Financial Reporting & Analysis Chapter 17 Solutions Statement of Cash Flows Exercises

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1 Financial Reporting & Analysis Chapter 17 Solutions Statement of Cash Flows Exercises Exercises E17-1. Determining cash flows from operations Using the indirect method, cash flow from operations is computed below: Net income $280,000 Add: Equity in investee loss $20,000 Decrease in prepaid expenses 7,000 Depreciation expense 13,000 Increase in salaries payable 8,000 48,000 Subtract: Amortization of premium on bonds (10,000) payable Increase in inventory (21,000) Increase in accounts receivable (15,000) Decrease in accounts payable (2,000) (48,000) Cash flow from operations $280,

2 E17-2. Determining cash flows from operations (AICPA adapted) Lino s net cash from operating activities is calculated below: Net income $150,000 Increase in accounts receivable 1 (5,800) Decrease in prepaid rent 4,200 Increase in accounts payable 3,000 Cash flow from operations $151,400 1 The increase in accounts receivable is net of the allowance for doubtful accounts: Beginning accounts receivable $23,000 Less: Beginning allowance for doubtful accounts (800 ) Beginning net accounts receivable $22,200 Ending accounts receivable $29,000 Less: Ending allowance for doubtful accounts (1,000) Ending net accounts receivable $28,000 Increase in net accounts receivable: Ending net accounts receivable $28,000 Beginning net accounts receivable (22,200) Increase in net accounts receivable $ 5,800 E17-3. Cash flows from operations (AICPA adapted) Requirement 1: Calculate accrual basis net income for December: Sales revenue $350,000 Cost of goods sold (70% of sales) (245,000) Gross profit (30% of sales) 105,000 Selling, general, and administrative expenses Fixed portion = $35,000 Variable portion = 15% $350,000 = 52,500 (87,500) Net income (accrual basis) $17,

3 Requirement 2: Adjust accrual basis income to obtain cash flows from operations: Accrual basis net income $17,500 - Increase in gross trade accounts receivable* (13,500) - Increase in inventory (5,000) + Charge for uncollectible accounts (1% $350,000) 3,500 + Depreciation expense included in S, G&A 20,000 Cash flows from operating activities $22,500 * ($10,500 + $3000 write-off of uncollectable accounts receivable) E17-4. Analysis of changes in balance sheet accounts (AICPA adapted) Requirement 1: Determining depreciation on machinery for 2001: Step 1: Determine the amount of accumulated depreciation on equipment sold during 2001: Cost of machine sold (given) $40,000 Less: Accumulated depreciation? Book value of equipment sold? Less: Cash received from sale 26,000 Loss on sale (given) $4,000 Working backwards, the book value of equipment sold is $30,000 and the accumulated depreciation is $10,000. Step 2: Analyze the accumulated depreciation account to determine the amount credited to this account when depreciation expense was recorded for the year: Accumulated depreciation on equipment sold (see above) Accumulated Depreciation $102,000 Beginning balance $10,000? Depreciation expense for the year $120,000 Ending balance 17-3

4 From the T-account analysis, we can determine that depreciation expense for the year is $28,000. Requirement 2: To determine machinery purchases, the solutions approach is to set up a T-account for machinery and solve for the missing debit for equipment purchases: Machinery Beginning balance $250,000 Purchases? $40,000 Cost of equipment sold Ending balance $320,000 The T-account can by analyzed to determine that 2001 machinery purchases totaled $110,000. E17-5. Cash flows from investing and financing activities (AICPA adapted) Requirement 1: Net cash flows from operating activities are computed as follows: Net income $300,000 + Depreciation 52,000 - Gain on sale of equipment (5,000) Cash flows from operating activities $347,000 Requirement 2: Below is the computation for cash flow from investing activities: Sale of equipment 1 $18,000 Purchase of equipment 2 (20,000) Cash outflow from investing activities ( $ 2,000 ) 1 Computation of cash from sale of equipment: Cost of equipment $25,000 Accumulated depreciation (12,000) Book value of equipment sold 13,000 Gain on sale of equipment 5,000 Amount of cash received in exchange for equipment $18,000 2 Computation of cash paid for equipment: Cost of new equipment $50,000 Less: amount paid with note payable (30,000) Cash paid for equipment $20,

5 E17-6. Cash flows from investing and financing activities (AICPA adapted) Requirement 1: Cash flow from investing activities: Sale of equipment $ 10,000 Purchase of A.S., Inc., bonds (180,000) Net cash used in investing activities ($170,000) Requirement 2: Cash flow from financing activities: Dividends paid ($38,000) Proceeds from sale of treasury stock 75,000 Net cash provided by financing activities $37,000 E17-7. Cash flows from investing activities (AICPA adapted) Purchase of stock in Maybel ($26,000) Sale of investment in Rate Motors 35,000 Purchase of 4-year certificate of deposit (50,000) Net cash used in investing activities ($41,000) E17-8. Cash flows from investing and financing activities (AICPA adapted) Requirement 1: Cash flows from investing activities: Sale of investment $500,000 Purchase of equipment (125,000) Purchase of real estate (550,000) Net cash used in investing activities ($175,000) Requirement 2: Cash flows from financing activities: Dividends paid ($600,000) Issue of common stock 250,000 Bank loan for real estate purchase 550,000 Paid toward bank loan (450,000) Net cash used in financing activities ($250,000) 17-5

6 E17-9. Determining operating cash flows (AICPA adapted) Net Income $150,000 Increase in investment in Videogold, Inc. (5,500) Increase in deferred income tax liability 1,800 Decrease in premium on bonds payable (1,400) Net cash provided by operating activities $144,900 E Determining operating, investing, and financing cash flows (AICPA adapted) Requirement 1: Net cash provided by operating activities: Net income $790,000 Gain on sale of long-term investment (35,000) Increase in inventory (80,000) Depreciation expense 250,000 Decrease in accounts payable and accrued liabilities (5,000) Net cash provided by operating activities $920,000 Requirement 2: Net cash used in investing activities: Purchase of short-term investments ($ 300,000) Sale of long-term investments 135,000 Sale of plant assets 350,000 Purchase of plant assets (see T-account which follows) (1,190,000) Net cash used in investing activities ($1,005,000) Plant Assets Cost of equipment acquired $110,000 $600,000 Cost of building sold Cost of plant assets purchased X Net increase $700,000 $110,000 + X - $600,000 = $700,000 X = $1,190,

7 Requirement 3: Net cash provided by financing activities: Payment of dividends ($500,000 - $160,000) ($340,000) Issuance of short-term debt 325,000 Issuance of common stock (10,000 $22) 220,000 Net cash provided by financing activities $205,000 Check : (Not required) Cash provided by operating activities $920,000 Cash used in investing activities (1,005,000) Cash provided by financing activities 205,000 Increase in cash and cash equivalents $120,

8 Financial Reporting & Analysis Chapter 17 Solutions Statement of Cash Flows Problems Problems P17-1. Determining cash provided (used) by operating, investing and financing activities (AICPA adapted) Requirement 1: Cash flows provided by operating activities: Net Income $690,000 Increase in inventory ($80,000) Increase in accounts payable 105,000 Gain on sale of investment 1 (35,000) Goodwill amortization 2 10,000 Depreciation expense 3 250, ,000 Cash flows from operations $940,000 1 Gain on sale of investment is determined as follows: Proceeds from sale of investments (given) $135,000 Less: Book value of investment sold ($300,000 - $200,000) (100,000 ) Gain on sale of investment $ 35,000 2 Goodwill amortized is equal to change in the goodwill account for the year = $100,000 - $90,000 = $10,000 3 Depreciation expense recorded in year 2001 is determined from an analysis of the accumulated depreciation T-account. 17-8

9 Accumulated Depreciation $450,000 Beginning balance Accumulated depreciation X Depreciation expense for year on equipment sold* $250,000 $450,000 Ending balance *Cost of equipment sold = $400,000 Less: Carrying value (150,000) Accumulated depreciation $250,000 Solving for depreciation expense amount X in T-account $450,000 + X - $250,000 = $450,000 X = $250,000 = Depreciation expense for year 2001 Requirement 2: Cash flows used in investing activities: Sale of equipment $ 150,000 Sale of long-term investment 135,000 Purchase of plant assets 4 (1,100,000) Purchase of short-term investments (300,000) Cash outflows from investing activities ($1,115,000) 4 Cash payments for plant assets is obtained from an analysis of the plant assets T-account: Plant Assets Beginning balance $1,000,000 $400,000 Cost of equipment sold Purchase of additional assets Ending balance $1,700,000 Solve for X: $1,000,000 + X - $400,000 = $1,700,000 X = $1,100,000 = Purchase of plant assets X 17-9

10 Requirement 3: Cash flows provided by financing activities: Dividends paid ($240,000) Sale of common stock 5 220,000 Short-term debt 325,000 Cash flows from financing activities $305, ,000 $22/sh. = $220,000 Proof : (Not required) Cash from operating activities $940,000 Cash used for investing activities (1,115,000) Cash from financing activities 305,000 Net increase in cash $130,

11 P17-2. Comparing direct and indirect methods of determining cash flows from operations (CMA adapted) Requirement 1: The statement of cash flows for Spoke Company, for the year ended May 31, 2001, using the direct method is presented below: Spoke Company Statement of Cash Flows For the Year Ended May 31, 2001 Cash Flows from Operating Activities: Cash received from customers 1 $1,235,250 Cash paid to suppliers 2 $664,000 to employees 3 276,850 for other expenses 4 10,150 for interest 5 73,000 for income taxes 6 43,000 1,067,000 Net cash provided by operating activities $168,250 Cash Flows from Investing Activities: Purchase of plant assets (40,000) Cash Flows from Financing Activities: Cash received from common stock issue $40,000 Cash paid for dividends (115,000) to retire bonds payable (30,000) Net cash used for financing activities (105,000) Net increase in cash 23,250 Cash, May 31, ,000 Cash, May 31, 2001 $ 43,250 Note 1: Schedule of noncash investing and financing activities. Issuance of common stock for plant assets $50,

12 Supporting calculations: 1 Collections from customers: Sales $1,255,250 Less: Increase in accounts receivable (20,000) Cash collected from customers $1,235,250 2 Cash paid to suppliers: Cost of merchandise sold $712,000 Less: Decrease in merchandise inventory (40,000) Increase in accounts payable (8,000) Cash paid to suppliers $664,000 3 Cash paid to employees: Salary expense $252,100 Add: Decrease in salaries payable 24,750 Cash paid to employees $276,850 4 Cash paid for other expenses: Other expense $8,150 Add: Increase in prepaid expenses 2,000 Cash paid for other expenses $10,150 5 Cash paid for interest: Interest expense $75,000 Less: Increase in interest payable (2,000) Cash paid for interest $73,000 6 Cash paid for income taxes: Income tax expense (given) $43,

13 Requirement 2: The calculation of the cash flow from operating activities for Spoke Company, for the year ended May 31, 2001, using the indirect method, follows: Spoke Company Statement of Cash Flows For the Year Ended May 31, 2001 Cash Flows from Operating Activities: Net income $140,000 Adjustments to reconcile net income to cash Provided from operations: Depreciation expense $25,000 Decrease in merchandise inventory 40,000 Increases in: Accounts payable 8,000 Interest payable 2,000 Accounts receivable (20,000) Prepaid expenses (2,000) Decrease in salaries payable (24,750) 28,250 Net cash provided by operating activities $168,250 Requirement 3: Both the direct method and the indirect method for reporting cash flows from operating activities are acceptable in preparing a statement of cash flows according to SFAS 95; however, the FASB encourages the use of the direct method. Under the direct method, the statement of cash flows reports the major classes of cash receipts and cash disbursements and discloses more information; this may be the statement s principal advantage. Under the indirect method, net income on the accrual basis is adjusted to the cash basis by adding or deducting noncash items included in net income, thereby providing a useful link between the statement of cash flows and the income statement and balance sheet

14 P17-3. Determining amounts reported on statement of cash flows (AICPA adapted) Requirement 1: Cash collections from customers can be determined by examining the accounts receivable T-account, shown below: Accounts Receivable Beginning balance $24,000 Sales 155,000 X Cash collections Ending balance $34,000 We can find the amount of cash collections from customers by solving for X. $24,000 + $155,000 - X = $34,000; X = $24,000 + $155,000 - $34,000; X = $145,000 Cash collections from customers would appear in cash flows from operating activities as $145,000. Requirement 2: Cash payments for purchase of property, plant, and equipment are calculated as follows: Property, Plant, & Equipment Beginning balance $247,000 $40,000 Sale of equipment Acquired from bond refinancing 20,000 Cash purchases X Ending balance $277,000 Solving for X: $247,000 + $20,000 + X - $40,000 = $277,000; X = $50,000 Purchases of PP&E would be classified as cash flows from investing activities

15 Requirement 3: Proceeds from sale of equipment can be found by first looking at the accumulated depreciation account: Depreciation on equipment sold Accumulated Depreciation $167,000 Beginning balance 33,000 Depreciation expense X $178,000 Ending balance By solving for X, we can find the depreciation on the equipment that was sold. $167,000 + $33,000 - X = $178,000; $167,000 + $33,000 - $178,000 = X X = $22,000 Since we know the accumulated depreciation on the equipment sold, we can determine its carrying value or book value as follows: Cost of equipment $40,000 Accumulated depreciation on equipment ( 22,000 ) Carrying value of equipment sold $18,000 Now that we know the carrying value of the equipment that was sold, we can determine the proceeds from sale of equipment. Carrying value (book value) of equipment sold $18,000 Gain on sale of equipment 13,000 Proceeds from sale of equipment $31,000 This amount would be classified as cash flows from investing activities

16 Requirement 4: To find dividends paid, we need to first determine dividends declared by analyzing retained earnings: Dividends declared Retained Earnings $91,000 Beginning balance 28,000 Net income X $104,000 Ending balance Solving for X, we get: $91,000 + $28,000 - X = $104,000 X = $91,000 + $28,000 - $104,000 X = $15,000 = dividends declared The amount of cash dividends paid can be determined by T-account analysis of dividends payable: Cash dividends paid Dividends Payable $5,000 Beginning balance 15,000 Dividends declared X $8,000 Ending balance Solving for X, we get: X = $5,000 + $15,000 - $8,000 X = $12,000 = Cash dividends paid $12,000 should be reported on the statement of cash flows as a financing activity

17 Requirement 5: Redemption of bonds payable can be found by using the bonds payable T-account: Redemption of bonds Bonds Payable $46,000 Beginning balance 20,000 Bonds issued in 2001 X $49,000 Ending balance Solve for X: $46,000 + $20,000 - X = $49,000; $46,000 + $20,000 - $49,000 = X X = $17,000 Redemption of bonds payable is $17,000 reported under cash flows from financing activities. P17-4. Determining amounts reported on statement of cash flows (AICPA adapted) Requirement 1: Cash collections from customers can be determined by examining the accounts receivable T-account below: Accounts Receivable Beginning balance $30,000 Sales 538,800 X Cash collections Ending balance $33,000 We can find cash collections from customers by solving for X. $30,000 + $538,800 - X = $33,000; $30,000 + $538,800 - $33,000 = X X = $535,800 Cash collections from customers are $535,

18 Requirement 2: To solve for cash paid for goods sold, we must first determine how much was purchased. We can do this by first looking at the inventory account to determine total purchases for the period: Inventory Beginning balance $47,000 Purchases X $250,000 Cost of goods sold Ending balance $31,000 To find purchases, solve for X. $47,000 + X - $250,000 = $31,000 X = $250,000 + $31,000 - $47,000 X = $234,000 Next, to find out how much cash was paid on accounts payable, we plug the purchases number into the accounts payable T-account and solve for cash payments on account: Cash paid Again, we can solve for X. $17,500 + $234,000 - X = $25,000 X = $17,500 + $234,000 - $25,000 X = $226,500 Accounts Payable $17,500 Beginning balance 234,000 Purchases X $25,000 Ending balance Cash paid for goods to be sold is $226,500. Requirement 3: We can determine cash paid for interest as follows: Interest expense (2001) $4,300 Less: Amortization of bond discount in 2001 (500 ) Cash paid for interest $3,

19 Requirement 4: Cash paid for income taxes: Income taxes paid Income Taxes Payable $27,100 Beginning balance 20,400 Income tax expense X $21,000 Ending balance Solving for X: $27,100 + $20,400 - X = $21,000 X = $27,100 + $20,400 - $21,000 X = $26,500 Next, we must take into account deferred income taxes. Ending balance $ 5,300 Beginning balance (4,600) Change in deferred income taxes payable $ 700 Income taxes paid $26,500 Change in deferred income taxes (700 ) Cash paid for income taxes $25,800 Requirement 5: Cash paid for selling expenses: One third of the depreciation expense has been allocated to selling expenses. This is a noncash expense and should be subtracted from selling expenses to find the answer. Selling expenses $141,500 Depreciation allocated to selling 1 (500) Cash paid for selling expenses $141,000 1 Depreciation expense calculated: Ending balance in accumulated depreciation $16,500 Beginning balance in accumulated depreciation (15,000) Depreciation expense for 2001 $ 1,500 One third allocated to selling expense $1,500/3 = $

20 P17-5. Preparation and analysis of cash flow statement Requirement 1: Statement of cash flows under indirect method: Global Trading Company Statement of Cash Flows For the Year Ended December 31, 2001 Cash flow from operations Net loss for the year ($279,500) + Depreciation expense 50,000 + Goodwill written off 70,000 + Decrease in net accounts receivable 240,000 + Decrease in inventory 170,000 + Decrease in prepaid insurance 20,000 + Increase in accounts payable 78,000 + Increase in salaries payable 6,000 Cash flow from operations $354,500 Cash flow from financing activities Repayment of bank loan ($307,500) Dividends paid 1 (35,000) Cash flow from financing activities ($342,500) Net increase in cash $ 12,000 1 Calculation of dividends Beginning retained earnings $320,000 - Net loss for the year (279,500) - Ending retained earnings (5,500) = Dividends paid $35,

21 Requirement 2: Assessment of financial performance of Global: Net loss for the year is an indication of poor operating performance. Positive cash flow may be misleading since cash flow does not do a good job of matching revenues and expenses. Goodwill written off is from an acquisition made last year indicating that the potential benefits from the acquisition have been exhausted. Decrease in accounts receivable coupled with a decrease in inventory is an indication of decreasing demand. A mere change in the collection policy cannot explain the reduction in inventory. Increase in accounts payable could indicate that the company is not paying off its suppliers because of the constraint on bank loan. The repayment of the bank loan probably is not voluntary but enforced by the debt covenants. Payment of dividends when the company is incurring substantial losses is not a sign of prudent financial management and drains the cash reserves of the company. Ratio of accumulated depreciation to property, plant, and equipment of 0.9 (last year was 0.8) implies that, on average, the life of the fixed assets is one year and the company needs to invest in these assets immediately

22 Requirement 3: Determination of bad debts written off can be obtained from T-account analysis of the allowance for doubtful accounts: Accounts written off Allowance for Doubtful Accounts $30,000 Beginning balance 55,000 Bad debt expense X $20,000 Ending balance Solve for X: $30,000 + $55,000 - X = $20,000 X = $65,000 = accounts written off in Determination of credit sales for the year can be obtained from T-account analysis of accounts receivable: Accounts Receivable Beginning balance $300,000 $65,000 Bad debts written off (see preceding page) Sales on account X 1,250,000 Collections on account Ending balance $50,000 Solve for X: $300,000 + X - $65,000 - $1,250,000 = $50,000 X = $1,065,000 = sales on account. Requirement 4: Effect of omission of inventory purchase: Income Statement No effect. (Purchases are understated, and ending inventory is understated by equal amounts. Thus, net effect on income is zero.) Statement of Cash Flows No effect. (Purchase was on account for credit.) Balance Sheet The balance sheet balances, but the year-end amounts for both accounts payable and inventory are understated by $35,

23 P17-6. Preparation of cash flow statement and balance sheet Requirement 1: Statement of cash flows under the direct method: JKI Advertising Agencies Statement of Cash Flows for the Year Ended 12/31/01 Direct Method Operating Activities: Cash collected from clients $215,000 Rent collected 50,000 Salaries paid (130,000) Cash paid for insurance (12,000) Cash paid for interest (9,000) Cash paid for customer lawsuit (32,000) Cash paid for taxes (31,000) Cash flows from operations $_51,000 Investing Activities: Proceeds from sale of land $150,000 Purchase of office equipment (20, 000 ) Cash flows from investing activities $130,000 Financing Activities: Borrowing from TownBank $50,000 Repayment of building loan (85,000) Issuance of capital stock 35,000 Dividends declared & paid (18,000) Cash flow from financing activities ($18,000) Increase in cash for the year $163,

24 Requirement 2: December 31, 2000 balance sheet The figures for the 12/31/00 balance sheet can be attained by T-account analysis of the relevant accounts: Accounts Receivable Balance as of 12/31/00 X Advertising revenue $250,000 $215,000 Cash collected from clients Balance as of 12/31/01 $80,000 Solve for X: $80,000 = X + $250,000 - $215,000 X = $45,000 Prepaid Insurance Balance as of 12/31/00 X Cash paid for insurance $12,000 $12,000 Insurance expense Balance as of 12/31/01 $3,000 Solve for X: $3,000 = X + $12,000 - $12,000 X = $3,000 Balance as of 12/31/00 Balance as of 12/31/01 $0 X Land $150,000 Sale of land (cash received = book value) Solve for X: $0 = X - $150,000 X = $150,

25 Solve for X: X = $380,000 - $20,000 X = $360,000 Accumulated Depreciation Building X Balance as of 12/31/00 $20,000 Depreciation expense - building $380,000 Balance as of 12/31/01 Office Equipment Balance as of 12/31/00 X Purchase of office equipment $20,000 Balance as of 12/31/01 $80,000 Solve for X: X = $80,000 - $20,000 X = $60,000 Solve for X: X = $39,000 - $8,000 X = $31,000 Accumulated Depreciation Office Equipment X Balance as of 12/31/00 $8,000 Depreciation expense office equipment $39,000 Balance as of 12/31/01 Salaries Payable X Balance as of 12/31/00 Salaries paid $130,000 $126,000 Salaries expense $7,000 Balance as of 12/31/01 Solve for X: X = $130,000 - $126,000 + $7,000 X = $11,

26 Interest Payable X Balance as of 12/31/00 Cash paid for interest $9,000 $10,000 Interest expense $3,500 Balance as of 12/31/01 Solve for X: X + $10,000 - $9,000 = $3,500 X = $2,500 Liability for Customer Lawsuit X Balance as of 12/31/00 Cash paid for customer lawsuit $32,000 $0 Balance as of 12/31/01 Solve for X: X - $32,000 = 0 X = $32,000 Rent Received in Advance X Balance as of 12/31/00 Rent revenue $36,000 $50,000 Rent collected $14,000 Balance as of 12/31/01 Solve for X: X = $50,000 - $36,000 - $14,000 X = $0 Solve for X: X + $25,200 = $25,200 X = $0 Bonus Payable X Balance as of 12/31/00 $25,200 Employee incentive bonus $25,200 Balance as of 12/31/01 Taxes Payable X Balance as of 12/31/00 Cash paid for taxes $31,000 $33,920 Income tax expense $2,920 Balance as of 12/31/01 Solve for X: $2,920 = X + $33,920 - $31,000 X = $

27 Solve for X: X + $50,000 = $50,000 X = $0 Borrowing from TownBank X Balance as of 12/31/00 $50,000 Borrowing from TownBank $50,000 Balance as of 12/31/01 Building Loan X Balance as of 12/31/00 Repayment of building loan $85,000 $35,000 Balance as of 12/31/01 Solve for X: $35,000 = X - $85,000 X = $120,000 Solve for X: $135,000 = X + $35,000 X = $100,000 Capital Stock X Balance as of 12/31/00 $35,000 Issuance of capital stock $135,000 Balance as of 12/31/01 Retained Earnings X Balance as of 12/31/00 Dividends declared & paid $18,000 $50,880 Net income $264,380 Balance as of 12/31/01 Solve for X: $264,380 = X + $50,880 - $18,000 X = $231,

28 JKI Advertising Agencies Balance Sheet as of 12/31/ Cash $ 30,000 Accounts receivable 45,000 Prepaid insurance 3,000 Land 150,000 Building 600,000 Less: Accumulated depreciation (360,000) Office equipment 60,000 Less: Accumulated depreciation (31,000) Total assets $497,000 Salaries payable $ 11,000 Interest payable 2,500 Liability for customer lawsuit 32,000 Rent received in advance Bonus payable Taxes payable Borrowing from TownBank Building loan 120,000 Capital stock 100,000 Retained earnings 231,500 Total of liabilities and equities $497,

29 Requirement 3: Operating section of cash flow statement under indirect approach: JKI Advertising Agencies Statement of Cash Flows for the Year Ended 12/31/01 Net income $50,880 + Depreciation expense building 20,000 + Depreciation expense office equipment 8,000 - Increase in accounts receivable (35,000) - Decrease in salaries payable (4,000) + Increase in interest payable 1,000 - Decrease in liability for customer lawsuit (32,000) + Increase in rent received in advance 14,000 + Increase in bonus payable 25,200 + Increase in taxes payable 2,920 Cash flow from operations $51,000 Requirement 4: Evaluation of statements: a) Depreciation is a noncash charge, and therefore, by adding depreciation to net income we, in effect, eliminate this noncash item from the net income figure. b) Note that while depreciation expense is subtracted in determining net income, the cost of long-lived assets is not subtracted from the cash flow from operations. Consequently, net income over the entire life of a company would be equal to the sum of cash flow from operations and cash flow from investing. Requirement 5: Effect of revised bonus formula on operating cash flows: Cash flow from operations for the year 2001 would remain unchanged since this is merely an accrual entry (i.e., liability increases and retained earnings decreases). However, when the incentive bonus is paid in cash, say, in 2002, it will show up as operating outflow

30 The operating section of the cash flow statement under the indirect approach demonstrates the main point. The three italicized items change when the incentive bonus is increased from 20% to 25%. However, because this is an accrual entry, the net effect of these three on the cash flow from operations is zero. Since the net income is different and since it is the beginning point for calculating the cash flow from operations, it might be tempting to say that the cash flow from operations will be lower. JKI Advertising Agencies Statement of Cash Flows for the Year Ended 12/31/01 Net income (see below) $47,100 + Depreciation expense building 20,000 + Depreciation expense office equipment 8,000 - Increase in accounts receivable (35,000) - Decrease in salaries payable (4,000) + Increase in interest payable 1,000 - Decrease in liability for customer lawsuit (32,000) + Increase in rent received in advance 14,000 + Increase in bonus payable (see below) 31,500 + Increase in taxes payable (see below) 400 Cash flow from operations $51,000 Supporting computations for revised cash flow statement: Revised bonus expense (.25 x 126,000) = $31,500 Previous bonus expense 25,200 Before-tax increase in bonus expense $ 6,300 Times (1 -.4) 1.6 After-tax decrease to net income $ 3,780 Previous net income 50,880 Revised net income $47,100 1 Tax rate is Income tax expense / Income before taxes = $33,920 / $84,800 = 40% 17-30

31 T-account to support change in taxes payable: Taxes Payable 0 Balance as of 12/31/00 Cash paid for taxes $31,000 $31,400 Income tax expense $400 Balance as of 12/31/01 Revised tax expense: Before-tax increase in bonus expense $ 6,300 Times tax savings.4 Decrease in income tax expense $ 2,520 Previous income tax expense 33,920 Revised income tax expense $31,400 P17-7. Reconciliation of changes in balance sheet accounts with amounts reported in cash flows statement Requirement 1: Reconciling changes in accounts receivable reported on the cash flow statement with change in receivables shown on the balance sheet: Briggs & Stratton Corp. For Briggs & Stratton, the decrease in receivables of $2,384,000 reported in the Year 2 cash flow statement is equal to the change in the net receivables as reported in the balance sheet ($122,597,000 - $124,981,000). Ramsay Health Care, Inc. Here, the decrease in receivables of $3,677,000 from the balance sheet (i.e., $23,019,000 $26,696,000) is different from the increase in the patient accounts receivables of $2,169,000 reported in the cash flow statement. Learning Objective The purpose of this exercise is to present the two different reporting practices commonly adopted by companies and illustrate how both approaches lead to the same cash flow numbers

32 Requirement 2: Explanation of different reporting practices with respect to receivables: It is instructive to discuss initially the mechanics of converting sales or service revenue to cash collected from customers. We reconstruct the T- accounts of Ramsay Health Care to figure out the cash collected from customers. Although one can arbitrarily choose any sales number to get the intuition, let us pick the actual Year 2 revenue of $137,002,000 (not provided in the problem). We first need to calculate the amount of receivables written off during the year from an analysis of the "Allowance for doubtful accounts" T-account. Bad debts written off Allowance for Doubtful Accounts $4,955,000 Beginning balance 5,846,000 Provision for bad debts X $3,925,000 Ending balance Solve for X: $4,955,000 + $5,846,000 - X = $3,925,000 X = $6,876,000 Plugging this number into the "Patient accounts receivable" account allows us to solve for cash collected: Patient Accounts Receivable Beginning balance $31,651,000 Revenue 137,002,000 $6,876,000 Bad debts written off (from previous page) X Cash collected Ending balance $26,944,000 Solve for X: $31,651,000 + $137,002,000 - $6,876,000 - X = $26,944,000 X = $134,833,000 The figure for cash collected can be determined using either one of the two reporting practices. For instance, if Ramsay had followed Briggs & Stratton s reporting practice, the adjustment for change in receivables would be as follows: 17-32

33 Ramsay Health Care, Inc., and Subsidiaries Using Briggs & Stratton s Reporting Strategy Revenue $137,002,000 - Provision for doubtful accounts (5,846,000) + Decrease in Net A/R 3,677,000 Cash collected from customers $134,833,000 Obviously, revenue less the provision for doubtful accounts is already reflected in the net income figure. It is important to understand that the net accounts receivable balance (gross A/R minus allowance for doubtful accounts) is affected by revenue as well as provision for doubtful accounts. Consequently, to figure out the cash collected from customers, we should jointly consider revenue, provision for doubtful accounts and change in receivables. The intuition behind the above table can be clarified by examining the reporting practice adopted by Ramsay Health Care, which follows. Ramsay Health Care, Inc. and Subsidiaries Revenue $137,002,000 - Provision for doubtful accounts (5,846,000) Adjustments to reconcile net income to cash flows + Provision for doubtful accounts 5,846,000 + Decrease in gross A/R* $4,707,000 - Bad debts written off* (6,876,000 ) - Decrease in patient accounts receivable (2,169,000 ) Cash collected from customers $134,833,000 Note: The two * items were not separately reported by Ramsay Health Care. Instead, it reported the sum of the two items, i.e., ($2,169,000) = $4,707,000 - $6,876,

34 Under this reporting practice, firms first add back the provision for doubtful accounts which, in essence, eliminates the noncash accrual expense. The remainder of the adjustments (revenue + decrease in gross accounts receivable - bad debts written off) represent all the items in the T-account for patient accounts receivable (i.e., gross accounts receivable) except for cash collected from customers which is being solved. Another way to provide the intuition is to focus on the two possible reasons for the decrease (in this example) in accounts receivable, i.e., (1) cash collections and (2) bad debts written off. By adding the decrease in gross accounts receivable, we attribute the entire decrease to cash collections. However, by subtracting the bad debts written off, we adjust for any decreases in accounts receivable that merely represent bad debts

35 P17-8. Preparation of cash flow statement indirect method (AICPA adapted) Cash flow for 2001 using the indirect method: Bergen Corporation Statement of Cash Flows For the Year Ended December 31, 2001 Operating Activities: Net income $253,000 Adjustments for noncash items: +Depreciation 149,000 - Amortization of bond premium (2,000) +Increase in deferred income taxes payable 15,000 - Gain on sale of securities (20,000) - Gain on sale of equipment (5,000) - Increase in accounts receivable, net (90,000) - Increase in inventories (115,000) - Decrease in accounts payable and accrued expenses (63,000) Net cash flow provided by operations 122,000 Investing Activities: Sale of securities 95,000 Sale of equipment 33,000 Purchase of equipment (392,000) Net cash outflow from investing activities (264,000) Financing Activities: Proceeds from long-term note payable 450,000 Cash dividends (30,000) Payment of tax assessment from prior period (20,000) Payment under capital lease (25,000) Net cash flow provided by financing activities 375,000 Net increase in cash 233,000 Beginning balance in cash 308,000 Ending balance in cash $541,

36 P17-9. Preparing an income statement from statement of cash flows and comparative balance sheets Kang-Iyer Financial Consultants Statement of Cash Flows for the Year Ended 12/31/01 Cash Flow from Operations: Cash collected from customers $250,000 Cash paid to employees (70,000) Cash paid for interest (50,000) Cash flow from operations $130,000 Cash Flow from Investing: Land purchased ($200,000) Building acquired (500,000) Cash flow from investing ($700,000) Cash Flow from Financing: Dividends paid ($ 15,000) Additional borrowings from village bank 500,000 Proceeds from share issue (capital contributions) 45,000 Cash flow from financing $530,000 Change in cash ($ 40,000) Beginning cash balance 70,000 Ending cash balance $ 30,

37 Kang-Iyer Financial Consultants Income Statement for the Year Ended 12/31/01 Consulting revenue $356,500 Less: Expenses Depreciation building $10,000 Salaries expense 150,000 Interest expense 65,000 Bad debts expense 48,000 Rent expense 30, ,000 Net income $ 53,500 Accounts Receivable Beginning balance $15,000 Consulting revenue X $41,500 Bad debts written off 250,000 Cash collected Ending balance $80,000 Solve for X: $80,000 = $15,000 + X - $41,500 - $250,000 X = $356,500 Allowance for Doubtful Accounts $1,500 Beginning balance Bad debts written off $41,500 X Provision for doubtful accounts $8,000 Ending balance Solve for X: $8,000 = $1,500 + X - $41,500 X = $48,

38 Salaries Payable $20,000 Beginning balance Cash paid $70,000 X Salaries expense $100,000 Ending balance Solve for X: $100,000 = $20,000 + X - $70,000 X = $150,000 Interest Payable $5,000 Beginning balance Cash paid $50,000 X Interest expense $20,000 Ending balance Solve for X: $20,000 = $5,000 + X - $50,000 X = $65,000 Prepaid Rent Beginning balance $30,000 X Cash paid 0 Ending balance $0 Rent expense Solve for X: $0 = $30,000 + $0 - X X = $30,000 Solve for X: $10,000 = $0 + X X = $10,000 Accumulated Depreciation Building $0 Beginning balance X Depreciation expense $10,000 Ending balance 17-38

39 P Determining components of cash flow statement (AICPA adapted) Requirements 1 3: Cash provided by operating, investing, and financing activities: Best Corporation Statement of Cash Flows For the Year Ended December 31, 2001 Cash Flow from Operating Activities: Net income $700,000 Add (Subtract): Depreciation expense $130,000 Increase in accounts receivable (280,000) Increase in inventory (290,000) Increase in accounts payable 390,000 Increase in accrued expenses 170,000 Loss on sale of fixtures 10, ,000 Cash provided by operating activities 830,000 Cash Flow from Investing Activities: Sale of fixtures 20,000 Purchase of fixtures (630,000) Cash used in investing activities (610,000) Cash Flow from Financing Activities: Issuance of common stock 125,000 Cash paid for dividends 1 (85,000) Cash provided by financing activities 40,000 Net change in cash balance $260,000 1 Dividends declared $125,000 - Increase in dividends payable (40,000) Cash dividends paid $ 85,

40 Fair market value of Best Corporation s common stock. The debit to retained earnings for the fair market value of the stock dividend can be found by an analysis of the retained earnings T-account: Retained Earnings $330,000 Beginning balance Dividends declared $125, ,000 Net income Stock dividend X $630,000 Ending balance Solve for X: $630,000 = $330,000 + $700,000 - $125,000 - X X = $275,000 = fair market value of stock dividend On a per-share basis, Best s common stock has a value of $275,000/20,000 shares = $

41 P Analysis of statement of cash flows Requirement 1: Statement of cash flows for the year ended : Cavalier Toy Stores Statement of Cash Flows For the Year Ended December 31, 2001 Cash Flow from Operating Activities: Net loss ($250,000) Add: Depreciation expense $75,000 Decrease in accounts receivable 405,000 Decrease in prepaid insurance 30,000 Decrease in inventory 500,000 Increase in salaries payable 20,000 Increase in accounts payable 188,000 1,218,000 Less: Decrease in interest payable (8,000) Cash flow from operating activities $960,000 Cash Flow from Investing Activities: Purchase of building (900,000) Cash flow from investing activities ($900,000) Cash Flow from Financing Activities: Loan from Thrifty Bank 140,000 Dividends (300,000) Decrease in dividends payable (50,000) Cash paid for dividends ($350,000) Cash flow from financing activities ($210,000) Net change in cash balance ($150,000 ) 17-41

42 Requirement 2: (a) Bad debts written off during the year: Beginning balance in allowance for doubtful accounts $ 30,000 Add: Bad debt expense 100,000 Less: Ending balance in allowance for doubtful accounts (10,000) Bad debts written off during the year $ 120,000 (b) Cash collected from customers: Beginning balance in accounts receivable $ 525,000 Add: Credit sales 1,500,000 Less: Bad debts written off (120,000) Less: Ending balance in accounts receivable (100,000) Cash collected from customers $1,805,000 (c) Purchases made during the year: Beginning inventory $550,000 Add: Purchases? Less: Ending inventory (50,000) Cost of goods sold 1,200,000 Purchases $700,000 (d) Cash paid to the suppliers for purchases of inventory: Beginning balance in accounts payable $ 64,000 Purchases 700,000 Less: Ending balance in accounts payable (252,000) Cash paid for inventory purchases $512,000 (e) Cash paid for insurance: Beginning balance in prepaid insurance $35,000 Add: Cash paid for insurance? Less: Ending balance in prepaid insurance (5,000) Insurance expense 30,000 Cash paid for insurance $

43 Requirement 3: Thrifty Bank should be concerned about renewing the loan or increasing the credit limit for the following reasons: (a) Depletion of accounts receivable and inventory and increase in accounts payable to boost cash flow from operations this cannot be done every year to increase cash flow from operations. (b) Use of working capital (accounts receivable and inventory and increase in accounts payable) to finance building a nonproductive asset (c) Very large dividend in a loss year. (d) Decreasing gross margins (from letter) from competitive pressures. (e) Net loss

44 P Preparation of cash flow statement (AICPA adapted) Farrell Corporation Statement of Cash Flows For the Year Ended December 31, 2001 Operating Activities: Net income $141,000 Add (Deduct): Depreciation $53,000 Amortization of goodwill 4,000 Loss on sale of equipment 5,000 Equity in net income of Hall, Inc. (13,000) Increase in deferred income tax payable 11,000 Decrease in accounts receivable 10,000 Increase in inventories (118,000) Increase in accounts payable and accrued expenses 41,000 (7,000) Net cash provided by operating activities 134,000 Investing Activities: Sale of equipment 19,000 Purchase of equipment (63,000) Net cash provided from investing activities (44,000) Financing Activities: Sale of common stock 23,000 Sale of treasury stock 25,000 Cash dividends paid (43,000) Net cash provided by financing activities 5,000 Simultaneous Financing and Investing Activity Not Affecting Cash: Purchase of land with long-term note 150,000 Net increase in cash $ 95,000 Beginning balance in cash account 180,000 Ending balance in cash account $275,

45 P Statement of cash flows indirect method (AICPA adapted) Omega Corporation Statement of Cash Flows For the Year Ended December 31, 2001 Cash Flow from Operating Activities: Net income $360,000 Adjustments to reconcile net income to cash provided by operating activities: Depreciation 1 $150,000 Gain on sale of equipment 2 (5,000) Undistributed earnings of Belle Co. 3 (30,000) Changes in assets and liabilities: Decrease in accounts receivable 40,000 Increase in inventories (135,000) Increase in accounts payable 60,000 Decrease in income taxes payable (20,000) 60,000 Net cash provided by operating activities 420,000 Cash Flows from Investing Activities: Proceeds from sale of equipment 40,000 Loan to Chase Co. (300,000) Principal payment of loan receivable 30,000 Net cash used in investing activities (230,000) Cash Flows from Financing Activities: Dividends paid (90,000 ) Net cash used in financing activities (90,000 ) Net increase in cash $100,000 Cash at beginning of year 700,000 Cash at end of year $800,

46 1 Depreciation Net increase in accumulated depreciation for the year ended December 31, 2001 $125,000 Accumulated depreciation on equipment sold: Cost $60,000 Carrying value (35,000) 25,000 Depreciation for 2001 $150,000 2 Gain on sale of equipment Proceeds $40,000 Carrying value 35,000 Gain $ 5,000 3 Undistributed earnings of Belle Co. Belle s net income for 2001 $120,000 Omega s ownership 25% Undistributed earnings of Belle Co. $ 30,

47 Financial Reporting & Analysis Chapter 17 Solutions Statement of Cash Flows Cases Cases C17-1. Q-Mart Retail Stores, Inc. (KR): Analysis of statement of cash flow Requirement 1: Q-Mart Retail Stores, Inc. Statement of Cash Flows for the Year Ended 12/31/01 Cash Flow from Operating Activities: Net income $ 81,250 + Depreciation expense building 25,000 + Depreciation expense computer 35,000 - Increase in net accounts receivable (361,000) - Increase in inventory (275,000) - Increase in prepaid insurance (20,000) - Decrease in salaries payable (32,000) - Decrease in accounts payable (5,000) + Increase in income tax currently payable 7,000 Cash flow from operations ($544,750) Cash Flow from Investing Activities: Additions to building ($250,000) Purchase of computer equipment (140,000) Cash flow from investing activities ($390,000) Cash Flow from Financing Activities: Borrowing from Upstate Bank $200,000 Proceeds from stock issuance 390,000 Dividends paid (40,000) 1 Cash flow from financing activities $550,000 Change in cash balance (384,750) + Beginning cash balance 504,750 Ending cash balance $120,

48 1 Calculation of dividends: Beginning balance of retained earnings $341,750 Add: Net income 81,250 Less: Ending balance of retained earnings -383,000 Dividends paid $ 40,000 Requirement 2: Bad debts written off = beginning balance of allowance for doubtful accounts + bad debts expense - ending balance of allowance for doubtful accounts = $11,000 + $50,000 - $50,000 = $11,000 Requirement 3: Cash collected = beginning balance of accounts receivable + sales - bad debts written off (from above) - ending balance in accounts receivable = $100,000 + $1,500,000 - $11,000 - $500,000 = $1,089,000 Requirement 4: Purchases of inventory = ending balance of inventory + cost of goods sold - beginning balance of inventory = $350,000 + $1,050,000 - $75,000 = $1,325,000 Requirement 5: Cash paid = beginning balance of accounts payable + purchases (from above) - ending balance of accounts payable = $17,000 + $1,325,000 - $12,000 = $1,330,000 Requirement 6: Cash flow from operations is the main reason for the decline. The increase in accounts receivable is a good signal if it is commensurate with growth in sales. On the other hand, it could suggest collection problems as well as inadequate provision for doubtful accounts. There is also an increase in inventory. This could be positive news if the buildup is in anticipation of demand. Again, this could be negative if the obsolete items have not been written down. The investment in property, plant, and equipment is financed by loan and equity

49 Additional information required: What is the sales increase over last year? By how much have the purchases increased over the last year? Why haven t the suppliers extended credit with the rise in purchases? What is the change in net income over last year? Requirement 7: If the sales had been stopped, the net income would be lowered, and, therefore, the cash flow from operations would decline ultimately. What is necessary is to reduce the average collection period for accounts receivable and speed up the collection process. Requirement 8: Depreciation is a noncash item and is added back to the net income. Therefore, even if higher depreciation had been provided, the amount that is added to the net income would have been originally subtracted from revenues to determine net income and, consequently, would not affect the cash flow. Requirement 9: Matching is an important feature of accrual accounting that is lacking in the cash flow statements. However, accruals are subject to greater managerial discretion. See answer to reasons for decline as an example of jointly analyzing the two statements

50 C17-2. Vulcan Corporation: Understanding cash flow statements Requirement 1: Vulcan s net income can be determined by adding the unrealized loss on investments to total comprehensive income reported for the year ended October 31, Vulcan Corporation Computation of Net Income Year Ended October 31, 2000 ($ in thousands) Comprehensive income as reported $ 336 Plus: Unrealized loss on investments classified as available-for-sale 286 Net income $

51 Requirement 2: In order to prepare Vulcan s income statement at October 31, 2000, the following items must be determined: sales, cost of goods sold, depreciation expense, general & administrative expense, interest expense and tax expense. These items can readily be determined from the information provided (see below Calculation of revenues and expenses). Vulcan Corporation Statement of Income and Comprehensive Income Year Ended ($ in thousands) Net sales October 31, 2000 $ 40,455 Cost of goods sold 28,598 Gross profit 11,857 General and administrative expense 8,690 Depreciation expense 1,322 Operating income 1,845 Interest expense 888 Income before income taxes 957 Income tax expense 335 Net income 622 Other comprehensive loss Unrealized loss on investments classified as available-for-sale (286) Comprehensive income $

52 Calculation of income statement revenues and expenses: Note all amounts are in thousands Sales Cash collected from customers $ 37,378 Plus increase in accounts receivable 3,077 Net sales $ 40,455 Cost of goods sold Cash paid to suppliers $ 26,884 Plus decrease in inventories 333 Plus increase in accounts payable 1,381 Cost of goods sold $ 28,598 General and administrative expense Cash paid for general and administrative expense $ 8,002 Plus increase in accrued general and administrative expense 688 General and administrative expense $ 8,690 Depreciation expense Plant, property & equipment at October 31, 2000 $ 10,707 Plant, property & equipment (PP&E) at October 31, ,523 Decrease in PP&E (816) Decrease in PP&E comprised of Equipment purchases 854 Equipment retirements at net book value (348) Depreciation expense (plug number) (1,322) Decrease in PP&E $ (816) Interest expense Cash paid for interest expense $ 810 Plus increase in interest payable 78 Interest expense $ 888 Income tax expense Cash paid for income taxes $ 74 Plus increase in deferred taxes 261 Income tax expense $

53 Requirement 3: Vulcan s net cash provided by operating activities, using the indirect method, would be $1,608,000. Vulcan Corporation Cash Flow From Operating Activities Year Ended October 31, 2000 ($ in thousands) Net income $ 622 Adjustments to net income: Depreciation $ 1,322 Deferred taxes 261 1,583 2,205 Changes in current assets and liabilities: Increase in accounts receivable (3,077) Decrease in inventories 333 Increase in accounts payable 1,381 Increase in interest payable 78 Increase in accrued general and administrative expense 688 (597) Net cash provided by operating activities $ 1,

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