Financial Reporting & Analysis

Chapter 16 Solutions
Statement of Cash Flows
Exercises

Exercises
E16-1.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
payable (10,000)
Increase in inventory (21,000)
Increase in accounts receivable (15,000)
Decrease in accounts payable (2,000)
(48,000)
Cash flow from operations $280,000
E16-2.Determining cash flows from operations
(AICPA adapted)

Lino’s net cash from operating activities is calculated below:

Net income $150,000

Increase in accounts receivable1 (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

E16-31. 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) $17,500

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)

713
 + 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 right off of uncollectable accounts receivable)
E16-41.Analysis of changes in balance sheet accounts
(AICPA adapted)

Requirement 1:
Determining depreciation on machinery for 1999:

Step 1: Determine the amount of accumulated depreciation on equipment sold

during 1999:

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
$102,000 Beginning balance
Accumulated depreciation on $10,000 ? Depreciation expense for the year
equipment sold (see above)
$120,000 Ending balance

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

714
 Ending balance $320,000

The T-account can by analyzed to determine that 1999 machinery purchases

totaled $110,000.

715
E16-5.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 equipment1 $18,000

Purchase of equipment2 (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 $20,000

E16-6.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
716
717
E16-7.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)

E16-8.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)

E16-9.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

718
E16-10.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 = $1,190,000

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 $120,000

719
 Financial Reporting & Analysis
Chapter 16 Solutions
Statement of Cash Flows
Problems

Problems
P16-1.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 investment1 (35,000)
Goodwill amortization2 10,000
Depreciation expense3 250,000
$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 2000 is determined from an analysis of the
accumulated depreciation T-account.

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

720
Solving for depreciation expense amount X in T-account
$450,000 + X - $250,000 = $450,000
X = $250,000 = Depreciation expense for year 2000

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 X
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

Requirement 3:
Cash flows provided by financing activities:

Dividends paid ($240,000)

Sale of common stock5 220,000
Short-term debt 325,000
Cash flows from financing activities $305,000
5
10,000 shares @ $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 $130,000

721
P16-2.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, 1998, using the direct method is presented below:

Spoke Company
Statement of Cash Flows
For the Year Ended May 31, 1998

Cash Flows from Operating Activities:

Cash received from customers1 $1,235,250
Cash paid
to suppliers2 $664,000
to employees3 276,850
for other expenses4 10,150
for interest5 73,000
for income taxes6 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, 1997 20,000
Cash, May 31, 1998 $43,250

Note 1: Schedule of noncash investing and financing activities.

Issuance of common stock for plant assets $50,000

722
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) $43,000

Requirement 2:
The calculation of the cash flow from operating activities for Spoke Company,
for the year ended May 31, 1998, using the indirect method, follows:

Spoke Company
Statement of Cash Flows
For the Year Ended May 31, 1998

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

723
 Accounts receivable (20,000)
Prepaid expenses (2,000)
Decrease in salaries payable (24,750) 28,250
Net cash provided by operating activities $168,250

724
 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.

P16-3.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

725
Purchases of PP&E would be classified as cash flows from investing activities.
Requirement 3:
Proceeds from sale of equipment can be found by first looking at the accumulated
depreciation account:
Accumulated Depreciation
$167,000 Beginning balance
33,000 Depreciation expense
Depreciation on equipment sold 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.

Requirement 4:
To find dividends paid, we need to first determine dividends declared by analyzing
retained earnings:
Retained Earnings
$91,000 Beginning balance
28,000 Net income
Dividends declared X
$104,000 Ending balance

Solving for X, we get:

$91,000 + $28,000 - X = $104,000
X = $91,000 + $28,000 - $104,000
726
X = $15,000 = dividends declared

The amount of cash dividends paid can be determined by T-account analysis of

dividends payable:
Dividends Payable
$5,000 Beginning balance
15,000 Dividends declared
Cash dividends paid 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.

Requirement 5:
Redemption of bonds payable can be found by using the bonds payable
T-account:
Bonds Payable
$46,000 Beginning balance
20,000 Bonds issued in 1998
Redemption of bonds 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.

727
P16-4.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 $535,800.

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

728
 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:

Accounts Payable
$17,500 Beginning balance
234,000 Purchases
Cash paid X
$25,000 Ending balance

Again, we can solve for X.

$17,500 + $234,000 - X = $25,000

X = $17,500 + $234,000 - $25,000
X = $226,500

Cash paid for goods to be sold is $226,500.

Requirement 3:
We can determine cash paid for interest as follows:

Interest expense (1998) $4,300

Less: Amortization of bond discount in 1998 (500)
Cash paid for interest $3,800

Requirement 4:
Cash paid for income taxes:

Income Taxes Payable

$27,100 Beginning balance
20,400 Income tax expense
Income taxes paid 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

729
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 selling1 (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 1998 $1,500

One third allocated to selling expense $1,500/3 = $500

730
P16-5.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, 1996

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 paid1 (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 $35,000

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.

731
∑ 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.

Requirement 3:
Determination of bad debts written off can be obtained from T-account analysis
of the allowance for doubtful accounts:
Allowance for Doubtful Accounts
$30,000 Beginning balance
55,000 Bad debt expense
Accounts written off X
$20,000 Ending balance

Solve for X:
+ $55,000 - X = $20,000
X = $65,000 = accounts written off in 1996.

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:
732
 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 $35,000.

P16-6.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 12/31/98
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)

733
Cash flow from financing activities ($18,000)

Increase in cash for the year $163,000

734
 Requirement 2:
December 31, 1997 balance sheet

The figures for the 12/31/97 balance sheet can be attained by T-account
analysis of the relevant accounts:

Accounts Receivable
Balance as of 12/31/97 X
Advertising revenue $250,000 $215,000 Cash collected from clients

Balance as of 12/31/98 $80,000

Solve for X:
$80,000 = X + $250,000 - $215,000
X = $45,000

Prepaid Insurance
Balance as of 12/31/97 X
Cash paid for insurance $12,000 $12,000 Insurance expense
Balance as of 12/31/98 $3,000

Solve for X:
$3,000 = X + $12,000 - $12,000
X = $3,000

Land
Balance as of 12/31/97 X
$150,000 Sale of land
(cash received = book value)
Balance as of 12/31/98 $0

Solve for X:
$0 = X - $150,000
X = $150,000

Accumulated DepreciationÐBuilding
X Balance as of 12/31/97
$20,000 Depreciation expense - building
$380,000 Balance as of 12/31/98

Solve for X:
X = $380,000 - $20,000
X = $360,000

735
 Office Equipment
Balance as of 12/31/97 X
Purchase of office
equipment $20,000
Balance as of 12/31/98 $80,000

Solve for X:
X = $80,000 - $20,000
X = $60,000
Accumulated DepreciationÐOffice Equipment
X Balance as of 12/31/97
$8,000 Depreciation expenseÐ
office equipment
$39,000 Balance as of 12/31/98

Solve for X:
X = $39,000 - $8,000
X = $31,000
Salaries Payable
X Balance as of 12/31/97
Salaries paid $130,000 $126,000 Salaries expense
$7,000 Balance as of 12/31/98

Solve for X:
X = $130,000 - $126,000 + $7,000
X = $11,000
Interest Payable
X Balance as of 12/31/97
Cash paid for interest $9,000 $10,000 Interest expense
$3,500 Balance as of 12/31/98

Solve for X:
X + $10,000 - $9,000 = $3,500
X = $2,500
Liability for Customer Lawsuit
X Balance as of 12/31/97
Cash paid for customer lawsuit $32,000
$0 Balance as of 12/31/98

Solve for X:
X - $32,000 = 0
X = $32,000

736
 Rent Received in Advance
X Balance as of 12/31/97
Rent revenue $36,000 $50,000 Rent collected
$14,000 Balance as of 12/31/98

Solve for X:
X = $50,000 - $36,000 - $14,000
X = $0

Bonus Payable
X Balance as of 12/31/97
$25,200 Employee incentive bonus
$25,200 Balance as of 12/31/98

Solve for X:
X + $25,200 = $25,200
X = $0

Taxes Payable
X Balance as of 12/31/97
Cash paid for taxes $31,000 $33,920 Income tax expense
$2,920 Balance as of 12/31/98

Solve for X:
$2,920 = X + $33,920 - $31,000
X = $0

Borrowing from TownBank

X Balance as of 12/31/97
$50,000 Borrowing from TownBank
$50,000 Balance as of 12/31/98

Solve for X:
X + $50,000 = $50,000
X = $0

Building Loan
X Balance as of 12/31/97
Repayment of building loan $85,000
$35,000 Balance as of 12/31/98

Solve for X:
$35,000 = X - $85,000
X = $120,000

737
 Capital Stock
X Balance as of 12/31/97
$35,000 Issuance of capital stock
$135,000 Balance as of 12/31/98

Solve for X:
$135,000 = X + $35,000
X = $100,000

Retained Earnings
X Balance as of 12/31/97
Dividends declared & paid $18,000 $50,880 Net income
$264,380 Balance as of 12/31/98

Solve for X:
$264,380 = X + $50,880 - $18,000
X = $231,500

JKI Advertising Agencies

Balance Sheet as of 12/31/97

1997
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

738
Total of liabilities and equities $497,000

739
Requirement 3:
Operating section of cash flow statement under indirect approach:

JKI Advertising Agencies

Statement of Cash Flows for the Year Ended 12/31/98

Net income $50,880

+ Depreciation expenseÐbuilding 20,000
+ Depreciation expenseÐoffice 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 1998 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 1999, it
will show up as operating outflow.

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
740
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 12/31/98
Net income (see below) $47,100
+ Depreciation expenseÐbuilding 20,000
+ Depreciation expenseÐoffice 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 ´ $126,000) = $31,500

Previous bonus expense 25,200
Before-tax increase in bonus expense $6,300
Times (1 - .4) .6
After-tax decrease to net income $3,780
Previous net income 50,880
Revised net income $47,100

T-account to support change in taxes payable:

Taxes Payable
0 Balance as of 12/31/97
Cash paid for taxes $31,000 $31,400 Income tax expense
$400 Balance as of 12/31/98

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

741
P16-7.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 1994 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.,
$23,019,000Ð$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
same cash flow numbers.

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 1994 revenue of $137,002,000 (not provided in the problem).

Allowance for Doubtful Accounts

$4,955,000 Beginning balance
5,846,000 Provision for bad debts
Bad debts written off X
$3,925,000 Ending balance

Solve for X:
$4,955,000 + $5,846,000 - X = $3,925,000
X = $6,876,000

742
743
 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 & StrattonÕs
reporting practice, the adjustment for change in receivables would be as
follows:

Ramsay Health Care, Inc., and Subsidiaries

Using Briggs & StrattonÕs 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.

744
 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
- $6,876,000

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) expect cash
collected from customers which is being solved.

Another way to provide the intuition is to focus on the two possible reasons for
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.

745
P16-8. Preparation of cash flow statementÐindirect method
(AICPA adapted)

Cash flow for 1998 using the indirect method:

Bergen Corporation
Statement of Cash Flows
For the Year Ended December 31, 1998

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 $541,000

746
P16-9.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 12/31/98

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 $30,000

Kang-Iyer Financial Consultants

Income Statement for the Year Ended 12/31/98

Consulting revenue $356,500

Less: Expenses
DepreciationÐbuilding $10,000
Salaries expense 150,000
Interest expense 65,000
Bad debts expense 48,000
Rent expense 30,000 303,000
Net income $53,500

747
 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 = $48,000

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

748
 Prepaid Rent
Beginning balance $30,000
X Rent expense
Cash paid 0
Ending balance $0

Solve for X:
$0 = $30,000 + $0 - X
X = $30,000

Accumulated DepreciationÐ Building

$0 Beginning balance
X Depreciation expense
$10,000 Ending balance

Solve for X:
$10,000 = $0 + X
X = $10,000

749
P16-10.Determining components of cash flow statement
(AICPA adapted)

Requirements 1Ð3:
Cash provided by operating, investing, and financing activities:

Best Corporation
Statement of Cash Flows
For the Year Ended December 31, 1999

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 dividends1
(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 $85,000

750
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 $125,000 700,000 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 = $13.75

751
P16-11.Analysis of statement of cash flows
Requirement 1:
Statement of cash flows for the year ended 12-31-1998:

Cavalier Toy Stores

Statement of Cash Flows
For the Year Ended December 31, 1998

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)

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

752
(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 $0

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 operationsÐthis 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 buildingÐa nonproductive asset

(c) Very large dividend in a loss year.

(d)Decreasing gross margins (from letter) from competitive pressures.

(e)Net loss.
753
754
P16-12.Preparation of cash flow statement
(AICPA adapted)

Farrell Corporation
Statement of Cash Flows
For the Year Ended December 31, 1998

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 $275,000

755
P16-13.Statement of cash flows—indirect method
(AICPA adapted)

Omega Corporation
Statement of Cash Flows
For the Year Ended December 31, 1996

Cash Flow from Operating Activities:

Net income $360,000
Adjustments to reconcile net income to cash provided
by operating activities:
Depreciation1 $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 $800,000

1
Depreciation
Net increase in accumulated depreciation
for the year ended December 31, 1996 $125,000
Accumulated depreciation on equipment sold:
Cost $60,000
Carrying value 35,000 25,000
Depreciation for 1996 $150,000

756
2
Gain on sale of equipment
Proceeds $40,000
Carrying value 35,000
Gain $5,000
3
Undistributed earnings of Belle Co.
BelleÕs net income for 1996 $120,000
OmegaÕs ownership 25%
Undistributed earnings of Belle Co. $30,000

757
 Financial Reporting & Analysis
Chapter 16ÊSolutions
Statement of Cash Flows
Cases

Cases
C16-11.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 12/31/98

Cash Flow from Operating Activities:

Net income $81,250
+ Depreciation expenseÐbuilding 25,000
+ Depreciation expenseÐcomputer 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)
Cash flow from financing activities $550,000

Change in cash balance (384,750)

+ Beginning cash balance 504,750
Ending cash balance $120,000

Calculation of dividends:
Beginning balance of retained earnings $341,750
758
 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.

759
 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.

C16-2. Tuesday Morning Corporation (CW): Analysis of cash flow statement

Requirement 1:
None of its 1994 sales were made on credit (i.e., they were 100% in cash).
This is because sales in the income statement of $190,081 is exactly the same
as cash received from customers in the cash flow statement.

Requirement 2:
Tuesday Morning paid $0 in cash for income taxes in 1994. The operating cash
flow section of the cash flow statement reveals that the firm received a cash
refund of $1,911.

Requirement 3:
Tuesday Morning reported $198 of interest income in its 1994 income
statement, all of which was received in cash in 1994 (see the operating cash
flow section of the cash flow statement).

760
Requirement 4:
Cash flow provided by operating activities using the indirect method:

Net earnings (loss) $2,651

Adjustments to reconcile net earnings (loss) to net
cash provided by (used in) operating activities
Depreciation and amortization 3,862
Deferred income taxes 313
Loss on sale of fixed assets 12
Changes in operating assets and liabilities:
Income taxes receivable 2,133
Inventories 6,736
Prepaid expenses (683)
Other current assets 597
Other assets (251)
Accounts payable (2,943)
Accrued expenses (1,359)
Income taxes payable 988
Total adjustments 9,405
Net cash provided by (used in) operating activities $12,056

761
C16-31.Comptronix Corporation (KR): Comprehensive statement of cash flows

Requirement 1:

Comptronix Corporation
Statement of Cash Flows for the Year Ended 12/31/93

Operating Activities:
Net loss ($11,403)
+ Dividend in kind 162
+ Depreciation 8,330
+ Loss on write-off of machinery & equipment 227
+ Non-cash portion of settlement with Exicom 1,775
+ Bad debt expense 238
+ Decrease in gross accounts receivable 13,782
- Bad debts written off (315)
+ Decrease in income tax receivable 6,731
+ Decrease in inventory 22,459
- Increase in prepaid expenses (835)
- Decrease in trade accounts payable (22,725)
- Decrease in accrued payroll (1,259)
+ Increase in accrued interest 33
- Decrease in other payables (19)
- Decrease in accrued settlement ($2,432)
- Decrease in long-term accrued settlement (1,500) (3,932)

- Increase in deferred financing costs (413)

+ Increase in ownersÕ equity for these costs 400 (13)
Cash flow from operations $13,236

Investing Activities:
Purchase of property, plant, and equipment (1,085)
Cash flow from investing activities ($1,085)

(continued)

762
 Financing Activities:
Increase in preferred stock $1,937
- Dividend in kind (162)
- Noncash settlement with Exicom (1,775) -
Repayment of principal on IDR bonds ($320)
Retired revolving line of credit (19,973)
Retired equipment line of credit (15,762)
Borrowing on new revolving line of credit 21,006
Borrowing on new equipment line of credit 6,000
Repayment of notes secured by equipment (3,982)

1993 bank loan secured by real property

(i) Borrowing 3,000
(ii) Repayment (1,500) 1,500

1993 equipment loan at 9%

(i) Borrowing 200
(ii) Repayment (97) 103

Increase in common stock + paid-in capital 526

- Non-cash stock for financing charges (400) 126
Cash flow from financing activities ($11,302)

Change in cash 849

Beginning cash balance 48
Ending cash balance $897

Details of selected T-accounts:

Accumulated Depreciation
$18,630 Beginning balance
8,330 Depreciation expense
Acc. dep. of asset written off $633
$26,327 Ending balance

Property, Plant and Equipment

Beginning balance $55,574
$8601 Original cost of asset written off
Purchase of PP&E 1,085
Ending balance $55,799

1
BV of asset written off $227

763
+ Acc dep. of asset written off 633
= Original cost of asset written off $860
Allowance for Doubtful Accounts
$608 Beginning balance
238 Bad debt expense
Bad debts written off $315
$531 Ending balance

Accounts Receivable
Beginning balance $32,803
Sales revenue 184,137 $315 Bad debts written off
197,604 Cash collected
Ending balance $19,021

764
Requirement 2:
Comptronix Corporation
Statement of Cash Flows for the Year Ended 12/31/93
Operating Section under the Direct Method
Cash collected from customers:
Sales revenue $184,137
+ Decrease in gross accounts receivable 13,782
- Bad debts written off (315) $197,604

Cash paid to suppliers:

Cost of sales (181,010)
+ Depreciation 8,330
+ Decrease in inventory 22,459
- Decrease in trade accounts payable (22,725) (172,946)

Cash paid for marketing, etc., expenses:

Marketing, general & admin. expenses (7,227)
+ Bad debt expense 238
- Increase in prepaid expenses (835)
- Decrease in accrued payroll (1,259) (9,083)

Cash paid for interest:

Interest expense (5,417)
+ Increase in accrued interest 33 (5,384)

Interest income on income tax refund 1,048

Cash paid for Exicom settlement:

Settlement with Exicom (1,837)
+ Noncash portion of settlement with Exicom 1,775 (62)

Cash paid for other expenses:

Other expenses (935)
+ Loss on write-off of machinery & equipment 227
- Decrease in other payables (19)
- Increase in deferred financing costs (413)
+ Increase in ownersÕ equity for these costs 400 (740)

Income tax refund received 6,731

Cash paid for accrued settlement costs:

- Decrease in accrued settlement (2,432)

765
- Decrease in long-term accrued settlement (1,500) (3,932)

Cash flow from operations $13,236

766
C16-41.MGM Grand, Inc. (KR): Comprehensive statement of cash flows

Requirement 1:

MGM Grand, Inc.

Statement of Cash Flows
For the Year Ended 12/31/93

Cash Flows from Operating Activities:

Net loss ($117,586)
+ Depreciation expense 8,018
+ Aircraft carrying value adjustment 68,948
+ Loss on sale of property, plant & equip.
(book value $2,501Ðcash received $684) 1,817
- Increase in net accounts receivable (29,869)
- Increase in prepaid expenses (10,536)
- Increase in inventories (12,508)
+ Decrease in pre-opening costs 10,677
- Increase in other operating assets (5,485)
+ Increase in accounts payable 9,859
+ Increase in accrued salaries & wages 7,249
+ Increase in accrued interest on LT debt 43
+ Increase in other accrued liabilities 23,758
+ Increase in deferred revenue 10,784
Cash flow from operations ($34,831)

Cash Flows from Investing Activities:

Sale of property, plant & equipment 684
Purchase of PP&E and cost of building (480,054)
+ Increase in construction payables1 64,548 (415,506)
Cash flow from investment activities (414,822)

Cash Flow from Financing Activities:

Repayment of principal in capital lease (1,564)
Additional borrowing (laundry loan) 10,000
Issuance of additional common stock 72,559
Cash flow from financing activities 80,995

Total change in cash (368,658)

Cash at 12/31/92 579,963
Cash at 12/31/93 $211,305

1
Alternatively, this could be shown as a financing activity cash inflow.
767
Note on significant non-cash transaction: The Company entered into a
capital lease agreement and recorded an asset and a corresponding liability for
$16,987.

Property, Plant and Equipment

Beginning balance $471,506
New capital lease 16,987 $14,751 Cost of asset sold (net book value
ÊÊ$2,501 + Acc. dep. $12,250)
Other new additions X
Ending balance $953,796

Solve for X:
$953,796 = $471,506 + $16,987 + X - $14,751
X = $480,054

Accumulated Depreciation
$21,796 Beginning balance
Acc. depr. of asset sold X 8,018 Depreciation expense
68,948 Carrying value adjustment
$86,512 Ending balance

Solve for X:
$86,512 = $21,796 + $8,018 + $68,948 - X
X = $12,250

Capital Lease Obligation (including current maturities)

$451 Beginning balance
Repayment of principal X 16,987 New capital lease
$15,874 Ending balance

Solve for X:
$15,874 = $451 + $16,987 - X
X = $1,564

768
 MGM Grand, Inc.ÐAlternative Approach
Statement of Cash Flows
For the Year Ended 12/31/93

Cash Flows from Operating Activities:

Net loss ($117,586)
+ Depreciation expense 8,018
+ Aircraft carrying value adjustment 68,948
+ Loss on sale of property, plant & equip.
(Book value $2,501 - Cash received $684) 1,817
+ Bad debt expense 3,855
- Increase in gross accounts receivable ($33,071)
- Bad debts written off (653) (33,724)
- Increase in prepaid expenses (10,536)
- Increase in inventories (12,508)
+ Decrease in pre-opening costs 10,677
- Increase in other operating assets (5,485)
+ Increase in accounts payable 9,859
+ Increase in accrued salaries & wages 7,249
+ Increase in accrued interest on LT debt 43
+ Increase in other accrued liabilities 23,758
+ Increase in deferred revenue 10,784
Cash flow from operations (34,831)

Cash Flows from Investing Activities:

Sale of property, plant & equipment 684
Purchase of PP&E and cost of building (480,054)
+ Increase in construction payables 64,548 (415,506)
Cash flow from investment activities (414,822)

Cash Flow from Financing Activities:

Repayment of principal in capital lease (1,564)
Additional borrowing (laundry loan) 10,000
Issuance of additional common stock 72,559
Cash flow from financing activities 80,995

Total change in cash (368,658)

Cash at 12/31/92 579,963
Cash at 12/31/93 $211,305

Under the alternative approach, we are merely breaking down the change in
net accounts receivable into three components which are italicized. This is

769
done in order to convert the indirect statement to a direct statement. Of course,
this step can be omitted.

Gross Accounts Receivable

Beginning balance $2,178 $653 Bad debts written off
Revenue 57,800 X Cash collected
Ending balance $35,249

Solve for X:
$35,249 = $2,178 + $57,800 - $653 - X
X = $24,076

Allowance for Doubtful Accounts

$1,531 Beginning balance
Bad debts written off X 3,855 Bad debt expense
$4,733 Ending balance

Solve for X:
$4,733 = $1,531 + $3,855 - X
X = $653

Note: These T-accounts may be useful when preparing the direct cash flow
statements. Note that we have to consider the change in deferred revenue to
calculate the “correct” amount of cash collected from customers.

770
Requirement 2:

MGM Grand, Inc.

Direct Method

Cash Flow from Operations

Cash collected from customers:
Total revenue $57,800
- Increase in gross A/R (33,071)
- Bad debts written off (653)
+Increase in deferred revenue 10,784 $34,860

Cash paid for direct operating expense (approx.):

Direct operating expense (casino + ... + airline) (39,262)
- Increase in prepaid expenses (10,536)
- Increase in inventories (12,508)
- Increase in other operating assets (5,485)
+Increase in accounts payable 9,859
+Increase in accrued salaries & wages 7,249
+Increase in other accrued liabilities 23,758 (26,925)

Cash paid for SG&A expenses:

SG&A expenses (19,679)
+Bad debt expense 3,855 (15,824)

Cash paid for hotel pre-opening expenses:

Hotel pre-opening expenses (45,130)
+Decrease in pre-opening costs 10,677 (34,453)

Interest income 12,231

Cash paid for interest expense:

Interest expense (6,596)
+ Increase in accrued interest on LT debt 43 (6,553)

Cash received from other non-operating items:

Other, net 16
+Loss on sale of PP&E 1,817 1,833

Cash flow from operations ($34,831)

771
Note: The direct approach obviously requires assumptions regarding which
operating assets and liabilities pertain to which revenue and expense items.

772
C16-5. Sound Advice, Inc. (KR): Preparation and analysis of the cash flow statement

Requirement 1:
Notes:

1) Since the company did not declare or pay any cash or stock dividends
during the year, the change in the retained earnings of $1,127,664 must be
the net income for the year.

2) The T-accounts for property and equipment and accumulated depreciation

are prepared to solve for the new acquisitions of property and equipment
during the year.

Accumulated Depreciation
$6,822,553 Balance as of 6/30/92
Acc. dep. of scrapped asset $57,107 2,265,735 Depreciation expense (given)
$9,031,181 Balance as of 6/30/93

Property and Equipment

Balance as of 6/30/92 $20,637,912
New acquisitions 1,608,943 $64,484 Orig. cost of the scrapped asset
Ê ($57,107 + $7,377)
Balance as of 6/30/93 $22,182,371

First by crediting the accumulated depreciation T-account with the depreciation

expense for the year, we find that the accumulated depreciation on the
scrapped asset must have been $57,107 (the plug number). Since the book
value of the scrapped asset was $7,377, the original cost of the asset must
have been $64,484 ($57,107 + $7,377). This amount would have been credited
to the property and equipment T-account. The resulting plug number of
$1,608,943 must be the cost of new property and equipment acquired during
the year.

3) The change in the accumulated amortization of $24,450 must represent the

non-cash amortization expense for the year.

4) The words “deferred credits” suggest that the liability account other liabilities
& deferred credits must be a operating liability rather than a financial liability.

5) To calculate the financing cash flows from long-term debt, it is useful to

focus on the total long-term rather than split them into current and long-term
portions.

773
Long-Term Debt: 6/30/93 6/30/92 Borrowing Repayments
Term loan $3,420,000 - $3,600,000 ($180,000)
Mortgage note 534,475 555,455 (20,980)
Total $3,954,475 $555,455 $3,600,000 ($200,980)
- Current installments (21,348)
(681,716)
Long-term debt (less)
current installments $3,272,759 $534,107

6) Although revolving credit agreements appear as a current liability, they are a

financing liability. Consequently, they will be reflected in the financing
section of the cash flow statement.

774
 Sound Advice, Inc.
Statement of Cash Flows
For the Year Ended 6/30/1993

Operating Activities:
Net income for the year $1,127,664
+ Amortization of goodwill 24,450
+ Depreciation expense 2,265,735
+ Loss on disposition of equipment 7,377
Decrease in net receivables 1,540,275
Decrease in inventories 815,162
Decrease in prepaid expenses 254,183
Decrease in income tax receivable 1,500,482
Increase in deferred tax asset (511,600)
Decrease in pre-opening costs 506,721
Increase in accounts payable 3,102,873
Increase in accrued liabilities 768,144
Increase in other liabilities & deferred credits 763,872
Cash flow from operations $12,165,338

Investing Activities:
Purchase of property and equipment ($1,608,943)
Cash flow from investing activities ($1,608,943)

Financing Activities:
Issuance of new shares 8,998
Borrowing on term loan 3,600,000
Repayment of term loan (180,000)
Repayment of mortgage note (20,980)
Repayments under revolving credit agreement (13,933,009)
Cash flow from financing activities ($10,524,991)

Change in cash $31,404

Cash balance as of 6/30/92 19,481
Cash balance as of 6/30/93 $50,885

Requirement 2:
Caveat: The analysis is handicapped by the limited amount of information
available in the problem. The learning objective of this assignment is to enable
the students to evaluate the cash flow statement rather than perform a
comprehensive analysis of the financial performance of Sound Advice, Inc.

775
The cash flow from operations (CFO) of Sound Advice, Inc., is almost 11 times
more than the net income of the company. Given the Wall Street adage that
“Cash Flow is King and Earnings Don’t Matter,” does this mean that the
financial performance of Sound Advice is really 11 times better than that
indicated by its net income? Let us examine the sources of the high CFO to
see whether Sound Advice can sustain this level of cash flows in the future.

First of all, the company’s receivables decreased by more than $1.5 million.
Roughly, the company collected that much more cash than the revenue booked
in the accrual accounting income statement. This might be good news if the
company has improved its collection efforts. Even so, this is unlikely to happen
year after year if a company is growing, i.e., collecting more cash than the
accrual revenue. Consequently, this is likely to be a temporary phenomenon.

A second source of the higher cash flow is the drop in the level of inventory.
One possibility is that the drop is due to an unexpected sale at the end of the
year. However, this is unlikely since the company experienced a drop in the
receivables also, i.e., if there were unexpectedly large sales at the end of the
year, we might expect the accounts receivable to go up. More importantly,
inventory level provides a signal about future demand, i.e., companies are
likely to build up (decrease) inventories when they expect a surge (fall) in
demand. Therefore, another possibility is that the company saved some cash in
the current year by buying less inventory, but it might generate less cash during
the next year by selling less inventory. In any case, it is unlikely that inventory
levels can continue to decrease when companies are growing. In fact, in the
following year, the company built up almost $10 million of inventory which
resulted in a negative CFO. The main message here is that neither cash flows
nor accounting income by itself can tell the whole story. A joint examination of
the two is likely to be constructive.

A third factor is the increase in accounts payable by more than $3 million. More
credit from suppliers is not necessarily a bad sign, i.e., suppliers are unlikely to
extend credit when they believe their customers have impending financial
difficulties. However, an increase in accounts payable usually happens when
there is a buildup in the inventory level. Consequently, one should examine
why Sound Advice’s accounts payable are increasing when its inventory level
is falling. One possibility is that the company was “forced” to pay off its
revolving credit under the current agreement (see financing cash flow). This
might have delayed the payment to the suppliers.

A fourth item is the cash received from the decrease in the income tax refund
receivable. When is it likely for a company to have an asset called income tax
refund receivable? There are two possibilities. First, the company paid more

776
 taxes during a year when compared to what it owed the IRS based on its actual
taxable income, i.e., the actual income was less than the anticipated income. A
second possibility is that the company incurred a net loss in the recent past,
and, using the loss carryback provision, the company is expecting to receive a
tax refund. Either scenario suggests that the company has encountered
difficulties in the recent past. In fact, Sound Advice incurred a net loss of
almost $2.5 million during the fiscal year 1992.
Similar comments can be made on other operating assets and liabilities.

The fact that the company borrowed a term loan of $3.6 million is a positive
signal. First of all, the company has convinced a creditor to lend it money.
Secondly, the loan is a long-term one, and therefore, a substantial portion of
the principal payments are unlikely to be due in the near term. The company
has paid back about 5% of the term over a 4-month period. On an annual
basis, this translates into 15% of the loan, i.e., the company has the potential to
use the term loan to finance a part of its working capital needs over the next
several years.

Collaborative Learning Case

C16-61.Best Buy Co., Inc. (KR): Analysis of financial performance from the cash flow
statement and other information

Caveat: Due to limited information available in the problem, our analysis

cannot provide a complete picture of the financial performance of the company
over the 3-year period. The learning objective for this problem is to enable the
student to examine the items that cause net income to be different from the
cash flow numbers.

Requirement 1:
Comparison of earnings and operating cash flows:

The company’s net income has consistently declined over the 3-year period,
from almost $60 million during the fiscal year 1995 to less than $2 million
during 1997. In contrast, the cash flow from operations (CFO) was the highest
during 1996 at almost $100 million. During 1995 and 1997, operations were a
drain on the company’s cash flows. If accrual accounting results in better
matching of revenues and expenses, then the company’s performance has
deteriorated over the 3-year period. However, how might an analyst interpret
the company’s CFO which did not change in the same direction as the net
income?

777
Recall that when operating assets increase (or decrease), they are a drain on
(or they increase) the operating cash flows. The opposite is true for the
operating liabilities. An examination of the operating section of the cash flow
statements suggests that Best Buy had been building up inventories and
receivables during 1995 and 1996, and had been liquidating its inventories and
receivables during 1997. An important task is for the analyst to understand
whether these trends signify positive or negative news about the company.

778
 To understand the buildup in inventories, let us focus on the statistics on new
store openings:

1997 1996 1995 1994

Number of stores at the end of year 272 251 204 151
Number of new stores opened during the year 21 47 53

When retail companies, such as Best Buy, expand by acquiring or building new
stores, then they experience a sudden demand for new working capital. This is
clearly communicated by Best Buy in its annual report.

Each new store requires approximately $3 million of working

capital, depending on the size of the store, for merchandise
inventory (net of vendor financing), leasehold improvements,
fixtures and equipment.

Note that the words “net of vendor financing” suggests that the $3 million is for
the investment in inventory and other assets minus the credit extended by the
suppliers through accounts payable.

It is quite likely that these new stores will not have reached their expected
annual revenue projections during the first year of operations. Consequently,
the increase in working capital will result in a drain on the operating cash flows
during the years of rapid expansion until the new stores reach their projected
annual sales targets.

Requirement 2:
Analysis of working capital needs:

Let us try to calculate the expected increase in the working capital during each
of the three years due to new store openings:

1997 1996 1995

Need for working capital per new store $3,000 $3,000 $3,000
Number of new stores opened during the year 21 47 53
Total working capital needed for the new stores $63,000 $141,000 $159,000

779
 Now, let us compare these figures with the actual change in the working capital
during the same period:

Change in Working Capital

For the fiscal years ended 03/01/97 03/02/96 02/25/95
Receivables ($41,857) $36,998 $31,496
Merchandise inventories (69,083) 293,465 269,727
Income taxes and prepaid expenses (8,174) 16,273 5,929
Accounts payable 186,050 (278,515) (106,920)
Other current liabilities (4,788) (50,599) (46,117)
Deferred revenue and other liabilities 27,262 (12,994 ) (19,723 )
Net increase in working capital $89,410 $4,628 $134,392

Note that each of the figures in the above table is taken from the operating
section of the statement of cash flows. However, their signs have been
reversed since working capital is defined as current assets (minus) current
liabilities. Consequently, increases in assets and liabilities have the positive
and negative signs, respectively. The opposite is true for the decreases.

Given the explosive growth during 1995 (adding 53 new stores), it is not
surprising that Best BuyÕs working capital increased by more than $130
million. In fact, it is less than the $159 million that was expected based on the
working capital requirements of the new stores. Consequently, an analyst is
unlikely to be concerned about the negative CFO during 1995 since it is
consistent with what might be expected based on the growth experienced by
Best Buy. However, an analyst must carefully follow up to examine how well
the new stores are doing.

Requirement 3:
Analysis of year-to-year changes in inventory and how these changes were
financed:

During 1996, although the company added another 47 stores, its working
capital increased only about $5 million compared to the expected increase of
more than $140 million. This is because there is a substantial difference in how
the growth in inventory was financed between the two years.

1996 1995
Increase in merchandise inventories $293,465 $269,727
Increase in accounts payable 278,515 106,920
% of increase in inventory financed by accounts payable 95% 40%

780
While only about 40% of the increase in inventory was financed through
supplier credit in 1995, almost the entire growth in inventory was financed by
the suppliers during 1996. One big question is whether this type of financing is
sustainable in the long run. The answer to this becomes apparent when we
examine the cash flows for 1997.

The fiscal year 1997 was obviously a challenging year for Best Buy. As
discussed before, the company’s profit during this year was the lowest in
recent history. The operating cash flows indicate that the company has taken
substantial efforts to improve its financial position by reducing its inventory
level by almost $70 million. While this may be an indication of improved
inventory management, it is also consistent with a fall in future demand, and,
therefore, the company is buying less inventory. In addition, as discussed
above, the company had to pay off its creditors (almost $190 million), and,
therefore, the smaller than expected growth in the 1996 working capital level
was not sustainable.

Accounts receivable follow a pattern similar to that of inventory. During 1995

and 1996, the company had been building up its receivables, which is
consistent with growth in sales. However, the company was liquidating its
receivables during 1997. Was this because the company changed its collection
policy? Was it because the growth in sales is decreasing? In essence, this is
an important item for the analyst to follow up with the company.

In addition to investment in inventory, pre-opening costs are also a significant

drain on the working capital of the company.

1997 1996 1995

Pre-opening costs per store $300 $300 $300
Number of new stores opened during the year 21 53
47
Total pre-opening costs per year $6,300 $14,100 $15,900

Based on the number of new stores opened, these costs ranged from $6.3
million in 1997 to almost $16 million in 1995. One would expect these one-time
costs as a necessary investment in business expansion. This must be kept in
mind when evaluating the negative operating cash flows during the growth
years.

Requirement 4:
Insights from the investing and financing sections of the cash flow statement:

The investing cash flows suggest that the company has substantially
decreased its capital expenditures during 1997 to less than $90 million from
781
around $120 million in the previous two years. Once again, this may be an
indication of downsizing by the company.

Finally, let us focus on the financing cash flows. The most important issue is
how the business expansion was financed. In addition to using supplier credit,
the company raised $230 million during 1995 by issuing convertible preferred
securities. Since opening new stores requires a “permanent” increase in the
working capital, it is optimal for the company to use a long-term financing
source, such as preferred stock, to fund the business expansion.

The following are selected excerpts from the management discussion and
analysis section of the 1997 fiscal year 10-K report of the company. The
management discusses many of the issues that were brought out in our
analysis of the cash flows of Best Buy.

In fiscal 1997, the Company curtailed the pace of expansion to a level that
could be reasonably supported by internally generated funds. The rapid
pace of growth and store openings in the two previous years was funded
with funds generated from the public securities and bank debt markets.
The funds from a securities offering in November 1994 and the
CompanyÕs bank-financed master lease facility provided the majority of
the financing to rapidly open stores and increase distribution capacity. Due
to the reduced profits available to support a high level of store
growth, the Company substantially reduced the number of new store
openings in fiscal 1997. (Emphasis added.)

Cash flow from operations in fiscal 1997, before changes in working

capital, was impacted by the decline in earnings. After adjusting for the
$25 million in noncash inventory charges, cash flow from operations,
before working capital changes, was $94 million, compared to $104 million
in fiscal 1996 and $97 million in fiscal 1995. Changes in the components of
working capital, after adjusting for markdown reserves, included a $44
million decrease in inventories in fiscal 1997, despite the addition of
21 new stores, due to improved inventory management. Inventories
increased $293 million in fiscal 1996 and $270 million in fiscal 1995 due to
the higher levels of business expansion in those years. Working capital
financing provided by accounts payable and financing arrangements was
reduced by $152 million in fiscal 1997 and increased by $291 million and
$178 million in fiscal 1996 and 1995, respectively, reflecting the change in
activity levels at each of the respective year ends.

782
Cash used in investing activities was $20 million in fiscal 1997, compared
to $159 million in fiscal 1996 and $192 million in fiscal 1995. Due to the
slower rate of growth in fiscal 1997, capital spending was $88 million,
compared to approximately $120 million in each of the two previous
years… Management expects that capital spending and investment in
property development will decline further in fiscal 1998 as the number of
store openings is reduced.

Management believes that, as a result of lower levels of investment in

property development and improvement in inventory management
resulting in faster inventory turns, the CompanyÕs working capital
borrowing requirements will be lower in fiscal 1998 than in fiscal 1997. The
ability of the Company to meet the covenants required by its credit facilities
is dependent upon future operating results. While there can be no
assurance that the Company will be able to achieve the required
performance necessary to remain in compliance, management believes
that sufficient alternative sources of working capital financing are available
to support the CompanyÕs planned operations for fiscal 1998.

783