purchase of equipment with short-term investmentsNo Dividends paid in cashYes Purchase of building with mortgage payableNo Additional short-term borrowing from bank

EXERCISES

E13–1.O 1. Depreciation.I 2. Additions to property, plant, and equipment.F 3. Increase (decrease) in notes payable. (The amount is owed to

financial institutions.)O 4. (Increase) decrease in other current assets.I 5. Disposal of property, plant, and equipment.F 6. Reductions in long-term debt including current portion.F 7. Repurchase of stock.O 8. (Increase) decrease in inventory.O 9. Net income.F 10. Additions to long-term debt.

E13–2.

1. – NCFI Plant and equipmentCash

2. NE InventoryAccounts payable

3. + NCFO CashAccounts receivable

4. NE Salaries expenseAccrued salaries payable

5. – NCFO Interest expenseCash

6. – NCFF Short-term debtCash

7. – NCFO Prepaid expenses (rent)Cash

8. + NCFI CashAccumulated depreciation

Plant and equipment


9. – NCFO Accounts payableCash

10. – NCFF Retained earningsCash


E13–3.

1. – NCFO Income tax expenseCash

2. + NCFF CashCommon stockAdditional paid-in capital

3. – NCFO Prepaid expenses (rent)Cash

4. NE ExpensePrepaid expense

5. – NCFI Plant and equipmentCash

6. + NCFF Cash Long-term Debt

7. + NCFO CashAccounts receivable

8. NE InventoryAccounts payable

9. – NCFO Salary expense Cash

10. NE Plant and equipmentNote payable


E13–4.

While depreciation is indeed added to net income to compute cash flow from operating activities, the new controller's idea will not work. If depreciation expense is increased, net income will decrease by exactly the same amount. When depreciation is added to the new net income number, the sum will be exactly the same as the amount that was computed before depreciation was increased. The only way to increase cash flow is to increase revenues, decrease expenses (other than depreciation), or improve the efficiency of operations (such as collecting receivables more quickly or operating with less inventory).

E13–5.

Comparison of Statement of Cash Flows direct and indirect reporting

Cash flows Statement of Cash Flows Method

(and related changes) Direct Indirect 1. Cash collections from customers X 2. Accounts receivable increase or decrease X 3. Payments to suppliers X 4. Inventory increase or decrease X 5. Accounts payable increase or decrease X 6. Payments to employees X 7. Wages payable, increase or decrease X 8. Depreciation expense X 9. Net income X

10. Cash flows from operating activities X X11. Cash flows from investing activities X X12. Cash flows from financing activities X X13. Net increase or decrease in cash during the period X X

The direct method reports cash flows from operating activities individually for each major revenue and expense. In contrast, the indirect method reports a reconciliation of net income to cash flow from operating activities. The two methods report the investing and financing activities in exactly the same way.


E13–6.

Cash flows from operating activities—indirect methodNet income............................................................................................... $12,000Depreciation expense.............................................................................. 6,000Accounts receivable increase ................................................................. (5,000)Merchandise inventory decrease............................................................. 8,000Salaries payable increase........................................................................ 500

Net cash provided by operating activities........................................... $21,500

E13–7.

Req. 1

Cash flows from operating activities—indirect methodNet loss.................................................................................................... ($8,000)Depreciation expense.............................................................................. 7,000Amortization of copyrights........................................................................ 300Accounts receivable decrease ................................................................ 12,000Salaries payable increase........................................................................ 9,000Other accrued liabilities decrease............................................................ (4,000)


Req. 2

The first reason for the net loss was the depreciation expense. This is a non-cash expense. Depreciation expense, along with decreased working capital requirements (current assets - current liabilities), turned the net loss into positive operating cash flow from operations. The reasons for the difference between net income and cash flow are important because they help the financial analyst to determine if the trends are sustainable or whether they represent one-time events.


E13–8.

Req. 1

Cash flows from operating activities—indirect method

Net loss................................................................................................... ($9,482)Depreciation and amortization................................................................ 33,305Increase in receivables............................................................................ (170)Decrease in inventories........................................................................... 643 Increase in prepaid expense................................................................... (664)Decrease in accounts payable................................................................ (2,282)Decrease in accrued liabilities................................................................. (719)Increase in income taxes payable........................................................... 1,861

Cash flows from operating activities.................................................. $22,492

Note: The reduction of long-term debt and additions to equipment do not affect cash flows from operating activities.

Req. 2

The primary reason for the net loss was the depreciation and amortization expense. These represent non-cash expenses. Large depreciation and amortization expense, offset partially by increased working capital requirements, turned Sizzler’s net loss into positive operating cash flow. The reasons for the difference between net income and cash flow from operations are important because they help the financial analyst to determine if the trends are sustainable or whether they represent one-time events.


E13–9.

Account ChangeReceivables IncreaseInventories DecreaseOther current assets DecreasePayables Decrease

E13–10.

Account ChangeAccounts receivable IncreaseInventories DecreaseOther current assets DecreaseAccounts payable IncreaseIncome taxes payable IncreaseOther current liabilities Increase

E13–11.

Req. 1

Cash flows from operating activities—direct methodCash collected from customers1

$62,000Cash payments to employees2

(33,000)

Cash paid for other expenses3(12,700)


1. Cash collected from customers = $50,000 + 12,000 = 62,0002. Cash payments to employees = $42,000 – 9,000 = 33,0003. Cash paid for other expenses = $7,000 + 1,700 + 4,000= 12,700

Req. 2

The first reason for the net loss was the depreciation expense. This is a non-cash expense. Depreciation expense, along with decreased working capital requirements (current assets - current liabilities), turned the net loss into positive operating cash flow. The reasons for the difference between net income and cash flow are important because they help the financial analyst to determine if the trends are sustainable or whether they represent one-time events.


E13–12.

Req. 1

Cash flows from operating activities—direct methodCash collected from customers1 $136,330 Cash payments to employees (56,835)Cash payments to suppliers2 (47,139)Cash payments for other expenses3 (9,164)Cash payments for income tax4 (700) Net cash provided by operating activities $22,492

1. Cash collected from customers: $136,500 – 170 = 136,3302. Cash payments to suppliers: 45,500 – 643 + 2,282 = 47,1393. Cash payments for other expenses: 7,781 + 664 + 719 = 9,1644. Cash payments for income taxes: 2,561 – 1,861 = 700

Req. 2

The primary reason for the net loss was the depreciation and amortization expense. These represent non-cash expenses. Large depreciation and amortization expense, offset partially by increased working capital requirements, turned Sizzler’s net loss into positive operating cash flow. The reasons for the difference between net income and cash flow from operations are important because they help the financial analyst to determine if the trends are sustainable or whether they represent one-time events.


E13–13.

Req. 1

Cash flows from operating activities—indirect method

Net income............................................................................................... $1,587.9Depreciation and amortization................................................................. 1,444.2Increase in accounts receivable............................................................... (161.0)Increase in inventory................................................................................ (89.5)Decrease in prepaid expense.................................................................. 3.3Increase in accounts payable................................................................... 143.2Decrease in taxes payable....................................................................... (125.1)Decrease in other current liabilities.......................................................... (96.7)

Cash flows from operating activities.................................................. $2,706.3

Note: The cash dividend paid and treasury stock purchased are not related to operating activities and do not affect cash flows from operating activities. The decrease in other current liabilities was not explained in the PepsiCo annual report, so its proper inclusion in this computation is a judgment call. If it was not related to operations, it should not be included in the previous computation. In reality, PepsiCo included the decrease on its statement of cash flows.

Req. 2

Quality of income ratio = Cash flow from operations = $2,706.3 = 1.70Net income $1,587.9

Req. 3

The reason the quality of income ratio was significantly greater than one was because of large non-cash depreciation charges, offset by modest increases in working capital.


E13–14.

The investing and financing sections of the statement of cash flows for Rowe Furniture:

Cash flows from investing activities:Purchase of property, plant & equipment.......................... (871)Sale of marketable securities............................................. 134 Proceeds from sale of property & equipment................... 6,594

Net cash flows from investing activities....................... 5,857

Cash flows from financing activities:Borrowings under line of credit........................................... 1,417 Proceeds from issuance of common stock....................... 11 Payments on long term debt............................................... (46)Payment of dividends.......................................................... (277)Purchase of treasury stock................................................. (1,583)

Net cash flows from financing activities....................... (478)

E13–15.

Req. 1

The investing and financing sections of the statement of cash flows for Gibraltar Steel Corporation:

Cash flows from investing activities:Purchase of property, plant & equipment.......................... (10,468)Sale of marketable securities............................................. 131 Proceeds from sale of property & equipment................... 1,817

Net cash flows from investing activities....................... (8,520)

Cash flows from financing activities:Proceeds from notes payable............................................. 3,848 Proceeds from issuance of long-term debt....................... 10,242 Proceeds from initial public offering of common stock... . 26,061 Payments on long-term debt.............................................. (17,832)Payment of notes payable.................................................. (8,598)

Net cash flows from financing activities....................... 13,721

Req. 2

Gibraltar’s management is using the cash proceeds from the initial public offering for two purposes. First, it is using the funds to finance the Company’s investment in property, plant & equipment. Second, some of the funds are being used to alter the Company’s capital structure, as common stock is being used to pay down long-term debt.


E13–16.

Req. 1

Capital acquisitions ratio = Cash flow from operations = $2,900 = 0.81Cash Paid for Plant &

Equipment$3,581

Req. 2

The capital acquisitions ratio measures the company's ability to finance plant and equipment purchases from operations. Since this amount was less than 1 (0.81), the remainder, or 19%, must have been financed from external sources or preexisting cash balances.

Req. 3

During year 3, Pete’s completed an initial public offering of its common stock.

E13–17.

Req. 1

Both of these transactions are considered noncash investing and financing activities, and are not reported on the statement of cash flows. The transactions must be disclosed in a separate schedule or in the footnotes. The information disclosed in the separate schedule would state:

a. Equipment valued at $26,000 was acquired by giving a $15,000, 12%, two-year note, and common stock with a market value of $11,000.

b. A machine valued at $8,700 was acquired by exchanging land with a book value of $8,700.

Req. 2

The capital acquisitions ratio measures the company's ability to finance plant and equipment purchases from operations. Since neither of these transactions enters the numerator or denominator of the ratio, they would have no effect. Many analysts believe that these transactions represent important capital acquisitions, and thus should be included in the denominator of the ratio to indicate what portion of all (not just cash) acquisitions are being financed from operations.


E13–18.

Year 3 Year 2 Year 1Proceeds from sale of property $14,768 $11,623 $1,797

The amounts reported as proceeds from the sale of property are the cash flows for each year. The gain on the sale of property is subtracted from net income to avoid double counting of the gain. The amount reported in the cash flow from investing activities section of the statement of cash flows is the total cash flow associated with the sale.

E13–19.

Equipment Accumulated DepreciationBeg. Bal. $12,500 $2,000 Beg. Bal.

$4,500*Sold Sold $300* 700 Dep. Exp.End. Bal. $ 8,000 $2,400 End. Bal.

*plug figures

Cost of equipment sold = $4,500Accumulated depreciation on sold equipment = $300

Book value of sold equipment............... $4,200 Less: Loss on sale (given).................... (3,000) Cash received from sale...................... $1,200


E13–20.

Balances Analysis BalancesItem 12/31/2003 Debit Credit 12/31/2004

Cash plus short-term investments 20,500 l 1,300 19,200Noncash accounts:Accounts receivable (net)............ 22,000 22,000Merchandise inventory................ 68,000 h 7,000 75,000Investments, long term................ d 15,000 15,000Equipment................................... 114,500 b 20,000 i 21,000 113,500 Total........................................... 225,000 244,700Accumulated depreciation........... 32,000 i 15,000 c 3,000 20,000Accounts payable........................ 17,000 e 3,000 14,000Wages payable............................ 2,500 f 1,000 1,500Income taxes payable................. 3,000 g 1,500 4,500Bonds payable............................. 54,000 54,000

j 6,000Common stock, no par................ 100,000 b 20,000 126,000

Retained earnings....................... 16,500 k 12,000 a 20,200 24,700 Total........................................... 225,000 244,700

Statement of Cash FlowsConversion of net income to cash flowfrom operating activities:

Inflows Outflows

Net income a 20,200 Depreciation expense c 3,000 Accounts payable decrease e 3,000 Wages payable decrease f 1,000 Income taxes payable increase g 1,500 Inventory increase h 7,000 $13,700

Cash flows from investing activities: Long-term investment purchased d 15,000 Sale of equipment i 6,000 (9,000)

Cash flows from financing activities: Sale of capital stock j 6,000 Dividends paid k 12,000 (6,000)Net increase (decrease) in cash l 1,300 Totals ($1,300)


PROBLEMS

P13–1.

Frank CorporationStatement of Cash Flows

For the Year Ended December 31, 2004Cash flows from operating activities:

Net income...............................................................................................$42,000 Add (deduct) to convert to cash basis: Depreciation expense.............................................................................9,200 Accounts receivable increase ($17,000 – $12,000)................................(5,000) Accounts payable decrease ($10,000 – $7,000).....................................(3,000) Inventory decrease ($60,000 – $52,000)................................................8,000 Wages payable decrease ($1,000 – $800).............................................(200) Income tax payable increase ($5,000 – $3,000).....................................2,000

Net cash flow from operating activities............................................... $53,000Cash flows from investing activities:

Machinery sold................................................................ 11,000 Machinery purchased*.................................................... (9,000) Investments purchased................................................... (5,000)

Net cash flow from investing activities................................................ (3,000)Cash flows from financing activities:

Borrowed on long-term note payable.............................. 15,000 Paid a cash dividend....................................................... (10,000)

Net cash flow from financing activities........................ 5,000Net increase in cash during 2004.......................................... 55,000Cash, beginning of 2004....................................................... 21,000Cash, end of 2004................................................................. $76,000

ADDITIONAL CASH FLOW INFORMATION

During 2004, the company also purchased machinery for $41,000 that was financed with a four-year note payable to the dealer. Income taxes paid were $9,800.** Interest paid was $12,200.

*Note that the $41,000 non-cash portion of the purchase and the related financing are not reported in the statement. They are reported separately in the note.

**Income taxes paid = Income tax expense – Increase in income taxes payable.


P13–2.

ROCKY MOUNTAIN CHOCOLATE FACTORY, INC.Statement of Cash Flows

For the Quarter Ended May 31, 1996

Cash flows from operating activities:Net income (accrual basis; from statement of income).... $ 163,837Add (deduct) to reconcile net income to net cash flow: Depreciation expense......................................................... 276,304 Amortization expense......................................................... 5,901 Accounts receivable increase............................................ (138,681) Inventories increase........................................................... (243,880) Other current assets increase........................................... (357,507) Accounts payable increase................................................ 280,935 Accrued liabilities increase................................................. 164,087 Income taxes payable decrease....................................... (43,031) Long-term A/R decrease.................................................... 11,382

Net cash inflow from operating activities.................... $ 119,347

Cash flows from investing activities: Fixed assets purchased................................................. (1,081,121) Other assets decrease....................................................... 50,055

Net cash inflow from operating activities (1,031,066)

Cash flows from financing activities: Repayment of short-term debt....................................... (1,000,000) Repayment of long-term debt............................................ (2,355,029) Issuance of long-term debt............................................. 4,659,466

Net cash inflow from financing activities..................... 1,304,437Net increase in cash during the quarter................................ 392,718Cash, February 29, 1996....................................................... 528,787Cash, May 31, 1996.............................................................. $ 921,505


P13–3.

Frank CorporationStatement of Cash Flows

For the Year Ended December 31, 2004Cash flows from operating activities:

Cash collected from customers (400,000 5,000) $395,000 Cash paid to suppliers (268,000 + 3,000 – 8,000) (263,000)Cash paid to employees (51,000 + 200) (51,200)Cash paid for rent (5,800)Cash paid for interest (12,200)Cash paid for income taxes (11,800 - 2,000) (9,800)

Net cash flow from operating activities............................................... $53,000Cash flows from investing activities:

Machinery sold................................................................ 11,000 Machinery purchased*.................................................... (9,000) Investments purchased................................................... (5,000)

Net cash flow from investing activities................................................ (3,000)Cash flows from financing activities:

Borrowed on long-term note payable.............................. 15,000 Paid a cash dividend....................................................... (10,000)

Net cash flow from financing activities........................ 5,000Net increase in cash during 2004.......................................... 55,000Cash, beginning of 2004....................................................... 21,000Cash, end of 2004................................................................. $76,000

ADDITIONAL CASH FLOW INFORMATION

During 2004, the company also purchased machinery for $41,000 that was financed with a four-year note payable to the dealer. Income taxes paid were $9,800.** Interest paid was $12,200.

*Note that the $41,000 non-cash portion of the purchase and the related financing are not reported in the statement. They are reported separately in the note.

**Income taxes paid = Income tax expense – Increase in income taxes payable.


P13–4.

Req. 1BETA COMPANY

Cash Flows from Operating ActivitiesDirect Method

Cash flows from operating activities: Cash receipts from customers................................................................ $20,670 Cash payments to suppliers.................................................................... (8,992) Cash payments for salaries..................................................................... (4,991) Cash payments for rent........................................................................... (2,499) Cash payments for insurance................................................................. (809) Cash payments for utilities...................................................................... (700) Cash payments for bond interest............................................................ (600)

Net cash provided by operating activities......................................... $ 2,079

Req. 2BETA COMPANY

Cash Flows from Operating ActivitiesIndirect Method

Cash flows from operating activities: Net loss........................................................................... $ (400) Adjustments to reconcile net loss to net cash provided by operating activities: Decrease in accounts receivable................................... $ 70 Increase in merchandise inventory................................ (22) Increase in accounts payable........................................ 30 Depreciation expense.................................................... 2,000 Increase in salaries payable.......................................... 9 Decrease in rent payable............................................... (4) Decrease in prepaid rent................................................ 5 Increase in prepaid insurance........................................ (9) Loss on sale of investments........................................... 400 Total adjustments.......................................................... 2,479

Net cash provided by operating activities.................. $2,079


P13–5.

Req.1Statement of Cash Flows Spreadsheet

Hunter CompanyFor the Year Ended December 31, 2004

12-31-2003 DR CR 12-31-2004

BALANCE SHEETCash 18,000 26,000 (k) 44,000Accounts receivable 29,000 2,000 (b) 27,000Merchandise inventory 36,000 6,000 (c) 30,000Fixed assets-net 72,000 9,000 (g) 6,000 (e) 75,000 Total 155,000 176,000Accounts payable 22,000 3,000 (d) 25,000Wages payable 1,000 200 (f) 800Notes payable, long-term 48,000 10,000 (h) 38,000Common stock-no par 60,000 20,000 (i) 80,000Retained earnings 24,000 3,800 (j) 12,000 (a) 32,200 Total 155,000 49,000 49,000 176,000


P13–5. (continued)

STATEMENT OF CASH FLOWS-INDIRECT METHOD

Inflow Outflow Cash flows from operating activities:Net income 12,000 (a)Adjustment to net incomeDecrease in accounts receivable 2,000 (b)Decrease in merchandise inventory 6,000 (c)Increase in accounts payable 3,000 (d)Depreciation expense 6,000 (e)Decrease in wages payable 200 (f) 28,800

Cash flows from investing activities:Cash payment to purchase fixed assets 9,000 (g) (9,000)

Cash flows from financing activities:Cash payments on long-term note 10,000 (h)Cash receipts from issuing stock 20,000 (i)Cash payments for dividends 3,800 (j) 6,200

Increase (decrease) in cash during the year 26,000 (k) 26,000Totals 49,000 49,000

Cash balance, Jan. 1 18,000Cash balance, Dec. 31 44,000


P3–5. (continued)

Req. 2HUNTER COMPANY

Statement of Cash FlowsFor the Year Ended December 31, 2004

Cash flows from operating activities: Net income...................................................................... $12,000 Adjustments to reconcile net income to net cash provided by operating activities: Decrease in accounts receivable................................... $ 2,000 Decrease in merchandise inventory............................... 6,000 Increase in accounts payable........................................ 3,000 Depreciation expense.................................................... 6,000 Decrease in wages payable........................................... (200) Total adjustments............................................................ 16,800

Net cash provided by operating activities.................. 28,800 Cash flows from investing activities:

Cash payments to purchase fixed assets....................... (9,000)Cash flows from financing activities:

Cash payments on long-term note.................................. (10,000) Cash receipts from issuing stock.................................... 20,000 Cash payments for dividends.......................................... (3,800)

Net cash provided by financing activities................... 6,200 Net increase in cash during the year..................................... 26,000 Cash balance, January 1, 2004............................................. 18,000 Cash balance, December 31, 2004....................................... $44,000

Req. 3

There were no noncash investing and financing activities during 2004.


ALTERNATE PROBLEMS

AP13–1.

STONEWALL COMPANYStatement of Cash Flows

For the Year Ended December 31, 2003

Cash flows from operating activities: Net income (accrual basis; from statement of income)... $ 9,000 Add (deduct) to reconcile net income to net cash flow: Accounts receivable increase......................................... (18,000) Inventory increase........................................................... (15,000) Accounts payable increase............................................. 10,000 Accrued expenses payable increase.............................. 21,000 Depreciation expense..................................................... 4,000

Net cash inflow from operating activities.................... $11,000Cash flows from investing activities:

Machinery purchased...................................................... (29,000)Cash flows from financing activities:

Issuance of capital stock................................................. 54,000 Borrowed on short-term note payable............................. 15,000 Paid a cash dividend....................................................... (3,000)

Net cash inflow from financing activities..................... 66,000Net increase in cash during 2003.......................................... 48,000Cash, beginning of 2003....................................................... –0–Cash, end of 2003*................................................................ $48,000

ADDITONAL CASH FLOW INFORMATION

During 2003, the company also exchanged plant machinery with a book value of $2,000 for office machines with a market value of $2,000.

*Because this is the first year of operations, all account balances are zero at the beginning of the year; therefore, the changes in the account balances were equal to the ending balances. The $48,000 agrees with the cash account.


AP13–2.

Req.1. Statement of Cash Flows Spreadsheet

Ellington Company


BALANCE SHEET

12-31-2003 DR CR 12-31-2004Cash 21,000 1,400 (n) 22,400Accounts receivable 18,000 3,000 (b) 21,000Inventory 35,000 3,000 (h) 32,000Prepaid insurance 2,400 1,000 (e) 1,400Investments, long term 12,500 3,200 (j) 9,300Fixed assets-net 31,100 33,000 (k) 4,500 (c) 59,600Patent 2,000 500 (d) 1,500 Total 122,000 147,200

Accounts payable 27,000 12,000 (i) 15,000Wages payable 4,000 3,000 (f) 1,000Income tax payable 2,000 200 (g) 2,200Note payable, long-term 20,000 10,000 (l) 10,000Common stock-$10 par 50,000 30,000 (k) 80,000Contributed capital 3,000 3,000 (k) 6,000Retained earnings 16,000 8,500 (m) 25,500 (a) 33,000 Total 122,000 70,900 70,900 147,200


AP13–2. (continued)

STATEMENT OF CASH FLOWS-INDIRECT METHOD

Inflow DR

Outflow CR

Cash flows from operating activities:Net income 25,500 (a)Adjustment to net income:Increase in accounts receivable 3,000 (b)Depreciation expense 4,500 (c)Patent amortization 500 (d)Decrease in prepaid insurance 1,000 (e)Decrease in wages payable 3,000 (f)Increase in income tax payable 200 (g)Decrease in inventory 3,000 (h)Decrease in accounts payable 12,000 (i) 16,700

Cash flows from investing activities: Cash receipts from sale of long-

term investments 3,200 (j) 3,200

Cash flows from financing activities:Cash payments on long-term note

payable 10,000 (l)Cash payments for dividends 8,500 (m) ( 18,500)

Increase (decrease) in cash during the year 1,400 (n) 1,400

Totals 37,900 37,900Cash balance, Jan. 1, 2004 21,000Cash balance, Dec. 31, 2004 22,400


AP13–2. (continued)

Req. 2ELLINGTON COMPANYStatement of Cash Flows


Cash flows from operating activities: Net income...................................................................... $25,500 Adjustments to reconcile net income to net cash............ provided by operating activities: Increase in accounts receivable..................................... $ (3,000) Depreciation expense.................................................... 4,500 Patent amortization........................................................ 500 Decrease in prepaid insurance...................................... 1,000 Decrease in wages payable........................................... (3,000) Increase in income tax payable..................................... 200 Decrease in inventory.................................................... 3,000 Decrease in accounts payable....................................... (12,000) Total adjustments............................................................ (8,800)

Net cash provided by operating activities.................. 16,700 Cash flows from investing activities:

Cash receipts from sale of long-term investments.......... 3,200 Cash flows from financing activities:

Cash payments on long-term note payable.................... (10,000) Cash payments for dividends.......................................... (8,500)

Net cash used by financing activities......................... (18,500)Net increase in cash during the year..................................... 1,400 Cash balance, January 1, 2004............................................. 21,000 Cash balance, December 31, 2004....................................... $22,400

Req. 3Schedule of Noncash

Investing and Financing Activities

The company issued common stock with a market value of $33,000 in exchange for fixed assets.


CASES AND PROJECTS

FINANCIAL REPORTING AND ANALYSIS CASES

CP13–1.

1. The company uses the indirect method.

2. Tax payments of $37,362 thousand were made (Note 2, Supplemental Disclosures of Cash Flow Information).

3. “Stock compensation” is a noncurrent accrued expense (an expense paid with common stock) like depreciation expense. It was added back to net income because this type of expense does not cause a cash outflow when it is recorded. “Loss on impairment and write-off of fixed assets” relates to an investing activity and did not affect cash. Like noncurrent accrued expenses, this loss must be added back to net income because it does not cause a cash outflow when it is recorded.

4. Free Cash Flow was $62,766 thousand, calculated as (in thousands):

Cash Flows from Operating Activities $150,591less Dividends 0less Capital Expenditures 87,825Free Cash Flow $62,766

5. No, the company has not paid cash dividends during the last three years. There are no dividend payments listed under the Financing section of the statement of cash flows.

CP13–2.

1. The three largest “Adjustments to reconcile net income to net cash provided by operating activities” were:

(a) Increase in inventories: the increase of $45,735 was subtracted from net income in the reconciliation because purchases of inventories were greater than the amount of inventory sold.

(b) Depreciation and amortization: the $30,731 expense was added to net income in the reconciliation because it is a noncurrent accrued expense, which does not cause a cash outflow when it is recorded.

(c) Increase in accounts payable and accrued liabilities: the $21,626 increase is added back to net income because actual payments were less than the expense recognized.


CP13–2. (continued)

2. Abercrombie & Fitch’s major uses of cash over the past three years have been capital expenditures, repurchases of treasury stock, and purchases of inventories. The major source of cash for these activities has been cash flow provided by operating activities. Over the next few years, the company expects to incur additional capital expenditures to support its planned expansion. The primary sources of financing these future expenditures are expected to be future cash flows provided by operating activities (as well as existing cash and cash equivalents). This is discussed in the “capital expenditures” section of Management’s Discussion and Analysis.

3. Free Cash Flow was $5,723 thousand, calculated as (in thousands):

Cash Flows from Operating Activities $151,189less Dividends 0less Capital Expenditures 153,481Free Cash Flow $(2,292)

This implies that the company is limited in its financial flexibility, although the negative free cash flow balance is mitigated by the high level of current cash and cash equivalents.

CP13–3.

1. Abercrombie & Fitch

American Eagle Outfitters

Quality of = Cash flow from operations $151,189 = 0.96 $150,591 = 1.61income ratio Net income 158,133 93,758

American Eagle Outfitters has a higher quality of income ratio than does Abercrombie & Fitch. This difference might be explained by fact that American Eagle significantly increased its short-term liabilities in the 2000 fiscal year (they increased from $88,425 to $149,147, or 69%), while Abercrombie & Fitch did not have a similar dramatic increase.


CP13–3. (continued)

2. Industry Average

Abercrombie & Fitch


Quality of Income = 1.61 0.96 1.61

Abercrombie & Fitch’s quality of income ratio is below the industry average, while American Eagle Outfitters’ quality of income ratio is equal to the industry average. Two things affect this ratio: the fact that these two companies are growing rapidly (see below), and the effect of operating leases on the cash flow statement. Because these companies rely primarily on operating leases for their stores, all of rent expense is included in Operating Cash Flows, whereas for other companies in the industry that own their stores, depreciation is added back to CFO.

Industry Average

Abercrombie & Fitch


Sales Growth = 9.04% 20.1%* 31.4%**

* ($1,237,604 – 1,030,858) / 1,030,858** ($1,093,477 – 832,104) / 832,104

Sales growth helps us explain some of the difference in the quality of income ratio. Both of these companies are in high growth mode, and are spending cash to advertise and build inventories in anticipation of higher sales in the future.

3. Abercrombie & Fitch


Capital = Cash flow from operations $151,189 = 0.99 $150,591 = 1.72

acquisitionsratio

Cash Paid for Plant & Equipment

153,481 87,825

American Eagle Outfitters has a higher capital acquisitions ratio than does Abercrombie & Fitch. This implies that American Eagle Outfitters has a greater ability to fund additional capital expenditures from the cash flow provided by its operating activities.

4. Industry Average

Abercrombie & Fitch


Capital Acquisitions = 0.65 0.99 1.71

Both American Eagle Outfitters’ and Abercrombie & Fitch’s Capital Acquisitions ratios are higher than the industry average. This implies that both companies have a greater ability to fund additional capital expenditures from the cash flow provided by their operating activities than the average company in the industry.


CP13–4.

1. The company uses an indirect method to present the operating section of the cash flow statement. Note 32 presents the reconciliation of income (in this case, beginning with operating profit) to cash flows from operating activities.

2. Some of the terms used in the statement may be unfamiliar to U.S. students. The statement itself is a "group” cash flow statement, compared to Boston Beer’s “consolidated” statement. In the reconciliation of net income to cash flow from operations, the changes in the typical balance sheet accounts are listed but may not be easily identified as such: decrease in stocks (inventory), decrease in debtors (accounts receivable), and decrease in creditors (accounts payable).

Differences also exist in the structure of the statement. Consider cash flows from operating activities. Cash flow from operating activities is presented in a note to the financial statements, not on the statement itself. Cash flow from operating activities is divided between cash from ordinary operating activities and unusual items. Interest received and interest paid are listed under “returns on investments and servicing of finance” rather as part of operating activities. Taxation payments are also listed separately. In Boston Beer’s statement, interest and tax payments are not readily available from the statement itself, but are provided in supplemental disclosure. As such, Scottish & Newcastle’s presentation of operating activities is arguably a mixture of the indirect and direct methods.

The investing section of the statement should look more familiar to U.S. students, with the exception that acquisitions and disposals are granted their own section on the statement. Under U.S. GAAP, these would be included as line items within the investing activities section.

More differences are found between the financing sections of the statements. Recall that under U.S. GAAP, dividends are treated as a financing item. In the Scottish & Newcastle statement, dividends are listed in two different locations: preferred dividends are listed along with interest under “returns on investments and servicing of finance” and dividends on common stock is listed as a separate line item (“equity dividends paid”).

A subtotal is provided before considering “liquid resources and financing.” Liquid resources are term deposits of less than one year. On Boston Beer’s statement, these would likely be listed as short-term investments (an investing activity).

The effect of these differences is to focus the investors’ attention away from operating activities (highlighted on U.S. statements) and onto service payments (such as interest, taxation, and dividends), liquidity, and solvency (discussed further in Chapter 14). This redirection is also visible in the additional notes required reconciling net cash flow to movement in net debt and the analysis of net debt.


CRITICAL THINKING CASES

CP13–5.

Date: (today’s date)To: Supervising AnalystFrom: (your name)Re: Evaluation of Carlyle Golf, Inc.’s Planned Expansion

While many companies experience losses and negative cash flows during the early years of their operations, the cash situation for Carlyle Golf is a major concern. The company has announced plans to increase inventory by $2.2 million but there is no obvious source to finance the acquisition of this inventory. The statement of cash flows shows that the company has to make cash deposits with its suppliers. It is unlikely that these suppliers will be a major source of financing for Carlyle's inventory. The company obviously does not have enough cash on hand to finance its expansion of inventory.

The planned expansion of inventory has additional implications. The company must have plans to expand its sales volume. There is no information in the company's report concerning whether this expansion will require additional expenditures, such as increased advertising or hiring new sales people. In any case, the expansion will most likely require an increase in accounts receivable. Most companies underestimate the amount of resources that must be tied up in inventory and accounts receivable when they expand sales volume.

Carlyle should seek additional capital to support an increased level of operations. Without this extra capital, it is unlikely that Carlyle can continue in business.

Instructor's note: Subsequent to September 1992, Carlyle sought new financing through an initial public offering. At the time of this writing, the company is still trying to develop a niche in a very competitive market.

FINANCIAL REPORTING AND ANALYSIS PROJECTS

CP13–6.

The solutions to this case will depend on the company and/or accounting period selected for analysis.


Documents

FINANCIAL REPORTING AND ANALYSIS CASES