Financial Reporting & Analysis Chapter 17 Solutions ...pages.stern.nyu.edu/~pzarowin/Zarowin-Solutions/ch17sol.pdf17-1 Financial Reporting & Analysis Chapter 17 Solutions Statement

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Financial Reporting & Analysis

Chapter 17 SolutionsStatement of Cash Flows

Exercises

ExercisesE17-1. Determining cash flows from operations

Using the indirect method, cash flow from operations is computed below:

Net income $280,000Add:

Equity in investee loss $20,000Decrease in prepaid expenses 7,000Depreciation expense 13,000Increase in salaries payable 8,000

48,000Subtract:

Amortization of premium onbonds

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

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E17-2. Determining cash flows from operations(AICPA adapted)

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

Net income $150,000Increase in accounts receivable1 (5,800)Decrease in prepaid rent 4,200Increase in accounts payable 3,000

Cash flow from operations $151,400

1The 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 $350,000Cost of goods sold (70% of sales) (245,000 )Gross profit (30% of sales) 105,000Selling, general, and administrative expenses

Fixed portion = $35,000Variable portion = 15% ´ $350,000 = 52,500 (87,500 )

Net income (accrual basis) $17,500

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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 soldduring 2001:

Cost of machine sold (given) $40,000Less: 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 theaccumulated depreciation is $10,000.

Step 2: Analyze the accumulated depreciation account to determine theamount credited to this account when depreciation expense wasrecorded for the year:

Accumulated Depreciation$102,000 Beginning balance

Accumulated depreciation onequipment sold (see above)

$10,000 ? Depreciation expense for the year

$120,000 Ending balance

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From the T-account analysis, we can determine that depreciation expense forthe year is $28,000.

Requirement 2:To determine machinery purchases, the solutions approach is to set up aT-account for machinery and solve for the missing debit for equipmentpurchases:

MachineryBeginning balance $250,000Purchases ? $40,000 Cost of equipment sold

Ending balance $320,000

The T-account can by analyzed to determine that 2001 machinery purchasestotaled $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 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

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E17-6. Cash flows from investing and financing activities(AICPA adapted)

Requirement 1:Cash flow from investing activities:

Sale of equipment $ 10,000Purchase 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 35,000Purchase 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 $500,000Purchase 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 250,000Bank loan for real estate purchase 550,000Paid toward bank loan (450,000 )Net cash used in financing activities ($250,000)

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E17-9. Determining operating cash flows(AICPA adapted)

Net Income $150,000Increase in investment in Videogold, Inc. (5,500)Increase in deferred income tax liability 1,800Decrease in premium on bonds payable (1,400 )Net cash provided by operating activities $144,900

E17-10. Determining operating, investing, and financing cash flows(AICPA adapted)

Requirement 1:Net cash provided by operating activities:

Net income $790,000Gain on sale of long-term investment (35,000)Increase in inventory (80,000)Depreciation expense 250,000Decrease 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 135,000Sale of plant assets 350,000Purchase of plant assets (see T-account which follows) (1,190,000 )Net cash used in investing activities ($1,005,000 )

Plant AssetsCost of equipment acquired $110,000 $600,000 Cost of building soldCost of plant assets purchased XNet increase $700,000

$110,000 + X - $600,000 = $700,000X = $1,190,000

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Requirement 3:Net cash provided by financing activities:

Payment of dividends ($500,000 - $160,000) ($340,000)Issuance of short-term debt 325,000Issuance of common stock (10,000 ´ $22) 220,000 Net cash provided by financing activities $205,000

Check : (Not required)Cash provided by operating activities $920,000Cash used in investing activities (1,005,000)Cash provided by financing activities 205,000 Increase in cash and cash equivalents $120,000

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Financial Reporting & AnalysisChapter 17 Solutions

Statement of Cash FlowsProblems

ProblemsP17-1. 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 105,000Gain on sale of investment1 (35,000)Goodwill amortization2 10,000Depreciation expense3 250,000 250,000 Cash flows from operations $940,000

1Gain on sale of investment is determined as follows:Proceeds from sale of investments (given) $135,000Less: Book value of investment sold($300,000 - $200,000) (100,000 )Gain on sale of investment $ 35,000

2Goodwill amortized is equal to change in the goodwill account for the year =$100,000 - $90,000 = $10,000

3Depreciation expense recorded in year 2001 is determined from an analysis of theaccumulated depreciation T-account.

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Accumulated depreciationon equipment sold* $250,000

X Depreciation expense for year


*Cost of equipment sold = $400,000Less: Carrying value (150,000 )Accumulated depreciation $250,000

Solving for depreciation expense amount X in T-account$450,000 + X - $250,000 = $450,000X = $250,000 = Depreciation expense for year 2001

Requirement 2:Cash flows used in investing activities:

Sale of equipment $ 150,000Sale of long-term investment 135,000Purchase 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 assetsT-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 = $1,700,000X = $1,100,000 = Purchase of plant assets

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Requirement 3:Cash flows provided by financing activities:

Dividends paid ($240,000)Sale of common stock5 220,000Short-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 $940,000Cash used for investing activities (1,115,000)Cash from financing activities 305,000 Net increase in cash $130,000

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P17-2. Comparing direct and indirect methods of determining cash flows fromoperations(CMA adapted)

Requirement 1:The statement of cash flows for Spoke Company, for the year endedMay 31, 2001, using the direct method is presented below:

Spoke CompanyStatement of Cash Flows

For the Year Ended May 31, 2001

Cash Flows from Operating Activities:Cash received from customers1 $1,235,250Cash paid

to suppliers2 $664,000to employees3 276,850for other expenses4 10,150for interest5 73,000for 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 $40,000Cash paid

for dividends (115,000)to retire bonds payable (30,000 )

Net cash used for financing activities (105,000 )

Net increase in cash 23,250Cash, May 31, 2000 20,000 Cash, May 31, 2001 $ 43,250

Note 1: Schedule of noncash investing and financing activities.

Issuance of common stock for plant assets $50,000

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Supporting calculations:1 Collections from customers:

Sales $1,255,250Less: Increase in accounts receivable (20,000)

Cash collected from customers $1,235,250

2 Cash paid to suppliers:Cost of merchandise sold $712,000Less: 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 $252,100Add: Decrease in salaries payable 24,750

Cash paid to employees $276,850

4 Cash paid for other expenses:Other expense $8,150Add: Increase in prepaid expenses 2,000

Cash paid for other expenses $10,150

5 Cash paid for interest:Interest expense $75,000Less: Increase in interest payable (2,000)

Cash paid for interest $73,000

6 Cash paid for income taxes:Income tax expense (given) $43,000

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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 CompanyStatement of Cash Flows

For the Year Ended May 31, 2001

Cash Flows from Operating Activities:Net income $140,000Adjustments to reconcile net income to cash

Provided from operations:Depreciation expense $25,000Decrease in merchandise inventory 40,000Increases in:

Accounts payable 8,000Interest payable 2,000Accounts 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 fromoperating activities are acceptable in preparing a statement of cash flowsaccording to SFAS 95; however, the FASB encourages the use of the directmethod. Under the direct method, the statement of cash flows reports themajor classes of cash receipts and cash disbursements and disclosesmore information; this may be the statement’s principal advantage. Underthe indirect method, net income on the accrual basis is adjusted to the cashbasis by adding or deducting noncash items included in net income, therebyproviding a useful link between the statement of cash flows and the incomestatement and balance sheet.

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P17-3. Determining amounts reported on statement of cash flows(AICPA adapted)

Requirement 1:Cash collections from customers can be determined by examining theaccounts receivable T-account, shown below:

Accounts ReceivableBeginning balance $24,000Sales 155,000 X Cash collectionsEnding 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 operatingactivities as $145,000.

Requirement 2:Cash payments for purchase of property, plant, and equipment are calculatedas follows:

Property, Plant, & EquipmentBeginning balance $247,000 $40,000 Sale of equipmentAcquired from bond refinancing 20,000Cash purchases XEnding 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 investingactivities.

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Requirement 3:Proceeds from sale of equipment can be found by first looking at theaccumulated depreciation account:


33,000 Depreciation expense

Depreciation on equipment sold X


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 = XX = $22,000

Since we know the accumulated depreciation on the equipment sold, we candetermine its carrying value or book value as follows:

Cost of equipment $40,000Accumulated 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 candetermine the proceeds from sale of equipment.

Carrying value (book value) of equipment sold $18,000Gain on sale of equipment 13,000 Proceeds from sale of equipment $31,000

This amount would be classified as cash flows from investing activities.

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Requirement 4:To find dividends paid, we need to first determine dividends declared byanalyzing retained earnings:

Retained Earnings$91,000 Beginning balance

28,000 Net incomeDividends declared X


Solving for X, we get:$91,000 + $28,000 - X = $104,000X = $91,000 + $28,000 - $104,000X = $15,000 = dividends declared

The amount of cash dividends paid can be determined by T-account analysisof dividends payable:

Dividends Payable $5,000 Beginning balance15,000 Dividends declared

Cash dividends paid X $8,000 Ending balance

Solving for X, we get:X = $5,000 + $15,000 - $8,000X = $12,000 = Cash dividends paid

$12,000 should be reported on the statement of cash flows as a financingactivity.

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Requirement 5:Redemption of bonds payable can be found by using the bonds payableT-account:

Bonds Payable$46,000 Beginning balance

20,000 Bonds issued in 2001Redemption of bonds X


Solve for X:$46,000 + $20,000 - X = $49,000; $46,000 + $20,000 - $49,000 = XX = $17,000

Redemption of bonds payable is $17,000 reported under cash flows fromfinancing activities.

P17-4. Determining amounts reported on statement of cash flows(AICPA adapted)

Requirement 1:Cash collections from customers can be determined by examining theaccounts receivable T-account below:

Accounts ReceivableBeginning balance $30,000Sales 538,800

X Cash collectionsEnding 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 = XX = $535,800

Cash collections from customers are $535,800.

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Requirement 2:To solve for cash paid for goods sold, we must first determine how much waspurchased. We can do this by first looking at the inventory account todetermine total purchases for the period:

InventoryBeginning balance $47,000Purchases X

$250,000 Cost of goods soldEnding balance $31,000

To find purchases, solve for X.

$47,000 + X - $250,000 = $31,000X = $250,000 + $31,000 - $47,000X = $234,000

Next, to find out how much cash was paid on accounts payable, we plug thepurchases number into the accounts payable T-account and solve for cashpayments on account:

Accounts Payable$17,500 Beginning balance234,000 Purchases

Cash paid X$25,000 Ending balance

Again, we can solve for X.

$17,500 + $234,000 - X = $25,000X = $17,500 + $234,000 - $25,000X = $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 (2001) $4,300Less: Amortization of bond discount in 2001 (500 )Cash paid for interest $3,800

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Requirement 4:Cash paid for income taxes:

Income Taxes Payable$27,100 Beginning balance

20,400 Income tax expenseIncome taxes paid X


Solving for X:$27,100 + $20,400 - X = $21,000X = $27,100 + $20,400 - $21,000X = $26,500

Next, we must take into account deferred income taxes.

Ending balance $ 5,300Beginning balance (4,600 )Change in deferred income taxes payable $ 700

Income taxes paid $26,500Change 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 sellingexpenses. This is a noncash expense and should be subtracted from sellingexpenses to find the answer.

Selling expenses $141,500Depreciation allocated to selling1 (500 )Cash paid for selling expenses $141,000 1 Depreciation expense calculated:

Ending balance in accumulated depreciation $16,500Beginning balance in accumulated depreciation (15,000 )Depreciation expense for 2001 $ 1,500

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

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P17-5. Preparation and analysis of cash flow statement

Requirement 1:Statement of cash flows under indirect method:

Global Trading CompanyStatement of Cash Flows

For the Year Ended December 31, 2001

Cash flow from operationsNet 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 financing activitiesRepayment of bank loan ($307,500)Dividends paid1 (35,000 )

Cash flow from financing activities ($342,500 )

Net increase in cash $ 12,000

1Calculation of dividendsBeginning retained earnings $320,000- Net loss for the year (279,500)- Ending retained earnings (5,500 )= Dividends paid $35,000

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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 goodjob of matching revenues and expenses.

· Goodwill written off is from an acquisition made last year indicating that thepotential benefits from the acquisition have been exhausted.

· Decrease in accounts receivable coupled with a decrease in inventory isan indication of decreasing demand. A mere change in the collectionpolicy cannot explain the reduction in inventory.

· Increase in accounts payable could indicate that the company is notpaying off its suppliers because of the constraint on bank loan.

· The repayment of the bank loan probably is not voluntary but enforced bythe debt covenants.

· Payment of dividends when the company is incurring substantial losses isnot a sign of prudent financial management and drains the cash reservesof 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 isone year and the company needs to invest in these assets immediately.

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Requirement 3:Determination of bad debts written off can be obtained from T-accountanalysis of the allowance for doubtful accounts:

Allowance for Doubtful Accounts$30,000 Beginning balance

55,000 Bad debt expenseAccounts written off X


Solve for X:$30,000 + $55,000 - X = $20,000X = $65,000 = accounts written off in 2001.

Determination of credit sales for the year can be obtained from T-accountanalysis of accounts receivable:

Accounts ReceivableBeginning balance $300,000

$65,000 Bad debts written off (see preceding page)Sales on account X 1,250,000 Collections on accountEnding balance $50,000

Solve for X:$300,000 + X - $65,000 - $1,250,000 = $50,000X = $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 understatedby equal amounts. Thus, net effect on income is zero.)

Statement of Cash Flows No effect. (Purchase was on account for credit.)

Balance SheetThe balance sheet balances, but the year-end amounts for both accountspayable and inventory are understated by $35,000.

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P17-6. Preparation of cash flow statement and balance sheet

Requirement 1:Statement of cash flows under the direct method:

JKI Advertising AgenciesStatement of Cash Flows for the Year Ended 12/31/01

Direct Method

Operating Activities:Cash collected from clients $215,000Rent collected 50,000Salaries 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 $150,000Purchase of office equipment (20, 000 )

Cash flows from investing activities $130,000

Financing Activities:Borrowing from TownBank $50,000Repayment of building loan (85,000)Issuance of capital stock 35,000Dividends declared & paid (18,000 )

Cash flow from financing activities ($18,000 )

Increase in cash for the year $163,000

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Requirement 2:December 31, 2000 balance sheet

The figures for the 12/31/00 balance sheet can be attained by T-accountanalysis of the relevant accounts:

Accounts ReceivableBalance as of 12/31/00 XAdvertising 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 - $215,000X = $45,000

Prepaid InsuranceBalance as of 12/31/00 XCash paid for insurance $12,000 $12,000 Insurance expenseBalance as of 12/31/01 $3,000

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

LandBalance as of 12/31/00 X

$150,000 Sale of land(cash received = book value)

Balance as of 12/31/01 $0

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

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Accumulated Depreciation–BuildingX Balance as of 12/31/00$20,000 Depreciation expense - building

$380,000 Balance as of 12/31/01

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

Office EquipmentBalance as of 12/31/00 XPurchase of office

equipment $20,000Balance as of 12/31/01 $80,000

Solve for X:X = $80,000 - $20,000X = $60,000

Accumulated Depreciation–Office EquipmentX Balance as of 12/31/00$8,000 Depreciation expense–

office equipment$39,000 Balance as of 12/31/01

Solve for X:X = $39,000 - $8,000X = $31,000

Salaries PayableX 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 + $7,000X = $11,000

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Interest PayableX 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 = $3,500X = $2,500

Liability for Customer LawsuitX 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 = 0X = $32,000

Rent Received in AdvanceX 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 - $14,000X = $0

Bonus PayableX Balance as of 12/31/00$25,200 Employee incentive bonus$25,200 Balance as of 12/31/01

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

Taxes PayableX 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 - $31,000X = $0

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Borrowing from TownBankX Balance as of 12/31/00

$50,000 Borrowing from TownBank$50,000 Balance as of 12/31/01

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

Building LoanX 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 - $85,000X = $120,000

Capital StockX Balance as of 12/31/00

$35,000 Issuance of capital stock$135,000 Balance as of 12/31/01

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

Retained EarningsX 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 - $18,000X = $231,500

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JKI Advertising AgenciesBalance Sheet as of 12/31/00

2000Cash $ 30,000Accounts receivable 45,000Prepaid insurance 3,000Land 150,000Building 600,000Less: Accumulated depreciation (360,000)Office equipment 60,000Less: Accumulated depreciation (31,000 )Total assets $497,000

Salaries payable $ 11,000Interest payable 2,500Liability for customer lawsuit 32,000Rent received in advance Bonus payable Taxes payable Borrowing from TownBank Building loan 120,000Capital stock 100,000Retained earnings 231,500 Total of liabilities and equities $497,000

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


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 tonet income we, in effect, eliminate this noncash item from the net incomefigure.

b) Note that while depreciation expense is subtracted in determining netincome, the cost of long-lived assets is not subtracted from the cash flowfrom operations. Consequently, net income over the entire life of a companywould be equal to the sum of cash flow from operations and cash flow frominvesting.

Requirement 5:Effect of revised bonus formula on operating cash flows:

Cash flow from operations for the year 2001 would remain unchanged sincethis is merely an accrual entry (i.e., liability increases and retained earningsdecreases). However, when the incentive bonus is paid in cash, say, in 2002,it will show up as operating outflow.

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The operating section of the cash flow statement under the indirect approachdemonstrates the main point. The three italicized items change when theincentive bonus is increased from 20% to 25%. However, because this is anaccrual entry, the net effect of these three on the cash flow from operations iszero. Since the net income is different and since it is the beginning point forcalculating the cash flow from operations, it might be tempting to say that thecash flow from operations will be lower.


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


Supporting computations for revised cash flow statement:

Revised bonus expense (.25 x 126,000) = $31,500Previous bonus expense 25,200

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

1 Tax rate is Income tax expense / Income before taxes = $33,920 / $84,800 = 40%

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T-account to support change in taxes payable:

Taxes Payable0 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 $ 6,300Times tax savings .4 Decrease in income tax expense $ 2,520Previous income tax expense 33,920 Revised income tax expense $31,400

P17-7. Reconciliation of changes in balance sheet accounts with amountsreported in cash flows statement

Requirement 1:Reconciling changes in accounts receivable reported on the cash flowstatement with change in receivables shown on the balance sheet:

Briggs & Stratton Corp.

For Briggs & Stratton, the decrease in receivables of $2,384,000 reported inthe Year 2 cash flow statement is equal to the change in the net receivablesas 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 patientaccounts receivables of $2,169,000 reported in the cash flow statement.

Learning Objective

The purpose of this exercise is to present the two different reportingpractices commonly adopted by companies and illustrate how bothapproaches lead to the same cash flow numbers.

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Requirement 2:Explanation of different reporting practices with respect to receivables:

It is instructive to discuss initially the mechanics of converting sales orservice revenue to cash collected from customers. We reconstruct the T-accounts of Ramsay Health Care to figure out the cash collected fromcustomers. Although one can arbitrarily choose any sales number to get theintuition, let us pick the actual Year 2 revenue of $137,002,000 (not providedin the problem).

We first need to calculate the amount of receivables written off during theyear from an analysis of the "Allowance for doubtful accounts" T-account.

Allowance for Doubtful Accounts$4,955,000 Beginning balance

5,846,000 Provision for bad debtsBad debts written off X

$3,925,000 Ending balance

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

Plugging this number into the "Patient accounts receivable" account allowsus to solve for cash collected:

Patient Accounts ReceivableBeginning balance $31,651,000Revenue 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 = $26,944,000X = $134,833,000

The figure for cash collected can be determined using either one of the tworeporting practices. For instance, if Ramsay had followed Briggs & Stratton’sreporting practice, the adjustment for change in receivables would be asfollows:

17-33

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


Obviously, revenue less the provision for doubtful accounts is alreadyreflected in the net income figure. It is important to understand that the netaccounts receivable balance (gross A/R minus allowance for doubtfulaccounts) is affected by revenue as well as provision for doubtful accounts.Consequently, to figure out the cash collected from customers, we shouldjointly consider revenue, provision for doubtful accounts and change inreceivables. The intuition behind the above table can be clarified byexamining the reporting practice adopted by Ramsay Health Care, whichfollows.

Ramsay Health Care, Inc. and Subsidiaries

Revenue $137,002,000

- Provision for doubtful accounts (5,846,000)

Adjustments to reconcile net income to cashflows

+ 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 )


Note: The two * items were not separately reported by Ramsay HealthCare. Instead, it reported the sum of the two items, i.e., ($2,169,000) =$4,707,000 - $6,876,000

17-34

Under this reporting practice, firms first add back the provision for doubtfulaccounts which, in essence, eliminates the noncash accrual expense. Theremainder of the adjustments (revenue + decrease in gross accountsreceivable - bad debts written off) represent all the items in the T-account forpatient accounts receivable (i.e., gross accounts receivable) except for cashcollected from customers which is being solved.

Another way to provide the intuition is to focus on the two possible reasonsfor the decrease (in this example) in accounts receivable, i.e., (1) cashcollections and (2) bad debts written off. By adding the decrease in grossaccounts receivable, we attribute the entire decrease to cash collections.However, by subtracting the bad debts written off, we adjust for anydecreases in accounts receivable that merely represent bad debts.

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P17-8. Preparation of cash flow statement–indirect method(AICPA adapted)

Cash flow for 2001 using the indirect method:

Bergen CorporationStatement of Cash Flows


Operating Activities:Net income $253,000Adjustments 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 95,000Sale of equipment 33,000Purchase of equipment (392,000 )

Net cash outflow from investing activities (264,000)

Financing Activities:Proceeds from long-term note payable 450,000Cash 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 233,000Beginning balance in cash 308,000 Ending balance in cash $541,000

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P17-9. Preparing an income statement from statement of cash flows andcomparative balance sheets

Kang-Iyer Financial ConsultantsStatement of Cash Flows for the Year Ended 12/31/01

Cash Flow from Operations:Cash collected from customers $250,000Cash 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 500,000Proceeds 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

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Kang-Iyer Financial ConsultantsIncome Statement for the Year Ended 12/31/01

Consulting revenue $356,500

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

Accounts ReceivableBeginning balance $15,000Consulting revenue X $41,500 Bad debts written off

250,000 Cash collectedEnding balance $80,000

Solve for X:$80,000 = $15,000 + X - $41,500 - $250,000X = $356,500


Bad debts written off $41,500X Provision for doubtful accounts$8,000 Ending balance

Solve for X:$8,000 = $1,500 + X - $41,500X = $48,000

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Salaries Payable$20,000 Beginning balance

Cash paid $70,000X Salaries expense$100,000 Ending balance

Solve for X:$100,000 = $20,000 + X - $70,000X = $150,000

Interest Payable$5,000 Beginning balance

Cash paid $50,000X Interest expense$20,000 Ending balance

Solve for X:$20,000 = $5,000 + X - $50,000X = $65,000

Prepaid RentBeginning balance $30,000

X Rent expenseCash paid 0Ending balance $0

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

Accumulated Depreciation–Building$0 Beginning balance

X Depreciation expense$10,000 Ending balance

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

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P17-10. Determining components of cash flow statement(AICPA adapted)

Requirements 1–3:Cash provided by operating, investing, and financing activities:

Best CorporationStatement of Cash Flows


Cash Flow from Operating Activities:Net income $700,000Add (Subtract):

Depreciation expense $130,000Increase in accounts receivable (280,000)Increase in inventory (290,000)Increase in accounts payable 390,000Increase in accrued expenses 170,000Loss on sale of fixtures 10,000 130,000

Cash provided by operating activities 830,000

Cash Flow from Investing Activities:Sale of fixtures 20,000Purchase of fixtures (630,000 )

Cash used in investing activities (610,000)

Cash Flow from Financing Activities:Issuance of common stock 125,000Cash 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

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Fair market value of Best Corporation’s common stock.

The debit to retained earnings for the fair market value of the stock dividendcan be found by an analysis of the retained earnings T-account:

Retained Earnings$330,000 Beginning balance

Dividends declared $125,000 700,000 Net incomeStock dividend X


Solve for X:$630,000 = $330,000 + $700,000 - $125,000 - XX = $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

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P17-11. Analysis of statement of cash flows

Requirement 1:Statement of cash flows for the year ended 12-31-2001:

Cavalier Toy StoresStatement of Cash Flows


Cash Flow from Operating Activities:Net loss ($250,000)Add:

Depreciation expense $75,000Decrease in accounts receivable 405,000Decrease in prepaid insurance 30,000Decrease in inventory 500,000Increase in salaries payable 20,000Increase 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 140,000Dividends (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 )

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Requirement 2:(a) Bad debts written off during the year:

Beginning balance in allowance for doubtful accounts $ 30,000Add: Bad debt expense 100,000Less: 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 $ 525,000Add: Credit sales 1,500,000Less: 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 $550,000Add: 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 $ 64,000Purchases 700,000Less: Ending balance in accounts payable (252,000 )Cash paid for inventory purchases $512,000

(e) Cash paid for insurance:

Beginning balance in prepaid insurance $35,000Add: Cash paid for insurance ?Less: Ending balance in prepaid insurance (5,000 )Insurance expense 30,000 Cash paid for insurance $0

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Requirement 3:Thrifty Bank should be concerned about renewing the loan or increasing thecredit limit for the following reasons:

(a) Depletion of accounts receivable and inventory and increase in accountspayable to boost cash flow from operations–this cannot be done everyyear to increase cash flow from operations.

(b) Use of working capital (accounts receivable and inventory and increase inaccounts 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.

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P17-12. Preparation of cash flow statement(AICPA adapted)

Farrell CorporationStatement of Cash Flows


Operating Activities:Net income $141,000Add (Deduct):

Depreciation $53,000Amortization of goodwill 4,000Loss on sale of equipment 5,000Equity in net income of Hall, Inc. (13,000)Increase in deferred income tax payable 11,000Decrease in accounts receivable 10,000Increase 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 19,000Purchase of equipment (63,000 )

Net cash provided from investing activities (44,000)

Financing Activities:Sale of common stock 23,000Sale of treasury stock 25,000Cash dividends paid (43,000 )

Net cash provided by financing activities 5,000

Simultaneous Financing and Investing ActivityNot Affecting Cash:Purchase of land with long-term note 150,000

Net increase in cash $ 95,000Beginning balance in cash account 180,000 Ending balance in cash account $275,000

17-45

P17-13. Statement of cash flows—indirect method(AICPA adapted)

Omega CorporationStatement of Cash Flows


Cash Flow from Operating Activities:Net income $360,000Adjustments to reconcile net income to cash provided by operating activities:

Depreciation1 $150,000Gain on sale of equipment2 (5,000)Undistributed earnings of Belle Co.3 (30,000)

Changes in assets and liabilities:Decrease in accounts receivable 40,000Increase in inventories (135,000)Increase in accounts payable 60,000Decrease 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 40,000Loan 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 $100,000Cash at beginning of year 700,000 Cash at end of year $800,000

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1DepreciationNet increase in accumulated depreciation

for the year ended December 31, 2001 $125,000Accumulated depreciation on equipment sold:Cost $60,000Carrying value (35,000 ) 25,000 Depreciation for 2001 $150,000

2Gain on sale of equipmentProceeds $40,000Carrying value 35,000

Gain $ 5,000

3Undistributed earnings of Belle Co.Belle’s net income for 2001 $120,000Omega’s ownership 25%

Undistributed earnings of Belle Co. $ 30,000

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Financial Reporting & AnalysisChapter 17 Solutions

Statement of Cash FlowsCases

CasesC17-1. 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 $200,000Proceeds from stock issuance 390,000Dividends 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 $120,000

17-48

1 Calculation of dividends: Beginning balance of retained earnings $341,750Add: Net income 81,250Less: 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 - baddebts 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 (fromabove) - 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 inaccounts receivable is a good signal if it is commensurate with growth insales. On the other hand, it could suggest collection problems as well asinadequate provision for doubtful accounts. There is also an increase ininventory. This could be positive news if the buildup is in anticipation ofdemand. Again, this could be negative if the obsolete items have not beenwritten down. The investment in property, plant, and equipment is financed byloan and equity.

17-49

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 isnecessary is to reduce the average collection period for accounts receivableand 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 isadded to the net income would have been originally subtracted fromrevenues to determine net income and, consequently, would not affect thecash flow.

Requirement 9:Matching is an important feature of accrual accounting that is lacking in thecash flow statements. However, accruals are subject to greater managerialdiscretion. See answer to “reasons for decline” as an example of jointlyanalyzing the two statements.

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C17-2. Vulcan Corporation: Understanding cash flow statements

Requirement 1:Vulcan’s net income can be determined by adding the unrealized loss oninvestments to total comprehensive income reported for the year endedOctober 31, 2000.

($ in thousands) Comprehensive income as reported 336$ Plus: Unrealized loss on investments classified as available-for-sale 286

Net income 622$

Vulcan Corporation

Year Ended October 31, 2000Computation of Net Income

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Requirement 2:In order to prepare Vulcan’s income statement at October 31, 2000, thefollowing items must be determined: sales, cost of goods sold, depreciationexpense, general & administrative expense, interest expense and taxexpense. These items can readily be determined from the informationprovided (see below—Calculation of revenues and expenses).

($ in thousands)Net sales 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 336$

Year Ended October 31, 2000

Vulcan CorporationStatement of Income and Comprehensive Income

17-52

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, 1999 11,523 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 335$

17-53

Requirement 3:Vulcan’s net cash provided by operating activities, using the indirect method,would be $1,608,000.

($ 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 1,608$

Vulcan CorporationCash Flow From Operating Activities

Year Ended October 31, 2000

17-54

C17-3. Fillio Corporation (KR): Comprehensive statement of cash flows

Requirement 1:

Fillio CorporationStatement of Cash Flows for the Year Ended 12/31/01

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 Sitco 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 owners’ 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)

17-55

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

2001 bank loan secured by real property(i) Borrowing 3,000(ii) Repayment (1,500) 1,500

2001 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 849Beginning cash balance 48 Ending cash balance $ 897

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Details of selected T-accounts:


8,330 Depreciation expenseAcc. dep. on asset written off $633


Property, Plant and EquipmentBeginning balance $55,574

$8601 Original cost of asset written offPurchase of PP&E 1,085Ending balance $55,799

1 Book value of asset written off $227+ Acc dep. on asset written off 633 = Original cost of asset written off $860

Allowance for Doubtful Accounts$608 Beginning balance

238 Bad debt expenseBad debts written off $315

$531 Ending balance

Accounts ReceivableBeginning balance $32,803

Sales revenue 184,137 $315 Bad debts written off197,604 Cash collected

Ending balance $19,021

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Requirement 2:

Fillio CorporationStatement of Cash Flows for the Year Ended 12/31/01

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 Sitco settlement:Settlement with Sitco (1,837)+ Noncash portion of settlement with Sitco 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 owners’ equity for these costs 400 (740)

Income tax refund received 6,731

Cash paid for accrued settlement costs:- Decrease in accrued settlement (2,432)- Decrease in long-term accrued settlement (1,500) (3,932 )

Cash flow from operations $ 13,236

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C17-4. Lucky Lady, Inc. (KR): Comprehensive statement of cash flows

Requirement 1:

Lucky Lady, Inc.Statement of Cash Flows

For the Year Ended 12/31/01

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- 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 684Purchase 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) 10,000Issuance of additional common stock 72,559 Cash flow from financing activities $ 80,995

Total change in cash (368,658)Cash at 12/31/00 579,963 Cash at 12/31/01 $211,305

1 Alternatively, this could be shown as a financing activity cash inflow.

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Note on significant non-cash transaction: The Company entered into acapital lease agreement and recorded an asset and a corresponding liabilityfor $16,987.

Property, Plant and EquipmentBeginning balance $471,506New capital lease 16,987 $14,751 Cost of asset sold (net book value

$2,501 + Acc. dep. $12,250)Other new additions XEnding balance $953,796

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


Acc. depr. on asset sold X 8,018 Depreciation expense68,948 Carrying value adjustment


Solve for X:$86,512 = $21,796 + $8,018 + $68,948 - XX = $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 - XX = $1,564

17-60

Lucky Lady, Inc.–Alternative ApproachStatement of Cash Flows


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 684Purchase 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) 10,000Issuance of additional common stock 72,559 Cash flow from financing activities 80,995

Total change in cash (368,658)Cash at 12/31/00 579,963 Cash at 12/31/01 $211,305

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Under the alternative approach, we are merely breaking down the change innet accounts receivable into three components which are italicized. This isdone in order to convert the indirect statement to a direct statement. Ofcourse, this step can be omitted.

Gross Accounts Receivable

Beginning balance $2,178 $653 Bad debts written offRevenue 57,800 X Cash collectedEnding balance $35,249

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


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

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

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

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Requirement 2:

Lucky Lady, Inc.Direct Method

Cash Flow from OperationsCash 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 )

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

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C17-5. Opus One, 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 dividendsduring the year, the change in the retained earnings of $1,127,664 must bethe net income for the year.

2) The T-accounts for property and equipment and accumulated depreciationare prepared to solve for the new acquisitions of property and equipmentduring the year.

Accumulated Depreciation$6,822,553 Balance as of 6/30/00

Acc. dep. on scrapped asset $57,107 2,265,735 Depreciation expense (given)$9,031,181 Balance as of 6/30/01

Property and EquipmentBalance as of 6/30/00 $20,637,912New acquisitions 1,608,943 $64,484 Orig. cost of the scrapped asset

($57,107 + $7,377)Balance as of 6/30/01 $22,182,371

First, by crediting the accumulated depreciation T-account with thedepreciation expense for the year, we find that the accumulated depreciationon the scrapped asset must have been $57,107 (the plug number). Since thebook value of the scrapped asset was $7,377, the original cost of the assetmust have been $64,484 ($57,107 + $7,377). This amount would have beencredited to the property and equipment T-account. The resulting plug numberof $1,608,943 must be the cost of new property and equipment acquiredduring the year.

3) The change in the accumulated amortization of $24,450 must representthe non-cash amortization expense for the year.

4) The words “deferred credits” suggest that the liability account “Otherliabilities & deferred credits” must be an operating liability rather than afinancial liability.

5) To calculate the financing cash flows from long-term debt, it is useful tofocus on the total long-term rather than split them into current and long-termportions.

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Long-Term Debt: 6/30/01 6/30/00 Borrowing RepaymentsTerm 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 (681,716 ) (21,348 )Long-term debt (less)current installments $3,272,759 $534,107

6) Although revolving credit agreements appear as a current liability, theyare a financing liability. Consequently, they will be reflected in the financingsection of the cash flow statement.

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Opus One, Inc.Statement of Cash Flows


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 7,377Decrease in net receivables 1,540,275Decrease in inventories 815,162Decrease in prepaid expenses 254,183Decrease in income tax receivable 1,500,482Increase in deferred tax asset (511,600)Decrease in pre-opening costs 506,721Increase in accounts payable 3,102,873Increase in accrued liabilities 768,144Increase 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 8,998Borrowing on term loan 3,600,000Repayment 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 $31,404Cash balance as of 6/30/00 19,481 Cash balance as of 6/30/01 $50,885

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Requirement 2:Caveat: The analysis is handicapped by the limited amount of informationavailable in the problem. The learning objective of this assignment is toenable the students to evaluate the cash flow statement rather than perform acomprehensive analysis of the financial performance of Opus One, Inc.

The cash flow from operations (CFO) of Opus One, Inc., is almost 11 timesthe net income of the company. Given the Wall Street adage that “Cash Flowis King and Earnings Don’t Matter,” does this mean that the financialperformance of Opus One is really 11 times better than that indicated by itsnet income? Let us examine the sources of the high CFO to see whetherOpus One 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 revenuebooked in the accrual accounting income statement. This might be goodnews if the company has improved its collection efforts. Even so, this isunlikely to happen year after year if a company is growing, i.e., collecting morecash than the accrual revenue. Consequently, this is likely to be a temporaryphenomenon.

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 theyear. However, this is unlikely since the company experienced a drop in thereceivables also; i.e, if there were unexpectedly large sales at the end of theyear, we might expect the accounts receivable to go up. More importantly,inventory level provides a signal about future demand; i.e, companies arelikely to build up (decrease) inventories when they expect a surge (fall) indemand. Therefore, another possibility is that the company saved some cashin the current year by buying less inventory, but it might generate less cashduring the next year by selling less inventory. In any case, it is unlikely thatinventory levels can continue to decrease when companies are growing. Infact, in the following year, the company built up almost $10 million of inventorywhich resulted in a negative CFO. The main message here is that neithercash flows nor accounting income by itself can tell the whole story. A jointexamination 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 areunlikely to extend credit when they believe their customers have impendingfinancial difficulties. However, an increase in accounts payable usuallyhappens when there is a buildup in the inventory level. Consequently, oneshould examine why Opus One's accounts payable are increasing when itsinventory level is falling. One possibility is that the company was “forced” topay off its revolving credit under the current agreement (see financing cashflow). This might have delayed the payment to the suppliers.

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A fourth item is the cash received from the decrease in the income tax refundreceivable. When is it likely for a company to have an asset called incometax refund receivable? There are two possibilities. First, the company paidmore taxes during a year when compared to what it owed the IRS based onits actual taxable income; i.e, the actual income was less than the anticipatedincome. A second possibility is that the company incurred a net loss in therecent past, and, using the loss carryback provision, the company isexpecting to receive a tax refund. Either scenario suggests that the companyhas encountered difficulties in the recent past. In fact, Opus One incurred anet loss of almost $2.5 million during the fiscal year 2000.

Similar comments can be made on other operating assets and liabilities.

The fact that the company arranged a term loan of $3.6 million is a positivesignal. 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 ofthe principal payments are unlikely to be due in the near term. The companyhas paid back about 5% of the term over a 4-month period. On an annualbasis, this translates into 15% of the loan; i.e, the company has the potentialto use the term loan to finance a part of its working capital needs over thenext several years.

Collaborative Learning Case

C17-6. Best Buy Company: Analysis of financial performance from the cash flowstatement and other information

Caveat: Due to limited information available in the problem, our analysiscannot provide a complete picture of the financial performance of thecompany over the three-year period. The learning objective for this problemis to enable the student to examine the items that cause net income to bedifferent from the cash flow numbers.

Requirement 1:Comparison of earnings and operating cash flows:

The company’s net income has consistently increased over the three-yearperiod, from almost $82 million during the fiscal year 1998 to more than $347million during 2000. Likewise, the cash flow from operations (CFO)experienced year-to-year increases during this period from $450 million infiscal 1998 to $760 million in 2000. During this three-year period, operationshave been the primary source of the company’s cash flows.

How might an analyst interpret the company’s increase in CFO? Recall thatwhen operating assets increase (or decrease), they are a use of (or a sourceof) operating cash flows. The opposite is true for the operating liabilities. An

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examination of the operating section of the cash flow statements suggeststhat Best Buy has been building receivables during the three-year periodending 2000. In addition, inventories increased dramatically during 2000when compared to 1999 and 1998’s decreasing inventory levels. Uponcloser examination, we see that from 1998 to 2000 Best Buy actuallyexperienced year-to-year inventory builds. One more important fact to note isthat the increase each year in accounts payable more than offset anyperceived cash flow deterioration resulting from an inventory build.

An important task is for the analyst to understand whether these trendssignify positive or negative news about the company. To understand thechange in inventories, let us focus on the statistics on new store openings:

2000 1999 1998 1997Number of stores at the end ofyear

357 311 284 272

Number of new stores openedduring the year

46 27 12

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

Each new store requires working capital of approximately $4 millionfor merchandise inventory (net of vendor financing) , leaseholdimprovements, fixtures and equipment.

Note that the words “net of vendor financing” suggests that the $4 million isfor the investment in inventory and other assets minus the credit extendedby the suppliers through accounts payable.

It is quite likely that these new stores will not yet have reached their annualrevenue projections during the first year of operations. Consequently, theincrease in accounts receivable and inventory will result in a drain on theoperating cash flows until the new stores reach their annual sales targets.

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Requirement 2:Analysis of working capital needs:

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

2000 1999 1998Need for working capital per new store $ 4,000 $ 4,000 $ 4,000Number of new stores opened during the year 46 27 12Total working capital needed for the new stores $184,000 $108,000 $48,000

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

For the fiscal year ended 2/26/2000 2/27/1999 2/28/1998Receivables 56,900$ 36,699$ 16,121$ Merchandise inventories 137,315 (14,422) (71,271) Other assets 11,005 4,251 3,278 Accounts payable (302,194) (249,094) (147,340) Other liabilities (108,829) (82,544) (63,950) Accrued income taxes (97,814) (62,672) (33,759) Net decrease in the working capital (303,617)$ (367,782)$ (296,921)$

Changes in Working Capital

Note that each of the figures in the above table are taken from the operatingsection of the statement of cash flows. However, their signs have beenreversed since working capital is defined as current assets (-) currentliabilities. Consequently, increases in assets and liabilities have the positiveand negative signs, respectively. The opposite is true for the decreases inassets and liabilities.

Given the significant growth during the three-year period ended 2000 (addinga total of 85 new stores), it is surprising that Best Buy's working capitalrequirements appear to have decreased. Looking at fiscal 2000, in which 46stores were opened, we see that working capital requirements were negative;however, they increased by more than $64 million when compared to 1999.This is considerable less than the $184 million that was expected based onthe working capital requirements of the new stores for 2000. Consequently,an analyst is likely to conclude that Best Buy’s growth strategy isconservative and can be easily financed through existing operations.

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However, an analyst must carefully follow up to examine how well the newstores are doing.

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

During 2000, although the company added another 46 stores, their workingcapital decreased about $304 million compared to the expected increase of$184 million. This is primarily the result of increased vendor financing ofinventory.

2000Increase in merchandise inventory 137,315$ Increase in accounts payable 302,194 % of increase in inventory financed by accounts payable 220%

Suppliers financed the entire growth in inventory during 2000. Similar vendorfinancing was achieved in fiscal 1999 and 1998. The question the analyst willask is whether this type of financing is sustainable in the long run.

Fiscal 2000 was good year for Best Buy. The company’s profits increasedover 60% from 1999 (which was 164% more than fiscal 1998). Operatingcash flows indicate that the company has made substantial efforts to improveits financial position by using vendor financing to offset increased inventorylevels in 2000. During 1999 and 1998 inventory levels decreased, whichappears to be inconsistent with operating results. That is, Best Buyexperienced tremendous growth in revenue during this period. As a result,inventory levels would have been expected to increase in order to supportthis growth. The fact that they did not indicates that management hasimplemented programs to improve inventory management and controlinventory levels.

Accounts receivable experienced year-to-year increases, which isconsistent with growth in sales. However, the analyst will want to follow upwith the company to insure that the increase in receivables is due toincreased sales volume versus a change in credit policy or credit terms.

Requirement 4:Insights from the “Investing” and “Financing” sections of the cash flowstatement.

The "Investing" section of the cash flow statement suggest that the companyhas substantially increased its capital expenditures during 2000 to more than$361 million from around $166 million and $72 million in 1999 and 1998,

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respectively. It appears that Best Buy is planning to continue its expansionprogram.

Finally, let us focus on the financing cash flows. The most important issue ishow the business expansion was financed:

· In 1998 borrowings and proceeds from issuing common stock werevirtually offset by long-term debt repayments.

· In 1999 and 2000 Best Buy used cash to reduce its long-term debt andrepurchase its common stock.

Based on the above, we can conclude that Best Buy is financing its growththrough operations (that is through increased earnings, improved inventorymanagement and extensive use of vendor financing). An analyst may want toask the question “Is it smart to finance long-term needs (permanentincreases in working capital for new store openings) and business expansionwith short-term financings.”

The following are selected excerpts from the management discussion andanalysis section of the 2000 fiscal year 10-K report of the company. Themanagement discusses many of the issues that were brought out in ouranalysis of the cash flows of Best Buy.

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Liquidity and Capital Resources Excerpts

Record financial performance enabled the Company to internally fund its businessexpansion and repurchase approximately $400 million of the Company's common stock,while maintaining its liquidity and strong financial position. Cash flow from operationsincreased $98 million in fiscal 2000, to $760 million, driven by earnings growth andcontinued improvement in inventory management.

Inventories at the end of fiscal 2000 were $1.2 billion, up only 13% compared with oneyear ago, even with a 24% sales increase, due to faster inventory turns. The increase ininventories was fully funded by an increase in accounts payable.

Trade receivables, mainly credit card and vendor-related receivables, increased $57 million from one year ago. The increase was primarily due to higher business volumesresulting from a 25% increase in fourth-quarter sales and amounts due from ISP promotionsubsidies. Receivables from sales on the Company's private-label credit card are sold tothird parties, without recourse, and the Company does not bear any risk of loss withrespect to these receivables.

Accounts payable and accrued liabilities increased compared with fiscal 1999, due tohigher business volume. Accrued compensation and related liabilities increased versusone year ago as a result of expenses associated with the expanding employee basesupporting the Company's growth.

Debt declined $30 million in fiscal 2000 due to the repayment of an $18 million note andscheduled maturities of capital leases and other loans.

Capital spending in fiscal 2000 was $361 million, compared with $166 million and$72 million in fiscal 1999 and fiscal 1998, respectively. The Company expanded its storebase by investing in 47 new stores and 13 remodeled or relocated stores during fiscal2000, compared with 28 new stores and five remodeled or relocated stores in fiscal 1999,and 13 new stores and five remodeled or relocated stores in fiscal 1998.

The Company increased its expansion program in fiscal 1999 after the initiatives toimprove operations resulted in an enhanced operating model and improved profitability.Capital spending in fiscal 2000 also included the initial development for some of the storesscheduled to open in fiscal 2001. Additionally, the Company expanded its corporatefacilities to support the growth of the business, the most significant investment being thepurchase of an additional office building to supplement the Company's corporate office.The Company also continued to invest in new systems and technology to better position itfor continued growth and to generate improvements in its existing business.

Documents

Financial Reporting & Analysis Chapter 17 Solutions ...pages.stern.nyu.edu/~pzarowin/Zarowin-Solutions/ch17sol.pdf17-1 Financial Reporting & Analysis Chapter 17 Solutions Statement