3
Chapter 16 Statement of Cash Flows 759 Special Activities Kelly Tough, president of Tu-Rock Industries Inc., believes that reporting operating cash flow per share on the income statement would be a useful addition to the company’s just completed financial statements. The following discussion took place between Kelly Tough and Tu-Rock controller, Tripp Kelso, in January, after the close of the fiscal year. Kelly: I have been reviewing our financial statements for the last year. I am disappointed that our net in- come per share has dropped by 10% from last year. This is not going to look good to our shareholders. Isn’t there anything we can do about this? Tripp: What do you mean? The past is the past, and the numbers are in. There isn’t much that can be done about it. Our financial statements were prepared according to generally accepted accounting princi- ples, and I don’t see much leeway for significant change at this point. Kelly: No, no. I’m not suggesting that we “cook the books.” But look at the cash flow from operating ac- tivities on the statement of cash flows. The cash flow from operating activities has increased by 20%. This is very good news—and, I might add, useful information. The higher cash flow from operating activities will give our creditors comfort. Tripp: Well, the cash flow from operating activities is on the statement of cash flows, so I guess users will be able to see the improved cash flow figures there. Kelly: This is true, but somehow I feel that this information should be given a much higher profile. I don’t like this information being “buried” in the statement of cash flows. You know as well as I do that many users will focus on the income statement. Therefore, I think we ought to include an operating cash flow per share number on the face of the income statement—someplace under the earnings per share num- ber. In this way, users will get the complete picture of our operating performance. Yes, our earnings per share dropped this year, but our cash flow from operating activities improved! And all the information is in one place where users can see and compare the figures. What do you think? Tripp: I’ve never really thought about it like that before. I guess we could put the operating cash flow per share on the income statement, under the earnings per share. Users would really benefit from this disclo- sure. Thanks for the idea—I’ll start working on it. Kelly: Glad to be of service. How would you interpret this situation? Is Tripp behaving in an ethical and professional manner? SA 16-1 Ethics and professional conduct in business The following additional information was taken from the records: a. Equipment and land were acquired for cash. b. There were no disposals of equipment during the year. c. The investments were sold for $54,000 cash. d. The common stock was issued for cash. e. There was a $60,000 debit to Retained Earnings for cash dividends declared. Instructions Prepare a statement of cash flows, using the direct method of present- ing cash flows from operating activities. SA 16-2 Using the statement of cash flows You are considering an investment in a new start-up company, Steamboat IQ Inc., an Internet service provider. A review of the company’s financial statements reveals a neg- ative retained earnings. In addition, it appears as though the company has been run- ning a negative cash flow from operating activities since the company’s inception. How is the company staying in business under these circumstances? Could this be a good investment? Jim Walker is the president and majority shareholder of Tech Trends Inc., a small re- tail store chain. Recently, Walker submitted a loan application for Tech Trends Inc. to Yadkin National Bank. It called for a $200,000, 9%, 10-year loan to help finance the con- struction of a building and the purchase of store equipment, costing a total of $250,000, to enable Tech Trends Inc. to open a store in Yadkin. Land for this purpose was ac- quired last year. The bank’s loan officer requested a statement of cash flows in addi- tion to the most recent income statement, balance sheet, and retained earnings state- ment that Walker had submitted with the loan application. SA 16-3 Analysis of statement of cash flows Chapter 16.qxd 5/27/08 2:17 PM Page 759

Special Activities - Cengage 16.qxd 5/27/08 2:17 PM Page 759. ... a return on invested capital of 10%, ... Analysis of cash flow from operations. Chapter 16.qxd 5/27/08 2:17 PM Page

Embed Size (px)

Citation preview

Page 1: Special Activities - Cengage 16.qxd 5/27/08 2:17 PM Page 759. ... a return on invested capital of 10%, ... Analysis of cash flow from operations. Chapter 16.qxd 5/27/08 2:17 PM Page

Chapter 16 Statement of Cash Flows 759

Special Activities

Kelly Tough, president of Tu-Rock Industries Inc., believes that reporting operating cash

flow per share on the income statement would be a useful addition to the company’s just

completed financial statements.The following discussion took place between Kelly Tough

and Tu-Rock controller, Tripp Kelso, in January, after the close of the fiscal year.

Kelly: I have been reviewing our financial statements for the last year. I am disappointed that our net in-come per share has dropped by 10% from last year. This is not going to look good to our shareholders.Isn’t there anything we can do about this?

Tripp: What do you mean? The past is the past, and the numbers are in. There isn’t much that can bedone about it. Our financial statements were prepared according to generally accepted accounting princi-ples, and I don’t see much leeway for significant change at this point.

Kelly: No, no. I’m not suggesting that we “cook the books.” But look at the cash flow from operating ac-tivities on the statement of cash flows. The cash flow from operating activities has increased by 20%. Thisis very good news—and, I might add, useful information. The higher cash flow from operating activitieswill give our creditors comfort.

Tripp: Well, the cash flow from operating activities is on the statement of cash flows, so I guess userswill be able to see the improved cash flow figures there.

Kelly: This is true, but somehow I feel that this information should be given a much higher profile. I don’tlike this information being “buried” in the statement of cash flows. You know as well as I do that manyusers will focus on the income statement. Therefore, I think we ought to include an operating cash flowper share number on the face of the income statement—someplace under the earnings per share num-ber. In this way, users will get the complete picture of our operating performance. Yes, our earnings pershare dropped this year, but our cash flow from operating activities improved! And all the information is inone place where users can see and compare the figures. What do you think?

Tripp: I’ve never really thought about it like that before. I guess we could put the operating cash flow pershare on the income statement, under the earnings per share. Users would really benefit from this disclo-sure. Thanks for the idea—I’ll start working on it.

Kelly: Glad to be of service.

How would you interpret this situation? Is Tripp behaving in an ethical andprofessional manner?

SA 16-1Ethics andprofessional conductin business

The following additional information was taken from the records:

a. Equipment and land were acquired for cash.b. There were no disposals of equipment during the year.c. The investments were sold for $54,000 cash.d. The common stock was issued for cash.e. There was a $60,000 debit to Retained Earnings for cash dividends declared.

Instructions Prepare a statement of cash flows, using the direct method of present-ing cash flows from operating activities.

SA 16-2Using the statementof cash flows

You are considering an investment in a new start-up company, Steamboat IQ Inc., an

Internet service provider. A review of the company’s financial statements reveals a neg-

ative retained earnings. In addition, it appears as though the company has been run-

ning a negative cash flow from operating activities since the company’s inception.How is the company staying in business under these circumstances? Could

this be a good investment?

Jim Walker is the president and majority shareholder of Tech Trends Inc., a small re-

tail store chain. Recently, Walker submitted a loan application for Tech Trends Inc. to

Yadkin National Bank. It called for a $200,000, 9%, 10-year loan to help finance the con-

struction of a building and the purchase of store equipment, costing a total of $250,000,

to enable Tech Trends Inc. to open a store in Yadkin. Land for this purpose was ac-

quired last year. The bank’s loan officer requested a statement of cash flows in addi-

tion to the most recent income statement, balance sheet, and retained earnings state-

ment that Walker had submitted with the loan application.

SA 16-3Analysis ofstatement of cashflows

Chapter 16.qxd 5/27/08 2:17 PM Page 759

tnewman
Rectangle
tnewman
Rectangle
tnewman
Text Box
Chapter 16
Page 2: Special Activities - Cengage 16.qxd 5/27/08 2:17 PM Page 759. ... a return on invested capital of 10%, ... Analysis of cash flow from operations. Chapter 16.qxd 5/27/08 2:17 PM Page

760 Chapter 16 Statement of Cash Flows

As a close family friend, Walker asked you to prepare a statement of cash flows.From the records provided, you prepared the following statement:

Tech Trends Inc.Statement of Cash Flows

For the Year Ended December 31, 2010

Cash flows from operating activities:Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000Adjustments to reconcile net income to net cash flow

from operating activities:Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,000Gain on sale of investments . . . . . . . . . . . . . . . . . . . . . . . . . (10,000)Changes in current operating assets and liabilities:

Decrease in accounts receivable . . . . . . . . . . . . . . . . . . . . 7,000Increase in inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . (14,000)Increase in accounts payable . . . . . . . . . . . . . . . . . . . . . . . 10,000Decrease in accrued expenses payable . . . . . . . . . . . . . . . (2,000)________

Net cash flow from operating activities . . . . . . . . . . . . . . . . . . . $119,000Cash flows from investing activities:

Cash received from investments sold . . . . . . . . . . . . . . . . . . . . . $60,000Less cash paid for purchase of store equipment . . . . . . . . . . . . . (40,000)_________Net cash flow provided by investing activities . . . . . . . . . . . . . . . 20,000

Cash flows from financing activities:Cash paid for dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $42,000_________Net cash flow used for financing activities . . . . . . . . . . . . . . . . . . (42,000)_________

Increase in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 97,000Cash at the beginning of the year . . . . . . . . . . . . . . . . . . . . . . . . . 36,000_________Cash at the end of the year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $133,000__________________

Schedule of Noncash Financing and Investing Activities:Issued common stock for land $ 80,000

After reviewing the statement, Walker telephoned you and commented, “Are you surethis statement is right?” Walker then raised the following questions:

1. “How can depreciation be a cash flow?”2. “Issuing common stock for the land is listed in a separate schedule. This transac-

tion has nothing to do with cash! Shouldn’t this transaction be eliminated from thestatement?”

3. “How can the gain on sale of investments be a deduction from net income in de-termining the cash flow from operating activities?”

4. “Why does the bank need this statement anyway? They can compute the increasein cash from the balance sheets for the last two years.”

After jotting down Walkers’ questions, you assured him that this statement was“right.” But to alleviate Walkers’ concern, you arranged a meeting for the following day.

a. How would you respond to each of Walkers’ questions?b. Do you think that the statement of cash flows enhances the chances of Tech

Trends Inc. receiving the loan? Discuss.

The Retailing Division of Most Excellent Purchase Inc. provided the following infor-

mation on its cash flow from operations:

Net income $ 540,000Increase in accounts receivable (648,000)Increase in inventory (720,000)Decrease in accounts payable (108,000)Depreciation 120,000_________Cash flow from operating activities $(816,000)__________________

The manager of the Retailing Division provided the accompanying memo with thisreport:

From: Senior Vice President, Retailing Division

I am pleased to report that we had earnings of $540,000 over the last period. This resulted ina return on invested capital of 10%, which is near our targets for this division. I have been

SA 16-4Analysis of cash flowfrom operations

Chapter 16.qxd 5/27/08 2:17 PM Page 760

Page 3: Special Activities - Cengage 16.qxd 5/27/08 2:17 PM Page 759. ... a return on invested capital of 10%, ... Analysis of cash flow from operations. Chapter 16.qxd 5/27/08 2:17 PM Page

Chapter 16 Statement of Cash Flows 761

This activity will require two teams to retrieve cash flow statement information from

the Internet. One team is to obtain the most recent year’s statement of cash flows for

Johnson & Johnson, and the other team the most recent year’s statement of cash flows

for AMR Corp.The statement of cash flows is included as part of the annual report information

that is a required disclosure to the Securities and Exchange Commission (SEC).SEC documents can be retrieved using the EdgarScanTM service at http://www.sec.gov/edgar/searchedgar/webusers.htm.

To obtain annual report information, type in a company name in the appropriatespace. EdgarScan will list the reports available to you for the company you’ve selected.Select the most recent annual report filing, identified as a 10-K or 10-K405. EdgarScanprovides an outline of the report, including the separate financial statements. You candouble-click the income statement and balance sheet for the selected company into anExcelTM spreadsheet for further analysis.

As a group, compare the two statements of cash flows.

a. How are Johnson & Johnson and AMR Corp. similar or different regarding cashflows?

b. Compute and compare the free cash flow for each company, assuming additions toproperty, plant, and equipment replace current capacity.

SA 16-5Statement of cashflows

Group Project

Internet Project

Answers to Self-Examination Questions

1. D Cash flows from operating activities affecttransactions that enter into the determination ofnet income, such as the receipt of cash from cus-tomers on account (answer D). Receipts of cashfrom the sale of stock (answer A) and the sale ofbonds (answer B) and payments of cash for div-idends (answer C) are cash flows from financingactivities.

2. A Cash flows from investing activities includereceipts from the sale of noncurrent assets, suchas equipment (answer A), and payments to ac-quire noncurrent assets. Receipts of cash fromthe sale of stock (answer B) and payments of cashfor dividends (answer C) and to acquire treas-ury stock (answer D) are cash flows from fi-nancing activities.

3. C Payment of cash for dividends (answer C) isan example of a financing activity. The receipt ofcash from customers on account (answer A) isan operating activity. The receipt of cash fromthe sale of equipment (answer B) is an investing

activity. The payment of cash to acquire land (an-swer D) is an example of an investing activity.

4. D The indirect method (answer D) reports cashflows from operating activities by beginning withnet income and adjusting it for revenues and ex-penses not involving the receipt or payment of cash.

5. C The Cash Flows from Operating Activitiessection of the statement of cash flows would re-port net cash flow from operating activities of$65,500, determined as follows:

Cash flows from operating activities:Net income . . . . . . . . . . . . . . . . . . . . . . $55,000Adjustments to reconcile net income to net cash flow from operating activities:

Depreciation . . . . . . . . . . . . . . . . . 22,000Changes in current operating assetsand liabilities:

Increase in accounts receivable . . (10,000)Decrease in inventories . . . . . . . . 5,000Decrease in prepaid expenses . . . 500Decrease in accounts payable . . . (7,000)_______

Net cash flow from operating activities . . $65,500

aggressive in building the revenue volume in the division. As a result, I am happy to reportthat we have increased the number of new credit card customers as a result of an aggressivemarketing campaign. In addition, we have found some excellent merchandise opportunities.Some of our suppliers have made some of their apparel merchandise available at a deep discount.We have purchased as much of these goods as possible in order to improve profitability. I’m alsohappy to report that our vendor payment problems have improved. We are nearly caught up onour overdue payables balances.

Comment on the senior vice president’s memo in light of the cash flowinformation.

Chapter 16.qxd 5/27/08 2:17 PM Page 761

tnewman
Rectangle